Friday, March 29, 2019
The developments in agricultural law and taxation keep rolling in. Many of you have requested more frequent posts on recent developments, so today’s post is devoted to just a handful that are important to farmers, ranchers and the professionals that represent them. In today’s post I take a look at a couple of recent farm bankruptcy cases, the use of a trust to hold farm and ranch property, and the rights of grazing permit holders on federal land.
Selected recent developments in agricultural law and tax – it’s the topic of today’s post.
Times continue to be difficult in agriculture with bankruptcy matters unfortunately taking on increased significance. In one recent case, In re Wulff, No. 17-31982-bhl, 2019 Bankr. LEXIS 388 (Bankr. E.D. Wis. Feb. 11, 2019), the debtor filed Chapter 12 bankruptcy and submitted a complete list of creditors. One of the creditors did not receive notice of the bankruptcy because of a bad address but became aware of the debtor’s bankruptcy upon attempting to collect on their account after the proof of claim deadline had passed. There were multiple plans submitted to the court that were rejected for various reasons, but every plan submitted accounted for the creditor that did not have notice. Ultimately, the debtor’s plan was confirmed. After confirmation, the creditor attempted to file a proof of claim and the trustee objected. The creditor maintained that it filed as soon as receiving notice of the proceedings. The court allowed the claim, but that the creditor had not established grounds for an extended timeframe to file the proof of claim. Even so, the court noted that the debtor’s initial plan and amended plans all accounted for the creditor’s claim. All the plans were consistent with the creditor’s late-filed proof of claim. Thus, the court confirmed the debtor’s reorganization plan with the late-filed proof of claim upon a finding that it was consistent with the plan.
In another bankruptcy case, In re Smith, Nos. 17-11591-WRS, 18-1068-WRS, 2019 Bankr. LEXIS 234 (Bankr. M.D. Ala. Jan. 29, 2019), the debtor filed bankruptcy in 2017. At the time of filing, the debtor had a 2006 loan secured by his farmland that had matured. Instead of foreclosing, the creditor bank and the debtor negotiated a renewal in 2012. Another creditor, an agricultural cooperative, held a 2009 lien. In determining priority, the court held that the bank’s liens were prior to the cooperative’s liens. The court determined that the 2012 renewal of the bank note, even if the bank new of the cooperative’s lien, did not cause the bank to lose priority. While the court noted that sometimes an advancement on an existing mortgage causes the underlying mortgage to lose priority over subsequent liens, the court determined that the 2012 renewal was not an advancement. There was no evidence that additional funds were loaned to the debtor by the bank. In addition, the court determined that the bank’s lowering of the interest rate on the obligation did not cause the creditor to lose priority.
Trusts and Estate Planning
Trusts are a popular tool in estate planning for various reasons. One reason is that a trust can help consolidate farming and ranching interests and aid in the succession planning process. The benefit of consolidating farm and ranch property in trust was the issue of a recent Wyoming case. In re Redland Family Trust, 2019 WY 17 (2019), involved a family that has been involved in contentious litigation over a family trust. The case had been before the Wyoming Supreme Court on multiple occasions. The trust was created in 1989 and amended in 1995. The amendment provided for the appointment of a successor trustee; always required the service of two trustees; created a marital trust for the survivor of the settlors; and revised the buyout provision. The grantors and their five children made contributions to the trust. Upon the death of one of the grantors in 2007 one of the children was appointed as co-trustee. Ligation arose when the surviving grantor’s property was not conveyed to the trust and then again involving removal of the trustees, and an appointed trustee moved to have the trust terminated due to the administrative difficulties to administer, family dysfunction, and because the trust no longer served its purpose. The defendants, (including the co-trustee that resigned) asserted that termination was moot and moved to have the new co-trustee removed.
The trial court did not remove the co-trustee and found that the trust was still valid. The trial court found that the co-trustee did not violate any fiduciary duties and that the defendants failed to show gross and willful misconduct to justify her removal. Further the trial court found that the co-trustee’s claims that the trust was invalid should have been raised in the original trust challenge. The trial court determined that the primary reason for the trust (to keep the lands and leases together for the Redland family) had not been frustrated and that the trust remained administratively functional and was not "unlawful, contrary to public policy, or impossible.
On appeal, the Wyoming Supreme Court affirmed. The Court determined that the trust still had a purpose - to keep the ranch holdings together to conduct business. Even though the other purpose of minimizing tax consequences had failed, consolidation of ranch holdings remained a legitimate purpose. The Court also determined that the co-trustee did not violate her fiduciary duties, her duties of impartiality or loyalty, and that her actions did not amount to gross and willful misconduct. In addition, the Court found that the duty of impartiality did not require the trustee to treat all beneficiaries fairly, but simply to act in the best interest of the beneficiaries and equally defend the intentions of the settlors. While the Court could find no precedent with respect to the duty of loyalty the Court held that merely seeking termination of the trust was not a breach of loyalty. In addition, the Court determined that hostility between parties did not warrant removal.
Rights of Grazing Permittees
In the U.S. West, the ability to graze on federally owned land is essential to economic success. An understanding of those rights is essential, and many legal battles in the West involve associated rights and responsibilities on federal land. One of those issues involves the erection of improvements. In Johnson v. Almida Land & Cattle Co., LLC, 2019 Ariz. App. Unpub. LEXIS 140 (Ariz. App. Ct. Jan. 31, 2019), the defendant owned a grazing allotment and was permitted to graze cattle on the allotted Forest Service land in Arizona. Consistent with the grazing permit, the defendant erected an electric fence on the allotment. In June 2011, the plaintiff collided with the fence while riding an off-road motorcycle, when he turned off a Forest Service road onto an unmarked, unimproved “two-track route” which the fence crossed. The plaintiff brought sued for negligence and the defendant moved for summary judgment on the basis that it owed no duty of care to the plaintiff. The trial court granted the motion, agreeing that there was no duty of care under the Restatement (Second) of Torts.
On appeal, the appellate court determined that the issue was whether a federal permittee owes a duty of care to the public with respect to construction of improvements on the land. Determination of that issue, the appellate court reasoned, was dependent on state law. On that point, the appellate court found that a criminal statute will establish a tort duty if the statute is designed to protect the class of persons in which the plaintiff is included, against the risk of the type of harm which has in fact occurred as a result of its violation, regardless of whether the statute mentions civil liability. The relevant AZ criminal statute held that a person commits a misdemeanor of public nuisance if that person knowingly and unlawfully obstructs a “public highway,” “public thoroughfare,” “roadway” or “highway.” The appellate court held that this public nuisance statute prohibiting the obstruction of certain types of pathways, also created a tort duty in those who erect improvements that impact those paths. Based on this interpretation, the court held that AZ law establishes a public policy giving rise to a tort duty with respect to the obstruction of certain types of public pathways. Consequently, a permittee on federal land owes a duty of care to the public when it erects an improvement across a publicly accessible route. However, the appellate court held that the facts were insufficient to determine, as a matter of law, whether the route at issue qualified as a “public highway,” “public thoroughfare,” “roadway” or “highway.” Consequently, the appellate court reversed on the duty of care issue and remanded to determine if the route fell within the scope of the relevant statutes.
Agricultural law is a “goldmine” of issues that landowners, producers and their legal and tax counsel must stay on top of. It’s a dynamic field. In a few more weeks, I will dig back into the caselaw for additional key recent developments.
Wednesday, March 27, 2019
While farm and ranch land is typically the largest-valued asset for the business, there may be items of significant value associated with the land. The land is not depreciable, but structures associated with the land are. From a depreciation standpoint, that means that there may be opportunities to allocate costs to personal property or land improvements that are depreciable. How is this allocation accomplished? One approach is to utilize a cost segregation study.
Agricultural cost segregation studies – that’s the topic of today’s post.
Cost Segregation Study – The Basics
A cost segregation study involves the combination of accounting and engineering concepts and techniques to identify costs associated with buildings and other structures and tangible personal property. The identification and allocation of costs to these items allows accelerated depreciation deductions to be available with the result that taxes can be reduced and cash flow for the business increased. Land is not depreciable and farm buildings are depreciated over 20 years.
When it comes to buildings, often a farmer will allocate the majority (if not all) of the cost of acquiring or constructing a building to real property. By doing so, the farmer may be overlooking the chance to allocate costs to personal property that has a shorter depreciation period than the 20 years over which a farm building is depreciated, and/or to depreciable land improvements. For example, the structural components of a building are often depreciable over 5-7 years. This would include such items as walls, windows, HVAC systems, plumbing and wiring. Land improvements are generally depreciable over 15 years.
For many taxpayers, the focus of a cost segregation study may be exclusively on a building. This is often the case, for example, for a commercial business. But, for a farmer, a cost segregation study has a broader application to examine whether depreciable items of personal property aren’t mistakenly lumped in with real property. As applied to farm buildings, a study will see if such things as parsing out the electrical wiring associated with a dairy parlor or a sow feeding system is possible. For fruit and vegetable farming operations, specialized equipment might be involved or there might also be some type of cooling system involved for a particular space or structure.
But, it’s not just buildings that need to be examined when it comes to ag. The farmland must also be looked at to account for improvements that have been made to the land for farming purposes. Land is not depreciable, but improvements to the land used in farming can be. These improvements include such things as pumps and wells that have been installed for irrigation purposes; fences; stock-watering ponds; earthen dams; soil conservation terraces; roads; fences and gates; drainage ditches and; water diversion channels.
Benefits of a Cost Segregation Study
Why conduct a cost segregation study? Depending on the situation, the tax savings that will enhance after-tax cash flow could be worth it. For example, assume that a farm building is acquired along with the purchase of a farm. If the farm was purchased for $500,000 and 100,000 was allocated to the farm building, that $100,000 would be depreciated over 20 years at five percent annually. In other words, the taxpayer could claim a $5,000 deduction annually attributable to the building. But, it may be the case that more of the cost can be allocated to depreciable property with shorter depreciable lives. If so, the depreciation deductions associated with the building and the items in the building will be enhanced. Breaking items out like this can also make it easier to make a partial asset disposition election and aid in deducting removal costs.
A “look-back” cost segregation study may also be used to identify missed deductions from prior years. To claim these deductions Form 3115 (application for a change in accounting method) must be filed with the IRS to claim these “catch-up” deductions on the current year return without filing amended returns. This can also be beneficial in certain circumstances in dealing with the limitations on deducting losses under the post-2017 rules.
Breaking out and identifying items that are depreciable personal property from real estate may also have a property tax benefit. In some states, farm personal property is not taxed for real estate purposes. Thus, if the items of depreciable personal property are broken out with a value assigned to them, real estate taxes may drop.
Another potential benefit of a cost segregation study is that it could result in a greater ability to take advantage of certain aspects of the Tax Cuts and Jobs Act (TCJA) of 2017. Under the TCJA, at least temporarily, first-year bonus depreciation is 100 percent and can apply to both new and used qualified property. In addition, I.R.C. §179 has been increased to $1,000,000 (and indexed), and the phase-out also increased. Thus, property that is reclassified into a category that qualifies for either bonus or expense-method depreciation will generate tax savings. As noted above, there may also be a benefit in dealing with losses.
Is a cost segregation study right for you? It depends on the situation. However, it might be worth having the conversation with your tax professional for a determination of whether it would be beneficial in your particular situation. A cost-segregation study is not cost-free. So, the question is whether the benefits will outweigh the costs. It’s just another consideration when it comes to tax planning for the farm or ranch. Depending on your situation and the type of farming operation that you have, it may be worthwhile. Have you thought about it?
Monday, March 25, 2019
Upon death, particularly the death of the surviving spouse, the estate executor may need to dispose of the decedent’s personal residence. When that happens, numerous tax considerations come into play. There are also some planning aspects to handling the personal residence.
The sale of the personal residence after death – that’s the topic of today’s post.
Income Tax Basis Issues
Upon death, the executor may face the need to dispose of the decedent’s personal residence. The starting point to determining any tax consequences of the disposition involves a determination of income tax basis. If the residence was included in the decedent’s gross estate, the tax basis will be determined in accordance with fair market value as of the date of the decedent’s death under the willing buyer-willing seller test. I.R.C. §1014. That is based largely on sales of comparable properties, and requires more than a simple market analysis by a real estate agent.
If the decedent was the first of the two spouses to die, a determination of how the residence was titled at death will need to be made. For a residence held in joint tenancy or tenancy in common, only the value of the decedent’s share of the residence will be included in the decedent’s estate and receive a basis step-up to fair market value. Id. In common-law property states where the residence is owned in joint tenancy between the spouses, the property is treated at the first death as belonging 50 percent to each spouse for federal estate tax purposes. I.R.C. § 2040(b). This is known as the “fractional share” rule. Thus, one-half of the value is taxed at the death of the first spouse to die and one-half receives a new income tax basis. However, in 1992 the Sixth Circuit Court of Appeals applied the “consideration furnished rule” to a husband-wife joint tenancy involving farmland. Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992). The result was that the entire value of the land acquired before 1977 was included in the estate of the first spouse to die. That meant that the full value was subject to federal estate tax, but was covered by the 100 percent federal estate tax marital deduction. The entire property received a new income tax basis which was the objective of the surviving spouse. Other federal courts have reached the same conclusion.
If the residence is community property, the decedent’s entire interest will receive a basis step-up to fair market value. If the residence is held in joint tenancy with rights of survivorship, the decedent’s interest passed by the survivorship designation to the designated survivor.
If a surviving spouse sells the marital home shortly after the first spouse’s death, the survivor will often realize a loss largely due to the expenses incurred with respect to the sale. If the survivor realizes a gain, then, the survivor is eligible for the $250,000 exclusion of gain. I.R.C. §121. That exclusion is a maximum of $500,000 if the sale occurs within two years of the first spouse’s death.
Residence Held in Trust
A revocable trust is a common estate planning tool. If the decedent’s personal residence was held in a revocable trust and passed to the surviving spouse upon the first spouse’s death under the terms of the trust to continue to be held in trust, the house receives a full step-up (or down) in basis to the current fair market value at the death of the surviving spouse. If the house is distributed outright to a beneficiary (or beneficiaries) and then the beneficiary immediately sells the home, a loss generally will be a nondeductible personal loss unless the home is first converted to a rental property before it is sold. This is a key point that may require some planning to allow for rental use for a period of time before sale.
If the residence must be sold by the estate or trust to pay debts or to satisfy cash distributions to beneficiaries, any loss on the sale might be deductible. That loss could potentially offset other income of the trust or estate, or it could flow through to the beneficiaries. However, the IRS position is that an estate or a trust cannot claim such a loss unless the residence is a rental property or is converted to a rental property before it is sold. This position has not been widely supported by the courts which have determined that a trust or estate can claim such a loss if no beneficiaries use the home as a residence after the decedent’s death and before it is sold. It is important to get good tax counsel on this issue. It’s an issue that comes up not infrequently.
The sale of the personal residence after death presents numerous tax issues. With a modest level of planning, negative tax consequences can be avoided and helpful tax provisions can be taken advantage of.
Thursday, March 21, 2019
The Packers and Stockyards Act (PSA) of 1921 was enacted with the purpose of ensuring fair competition in and trade practices involving livestock marketing, meat and poultry. 7 U.S.C. §§181-229. See also Armour & Company v. United States, 402 F.2d 712 (7th Cir. 1968). The scope of the PSA is quite broad, vesting in the U.S. Secretary of Agriculture (Secretary) wide discretion to investigate and regulate all activities connected with livestock marketing. See, e.g., Rice v. Wilcox, 630 F.2d 586 (8th Cir. 1980).
What happens when a livestock packer, market agency or a livestock dealer fails to pay for livestock that it buys from a livestock seller? The “prompt payment rule and the statutory trust of the PSA – that’s the topic of today’s post.
Rules Governing Payment For Livestock
Prompt payment rule. The PSA provides for failure to make prompt and full payment for livestock. Generally, to not be deemed to be engaged in an “unfair practice” under the PSA, a packer must make full payment of the livestock’s purchase price “before the close of the next business day following the purchase of livestock and transfer of possession thereof.” 7 U.S.C. §§228b(a) and (c). A packer subject to the prompt payment rule is defined as “any person engaged in the business (a) of buying livestock in commerce for purposes of slaughter, or (b) of manufacturing or preparing meats or meat food products for sale or shipment in commerce, or (c) of marketing meats, meat food products, or livestock products in an unmanufactured form acting as a wholesale broker, dealer, or distributor in commerce.” 7 U.S.C. §191. When livestock is purchased for slaughter, payment must be made to the seller or the seller’s representative at the point of transfer or the funds must be wired to the seller’s account by the close of the next business day. Id. If the sale is based on carcass weight, or is a grade/yield sale, the same rule applies once the purchase amount has been determined. Id. If the seller (or the seller’s agent) is not present to receive payment at the point of sale, the packer is to either wire the funds to the seller and put a check in the mail for the full amount by the close of the next business day. Id.
The prompt payment requirement can be waived by written agreement that is entered into before the purchase or sale of livestock. 7 U.S.C. §228(b)(b). The regulations provide a format for the waiver. 9 C.F.R. §201.200(a). The agreement must be disclosed in the business records of the buyer and the seller, and on the accounts or other documents that the buyer issues relating to the transaction. 7 U.S.C. §228b(b). But, if the prompt payment requirement is waived, the seller will lose any interest the seller has in the statutory trust (discussed below). 7 U.S.C. §196(c).
The prompt payment rule also applies to “market agencies” and “dealers” in addition to packers (as defined above). A “market agency” is any person “engaged in the business of (1) buying or selling in commerce livestock on a commission basis or (2) furnishing stockyard services.” 7 U.S.C. §201(c). Simply denoting “commission” on an invoice does not, by itself, indicate that the sale was on a commission basis. It’s the nature of the business relationship of the parties and the surrounding facts and circumstances that are determinative. See, e.g., Ferguson v. United States Department of Agriculture, 911 F.2d 1273 (8th Cir. 1990). A “dealer” is “any person, not a market agency, engaged in the business of buying or selling in commerce livestock, either on his own account or as the employee or agent of the vendor or purchaser.” 7 U.S.C. §201(d). In Kelly v. United States, 202 F.2d 838 (10th Cir. 1953), the court said that a person can be a “dealer” even if the buying and selling of livestock is not the person’s only business.
A violation of the prompt payment rule constitutes an “unfair practice” under the PSA. 7 U.S.C. §228b(c). The same is true for the issuance of an insufficient funds check and the failure to pay when due. 7 U.S.C. §213(a); 7 U.S.C. §228(b).
The inability to make prompt payment is sometimes tied to the financial condition of the buyer. Consequently, all market agencies are prohibited from operating while insolvent – when current liabilities exceed current assets. 7 U.S.C. §204. See also United States v. Ocala Livestock Market, Inc., 861 F. Supp. 2d 1328 (M.D. Fla. 2012).
Statutory Trust. For packers with average annual purchases of livestock exceeding $500,000, the PSA establishes a statutory trust for the benefit of unpaid cash sellers. A “cash sale” is any sale where the seller does not expressly extend credit to the packer. 7 U.S.C. §196(a); Kunkel v. Sprague National Bank, 128 F.3d 636 (8th Cir. 1997). The provision extends to “all inventories of, or receivables or proceeds from meat, meat food products, or livestock products derived therefrom….” 7 U.S.C. §196(b). The funds must be held in the trust for the benefit of al unpaid cash sellers of livestock until full payment has been received by the unpaid seller. Id.
If a packer files bankruptcy, assets contained in the statutory trust are not part of the bankruptcy estate. 11 U.S.C. §541(d). This means that the unpaid cash sellers of livestock do not have to compete with the bankrupt debtor’s secured creditors for the assets contained in the trust. See, e.g., Rogers and King, Collier Farm Bankruptcy Guide §105. Claims for payment from the statutory trust will defeat a properly perfected Uniform Commercial Code lien. See, e.g., In re Gotham Provision Company, 669 F.2d 1000 (5th Cir. 1982). Likewise, a bank creditor of a packer is not able to setoff funds held in the statutory trust. See, e.g., In re Jack-Rich, Inc., 176 B.R. 476 (Bankr. C.D. Ill. 1994). Also, payment from a statutory trust to livestock sellers are not recoverable as a preference item in bankruptcy. But, what constitutes cash collateral can present issues.
An unpaid cash seller can make a claim against trust assets by providing notice to the Secretary within 30 days of the final date for making prompt payment under 7 U.S.C. §228(b) or within 15 business days of being notified that the seller’s check has been dishonored, whichever is later. 7 U.S.C. §196(b); see also 9 C.F.R. §203.15.
The statutory trust requirement does not apply to livestock purchases by market agencies and dealers. However, payments that a livestock buyer makes to a market agency for sales on commission are considered to be trust funds that must be deposited into a custodial account. 9 C.F.R.§201.42(a), (b). In other words, a market agency or a dealer must maintain a custodial account for trust funds. By close of the next business day after an auction, market agencies must deposit into the custodial account: (1) all proceeds collected from the auction, and (2) an amount equal to the proceeds receivable from the livestock sale that are due from the market agency; any owner, employee, or officer of the market agency; and any buyer to whom the market agency has extended credit. 7 U.S.C. §201.42(c)-(d); 9 C.F.R. §201.42(c). In addition, a market agency must deposit an amount equal to all of the remaining proceeds receivable into the custodial account within seven days of the auction, even if some of the proceeds remain uncollected. Id. Funds in the custodial account can only be withdrawn to remit the net proceeds due a seller, to pay lawful charges which the market agency is required to pay, and to obtain sums due the market agency as compensation for its services. 9 C.F.R. §201.42(d). A market agency must transmit or deliver the net proceeds received from the sale to the seller by the close of business on the day after the sale. 7 U.S.C. §228b(a); 9 C.F.R. §201.43(a).
To make a statutory trust claim, written notice must be given to the buyer and the Grain Inspection Packers and Stockyards Administration (GIPSA). The livestock not paid for must be identified along with the date of delivery. The applicable “look-back” period is 30 days before receipt by the buyer and the Secretary.
Note: Effective November 29, 2018, GIPSA is no longer a standalone agency within the United States Department of Agriculture (USDA), but is contained within the USDA’s Agricultural Marketing Service (AMS). The USDA final rule detailing the reorganization is found at 83 FR 61309 (Nov. 29, 2018).
Reparation. A livestock seller that has sustained a PSA “injury” at the hands of a market agency or a dealer can sue in federal district court “for the full amount of damages sustained in consequence of such violation.” 7 U.S.C. §209(a), (b). Another option for a disaffected livestock seller is to begin a reparation proceeding for money damages. 7 U.S.C. §§209(b); 210. A filing for a reparation proceeding must be made within 90 days after the cause of action accrues. 7 U.S.C. §210(a). See also 9 C.F.R. §§202.101-.123. The filing is made with the Secretary at the AMS/GIPSA Regional Office. The complaint must state the cause of the action; the date of the transaction; amount of damages; method of computation; place where the transaction occurred; and the name of the parties. No particular Form is needed to file the complaint, however the P&SP Form 5000 is recommended. The Form is available here: https://www.gipsa.usda.gov/psp/forms-psp/PSP5000.pdf
Once the complaint is processed and investigated, AMS/GIPSA will serve the complaint on the defendant. The defendant will then have 20 days upon receipt to file an answer to the complaint. Once an answer is received, or the time for responding has expired, the complaint is filed with a GIPS hearing clerk. A hearing will be scheduled will be in writing unless an oral hearing is requested and claimed damages exceed $10,000. An oral hearing can also occur if necessary to establish the facts and circumstances that gave rise to the controversy. If AMS/GIPSA determines that a hearing should be in writing, each party will be given notice and 20 days to file objections. Written hearings allow for additional evidence to be given, and have additional procedures that must be followed.
If the Secretary determines that the livestock seller is entitled to damages, the Secretary will order the defendant “to pay to the complainant the sum to which he is entitled on or before a day named.” 7 U.S.C. §210(b). AMS/GIPSA cannot enforce payment of any award, but the order can be enforced by the applicable federal district court (or any state court having general jurisdiction of the parties) upon an enforcement action being filed with the court within one year of the date of the order. The order is deemed to be prima facie evidence of the facts stated in the order, and a prevailing livestock seller is entitled to reasonable attorney fees. Id.
A complaint can be withdrawn at any time to terminate the reparation unless there is a counterclaim.
Injunction. 7 U.S.C. §228a authorizes a statutory injunction and allows the United States to apply for a temporary injunction or restraining order when it has reason to believe that any person governed by the PSA has “(a) failed to pay or is unable to pay for livestock, meats, meat food products, or livestock products in unmanufactured form, … or has failed to remit to the person entitled thereto the net proceeds from the sale of any such commodity sold on a commission basis; or (b) has operated while insolvent, or otherwise in violation of [the PSA] in a manner which may reasonably be expected to cause irreparable damage to another person; or (c) does not have the required bond; and that it would be in the public interest to enjoin such person from operating subject to this chapter or enjoin him from operating subject to this chapter except under such conditions as would protect vendors or consignors of such commodities or other affected persons.” When the United States makes such a “proper showing,” the court “shall…issue a temporary injunction or restraining order.” Id.
The PSA is a major piece of legislation significantly regulating livestock sales involving covered entities. It provides a level of protection for livestock sellers in terms of ensuring payment. In addition, it is a good practice for lenders that finance PSA-covered entities to ensure that these entities promptly pay for all livestock purchased.
Tuesday, March 19, 2019
This week’s two posts will be devoted to the Packers and Stockyards Act (PSA). 7 U.S.C. §181 et seq. Recent news of a sale barn bankruptcy in Kansas has brought renewed attention to how the PSA works and its various provisions. In today’s post, I will detail a bit of the history of the PSA and several of the basic provisions of the law. In Thursday’s post, I will deal specifically with the PSA trust that is created to protect unpaid cash sellers of livestock when a buyer files bankruptcy – the problem facing some Kansas cattlemen at the present time.
The PSA – it’s history and basic provisions, that’s the topic of today’s post.
History of the PSA
The PSA is enforced by the USDA’s Packers and Stockyards Administration which regulates the livestock and poultry marketing system in the U.S. The stated purpose of the PSA is to assure the free flow of livestock from livestock farms and ranches to the marketplace. See, e.g., Stafford v. Wallace, 258 U.S. 495 (1922). The PSA regulates both packers and stockyards.
The genesis of the PSA dates back to 1888. That’s when the U.S. Senate authorized an investigation of the buying and selling of livestock to determine if anti-competitive practices were present. The investigation revealed that major meatpackers were engaging in unfair, discriminatory and anti-competitive practices by means of price fixing, agreements not to compete, refusals to deal and similar arrangements. The Senate report contributed to the political support for the Sherman Act of 1890.
In 1902, an injunction was sought against the major meatpackers alleging antitrust violations. The injunction was issued in 1903 and the Supreme Court sustained it in 1905. Swift & Company v. United States, 196 U.S. 375 (1905). The injunction, however, was not successful in correcting the situations deemed anti-competitive. The same defendants or their successors were indicted and tried for alleged violations of the antitrust laws but were acquitted after trial in 1912. The dominance and anti-competitive activities of the packers continued, and in 1917, President Wilson directed the Federal Trade Commission (FTC) to investigate the packing industry. The FTC report documented widespread anti-competitive practices involving operations of stockyards, actions of commission persons, operation of weighing facilities, disposal of dead animals and control of packing plants.
During congressional debate of the PSA, the major packers signed a consent decree in an attempt to ward off the new legislation. The consent decree was entered into on February 27, 1920, and it enjoined the “Big Five” meatpackers (Swift & Co., Armour & Co., Cudahy Packing Co., Wilson & Co., and Morris & Co.) from certain activities. The Big Five were prohibited from maintaining or entering into any contract, combination or conspiracy, in restraint of trade or commerce, or monopolizing or attempting to monopolize trade or commerce. The consent decree also prohibited the Big Five from engaging in any illegal trade practice as well as owning an interest in any public stockyard company, any stockyard terminal railroad or any stockyard market newspaper or journal. The injunction also prohibited the Big Five from having an interest in the business of manufacturing, selling or transporting, distributing or otherwise dealing in any of numerous food products, mainly fish, vegetables, fruits, and groceries and many other commodities not related to the meatpacking industry. Similarly, the injunction prohibited the Big Five from using or permitting others to use their distribution systems or facilities for the purchase, sale, handling, transporting or dealing in any of the enumerated articles or commodities. The injunction also prevented the owning or operating of any retail meat markets except in-plant sales to accommodate employees. Because the Big Five controlled all the warehousing in their exercise of monopoly power, the injunction prevented them from having an interest in any public cold storage warehouse or engaging in the business of selling or dealing in fresh milk or cream.
Even though the Attorney General of the United States personally appeared before the House Committee on Agriculture and recommended against the proposed legislation on the ground that the consent decree would eliminate the evils in the packing industry and make legislation unnecessary, President Harding signed the PSA into law on April 15, 1921. Consequently, some of the “Big Five” filed suit seeking to have the consent decree either vacated or declared void. However, in 1928, the United States Supreme Court upheld the consent decree. Swift & Co. v. United States, 276 U.S. 311 (1928). Similarly, the Supreme Court turned down requests to modify the decree in 1932 (Swift & Co. v. United States, 286 U.S. 106 (1932)) and 1961. Swift & Co. v. United States, 367 U.S. 909 (1961). The decree, however, was terminated on November 23, 1981. United States v. Swift & Co., 1982-1 Trade Cas. (CCH) ¶64,464 (N.D. Ill. 1981).
While the PSA was “the most far-reaching measure and extend[ed] further than any previous law into the regulation of private business with few exceptions,” (61 Cong. Rec. 1872 (1921) and the powers given to the Secretary of Agriculture were more “wide-ranging” than the powers granted to the FTC, the Act was upheld as constitutional in several court cases from 1922 to 1934. Unquestionably, the PSA extends well beyond the scope of other antitrust law.
Selected Provisions of the Act
Registration Requirement. The PSA requires all marketing agencies that handle livestock to register with the USDA which has the authority to suspend registration for violations of the Act for insolvency. 7 U.S.C. Sec. 181 et seq.
Bonding. Packer bonding is required except for those with average annual purchases of $500,000 or less. Thus, there is a danger posed to persons or entities selling livestock to relatively small buyers. Selling to a local locker does not provide the protection that the PSA affords had the sale been to a packer purchasing at least $500,000 worth of livestock per year.
False Weighing. False weighing of livestock is also prohibited. False weighing of livestock had been a serious longstanding problem. “Back balancing” had been a relatively common practice (failure to empty the scales to show a balanced condition). False weighing is viewed as a serious offense and the regulations impose several detailed requirements to discourage false weighing. See 9 C.F.R. §§ 201.49-201.99. For example, whenever livestock is weighed for the purpose of sale, a scale ticket must be issued which must be serially numbered and used in sequential order. 9 C.F.R. §201.49(a). The scale tickets must be retained as part of the market agency's or dealer's business records to substantiate each transaction, and must include: 1) the name and location of the weighing; 2) the date of the weighing; 3) the name of the buyer and seller or consigned, or a readily identifiable designation thereof; 4) the number of livestock; 5) the kind of livestock; 6) the actual weight of each draft of livestock; and 7) the identity of the person who weighed the livestock, or their signature if required by State law. 9 C.F.R. §201.49(b).
Gratuities. The Packers and Stockyards Act also prohibits the practice of a stockyard owner or market agency giving gratuities to truckers, consignors or shippers. Providing free trucking to consignors as an inducement to consign livestock to a particular market is an unfair practice and a willful violation of the PSA that discriminates against those consignors not given free trucking. The practice also constitutes an unfair and unjust practice against competing markets, forcing them to give free trucking in order to remain in business.
Coordinated Buying. The “turn system” of selling livestock has been held to violate the PSA. Berigan v. United States, 257 F.2d 852 (8th Cir. 1958). Under the “turn system” of selling livestock, livestock dealers engage in the practice of flipping coins to establish the “order” or “turn” in which they would look at, bid on and have the opportunity to buy stocker and feeder cattle consigned for sale to a market agency. This method of selling livestock limits the number of buyers or prospective buyers which increases the value of the position or turn of those not eliminated with the effect of restricting competition and depressing the market.
Bribery. The PSA also prohibits the bribery of weighmasters. Likewise, bribing employees of a market agency by a dealer to obtain favored treatment in sale of livestock has been held to violate the PSA. See, e.g., In re McNulty, 13 Agric. Dec. 345 (1954). Other violations of the PSA include market agencies purchasing animals from consignments for resale, price discounts being offered to some purchasers of meat products, and the use of “bait and switch” tactics in selling meat.
Recordkeeping. The PSA requires that books and records be kept. Penalties for failure to do so include a $5,000 fine or three years in prison or both. Private actions may be brought for “reparations” under the Act by filing a complaint with the USDA within 90 days after the cause of action accrues. USDA issues the order requiring payment.
Other Prohibited Practices. The Act prohibits any “unfair, unjustly discriminatory, or deceptive practice or device. 7 U.S.C. §192(a). But, in Kinkaid v. John Morrell & Co., 321 F. Supp. 2d 1090 (N.D. Iowa 2004), the court held that hog contracts containing a deduction charge for hogs dying in transit was not an unfair or deceptive practice and did not constitute an unauthorized sale of insurance under state (Iowa) law because the primary purpose of contracts was the sale of hogs.
Enforcement. Enforcement of the PSA is either by a civil action, initiated by the person aggrieved by the violation of the PSA, or by an action taken by the U.S. Attorney upon request of the Secretary of Agriculture. Jurisdiction is in the federal district court.
In part two on Thursday, I will dig into the PSA trust provision and the protection it provides for unpaid cash sellers of livestock. That’s a provision that is of particular importance when a livestock buyer files bankruptcy after buying livestock but before making payment for them. I will also look at some PSA market competition issues. Stay tuned.
Friday, March 15, 2019
If the federal estate tax isn’t paid when due nine months after the date of the decedent’s death, is a person that receives property from the decedent’s estate personally liable for the unpaid tax? Does it matter how the person received the property - either by gift, as a surviving joint tenant or as a beneficiary of the estate? How long does the IRS have to collect the tax? These are all important questions, especially with respect to a farmer’s estate where present economic and financial conditions may have dissipated estate property such that the estate no longer has assets and funds with which to pay the tax, or where the assets have already been distributed.
The personal liability of estate beneficiaries for federal estate tax – that’s the topic of today’s post.
With the present level of the exemption from federal estate tax pegged at $11.4 million for deaths in 2019, it’s very unlikely that any particular estate will have to worry about federal estate tax. But, this enhanced level of exemption (it was, in essence, doubled by the late 2017 tax legislation) is set to expire at the end of 2025 and go back to the pre-2018 level of $5 million (adjusted for inflation). Also, it is possible that a change in the political winds come 2020, could reduce the exemption below $5 million. That would make it far more relevant again for many farm and ranch families.
When a decedent’s estate has a federal estate tax liability, it is due nine-months after the date of death. I.R.C. §6075(a). A six-month extension is available. But, if the tax is not paid when it is due, any transferee, surviving tenant or beneficiary of the estate is personally liable for the unpaid estate tax to the extent the property they received was included in the decedent’s gross estate under I.R.C. §2034 through I.R.C. §2042. I.R.C. §6324(a)(2). The IRS also has a special lien for any unpaid gift tax. I.R.C. §6324(b). These liens arise automatically – no assessment, notice or demand for payment or filing is required. The lien attaches to the gross estate and lasts for the earlier of ten years from the date of the decedent’s death or until the tax is paid. I.R.C. §6324(a). The lien attaches to the extent of tax shown to be due by the return and of any deficiency in tax found to be due. Treas. Reg. §301.6324-1(a)(1).
The IRS must prove that an unpaid tax exists at the time of death and that a beneficiary received property that was included in the decedent’s gross estate at death. I.R.C. §§ 2035-2042 list the various types of property and the rules governing how those types of property are included in the decedent’s gross estate for estate tax purposes. Each beneficiary of estate property is personally liable for any unpaid estate tax based on the property they received from the estate and to the extent of the property’s value at the time of the decedent’s death. I.R.C. 6324(a)(2). See also Baptiste v. Comr., 29 F.3d 433 (8th Cir. 1994), aff’g. in part and rev’g. in part 100 T.C. 52 (1993); Baptiste v. Comr., 29 F.3d 1533 (11th Cir. 1194), aff’g., 100 T.C. 252 (1993).
Procedurally, the IRS is not required to follow the normal process for collecting a deficiency when it moves to assert the lien against a transferee of estate property. See, e.g., United States v. Geniviva, 16 F.3d 522 (3rd Cir. 1994). The special estate tax lien is also not subject to the filing and notice requirements of the general IRS lien of I.R.C. §6321. I.R.C. §6323(a). Thus, buyers, holders of security interests, other lien holders and judgment lien creditors may not be protected unless I.R.C. §6324 provides protection. Rev. Rul. 69-23, 1969-1 CB 302.
Some property is exempt from the IRS lien. Included in the exempt list is any part of the decedent’s gross estate that is used to pay charges against the estate or pay administrative costs. I.R.C. §6324(a)(1). The lien also doesn’t apply to any part of the decedent’s property that is transferred to a bona fide buyer or holder of a security interest, except that the lien attaches to any consideration received. I.R.C. §§6324(a)(2)-(3). Also, any property that is released via certificate is exempt. I.R.C. §6325; Treas. Reg. §301.6324-1(a)(2)(iv).
The issue of liability of estate beneficiaries for unpaid estate tax came up in a recent case from South Dakota. In United States v. Ringling, No. 4:17-cv-04006-KES, 2019 U.S. Dist. LEXIS 28146 (D. S.D. Feb. 21, 2019), the defendants were the daughters and one grandson of the decedent. The decedent died in late 1999 leaving his estate equally to his daughters and providing a specific bequest of farmland to one of the daughters as part of her co-equal share of the estate. The will named the daughters as co-personal representatives of his estate. The estate included farmland and crops among other assets. In 1999, the federal estate tax exemption equivalent of the unified credit was $650,000 and the top rate was 55 percent.
In 1996, the decedent entered into an agreement with his grandson to buy additional farmland. Under that agreement, the decedent bought the land and the grandson was to pay the decedent $32,000 via an installment contract. Ten days before his death in 1999, the decedent forgave the remaining balance due on the contract of $27,600.96. Also, in 1996 the decedent conveyed a warranty deed to his grandson for the family farm along with irrigation equipment and permits, retaining a life estate and the right to receive the rent income and profits from the farm during his life. After death, the farm was appraised at $345,700. Six days before death, the decedent and his grandson entered into a contract for deed of additional farmland. This contract called for the grandson to pay $90,000 to the decedent, with $10,000 to be paid before or at the time of deed execution and the balance to be paid in 20 equal installments. The grandson would not take possession until March 1, 2000. At the time of the decedent’s death in late 1999, the unpaid balance on the contract was $80,093.30.
In early 2008, the estate filed Form 706 reporting a gross estate of $834,336 and a net estate tax due of $28,939. No payment accompanied the filing. On Form 706, the estate reported assets as three pieces of farmland; co-op shares; stocks; bonds; two contracts for deed; cash; bank accounts; certificates of deposit (CDs); two life insurance policies; a corn crop that had been gifted to the grandson; the decedent’s pickup truck; a van; and other miscellaneous property. The Form 706 reported that each of the daughters received $121,988 and that the grandson received $416,116. Later in 2008, the IRS agreed that the estate tax was $28,939, but that a late filing penalty of $6,511.27 and a failure to pay penalty of $7,234.75 should be added on. In addition, the IRS assessed interest of $23,189.78. The total amount the IRS asserted due was $65,874.80. In 2010, the estate requested an abatement of the penalties and interest. The IRS denied the request. In 2013, the IRS sent the defendants Form 10492 Notice of Federal Taxes Due with respect to the estate. Later in 2013, the IRS filed a Notice of Federal Tax Lien on the farmland. The Notice was also sent to the estate. A hearing was not requested. Beginning in 2010, the defendants had made some payments on the estate tax liability, but as of mid-2018 over $63,000 remained due. The IRS then sued seeking payment from the daughters and the grandson personally via I.R.C. §6324(a)(2) and sought summary judgment. Only one daughter filed a response in opposition to summary judgment.
The court noted that each of the daughters and the grandson jointly owned property with the decedent at the time of his death. The jointly owned property also included a checking account on which one of the daughters continued to write checks after the decedent’s death. Under I.R.C. §2040, the court noted, the decedent’s gross estate included all property that he and any other person held as joint tenants with rights of survivorship. The two life insurance policies were included in the estate by virtue of I.R.C. §2042. Various gifts were also included in the gross estate under I.R.C. §2035. These included the decedent’s transfer of the corn crop and CDs to the grandson, as well as the forgiveness of the balance due on the contract for deed. These were all included in the estate because they had been transferred within three years of death. Also included in the decedent’s gross estate was the decedent’s retained life estate in the family farm that he had transferred to his grandson. The retained life estate caused the farm to be included in the gross estate and made it subject to the special estate tax lien as I.R.C. §6324(a)(2) property.
The court held that the defendants were personally liable for the unpaid federal estate tax as transferees of estate property and that they did not receive the property free and clear of estate tax liabilities. The court noted that transferee liability is not limited to those receiving a gift or bequest under a decedent’s will or via the administration of a revocable trust. Rather, liability extends to recipients of all property included in the gross estate including transferees who received lifetime gifts that are included in the gross estate under I.R.C. §2035 because they were made within three years of death; gift recipients whose gift was a discharge of indebtedness to the decedent; transferees who receive the property as surviving join tenants; property passing to remaindermen when the decedent had a life tenancy in the property; and life insurance proceeds on the life of the decedent.
The one daughter that filed a response to the IRS summary judgment motion asserted that the government was barred by the statute of limitations. After all, she noted, the decedent died in 1999 and the IRS didn’t file suit to collect the tax until early 2017. However, under I.R.C. §6324(a)(2), personal liability for unpaid estate tax can be asserted by the IRS ten years from the date the assessment is made against the estate. I.R.C. §6502(a)(1). See also United States v. Botefuhr, 309 F.3d 1263 (10th Cir. 2002). The assessment was made in 2008 (remember the estate didn’t file Form 706 until 2008) and the IRS sued in 2017, nine years into the 10-year timeframe for doing so and 18 years after the decedent’s death. The daughter challenging the government’s motion didn’t dispute these facts. Now, the court’s decision finding the daughters and grandson personally liable for the unpaid estate tax comes just over 19 years after the decedent’s death.
The clear lesson of the case is that federal estate tax liability just doesn’t go away if the estate doesn’t pay it. In addition, the IRS has a lengthy timeframe to collect the tax. Proper pre-death planning can, of course, help to either minimize or eliminate the tax. Also, if the exemption from federal estate tax were to drop in the future, more farms, ranches and small businesses would get caught in its snare. That was certainly the result for the South Dakota farming operation in the recent case.
Wednesday, March 13, 2019
Last April I devoted a post to the general grouping rules under I.R.C. §469. https://lawprofessors.typepad.com/agriculturallaw/2018/04/passive-activities-and-grouping.html Those rules allow the grouping of passive investment activities with other activities in which the taxpayer materially participates. Thus, for example, an investor in an ethanol plant might be able to group the losses from that investment with the taxpayer’s farming activity. Grouping may make it more likely that the taxpayer can avoid the passive loss rules and fully deduct any resulting losses.
But, there’s another grouping rule – one that applies to a taxpayer that has satisfied the tests to be a real estate professional and it’s only for purposes of determining material participation in rental activities. This election is an all-or-nothing election – either all of the taxpayer’s rental activities are aggregated or none of them are.
The aggregation election for real estate professionals – that’s the focus of today’s post.
Real Estate Professional
In last Thursday’s post, https://lawprofessors.typepad.com/agriculturallaw/2019/03/passive-losses-and-real-estate-professionals.html I detailed the rules under I.R.C. §469 pertaining to a real estate professional. To qualify as a “real estate professional” two test must be satisfied: (1) more than 50 percent of the personal services that the taxpayer performs in trades or business for the tax year must be performed in real property trades or businesses in which the taxpayer materially participates; and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. I.R.C. §469(c)(7). If the two tests are satisfied, as noted above, the rental activity is no longer presumed to be passive and, if material participation is present, the rental activity is non-passive. I.R.C. §469(c)(7)(A)(i).Another way of putting is that once the tests of I.R.C. §469(c)(7) are satisfied it doesn’t necessarily mean that rental losses are non-passive and deductible, it just means that the rental losses aren’t per se as passive under I.R.C. §469(c)(2). See, e.g., Gragg v. United States, 831 F.3d 1189 (9th Cir. 2016); Perez v. Comr., T.C. Memo. 2010-232. An additional step remains – the taxpayer must materially participate in each separate rental activity (if there are multiple activities).
Note: The issue of whether a taxpayer is a real estate professional is determined on an annual basis. See, e.g., Bailey v. Comr., T.C. Memo. 2001-296. In addition, when a joint return is filed, the requirements to qualify as a real estate professional are satisfied if either spouse separately satisfies the requirements. I.R.C. §469(c)(7)(B).
Is Separate Really the Rule?
As noted above, if a taxpayer has multiple rental activities, the taxpayer must materially participate in each activity. That can be a rather harsh rule. But, there is an exception. Actually, there are two. If material participation test cannot be satisfied, the taxpayer can use a relaxed rule of active participation. I.R.C. §469(i). That rule allows the deduction of up to $25,000 of losses (subject to an income phase-out). In addition, the taxpayer can make an election to aggregate all of the rental activities that the taxpayer is involved in for purposes of meeting the material participation test. Treas. Reg. §1.469-9(g)(1). This aggregation election is available to a taxpayer that has satisfied the requirements to be a qualified real estate professional under I.R.C. §469(c)(7). See, e.g., C.C.A. 201427016 (Jul 3, 2014).
Points on aggregation. Aggregation only applies to the taxpayer’s rental activities. Activities that aren’t rental activities can’t be grouped with rental activities. In addition, it’s only for purposes of determining whether the material participation test has been met. Because the election only applies to rental activities, time spent on non-rental activities won’t help the taxpayer meet the material participation test for the rental activities. This makes the definition of a “rental activity” important. I highlighted the designated rental activities in last Thursday’s post. One of them is that the real estate must be used in a rental activity rather be realty that is held in the taxpayer’s trade or business where the average period of customer use for the property is seven days or less. Temp. Treas. Reg. §1.469-1T(e)(3)(ii); see also Bailey v. Comr., T.C. Memo. 2001-296.
By election only. Aggregation is accomplished only by election. Treas. Reg. §1.469-9(g)(3). It’s not enough to simply list all of the rental activities of the taxpayer in a single column on Schedule E. In Kosonen v. Comr., T.C. Memo. 2000-107, the petitioner owned seven residential rental properties. As of the beginning of 1994, he had non-deductible suspended losses of $215,860 from his properties. He put in almost 1,000 hours in rental activities in each of 1994 and 1995. On this 1994 return, he listed each rental property and loss separately on Schedule E and reported a combined loss of $56,954 on line 42 of Schedule E – the line where a taxpayer that is materially participating in rental activities reports net income or loss from all rental activities. He also reported the loss on line 17 of Form 1040 and subtracted it from other income to compute his adjusted gross income. He also filed Form 8582 to report the $56,954 loss. However, he didn’t attach an aggregation statement to the return noting that he was electing to treat his rental real estate activities as a single activity. He also didn’t combine his 1994 Schedule E rental real estate losses with his previously suspended losses. The IRS noted that had a proper election been made that the petitioner would have satisfied the material participation requirement. But, the IRS took the position that an election had not been made and as a result the material participation requirement had to be satisfied with respect to each separate activity. Because he could meet the material participation test in any single activity by itself, the IRS asserted, the resulting losses were suspended and couldn’t offset active income. The Tax Court agreed with the IRS. While the form of his entries on the return were consistent with an aggregation election, the Tax Court held that his method of reporting net losses as active income was not clear notice of an aggregation election. The fact that the IRS had not yet issued guidance on how to make an aggregation election didn’t eliminate the statutory requirement to aggregate, the Tax Court concluded.
Attached statement. To satisfy the statutory election requirement, the election statement attached to the return should clearly state that an election to aggregate rental activities is being made via I.R.C. §469(c)(7)(A) and that the taxpayer is a qualifying taxpayer in accordance with I.R.C. §469(c)(7)(B).
Late election relief. It is possible to make a late election via an amended return. In Rev. Proc. 2011-34, 2011-24 I.R.B. 875, the IRS said a late election can be made in situations where the taxpayer has filed returns that are consistent with having made the election. In that event, the late election applies to all tax years for which the taxpayer is seeking relief. The late election is made by making the election in the proper manner as indicated above as an attachment to the amended return for the current tax year. The attachment must identify the tax year(s) for which the late election is to apply, and explain why a timely election wasn’t initially made. The opportunity to make a late election is important. See, e.g., Estate of Ramirez, et al. v. Comr., T.C. Memo. 2018-196.
Binding election. The aggregation election cannot be revoked once it is made – it is binding for the tax year in which it is made and for all future years in which the taxpayer is a qualifying real estate professional. If intervening years exist in which the taxpayer was not a qualified real estate professional, the election has no effect in those years and the taxpayer’s activities will be evaluated under the general grouping rule of Treas. Reg. §1.469-4. Treas. Reg. §1.469-9(g)(1).
Years applicable. If the election hasn’t been made in a year during which the taxpayer was a qualified real estate professional, it can still be made in a later year. But, the election is of no effect if it is made in a year that the taxpayer doesn’t satisfy the requirements to be a real estate professional. Treas. Reg. §1.469-9(g)(1). In other words, the election may be made in any year in which the taxpayer is a qualifying taxpayer for any tax year in which the taxpayer is a qualifying taxpayer. In addition, the failure to make the election in one year doesn't bar the taxpayer from making the election in a later year. Treas. Regs. §§1.469-9(g)(1) and (3).
Revocation. While the aggregation election is normally binding, the aggregation election can be revoked for a year during which the taxpayer’s facts and circumstances change in a material way. If that happens, the election can be revoked by filing a statement with the original tax return for that year. According to the regulations, the statement must provide that the I.R.C. §469(c)(7)(A) election is being revoked and describe the material change in the taxpayer’s factual situation that justifies the revocation. Treas. Reg. §1.469-9(g)(3).
Rental real estate activities held in limited partnerships. What happens if the taxpayer makes the election to aggregate all real estate rental activities but not all of the taxpayer’s interests in real estate activities are held individually by the taxpayer? The regulations address this possibility and use an example of an interest in a rental real estate activity held by the taxpayer as a limited partnership interest. Treas. Reg. §1.469-9(f)(1). The result is that the effect of the aggregation election doesn’t necessarily apply in this situation. Instead, the taxpayer’s combined rental activities are deemed to be a limited partnership interest when determining material participation and the taxpayer must establish material participation under one of the tests that apply to determine the material participation of a limited partner contained in Treas. Reg. 1.469-5T(e)(2). Treas. Reg. §1.469-9(f)(1). But, there is a de minimis exception that applies if the taxpayer’s share of gross rental income from all limited partnership interests in rental real estate is less than 10 percent of the taxpayer’s share of gross rental income from all of the taxpayer’s interests in rental real estate for the tax year. In this situation, the taxpayer can determine material participation by using any of the tests for material participation in Treas. Reg. §1.469-5T(a) that apply to rental real estate activities. Treas. Reg. §1.469-9(f)(2). This is also the rule if the taxpayer has an interest in a rental real estate activity via an LLC. An LLC interest is not treated as a limited partnership interest for this purpose. Thus, the taxpayer can use any of the seven tests for material participation contained in Treas. Reg. §1.469-5T(a). See, e.g., Garnett v. Comr., 132 T.C. 368 (2009); Hegarty v. Comr., T.C. Sum. Op. 2009-153; Newell v. Comr., T.C. Memo. 2010-23; Thompson v. Comr., 87 Fed. Cl. 728 (2009), acq. in result only, A.O.D. 2010-002 (Apr. 5, 2010); Chambers v. Comr., T.C. Sum. Op. 2012-91.
It should be noted that in its 2017-2018 Priority Guidance Plan, the IRS stated that it planned to finalize regulations under I.R.C. §469(h)(2). That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. Those regulations were initially issued in temporary form and became proposed regulations in 2011. Until the IRS takes action to effectively overturn the Tax Court decisions via regulation, the issue will boil down (as it has in the Tax Court cases referenced above) to an analysis of a particular state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership.
Effect on losses. The aggregation election also impacts the handling of losses. Once the aggregation election is made, prior year disallowed passive losses from any of the aggregated real estate rental activities can be used to offset current net income from the aggregated activities regardless of which activity produces the income or prior year loss. At least this is the position take in the preamble to the regulations. See Preamble to T.D. 8645 (Dec. 21, 1995). This is the result even if the disallowed prior year losses occurred in tax years before the aggregation election was made. Treas. Reg. §1.469-9(e)(4).
Any suspended losses remain suspended until substantially all of the combined activities (by virtue of the election) are disposed of in a fully taxable transaction. This would be an issue if a rental real estate activity with a suspended loss is aggregated with other rental real estate activities. Those suspended losses would not be deductible until the entire aggregated activity (now treated as a single activity) is disposed of. Thus, depending on the amount of the suspended losses at issue, it may not be a good idea to make the aggregation election in this situation. Likewise, it also may not be a good idea to make the aggregation election if the taxpayer has positive net income from rental real estate activities and passive losses from activities other than rental real estate activities. If the election is made in this situation, the rental activities won’t be passive, and the taxpayer won’t be able to use the losses from the other passive activities to offset the income from the rental real estate activities. The losses could then end up being suspended and non-deductible until the entire (combined) activity is disposed of.
The aggregation election is an election that is available only for real estate professionals and can make satisfying the material participation test easier. That can allow for full deductibility of losses from rental real estate activities. But, the terrain is rocky. Good tax advice and planning is essential.
Monday, March 11, 2019
Earlier in the year I devoted a blog post to a few current developments in the realm of agricultural law and taxation. That post was quite popular with numerous requests to devote a post to recent developments periodically. As a result, I take a break from my series of posts on the passive loss rules to feature some current developments.
Selected recent developments in agricultural law and taxation – that’s the topic of today’s post.
While economic matters remain tough in Midwest crop agriculture and dairy operations all over the country and the projection is for the third-lowest net farm income in the past 10 years, it hasn’t resulted in an increase in Chapter 12 bankruptcy filings. For the fiscal year ended September 30, 2018, filings nationwide were down 8 percent from the prior fiscal year. However, the number of filing is still about 25 percent higher than it was in 2014. The filings, however, are concentrated in the parts of the country where traditional row crops are grown and livestock and dairy operations predominate. For example, according to the U.S. Courts and reports filed by the Chapter 12 trustees, the states comprising the U.S. Circuit Court of Appeals for the Eighth Circuit (Midwest and northern Central Plains) show a 45 percent increase in Chapter 12 filings when fiscal year 2018 is compared to fiscal year 2017. The Second Circuit (parts of the Northeast) is up 38 percent during the same timeframe. Offsetting these numbers are the Eleventh Circuit (Southeast) which showed a 47 percent decline in filings during fiscal year 2018 compared to fiscal year 2017. The far West and Northwest also showed a 41 percent decline in filings during the same timeframe.
USDA data indicates some rough economic/financial data. Debt-to-asset ratios are on the rise and the debt-service ratio (the share of ag production that is used for ag payments) is projected to reach an all-time high. The current ratio for farming operations is projected to reach an all-time low (but this data has only been kept since 2009). Unfortunately, the U.S. is very good at infusing agriculture with debt capital. In addition, there are numerous tax incentives for the seller financing of farmland. In addition, federal farm programs encourage higher debt levels to the extent they artificially reduce farming risk. This accelerates economic vulnerability when farm asset values decline.
Recent case. A recent Virginia case illustrates how important it is for a farmer to comply with all of the Chapter 12 rules when trying to get a Chapter 12 reorganization plan confirmed. In In re Akers, 594 B.R. 362 (Bankr. W.D. Va. 2019), the debtor owed three secured creditors approximately $350,000 in addition to other unsecured creditors. Two of the secured creditors and the trustee objected to the debtor’s proposed reorganization plan. At the hearing on the confirmation of the reorganization plan, it was revealed that the debtor had not provided any of the required monthly reports. As a result, the court denied plan confirmation and required the debtor to put together an amended plan. The debtor subsequently submitted multiple amended plans, and all were denied confirmation because of the debtor’s inaccurate financial reporting and miscalculation of income and expense. In addition, the current proposed plan was not clear as to how much the largest creditor was to be paid. The creditor had foreclosed, and some payments had been made but the payments were not detailed in the plan. The court denied plan confirmation and denied the debtor’s request to file another amended plan and dismissed the case. The court was not convinced that the debtor would ever be able to put together an accurate and manageable plan that he could comply with, having already had five opportunities to do so.
A recent Iowa case illustrates the need for ag producers to put business agreements in writing. In Quality Egg, LLC v. Hickmans’s Egg Ranch, Inc., No 17-1690, 2019 Iowa App. LEXIS 158 (Iowa App. Ct. Feb. 20, 2019), the plaintiff, in 2002, entered into an oral contract to sell eggs to the defendant via a formula to determine the price paid for the eggs. The business relationship continued smoothly until 2008, when the plaintiff received a check from the defendant that it determined to be far short of the amount due on the account. Notwithstanding the discrepancy, the parties continued doing business until 2011. In 2014, the plaintiff filed sued to recover the amount due, claiming that the defendant purchased eggs on an open account, and still owed about $1.2 million on that account. The defendant counter-claimed, asserting that the transaction did not involve an open account but simply an oral contract to purchase eggs that had been modified in 2008. Consequently, the defendant claimed that the disputed amount was roughly $580,000, based on the modified oral contract.
The trial court jury found that the ongoing series of transactions for the sale and purchase of eggs was an “open and continuous account” at the time of the short pay, yet still found for the defendant. The plaintiff appealed, asserting that the trial court had erred by allowing oral testimony used to prove the existence of a modified oral contract in violation of the statute of frauds. The appellate court remanded for a new trial on the issue, and the second jury trial in 2017 again found for the defendant. The plaintiff again appealed, asserting the statute of frauds as a defense. The plaintiff also asserted that the trial court had failed to instruct the jury on an open account, depriving the jury of the ability to decide the specific elements of its open account claim. The trial court provided only jury instructions on the elements of the breach of contract counter-claim brought by the defendant. On the statute of frauds issue, the appellate court noted that the defendant had admitted written correspondence, checks, and credit statements to support the oral testimony at trial in support of the oral testimony. Thus, the statute of frauds was not violated. However, on the open account jury instruction issue, the appellate court found that the instructions given were improper because the plaintiff’s burden was to prove its claim of money due on an open account, not to disprove an assertion from the defendant of an amended oral contract. The appellate court found that the instructions never mentioned an open account or discussed an open account in any way, and because of that, the jury was never able to render a proper verdict on the plaintiff’s claim. Accordingly, the appellate court concluded that the jury instructions were insufficient and reversed and remanded for a new trial limited to the open-account claim.
Get it in writing!
The qualified business income deduction (QBID) continues to bedevil the tax software programs. It’s the primary reason that the IRS extended the March 1 filing deadline to April 15. The IRS also released a draft Form 8995 to use in calculating the QBID for 2019 returns. But, the actual calculation of the QBID is not that complicated. The difficult part is knowing what is QBI and whether the specified service trade or business limits apply. No worksheet is going to help with that. Understand the concepts! Also, the IRS now says that a PDF attachment of the safe harbor election for rental activities must be combined with the e-filed return. In addition, the election must be signed under penalty of perjury. As I see it, this is just another reason to not use the QBID safe harbor election if you don’t have to.
The U.S. Senate is finally working on tax extender legislation that will extend provisions that expired at the end of 2017. The legislation would extend those expired provisions for two years, 2018-2019. The Senate Finance Committee has released a summary of the proposed bill language: https://www.finance.senate.gov/imo/media/doc/Tax%20Extender%20and%20Disaster%20Relief%20Act%20of%202019%20Summary.pdf
Court says that “Roberts tax” is a non-dischargeable priority claim in bankruptcy. United States v. Chesteen, No. 18-2077, 2019 U.S. Dist. LEXIS 29346 (E.D. La. Feb. 25, 2019). The debtor filed Chapter 13 bankruptcy. The IRS filed a proof of priority claim for $5,100.10, later amending the claim to $5,795.10 with $695 of that amount being an excise tax under I.R.C. §5000A as a result of the debtor’s failure to maintain government mandated health insurance under Obamacare. The debtor object to the $695 amount being a priority claim that could not be discharged, and the bankruptcy court agreed, finding that the “Roberts Tax” under Obamacare was not a priority claim, but rather a dischargeable penalty in a Chapter 13 case. On appeal, the appellate court reversed. The appellate court noted that the creditor bore the burden to establish that the Roberts Tax was a priority claim and noted that it was the purpose and substance of the statute creating the tax that controlled whether the tax was a tax or a penalty. The appellate court noted that a tax is a pecuniary burden levied for the purpose of supporting government while a monetary penalty is a punishment for an unlawful act or omission. On this point, the appellate court noted that Chief Justice Roberts, in National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012), upheld the constitutionality of Obamacare on the basis that the “shared responsibility payment” was a tax paid via a federal income tax return and had no application to persons who did not pay federal income tax. The appellate court noted that the amount was collected by the IRS and produced revenue for the government. It also did not punish an individual for any unlawful activity and, the appellate court noted, the IRS has no criminal enforcement authority if a taxpayer failed to pay the amount.
Court says that the IRS can charge for PTINs.In 2010 and 2011, the Treasury Department developed regulations that imposed certain requirements that an individual had to comply with to be able to prepare tax returns for a fee - a person had to become a “registered tax return preparer.” These previously unregulated persons had to pass a one-time competency exam and a suitability check. They also had to (along with all other preparers) obtain a Preparer Tax Identification Number (PTIN) and paying a user fee to obtain the PTIN. The plaintiff class challenged the authority of the government to require a PTIN and charge a fee for obtaining it. The IRS claimed that the regulations were necessary for the need to oversee tax return preparers to ensure good service. I.R.C. §6109(a)(4), in existence prior to the regulations at issue, requires a preparer to provide identification and state that the preparer’s social security number shall be used as the required identification. The regulations at issue, however, required preparers to obtain (at a fee paid to the Treasury) a PTIN as the identifying number. Preparers without a PTIN could no longer prepare returns for a fee. The IRS argued that by creating the PTIN requirement, it had created a “thing of value” which allowed it to charge a fee, citing 31 U.S.C. §9701(b). However, the plaintiffs claimed that the PTIN requirements are arbitrary and capricious under the Administrative Procedure Act or, alternatively is unlawful as an unauthorized exercise of licensing authority over tax return preparers because the fee does not confer a “service or thing of value.”
The trial court determined that the IRS can require the exclusive use of a PTIN because it aids in the identification and oversight of preparers and their administration. However, the trial court held that the IRS cannot impose user fees for PTINs. The trial court determined that PTINs are not a “service or thing of value” because they are interrelated to testing and eligibility requirements and the accuracy of tax returns is unrelated to paying a PTIN fee. Steele v. United States, 260 F. Supp. 3d 52 (D. D.C. 2017). A prior federal court decision held that the IRS cannot regulate tax return preparers (Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2014), thus charging a fee for a PTIN would be the equivalent of imposing a regulatory licensing scheme which IRS cannot do. The trial court determined that prior caselaw holding that the IRS can charge a fee for a PTIN were issued before the Loving decision and are no longer good law.
On appeal, the appellate court vacated the trial court’s decision and remanded the case. The appellate court determined that the IRS does provide a service in exchange for the PTIN fee which the court defined as the service of providing preparers a PTIN and enabling preparers to place the PTIN on a return rather than their Social Security number and generating and maintaining a PTIN database. Thus, according to the appellate court, the PTIN fee was associated with an “identifiable group” rather than the public at large and the fee was justified on that ground under the Independent Offices Appropriations Act. The appellate court also believed the IRS claim that the PTIN fee improves tax compliance and administration. The appellate court remanded the case for further proceeding, including an assessment of whether the amount of the PTIN fee unreasonable exceeds the costs to the IRS to issue and maintain PTINs. Montrois, et al. v. United States, No. 17-5204, 2019 U.S. App. LEXIS 6260 (D.C. Cir. Mar. 1, 2019), vac’g,. and rem’g., Steele v. United States, 260 F. Supp. 3d 52 (D. D.C. 2017).
Sanders (and Democrat) transfer tax proposals. The Tax Cuts and Jobs Act (TCJA) increased the exemption equivalent of the federal estate and gift tax unified credit to (for 2019) $11.4 million. Beginning for deaths occurring and for gifts made in 2026, the $11.4 million drops to the pre-TCJA level ($5 million adjusted for inflation). That will catch more taxpayers. This is, of course, if the Congress doesn’t change the amount before 2026. S. 309, recently filed in the Senate by Presidential candidate Bernie Sanders provides insight as to what the tax rules impacting estate and business planning would look like if he (or probably any other Democrat candidate for that matter) were ever to win the White House and have a compliant Congress. The bill drops the unified credit exemption to $3.5 million and raises the maximum tax rate to 77 percent (up from the present 40 percent. It would also eliminate entity valuation discounts with respect to entity assets that aren’t business assets, and impose a 10-year minimum term for grantor retained annuity trusts. In addition, the bill would require the inclusion of a grantor trust in the estate of the owner and would limit the generation-skipping transfer tax exemption to a 50-year term. The present interest gift tax exclusion would also be reduced from its present level of $15,000.
These are just a snippet of the many developments in agricultural taxation and law recently. Of course, you can find more of these developments on the annotation pages of my website – www.washburnlaw.edu/waltr. I also use Twitter to convey education information. If you have a twitter account, you can follow me at @WashburnWaltr. On my website you will also find my CPE calendar. My national travels for the year start in earnest later this week with a presentation in Milwaukee. Later this month finds me in Wyoming. Also, forthcoming soon is the agenda and registration information for the ag law and tax seminar in Steamboat Springs, Colorado on August 12-14. Hope to see you at an event this year.
On Wednesday, I resume my perusal of the rental real estate exception of the passive loss rules. I get a break on the teaching side of things this week – it’s Spring Break week at both the law school and at Kansas State University.
Thursday, March 7, 2019
Tuesday’s post was the first installment in a series of blog posts on the passive loss rules of I.R.C. §469. In that post, I noted that under I.R.C. §469, a taxpayer is limited in the ability to use losses from passive activities against income from a trade or business that the taxpayer is engaged in. In that post, I noted that a passive activity includes trades and businesses in which the taxpayer does not materially participate. Active participation provides a limited ability to deduct losses.
While a rental activity is normally treated as “per se” passive by presumption, if the taxpayer is deemed to be a “real estate professional” then the presumption is overcome, and the taxpayer will be treated as non-passive if the taxpayer materially participates in the rental activity.
The rule that rents are presumed to be passive is also a concern because of the Net Investment Income Tax (NIIT). I.R.C. §1411. The NIIT imposes an additional tax of 3.8 percent on passive income, including passive rental income.
The real estate professional test of the passive loss rules – that’s the topic of today’s post.
History and Basics of the Rule
As noted in Tuesday’s post, the passive loss rules of I.R.C. §469 became effective for tax years beginning after December 31, 1986. As originally enacted, a passive activity was defined to include any rental activity regardless of much the taxpayer participated in the activity. This barred rental activities from being used to shelter the taxpayer’s income from other trade or business activity. Rental activities could often produce a tax loss particularly due to depreciation deductions while the underlying property simultaneously appreciated in value. The rule was particularly harsh on real estate developers with multiple development projects. One project would be developed and sold while another project would be rented out. In this situation, the developer had two activities - one that was the taxpayer’s trade or business activity (non-passive); and one that was a rental activity (passive). This produced a different result, for example, from what a farmer would achieve if the farmer lost money on the livestock side of the business while making money on the crop portion. In that situation, the livestock loss would offset the crop income.
To address this perceived inequity, the Congress amended the passive loss rules to provide a narrow exception to the per se categorization of rental activities as passive. Under the exception, a “real estate professional” that materially participates in a rental activity is not engaged in a passive activity. I.R.C. §469(c)(7). Thus, rental activities remain passive activities unless the taxpayer satisfies the requirements to be a real estate professional.
To be a real estate professional two tests must be satisfied: (1) more that 50 percent of the personal services that the taxpayer performs in trades or business for the tax year must be performed in real property trades or businesses in which the taxpayer materially participates; and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. I.R.C. §469(c)(7). If the two tests are satisfied, as noted above, the rental activity is no longer presumed to be passive and, if material participation is present, the rental activity is non-passive. I.R.C. §469(c)(7)(A)(i).
The issue of whether a taxpayer is a real estate professional is determined on an annual basis. See, e.g., Bailey v. Comr., T.C. Memo. 2001-296.
What is a Real Property Trade Or Business?
To qualify for the real estate professional exception, the taxpayer must perform services in a real property trade or business. Obviously, production agriculture involves farm and ranch land. This raises a question as to the types of business associated with farming and ranching that could be engaged in a real property trade or business for purposes of the passive loss rules. Under I.R.C. §469(c)(7)(C), those are: real property development; redevelopment construction; reconstruction; acquisition; conversion; rental; operation; management; leasing; or brokerage.
Mortgage brokers and real estate agents present an interesting question as to whether they are engaged in a real estate trade or business. In general, a mortgage broker is not deemed to be engaged in a real property trade or business for purposes of the passive loss rules. That’s the outcome even if state law considers the taxpayer to be in a real estate business. What the courts and IRS have determined is that brokerage, to be a real estate business, must involve the bringing together of real estate buyers and sellers. It doesn’t include brokering financial instruments. See, e.g., Guarino v. Comr., T.C. Sum. Op. 2016-12; C.C.A. 201504010 (Dec. 17, 2014). The definition of a real estate trade or business also does not include mortgage brokering. See, e.g., Hickam v. Comr., T.C. Sum. Op. 2017-66. But, if a licensed real estate agent negotiates real estate contracts, lists real estate for sale and finds prospective buyers, that is likely enough for the agent to be deemed to be in a real estate trade or business for purposes of the passive loss rules. See, e.g., Agarwal v. Comr., T.C. Sum. Op. 2009-29.
A licensed farm real estate appraiser might also be determined to be in a real estate trade or business if the facts are right. See, e.g., Calvanico v. Comr., T.C. Sum. Op. 2015-64. A real estate appraisal business involves direct work in the real estate industry. But, associated services that are only indirectly related to the trade or business of real estate (such as a service business associated with real estate) would not seem to meet the requirements of I.R.C. §469(c)(7). Indeed, this is the position the IRS has taken in its audit technique guide for passive activities. See IRS Passive Activity Loss Audit Technique Guide at www.irs.gov/pub/irs-mssp/pal.pdf
What about a taxpayer that works for a farm management company? The services of a farm management company are a bit different than a real estate management company that is engaged in the real estate business. See, e.g., Stanley v. United States, No. 5:14-CV-05236, 2015 U.S. Dist. LEXIS 153166 (W.D. Ark. Nov. 12, 2015), nonacq., A.O.D. 2017-07 (Oct. 16, 2017). But, perhaps services performed that directly relate to the real estate business would count – putting together rental arrangements, managing the leases, dealing with on-farm tenant housing, etc. Economic related services such as cropping and livestock decisions would seem to not be real estate related. In any event, the taxpayer would need to be at least a five percent owner of the farm management company for the taxpayer’s hours to count toward the I.R.C. §469(c)(7) tests. I.R.C. §469(c)(7)(D)(ii); Treas. Reg. §1.469-9(c)(5).
Importantly, a real property trade or business can be comprised of multiple real estate trade or business activities. Treas. Reg. §1.469-9(d)(1). This implies that multiple activities can be grouped together into a single activity. That is, indeed, the case. Treas. Reg. §1.469-4 allows the grouping of activities that represent an “appropriate economic unit.” Under that standard, non-rental activities cannot be grouped with rental activities. Treas. Reg. §1.469-9(g) allows a real estate professional to group all interests in rental activities as a single activity. If this election is made, the real estate professional can add all of their time spent on all of the rental activities together for purposes of the 750-hour test.
In Chief Counsel Advice 201427016 (Apr. 28, 2014), the IRS stated that the Treas. Reg. §1.469-9(g) aggregation election “is relevant only after the determination of whether the taxpayer is a qualifying taxpayer.” Thus, whether a taxpayer is a real estate professional for purposes of the passive loss rules is not affected by an election under Treas. Reg. §1.469-9(g). In other words, the election under Treas. Reg. 1.469-9(g) has no bearing on the issue of whether a taxpayer qualifies as a real estate professional – puts in more than 750 hours in real estate activities and satisfies the 50 percent test. See also Miller v. Comr., T.C. Memo. 2011-219. But, grouping can make it easier for the taxpayer to meet the required hours test of I.R.C. §469(c)(7) and be deemed to be materially participating in the activity.
Regroupings are not allowed in later years unless the facts and circumstances change significantly, or the initial grouping was clearly not appropriate. Treas. Reg. §1.469-9(d)(2).
The IRS has taken the position that only an individual can be a real estate professional for purposes of the passive loss rules. C.C.A. 201244017 (Nov. 2, 2012). That’s important as applied to trusts. Much farm and ranch land that is rented out is held in trust. That would mean that the only way the trust rental income would not be passive is if the trustee, acting in the capacity as trustee, satisfies the tests of I.R.C. §469(c)(7). The one federal district court that has addressed the issue has rejected the IRS position. Mattie Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003). The Tax Court agrees.
In Frank Aragona Trust v. Comr., 142 T.C. 165 (2014), a trust incurred losses from rental activities which the IRS treated as passive. The trust had six trustees – the settlor’s five children and an independent trustee. One of the children handled the daily operation of the trust activities and the other trustees acted as a managing board. Also, three of the children (including the one handling daily operations) were full-time employees of an LLC that the trust owned. The LLC was treated as a disregarded entity and operated most of the rental properties. The trust had essentially no activity other than the rental real estate. The IRS, in treating the losses as passive said that the trustees were acting as LLC employees and not as trustees. The Tax Court disagreed with the IRS position, finding that the trust materially participated in the rental real estate activities and that the losses were non-passive. The trustees, the Tax Court noted, managed the trust assets for the beneficiaries, and if the trustees are individuals and work on a trade or business as part of their duties, then their work would be “performed by an individual in connection with a trade or business.” Thus, a trust, rather than just the trustees, is capable of performing personal services.
The Tax Court’s position in Frank Aragona Trust could be particularly important in agriculture. A great deal of leased farm ground is held in trust. The trust will be able to meet the material participation standard via the conduct of the trustees. That will allow full deductibility of losses. In addition, the trust income will not be subjected to the additional 3.8 percent tax of I.R.C. §1411.
The real estate professional exception to the per se rule that rental activities are passive is an important one. The issue may occur quite often in agricultural settings. In the next post on Monday, we will dig a little further on the passive loss rules.
Tuesday, March 5, 2019
The passive loss rules have a substantial impact on farmers and ranchers and investors in farm and ranch land. Until 1987, it was commonplace for non-farm investors to purchase agricultural real estate and run up losses which were used to offset the investor's wage or other income. However, the Congress stepped-in and enacted the passive loss rules in 1986. I.R.C. §469. Those rules reduce the possibility of offsetting passive losses against active income unless the taxpayer materially participates in the activity.
A look at the passive loss rules and material participation – that’s the topic of today’s post.
The Basic Concept
The passive loss rules apply to activities that involve the conduct of a trade or business and the taxpayer does not materially participate in the activity or in rental activity on a basis which is regular, continuous and substantial. If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains).
For farmers, the passive loss rules are likely to come into play in situations where the farmer is a passive investor in a separate business venture apart from the farming operation. In that case, the losses from the venture cannot be used to offset the income from the farming operation. The rules also get invoked when a non-farmer loses money in an activity that is a purported farming activity.
Unless an investor or other individual can meet one of two critical tests, the passive loss rules apply. The first of these tests is the test of material participation. If an individual can satisfy the material participation test, then passive losses can be deducted against active income. If, for example, a physician is materially participating in a farming or ranching activity, the losses from the farming or ranching activity can be used as a deduction against the physician's income from the practice of medicine.
Does an agent’s activity count? An investor is treated as materially participating in an activity only if the person “is involved in the operation of the activity on a basis which is regular, continuous, and substantial.” I.R.C. §469(h)(1). In determining whether an individual taxpayer materially participates (or actively participates), the participation of the taxpayer's spouse is taken into account, whether or not they file a joint income tax return. In addition, while the statute refers to material participation by the taxpayer, it does not specifically bar imputation of the services of an agent or specifically embrace the rules of the self-employment tax statute (I.R.C. § 1402), which does bar the ability of a taxpayer to impute the of an agent. However, a Committee Report and the regulations state that activities of an agent are not attributed to an individual taxpayer and the individual must personally perform sufficient services to establish material participation. Indeed, an individual’s own participation is not taken into account if a paid manager participates in the activity and someone else performs services in connection with management of the activity which exceed the amount of service performed by the taxpayer. See, e.g., Robison v. Comm’r, T.C. Memo. 2018-88.
Satisfying material participation. Farm and ranch taxpayers can qualify as materially participating if they materially participated for five or more years in the eight-year period before retirement or disability. In addition, the material participation test is met by surviving spouses who inherit qualified real property from a deceased spouse if the surviving spouse engages in “active management.” C corporations are treated as materially participating in an activity with respect to which one or more shareholders, owning a total of more than 50 percent of the outstanding corporate stock, materially participates. Treas. Reg. §1.469-1T(g)(3)(i)(A). In other words, the corporation must be organized such that at least one shareholder materially participates, and the materially participating shareholders own more than 50 percent of the corporate stock. Estates and trusts, except for grantor trusts are treated as materially participating (or as actively participating) if a fiduciary meets the participation test. See, e.g., Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003); Aragona Trust v. Comr., 142 T.C. 165 (2014).
Regulations. In February 1988, the IRS issued temporary regulations specifying the requirements for the material participation test. Treas. Reg. 1.469-5T. These regulations have great relevance, especially for tenants renting agricultural real estate from the local physician, veterinarian or lawyer or any other non-farm investor. The temporary regulations lay out seven tests for material participation.
Under the first test, an individual is considered to be materially participating if the individual participates in the activity for more than 500 hours during the year. Treas. Reg. §1.469-5T(a)(1). This is a substantial amount of time; almost ten hours per week. In fact, this is more time than some tenants put into the operation on an annual basis. As a result, this test is exceedingly difficult for most investors to satisfy.
The second test involves situations where an individual's participation is less than 500 hours, but constitutes “substantially all of the participation” in the activity by all individuals during the year. Treas. Reg. §1.469-5T(a)(2). In other words, if the investor puts in less than 500 hours annually in the farming or ranching operation, but substantially all of the involvement comes from the investor, the material participation test will be satisfied. However, the investor cannot meet this test if there is a tenant involved, because a tenant will probably put more time in than the investor. Consequently, this test also tends to be difficult to meet.
Under the third test, an individual is considered to be materially participating if the individual puts more than 100 hours per year into the activity and the individual's participation is not less than that of any other individual. Again, if there is a tenant, this test is nearly impossible to meet because of the likelihood that the tenant will put more hours into the activity than the investor. Treas. Reg. §1.469-5T(a)(3).
The fourth test involves “significant participation.” An individual is treated as materially participating in significant participation activities if the individual's aggregate participation activities for the year exceed 500 hours. Treas. Reg. §1.469-5T(a)(4). A “significant participation activity” is a trade or business activity in which the individual participates for more than 100 hours for the taxable year. This is an aggregate test. For example, let us assume that an investor owns a farm, two fast food restaurants, and a convenience store. This rule permits an aggregation of all of those together, provided the investor puts in more than 100 hours in each activity. If the investor spends more than 100 hours in each activity, then each activity can be aggregated to see if the 500-hour test has been met. Thus, if an investor puts more than 100 hours into a farm activity, more than 100 hours into, for example, convenience store, and more than 100 hours into each of several restaurants, the total hours may exceed 500.
Under the fifth test the individual is treated as materially participating if the individual materially participated in the activity for any five of the ten taxable years immediately preceding the taxable year. Treas. Reg. §1.469-5T(a)(5). The idea behind this rule is that substantial involvement over a lengthy period indicates that the activity was probably the individual's principal livelihood. This is a very useful test for a retired farmer who has had several years of involvement.
The sixth test is for individuals involved in personal service activities. An individual is treated as materially participating in a personal service activity for a taxable year if the taxpayer materially participated in the activity for any three taxable years preceding the taxable year in question. This is a test solely for personal service activities. Treas. Reg. §1.469-5T(a)(6). Thus, it is a rule that can be used by taxpayer’s engaged in accounting, law practice, medicine and other professional services.
The seventh and final test is a “facts and circumstances” test. Treas. Reg. §1.469-5T(a)(7). This is the rule under which most farm investors try to qualify, and it requires that the taxpayer participate in the activity during the tax year on a basis that is regular, continuous and substantial. What a taxpayer does for any other purpose (such as material participation for Social Security purposes), does not count for purposes of the material participation test of I.R.C. §469. Treas. Reg. §1.469-5T(b)(2)(i). In addition, the facts and circumstances test cannot be satisfied unless the taxpayer participates more than 100 hours in the activity during the year as a threshold requirement. Treas. Reg. §1.469-5T(b)(2)(iii). Also, as noted above, if the taxpayer is represented by a paid manager, the taxpayer’s own record of involvement does not count. Treas. Reg. §1.469-5T(b)(2)(ii)(A). Thus, the involvement of a paid farm manager eliminates the possibility of the investor counting his or her own hours of participation.
Active participation. Farm landlords receiving crop share rent will likely have difficulty in satisfying any of the tests for material participation. However, if a taxpayer fails to meet the material participation test, there is a fallback test of active participation if the taxpayer owns at least 10 percent of the value of the interests in the rental activity and is not a corporation. I.R.C. §469(i). Active participation requires less than the material participation test, and allows the taxpayer to deduct up to $25,000 each year in losses from a rental real estate activity.
The IRS position is that a crop-share lease is a joint venture and not a rental real estate activity. Treas. Reg. § 1.469-1T(e)(3)(viii), Example (8). Thus, according to the IRS, a crop-share landlord will not qualify under the active participation test.
The active participation test is unavailable to taxpayers with adjusted gross income in excess of $150,000. As adjusted income exceeds $100,000, the $25,000 amount is phased-out over a $50,000 adjusted gross income (determined without regard to passive activity losses) range.
The passive loss rules are important in agriculture. While they operate to bar passive losses from offsetting passive income, material (or active) participation can suffice to allow full deductibility of losses. In the next post, we will dig deeper into the passive loss rules.
Friday, March 1, 2019
Donations to charity can provide a tax deduction for the donor. Normally, the tax deduction is tied to the value of the property donated to a qualified charity. That’s an easy determination if the gift is cash. But what if the gift consists of property other than cash? How is that valued for charitable deduction purposes?
Valuing non-cash gifts to charity – that’s the topic of today’s post.
When a charitable contribution of property other than money is made, the amount of the contribution is generally the fair market value (FMV) of the donated property at the time of the donation. Treas. Reg. §1.170A-1(c)(1). What is FMV? It’s “the price at which the property would change hands between a willing buyer and seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Treas. Reg. §1.170A-1(c)(2). Sometimes FMV is relatively easy to determine under this standard. Other times, it’s not as easy – especially if the non-cash gift is a unique asset. In that situation, the IRS has two approaches to arrive at FMV: the comparable sales method; and the replacement value of the donated property. In a relatively recent Tax Court case, these valuation approaches to a substantial non-cash donation to charity were on display.
In Gardner v. Comr., T.C. Memo. 2017-165, the petitioner was a big-game hunter that had been on numerous safaris and other big-game hunts around the world. In one two-year period he had been on over 20 safaris. Like many big-game hunters, he provided the meat from his kills to the local community and then had taxidermists prepare the hide for eventual display in the “trophy room” of his home. Some of the displays were full body mounts, others were wall hangings or rugs. These types of displays are the most attractive and desirable in the hunting business. His trophy room was, at one point, featured in a hunting publication, “Trophy Rooms Around the World.”
Ultimately, the petitioner downsized his collection by donating 177 of the “less desirable” pieces in his collection to a charity (an ecological foundation). None of the donated specimens were of “record book” quality. Before making the donation, he had the donated specimens appraised. Based on that FMV appraisal, he claimed a charitable deduction of $1,425,900. That figure was derived from his appraiser’s computation of the replacement cost of each donated item – what it could cost him to replace each item with an item of similar quality. Replacement cost was computed by projecting the out-of-pocket expenses for the petitioner to travel to a hunting site; take part in a safari; kill the animal; remove and preserve the carcass; ship the carcass to the U.S.; and pay for taxidermy services to prepay the specimen for display. The petitioner’s appraiser gave every one of the donated items a quality rating of “excellent” for specimen quality and taxidermy quality. For provenance, the appraiser listed the items as “meager.” The appraiser, however, did not provide any evidence for the rational of why he utilized the replacement cost approach.
On audit, the IRS valued the donated specimens at $163,045 based on their expert’s report. The expert appraiser for the IRS had been a licensed taxidermist for more than 30 years and was a certified appraiser specializing in taxidermy items. He characterized the donated items as mostly “remnants and scraps” of a trophy collection – what’s left over after mounting an animal or “what’s left over when you’re done mounting an animal.” He testified that there was an active market among taxidermists for such items to either complete projects or mount them for their own collections. That market, the IRS expert noted, has been expanded by the internet and allowed a ready determination of market value. Indeed, the IRS expert found 504 comparable sales transactions via traditional auctions and internet auction sites. This wasn’t the situation, the IRS expert asserted, where world-class trophy mounts were involved with a thin to non-existent market (which would support the use of the replacement cost approach). Thus, based on the comparable sale approach, the IRS arrived at the $163,045 value.
The matter ended up in the Tax Court, and the Tax Court first noted that it had previously determined how to value hunting specimens donated to charity in 1992. In Epping v. Comr., T.C. Memo. 1992-279, the Tax Court reasoned that if an active market exists, the general rule is to use comparable sales to arrive at a value of the donated property. The Epping case involved “an assortment of animal mounts, horns, rugs, and antlers.” The Tax Court in that case determined that there was an active market in hunting specimens with substantial comparable sales.” However, the Tax Court also noted that replacement cost is appropriate when the donated property is unique, and no evidence of comparable sales exists. Thus, to be able for a taxpayer to use replacement cost to value the donated items, the taxpayer must show that there is no active market for the comparable items and that there is a correlation between the replacement cost and FMV. That’s a tough hurdle to clear in many situations.
In the present case, the Tax Court, was persuaded by the IRS expert’s testimony that the 177 donated items were neither of “world-class” nor museum quality. Instead, the Tax Court agreed that they were mostly “remnants, leftovers, and scraps” of the petitioner’s collection. In addition, the Tax Court noted that the petitioner’s own testimony indicated that he wanted to “downsize” his collection by getting rid of unwanted items. The Tax Court also noted that photographs of the specimens provided by his expert indicated that the donated specimens were not high quality, and none were of record-book quality. In addition, the Tax Court noted that the IRS expert had established an active market for items similar to those the petitioner donated. Thus, the Tax Court determined that the specimens were commodities rather than collectibles and would be appropriately valued based on the market price for similar items – the IRS approach. To further support the use of the comparable sales approach, the Tax Court concluded that the petitioner did not really attempt to challenge the IRS expert’s data and didn’t introduce any evidence of market prices for comparable items. The petitioner failed to prove that the FMV of the 177 donated items exceeded the $163,045 value that the IRS established.
Valuing non-cash charitable gifts can be tricky. Establishing FMV of the donated property must be backed up with sufficient evidence that supports the valuation approach. Truly unique items that lack a ready market may be able to be valued under the replacement cost approach. A good appraiser goes a long way to making that determination. As the Tax Court stated, “To paraphrase Ernest Hemingway, there is no hunting like the hunting for tax deductions.”