Tuesday, April 30, 2019
A good number of the readers of this blog are tax practitioners. As a result, during tax season, significant developments tend to go unnoticed if they don’t directly impact client tax prep work currently. With today’s post, I take a brief look at what happened in federal tax while the tax season was raging on.
Some current developments in federal tax – that’s the topic of today’s post.
Obamacare Individual Mandate
For those of you who attended a tax seminar that I did last year, you heard me discuss the pending litigation concerning the constitutionality of Obamacare. Because Chief Justice Roberts hinged the Constitutionality of the law on the individual mandate (contained in I.R.C. §5000A) being a tax and, therefore, within the taxing authority of the Congress, if that tax is eliminated the law becomes Constitutionally suspect. National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012). At least that’s the argument that I mentioned was being made in court and that we could expect a federal court decision on that issue. The reason for the court challenge, of course, was because of the elimination by the Tax Cuts and Jobs Act (TCJA) of the individual mandate “tax” effective for months beginning after 12/31/18. Indeed, that opinion came out in late 2018 before the tax season began in Texas v. United States, No. 4:18-cv-00167-O, 2018 U.S. Dist. LEXIS 211547 (N.D. Tex. Dec. 14, 2018). The court noted that the payment was distinct from the individual mandate and determined that the individual mandate was no longer constitutional as of 1/1/2019 because it would no longer trigger any tax. In addition, because the individual mandate was the linchpin of the entire law, the provision could not be severed from the balance of the law. As a result, the court reasoned, as of January 1, 2019, Obamacare no longer has any constitutional basis and is invalidated as unconstitutional. The case is on appeal.
Since this ruling in December, two other courts have determined that the individual mandate is a tax. In re Cousins, No. 18-10739, 2019 Bankr. LEXIS 1156 (Bankr. E.D. La. Apr. 10, 2019), held that the provision was a tax for purposes of the bankruptcy Code. The Bankruptcy Code, in accordance with 11 U.S.C. §1328(a), allows a debt to be discharged unless it is listed as a priority claim in 11 U.S.C. §507(a). Priority taxes cannot be discharged, but a penalty amount is dischargeable. In this case, the debtors (a married couple) filed a proof of claim that included a $2,085 mandate assessment which the debtors claimed was dischargeable as a penalty. The IRS disagreed, citing National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012) in which the U.S. Supreme Court concluded that the assessment was a tax for constitutional purposes and cited the Bankruptcy Code in making its determination. The court also found that refusing to purchase health insurance and instead paying an assessment didn't constitute an "unlawful act," which was a strong indication that the individual mandate was not a penalty. In addition, the legislative history implied that the individual mandate was a tax since Congress referred multiple times to how it would raise revenue, the court said. Thus, the assessment was a nondischrgeable tax and was entitled to priority under 11 U.S.C. §507(a)(8) and the court denied the debtors’ objection to the IRS claim. The same result was reached in United States v. Chesteen, No. 18-2077, 2019 U.S. Dist. LEXIS 29346 (E.D. La. Feb. 25, 2019).
IRS Provides “Guidance” on How Farm Income Averaging Interacts With the QBID
In an item posted to its website shortly after the tax filing deadline, the IRS attempted to provide guidance on the Qualified Business Income Deduction (QBID) and a farmer (or fisherman) that makes an election under I.R.C. §1301 to average income. Under a farm income averaging election, a farm taxpayer’s income tax liability is the sum of the I.R.C. §1 tax computed on taxable income reduced by “elected farm income” (EFI) plus the increase in tax imposed by I.R.C. §1 that would result if taxable income for the three prior years were increased by an amount equal to one-third of the EFI. The IRS has stated that "[i]n figuring the amount [of the]... Qualified Business Income Deduction, income, gains, losses, and deductions from farming or fishing should be taken into account, but only to the extent that deduction is attributable to your farming or fishing business and included in elected farm income on line 2a of Schedule J (Form 1040)."
This appears to be saying that if an income averaging election is made, the taxpayer must use EFI to calculate the QBID. With the “guidance,” the IRS appears to be attempting to construe I.R.C. §199A(c)(3)(A)(ii) in this situation. The IRS may need to issue a further clarification. Elected Farm Income May Be Used To Figure Qualified Business Income Deduction, IRS Website, Apr.19, 2019
S Corporations and the Self-Employed Health Insurance Deduction
Just a few days ago, the IRS confirmed the position that many tax practitioners believed was correct with respect to S corporations and the deduction for self-employed health insurance. I.R.C. §1372 says that, for purposes of applying the provisions of the I.R.C. that relate to employee fringe benefits, an S corporation is treated as a partnership. Likewise, any 2 percent (as defined in I.R.C. §318 as owning more than two percent of the corporate stock) S corporation shareholder is treated as a partner in the partnership in accordance with I.R.C. §1372. An S corporation can deduct the cost of accident and health insurance premiums that the S corporation pays for or furnishes on behalf (i.e., reimburses) of its 2 percent shareholders. The two percent shareholders must include the amounts in gross income in accordance with Notice 2008-1, 2008-2 IRB 251 (i.e., the S corporation reports the amounts as wages on the shareholder’s W-2) provided that the shareholder meets the requirements of I.R.C. §162(l) and the S corporation establishes the plan providing medical care coverage.
Under the facts of C.C.A. 2019012001 (Dec. 21, 2019), a taxpayer owned 100 percent of an S corporation which employed the taxpayer’s family member. The family member is a two-percent shareholder under the attribution rules of I.R.C. §318. The S corporation provides a group health plan for all employees, and the amounts paid by the S corporation under the plan are included in the family members gross income. Provided the requirements of I.R.C. §162(l) are satisfied, the IRS determined that the family member could claim a deduction for the amounts the S corporation paid. Thus, the family member could convert what might be a nondeductible expense (because of either the 10 percent floor for medical expenses or because the family member takes the standard deduction) into an above-the-line deduction.
SALT Deduction Guidance
In early April, the IRS provided guidance on how the $10,000 limitation on the deduction of state and local taxes (SALT) under the TCJA and I.R.C. §280A work in conjunction with each other. For a taxpayer with SALT deductions at or exceeding $10,000, or who chooses to take the standard deduction, none of the SALT relating to the taxpayer’s business use of the home are treated as expenses under I.R.C. §280A(b). However, expenses relating to the taxpayer’s exclusive use of a portion of the taxpayer’s personal residence for business purposes remain deductible under I.R.C. §280A(b) or (c) or under another exception to the general rule of disallowance in I.R.C. §280A. The same rationale applies to other deductions that are subject to various limitations or disallowances, including home mortgage interest and casualty losses. For instance, interest on a mortgage balance exceeding the acquisition debt limitations becomes an I.R.C. §280A(c) limited expense when claiming a home office deduction. IRS Program Manager Technical Advice 2019-001 (Dec. 7, 2018).
Ministerial Housing Allowance
In mid-March, the appellate court issued it’s decision on the Constitutionality of the ministerial housing allowance of I.R.C. §107(2) that excludes from gross income a minister's rental allowance paid to the minister as part of compensation for a home that the minister owns. The plaintiff, an atheist organization, challenged the constitutionality of the provision. The trial court agreed, but the appellate court reversed. The appellate court noted that while the exclusion of housing provided for the convenience of the employer provision was not made available to ministers of the gospel, the Congress soon provided an exclusion for church-provided ministerial housing as well as the cash allowance provision of I.R.C. §107(2) at issue in this case. The appellate court determined that the provision was simply an additional provision providing tax exemption to employees that having a work-related housing requirement. The appellate court viewed a categorial exemption for ministers as requiring much less government “entanglement” in religion than lumping ministers under the general employer-provided housing exclusion of I.R.C. §119. The appellate court also noted the long history of tax exemption for religious organizations, and deemed this long history of significance and that I.R.C. §§107(1)-(2) continued that history. Gaylor, et al., v. Mnuchin, No. 18-1277 (7th Cir. Mar. 15, 2019), rev’g., Gaylor v. Mnuchin, 16-cv-215-bbc, 2017 U.S. Dist. LEXIS 165957 (W.D. Wisc. Oct. 6, 2017).
That’s just a bit of what happened in federal tax during tax season while many of you had your head down plowing through this trying tax season.
Friday, April 26, 2019
This summer, Washburn University School of Law will be sponsoring a two-day Farm and Ranch Tax and Estate/Business Planning Seminar in Steamboat Springs, CO. The event will be on August 13-14 at the Steamboat Grand Hotel. This seminar presents an extensive, in-depth coverage and analysis of tax and estate/business problems and issues involving farm and ranch clients over two-days. Attendance can either be in-person or via online over the web.
In today’s post, I outline the coverage of the topics at the seminar and the presenters as well as related information about registering. Steamboat Springs – Summer of 2019!
Topics and Speakers
On Day 1 (August 13), Paul Neiffer (CPA with CliftonLarsonAllen and author of the FarmCPA blog) will be presenting with me. We will start the day with a discussion of the I.R.C. §199A (QBI) deduction. Many issues surfaced during the 2018 tax filing season concerning the QBI deduction. The IRS produced contradictory statements concerning the deduction and the tax software companies also struggled to keep the software up with the developments. During this opening session, Paul and I will walk through QBI deduction issues as applied to farm and ranch clients and address many questions with detailed answers – a very real “hands-on” approach that is practitioner-friendly.
During the next session on Day 1, I Paul and I will take two hours to cover a potpourri of selected farm income tax topics. Those issues that are the present “biggies” will be addressed as well as current issues that practitioners are having with the IRS involving ag clients.
After lunch on Day 1, I will highlight some of the most important recent cases and rulings for farm and ranch taxpayers, and what those developments mean as applied on the farm and in the farm economy. Any new legislation will also be addressed, whether it’s income tax or other areas of the law (such as bankruptcy) that impact ag clients.
We will then devote an hour to common depreciation issues and how the rules have changed and are to be applied post-TCJA. What are the best depreciation planning techniques? We will work through the answers.
Following the afternoon break, I will dive into the passive loss rules. What do they mean? How do they apply to a farm client? How do they interact with the QBI deduction? What is a real estate professional? How to the grouping rules work? These questions (and more) will be answered and numerous examples will show how the rules work in various contexts.
Day 1 finishes out with Paul covering tax and planning issues associated with the 2018 Farm Bill and the choices farm clients have and how the new rules work. I will then cover the tax rules associated with ag disasters and casualties. There are many of those issues for clients that will show up during the 2019 tax filing season, especially for farm/ranch clients in the Midwest and Plains states.
On Day 2, our focus turns to farm and ranch estate and business planning. I will begin the day with an update of the key recent developments that impact the estate and succession planning process. What were the key cases of the past year? What about IRS rulings and pronouncements? I will cover those and show you how they apply to your clients.
Day 2 then continues with a key session on how to use estate planning concepts to minimize family disharmony. This session is presented by Tim O’Sullivan with Foulston Siefken LLP in Wichita, KS. Tim has a broad level of experience in estate planning and the handling of decedent’s estates. This is a “must attend” session for estate planners and deals with a topic that is often overlooked as an element in putting together a successful estate and business transition plan.
After the morning break on Day 2, I will cover the tax and legal issues associated with the use of trusts. Trusts are an often-used tool for farm and ranch clients, but what is the correct type for your client? The answer to that question is tied to the facts. Also, can a state tax a trust beneficiary or the trust itself if there isn’t any physical connection with the state? It’s an issue presently before the U.S. Supreme Court. By the time of the seminar, we will likely have an answer to that question.
How does the TCJA impact charitable giving? What are the new charitable planning techniques? What factors are important? I will address these questions and more in the session leading up to lunch.
After the lunch break on Day 2, I will deal with an unfortunate, but important topic- what is appropriate estate and business planning in second marriage situations? If the plan doesn’t account for this issue, significant disruptions can occur, and expectations may not be met. This is an important session dealing with a topic that tends to be overlooked.
I will then provide a breather from some heavy topics with a lighter (and fun) one – what are common estate and business planning mistakes? What classic situations have you dealt with in your practice over the years? Mistakes are frequent, but some seem to occur over and over. Can they be identified and prevented? That’s the goal of this session.
Tim O’Sullivan then returns for another session. This time, Tim does a deep dig into long-term health care planning. How can farm and ranch assets and resources be preserved? What are the applicable rules? What if only one spouse needs long-term care? Should assets be transferred? If so, to whom? This is a very important session designed to give you the tools you need for your long-term care planning toolbox.
Day 2 finishes with a key session by Stan Miller on how estate and business planning concepts can be used to help make sure the family farm survives for families that want it to survive as a viable economic unit. Stan is a founder of WealthCounsel, LLC and a principal in the company. Stan has a long background in estate and business planning. He is also a partner with ILP + McChain Miller Nissman in Little Rock, Arkansas. This session is a great capstone session for the day that will bring the day’s discussion together and get down to how the concepts discuss throughout the day can be used to help the farming and ranching business of a client survive the ups and downs of the economy, as well as family situations.
The seminar will be held on Tuesday and Wednesday, August 13-14 at the Steamboat Grand Hotel, in Steamboat, Colorado. It is co-sponsored by the Kansas State University Department of Agricultural Economics and WealthCounsel, LLC. You can find more registration information here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
On another note, on Monday, August 12, also in Steamboat, I will be participating in another seminar (also in Steamboat Springs) sponsored by the Colorado Cattlemen’s Agricultural Land Trust, the Eagle Valley Land Trust, and the Yampa Valley Land Trust. Half of the day will concern legal issues associated with conservation land trusts. The other half of the day will address real estate issues associated with conservation land trusts. These issues are very important in many parts of the country in addition to Colorado. As further details are provided, I will pass those along. This all means that there will be three full days of tax and legal information available this coming August in Steamboat Springs.
As I noted above, the seminar can be attended either in-person on online via the web. Registration will open up soon, so get your seat reserved. Steamboat Springs, CO is a beautiful area on the western slope of the Colorado Rockies.
Hope to see you there!!
Wednesday, April 24, 2019
Recently, it was reported that astronomers captured the first ever images of a black hole – an abyss they say that is so deep that not even light can escape it. Tax law has its own “black-hole.” It has to do with tax refund claims. But, an appellate court has found light coming from this tax “black- hole.” In addition, the manner in which the appellate court decided the case may shed light on how courts could construe unclear statutory provisions of the Tax Cuts and Jobs Act (TCJA).
Refund claims and statutory construction – these are the topics of today’s post.
The Tax Court has jurisdiction to determine the amount of any overpayment of tax if the taxpayer paid the amount to be refunded within a “look-back” period. I.R.C. §6512(b)(3)(B). That “look-back” period is specified as three years after the return was filed or two years after payment. I.R.C. §6511(b)(2). Wait too long to file or pay and it may be too late. In addition, the flush language (language not accompanied by a number or letter and is flush against the margin) at the end of I.R.C. §6512(b)(3)(B) says that, “In a case described in subparagraph (B) where the date of the mailing of the notice of deficiency is during the third year after the due date (with extensions) for filing the return of the tax and no return was filed before such date, the applicable period under subsections (a) and (b)(2) of [I.R.C. §6511] shall be 3 years.”
Confused? Let’s take a look at how this provision was applied in a recent case.
In Borenstein v. Comr., No. 17-3900, 2019 U.S. App. LEXIS 9650 (2d Cir. Apr. 2, 2019), rev’g., 149 T.C. 263 (2017), the taxpayer’s return for 2012 was due on April 15, 2013. At the taxpayer’s request, she received a six-month extension of time to file the return. That made the due date October 15, 2013. But, she still had to pay. When an extension of time to file is granted, that doesn’t extend the time to pay. Thus, she made several tax payments for 2012 totaling $112,000 that were all deemed to be made on April 15, 2013 in accordance with I.R.C. §6513. However, she didn’t file the return by October 15, 2013. In fact, she didn’t file a return for the next 22 months. That got the attention of the IRS. IRS then sent the taxpayer a statutory notice of deficiency (SNOD) on June 19, 2015, for her 2012 return. She then filed her 2012 return on August 29, 2015. On that return, she reported a tax liability of $79,559. The IRS agreed that the $79,559 was the taxpayer’s correct tax liability and that she had overpaid by $32,441. But, the kindler, gentler IRS said it was so sorry that it couldn’t issue her a credit or refund of the $32,441 because she made the overpayment outside the applicable look-back period tied to the SNOD. According to the IRS, the parenthetical phrase "with extensions" contained in the statute modified "due date." That meant, according to the IRS, the "due date (with extensions) for filing the return of tax" was October 15, 2013, pursuant to the automatic extension that the taxpayer received to file her 2012 return. Thus, the "third year" after that date, the IRS said, began on October 15, 2015. However, the IRS mailed the SNOD on June 19, 2015 – during the second year and not the third year "after the due date (with extensions) for filing the return." In addition, the IRS claimed, the last sentence of I.R.C. §6512(b)(3) did not apply. In essence, the parties were arguing over what “with extensions” means in I.R.C. §6512(b)(3) in terms of whether the Tax Court had jurisdiction to authorize a refund to the taxpayer.
The Tax Court, agreeing with the IRS, trotted out the statutory language of I.R.C. §6512(b)(3), which says the Tax Court has jurisdiction to order a refund of overpayments made during the three years immediately preceding the mailing of the notice of deficiency (i.e., a three‐year look‐back period) if the taxpayer failed to file a return before the mailing of the notice of deficiency and “the date of the mailing of the notice of deficiency is during the third year after the due date (with extensions) for filing the return of tax.” The Tax Court held that “(with extensions)” was unambiguous and modified only “due date” and had the effect of delaying by six months the beginning of the “third year after the due date.” The flush language and it’s three-year look-back period didn’t apply. That meant that there were only two years remaining from the date the SNOD was issued. Thus, the taxpayer’s overpayment was outside the two-year look-back by two months and the Tax Court determined it didn’t have jurisdiction to order the refund. Remember, there was no question the taxpayer was entitled to the refund. The IRS was taking the position that the Tax Court couldn’t order the IRS to issue the refund and the Tax Court agreed. The tax black-hole!
On appeal, the U.S. Court of Appeals for the Second Circuit reversed. The appellate court held that “with extensions” in I.R.C. §6512(b)(3) extended by six months the “third year after the due date.” Thus, the look-back period was three years rather than two and the Tax Court had jurisdiction to order the refund. Importantly, the appellate court said that I.R.C. §6512(b)(3) was unclear and, as a result, legislative history should be examined. That history, the appellate court determined, was in the taxpayer’s favor and that uncertain statutory language should be resolved against the government. The flush language, the appellate court noted, was intended to increase the Tax Court’s jurisdiction to order refunds to taxpayers that didn’t file a return before the mailing of the SNOD. No more black-hole.
Application to the TCJA?
Does Borenstein have any application to the tax provisions contained in the TCJA. It could. As noted, the appellate court said that uncertain tax provisions are to be construed against the government. There are more than a few unclear provisions in the TCJA. Even the IRS is struggling to come up with consistent interpretations of various TCJA provisions. In addition, there is very little legislative history concerning the bulk of the TCJA provisions. That could ultimately work in taxpayers’ favor if future courts construing TCJA provisions take the same position on statutory construction as did the appellate court in Borenstein.
The refund black-hole issue has been the subject of a couple of cases decided in recent months. At least in the Second Circuit the black-hole has disappeared. That’s Connecticut, New York and Vermont. The Borenstein decision is persuasive authority, but not binding, on the IRS outside the Second Circuit.
Monday, April 22, 2019
Last week’s post on the self-rental rule of Treas. Reg. §1.469-2T(f)(6) generated a lot of interest. As noted in that post, the self-rental rule bars a taxpayer with passive losses from artificially creating passive income from another activity to offset the passive losses. One way to potentially do this is to self-rent property. Questions were raised as to the rule’s application to S corporations. In addition, there were additional questions raised as to how the rule applied with respect to the net investment income tax (NIIT) of I.R.C. §1411 and whether self-rentals are eligible for a qualified business income deduction (QBID) under I.R.C. §199A.
Digging a bit deeper on the self-rental rule – it’s the topic of today’s post.
In general. In prior posts last year and earlier this year, I wrote on the various aspects of the QBID. The QBID was created under the Tax Cuts and Jobs Act and is effective for tax years beginning after 2017 and before 2026. The QBID is a 20 percent deduction for noncorporate taxpayers against qualified business income (QBI). QBI is the net amount of items of income, gain, deduction and loss with respect to a trade or business. A qualified trade or business is any trade or business other than a specified service trade or business (SSTB) or the business of performing services as an employee. An SSTB is a trade or business involving performance of services in the field of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. Taxpayers who own an SSTB may still qualify for the deduction if a taxpayer’s taxable income (for 2019) does not exceed $321,400 for a married couple filing a joint return, or $160,700 for all other taxpayers except that married filing separate taxpayers have a $160,725 threshold.
Rental activities. To be eligible for the QBID, a rental activity must rise to the level of trade or business in accordance with I.R.C. §162. That is a different (and more stringent) standard than that utilized for purposes of the passive loss rules of I.R.C. §469, and it requires regularity and continuity in the activity. There are many decided cases involving the issue of whether a trade or business exists under the I.R.C. §162 standard with the courts utilizing numerous factors such as the type and number of properties rented; how involved the taxpayer is in the business; whether any ancillary services are provided under the lease and, if so, the type; and, the type of the lease. These factors are also listed in the preamble to the I.R.C. §1411 regulations.
In August of 2018 QBID proposed regulations were released. The proposed regulations defined “self-rentals” as a “trade or business.” Thus, the income from a self-rental will qualify for the QBID if the self-rental is being leased through a passthrough business that is under “common control.” Common control is necessary to combine rentals with other business activities and is defined when the same person or group, directly or indirectly own 50% or more of each trade or business.
Seth Poole is the sole owner of an S corporation that is engaged in manufacturing widgets. Seth also owns an office building that he holds in his single member limited liability company (LLC). The LLC leases the office building to the S corporation under a triple-net lease (a lease agreement where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees such as rent, utilities, etc.). Because the office building is leased between entities that are under common control, and the S corporation is carrying on a trade or business, the triple-net lease activity qualifies as eligible for the QBID.
The “takeaway” from the proposed regulations was that self-rentals between entities that are under common control can produce a significant QBID.
In mid-January of 2018, the Treasury released the QBID final regulations. Issued along with those final regulations was Notice 2019-07 providing safe harbor rules for rental activities on the trade or business issue. In essence, to qualify for the safe harbor, a rental real estate activity is a QBI-qualifying trade or business under I.R.C. §199A if the taxpayer provides at least 250 hours of services during the tax year. But, it is important to remember that the safe-harbor is just that – a safe-harbor. A rental activity can qualify as an I.R.C. §162 trade or business without meeting the safe harbor requirements if the facts and circumstances support such a finding.
Under the final regulations, a self-rental constitutes an I.R.C. §162 trade or business for QBID purposes if the rental involves commonly controlled entities (either directly or via attribution under I.R.C. §§267(b) or 707(b)) where the self-rental income is not received from a C corporation. The final regulations also bar taxpayers from shifting SSTB income to non-SSTB status by using a self-rental activity where property or services are provided to an SSTB by a trade or business with common ownership. Under the rule, a portion of the trade or business that provides property to the commonly owned SSTB is treated as part of the SSTB with respect to the related parties if there is at least 50 percent common ownership.
A group of CPAs own a building. They lease 80 percent of the building space to the CPA firm and 20 percent of the building to an unrelated chiropractor. The 20 percent would be classified as non-SSTB income while the 80 percent would be treated as SSTB income. The general rule is that a rental real estate trade or business is not treated as an SSTB, subject to the taxable income limitations. However, that rule changes if there is common ownership exceeding 50 percent. If there is, the rental income attributable to the commonly controlled SSTB is treated as if it were SSTB income.
Even though the passive loss rules of I.R.C. §469 don’t specify that they apply to S corporations, the Tax Court has held that the self-rental rule applies to rentals by S corporations. In Williams v. Comr., T.C. Memo. 2015-76, the taxpayers (a married couple) owned 100 percent of an S corporation and 100 percent of a C corporation. The husband worked full-time for the C corporation during 2009 and 2010, and materially participated in its activities. Neither of the taxpayers materially participated in the S corporation or the rental of commercial real estate to C corporation. They also were not engaged in a real estate trade or business. In 2009 and 2010, the S corporation leased commercial real estate to the C corporation so that the C corporation could use it in its business. For those years, the S corporation had net rental income that the taxpayers reported as passive income on Schedule E which they then offset with passive losses. The IRS disagreed and recharacterized the rental income as non-passive under the self-rental rule.
In upholding the IRS position, the Tax Court determined that passthrough entities are subject to I.R.C. §469 (which included the taxpayers’ S corporation) even though not specifically mentioned by the statute. They did not need to be mentioned, the Tax Court reasoned, because they were not taxpayers. The Tax Court also rejected the taxpayers’ argument that the self-rental rule didn’t apply because the S corporation did not participate in the C corporation’s trade or business. It was enough that the husband personally provided material participation in the C corporation’s business to trigger the application of the self-rental rule. The rental income from the lease was non-passive.
The 3.8 percent NIIT applies to taxpayer’s with passive income that exceeds $250,000 on a joint return ($125,000 married filing separately; $200,000 for other filing statuses). Generally, the passive loss rules apply in determining whether an I.R.C. §162 trade or business is passive for NIIT purposes. Thus, if a taxpayer has rental income from an activity in which the taxpayer materially participates, the NIIT will not apply. But, what about the self-rental recharacterization rule? Treas. Reg. §1.1411-5(b)(2) specifies that, “To the extent that any income or gain from a trade or business is recharacterized as “not from a passive activity” by reason of . . . §1.469-2(f)(6), such trade or business does not constitute a passive activity . . . with respect to such recharacterized income or gain.”
Thus, if the self-rental recharacterization rule applies, it will cause the trade or business at issue to not be passive for NIIT purposes only with respect to the recharacterized income or gain. Treas. Reg. §1.1411-5(b)(2)(iii). When gross rental income is treated as not being derived from a passive activity because of a grouping a rental activity with a trade or business activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business. Thus, the NIIT would not apply. Treas. Reg. §1.1411-4(g)(6)(i).
For purposes of the NIIT, the self-rental rule is applied on a person-by-person basis. Thus, there can be situations involving multiple owners in a rental entity where some will be subject to the NIIT and others who will not be subject to the NIIT based on individual levels of participation in the activity.
The self-rental rules involve numerous traps for the unwary. For taxpayers with such scenarios, seeking competent tax counsel is a must.
Thursday, April 18, 2019
In recent weeks, I have written a couple of posts on various aspects of the passive loss rules contained in I.R.C. §469. Indeed, over the past two years, I have written six posts on the various aspects of the passive loss rules and their application to farm and ranch taxpayers. With today’s post, I add to those numbers by examining another aspect of the passive loss rules and how it applies to a common tax and business planning technique of farmers and ranchers – renting the farm/ranch land to the farm/ranch operating entity.
The “self-rental” limitation of the passive loss rules – it’s the topic of today’s post.
Passive Loss Rules - Basics
As noted in prior posts, to deduct passive losses (the amount by which the taxpayer’s aggregate losses from all passive activities for the tax year exceed aggregate income from those activities), an investor must have passive income. Stated another way, a passive activity loss can only offset passive income (with a few exceptions). The rule makes it quite difficult for a taxpayer to deduct passive losses unless they have another activity that is generating passive income.
Avoiding Passive Losses
Materially participate. There are two ways to approach the limitation of passive loss rules. One is to not be engaged in passive activities. A passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not materially participate. I.R.C. §469(c). Under the general rule, rental activities are passive. I.R.C. §469(c)(2). But, as noted in prior posts, there are exceptions. In addition, the activity is not a passive activity if the taxpayer is involved in it on a basis that is regular continuous and substantial. Basically, the taxpayer has to be involved in the daily management of the activity for a sufficient amount of time. The regulations provide seven tests for material participation. Treas. Reg. §1.469-5T(a)(1)-(7).
Create passive income and the risk of recharacterization. The other approach is be involved in activity that generates passive income that could then be offset by passive losses from another activity. Indeed, when the passive loss rules became law, there was immediate interest in creating what came to be known as passive income generators (PIGs). These are investment activities that throw off passive income, allowing the investor to match the passive income from the activity against passive losses. The IRS anticipated this and published regulations in the mid-1980's that recharacterized, or gave the IRS the power to recharacterize, passive income as non-passive income which was ineligible to offset passive losses. This became known as the “slaughter of pigs.” There are ten categories of recharacterization.
Bare land leases. One recharacterization rule applies to bare land leases. Treas. Reg. §1.469-2T(f)(3). Under this recharacterization rule, net income from a rental activity is considered not from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Id. The rule converts both net rental income and any gain on disposition from passive income to portfolio income (i.e., income from investments, dividends, interest, capital gains). But, the recharacterization rule only applies if there is net income from the rental activity. If there is a loss, the loss remains passive.
Example: Dr. Sawbones owns interests in multiple limited partnerships that have suspended losses. In an attempt to use those losses, Sawbones bought farmland for $400,000. $100,000 of the purchase price was allocated to fences, tile lines, grain bins and other depreciable property. Sawbones cash leased the land to his cousin via a cash rent lease in an attempt to generate passive income that he could offset with the suspended passive losses. However, because only 25 percent of the unadjusted basis is attributable to depreciable property, the cash rent income is recharacterized (for passive loss rule purposes) as portfolio income and will not offset the suspended passive losses from the limited partnerships. However, if the cash rent produces a net loss after taxes, interest and depreciation, the loss is a passive loss. This is not the result that Sawbones was hoping to achieve. The regulation has been upheld as valid. See, e.g., Wiseman v. Comr., T.C. Memo. 1995-303.
Self-rentals. Farmers and ranchers sometimes structure their businesses in multiple entities for estate and business planning (and tax) purposes. Such a structure may involve the individual ownership of the land that is then rented to the operating entity that the landlord also has an ownership interest in. Alternatively, the land may be held in some type of non-C corporation entity and rented to the operating entity. If the land lease does not involve the landlord’s material participation and the rental amount is set at fair market value (or slightly less), self-employment tax is avoided on the rental income even though the landlord materially participates in the operating entity as an owner. See Martin v. Comr., 149 T.C. 293 (2017). However, it’s also a classic self-rental situation that trips another recharacterization rule for passive loss purposes. Under this rule, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates. Treas. Reg. §1.469-2(f)(6). But, just like the recharacterization rule mentioned above for bare land leases, recharacterization only applies if there is net income from the self-rental activity. If a loss occurs, the loss remains passive. While an exception exists for rentals in accordance with a written binding contract entered into before February 19, 1988, that lease must have been a rather long-term lease at the time it was entered into for the grandfathering provision to still apply. Treas. Reg. §1.469-11(c)(1)(ii). It’s not possible to renew or draft an addendum to the original lease and come within the exception. See, e.g., Krukowski v. Comr., 114 T.C. 366 (2000), aff’d., 239 F.3d 547 (7th Cir. 2002). It also applies to S corporations. Williams v. Comr., No. 15-60341, 2016 U.S. App. LEXIS 1756 (5th Cir. Feb. 5, 2016), aff’g., T.C. Memo. 2015-76.
Example: For estate and business planning purposes, Mary put most of her farmland in an entity that she is the sole owner and employee of. Mary continued to own her livestock buildings, a machine shed and additional farmland, and rented them to the entity under a cash lease. Mary reported the rental income on Schedule E (Form 1040). However, because the rental income is derived from a business in which Mary materially participates, she cannot carry the rental income to Form 8582 (the passive activity loss Schedule) within her Form 1040. Instead, the net rental income is treated as coming from a non-passive activity. Mary will have to carry the net rental income from Schedule E directly to page one of her Form 1040. If Mary has passive losses from other sources, she will not be able to use those losses to offset the rental income.
It’s not possible to make a grouping election to overcome the self-rental regulation. See, e.g., Carlos v. Comr., 123 T.C. 275 (2000). As I noted in a prior post on the passive loss rules, a taxpayer can make an election to group multiple rentals as a single activity for passive loss rule purposes if the rental activities represent an appropriate economic unit. Treas. Reg. §1.469-4(c). But, even with such a grouping election the self-rental rule will still apply.
Example: Bill and Belinda are married and file a joint return. They own two tracts of farmland and cash lease each tract to the farming entity (an S corporation) that they own and operate. One of the tracts generates cash rental income of $200,000. The other tract produces an $80,000 loss. On their Schedule E for the tax year, they group the two tracts together as a single activity with the result that the net rental income reported is $120,000. Under the self-rental regulation, the IRS could separate the two rental tracts with the result that the $200,000 of income from one tract is recharacterized as non-passive and the $80,000 loss remains passive and cannot offset the $200,000 income. The $80,000 loss will be a suspended passive activity loss on Form 1040.
One option might be for Bill and Belinda to group the land rental activity that produces a loss with their operating entity. They can do that if the rental activity is “insubstantial” in relation to the business activity. Treas. Reg. §1.469-4(d)(1). In addition, they could group the rental activity that produced a loss with the operating entity (business activity) if they each have the same percentage ownership in the operating entity that they do in the rental activity. Such a grouping will result in the rental activity loss not being passive if they materially participate in the operating entity.
One more point on grouping – can a self-rental be grouped (“aggregated”) with the farming entity to maximize an I.R.C. §199A deduction? I.R.C. §199A is the new 20 percent deduction available for sole-proprietors and pass-through businesses on qualified business income. The answer is that as long as the farming entity and the land rental are part of a common group and have the same tax year, the rent will be aggregated with the farm income. That can optimize the use of the 20 percent deduction.
The passive loss rules are tricky. The cases are legion. Rentals are tricky, and the IRS can recharacterize rental activities to eliminate hoped-for passive income generators. Make sure you understand how the rules apply.
Tuesday, April 16, 2019
When we think of the Constitution, we tend to think of freedom of religion or freedom of the press. Maybe due process or equal protection comes to mind. Hardly ever does the right to not have soldiers quartered in our homes during peace time without consent ever cross one’s mind. Neither does soil erosion. But, is there a connection?
Soil erosion and the Constitution – that’s the topic of today’s post.
In terms of quantity, sediment - the soil or mineral material transported by water and deposited in streams or other bodies of water - is the worst pollutant of the nation's waters. While the non-farm media tends to pin the blame on agriculture, and it is true that a significant portion of it results from soil erosion of farmland, much of the sediment comes from nonagricultural activities. In either situation, the most effective way of controlling soil erosion is by the use of proper soil conservation practices and techniques. The nation’s farmers and ranchers are to be commended for utilizing them. The few “bad apples” that exist give a bad rap to the vast majority who carefully and thoughtfully utilize good husbandry practices.
Federal regulation. The federal government has long been concerned with the problem of soil erosion. Two major agencies within the United States Department of Agriculture (USDA) that have substantial soil erosion responsibilities are the Natural Resource Conservation Service (NRCS) and the Farm Service Agency (FSA). In general, the federal soil conservation programs are limited to conservation incentives in the form of technical assistance and cost sharing. The Soil Conservation Service (SCS) was created in 1935 to be the primary federal agency involved in soil erosion control. Its programs, consisting mainly of technical assistance, are administered in cooperation with local soil and water conservation districts. The Agricultural Stabilization and Conservation Service (forerunner of the FSA) was created at approximately the same time as the SCS, but for a different purpose. The original purpose of the ASCS was to be the vehicle for administering the Agricultural Adjustment Act (AAA) of 1938, an act that provided for a series of direct payments to farmers in exchange for their participation in acreage reduction programs. When the initial acreage reduction program was held unconstitutional in United States v. Butler, 297 U.S. 1 (1936), a temporary program was instituted to provide payments to farmers for planting cover crops to conserve soil, a backdoor means of lowering the production of certain agricultural commodities, and thereby increasing crop prices. That program was continued in the Soil Bank and continues presently in the form of the Conservation Reserve Program .
State regulation. Many states also have soil erosion and sediment control statutes that require landowners to take certain actions designed to minimize soil erosion. In some states, such as Kansas, the burden is placed upon local county commissioners to take action designed to minimize soil erosion.
1979 Iowa case. Landowners occasionally have challenged the validity of state soil erosion laws on the basis that the statutes are an unconstitutional exercise of the state's police power. In an Iowa case, Woodbury County Soil Conservation District v. Ortner, 279 N.W.2d 276 (Iowa 1979), one landowner filed a complaint against an adjacent landowner with the plaintiff (county soil conservation district) claiming that his farm was being damaged by water and soil erosion from the defendant’s land. Ultimately, complaint was settled without the plaintiff taking any action. However, the next year the same landowner filed another complaint claiming similar damage. This time the county soil conservation district investigated in accordance with state law and found that the soil loss on both adjoining farms exceeded the statutory limit. The plaintiff ordered both landowners to remedy the situation within six months and gave them two options: 1) seed the land to permanent pasture or hay; or 2) terrace the land. They did nothing, and the county soil conservation district sued to enforce its order. It was undisputed that terracing would cost the defendant about $12,000 and the adjoining landowner approximately $1,500. In addition, some of each landowner’s farmland would become untillable. While seeding the ground to pasture or hay was less expansive, some of the farmland would be removed from crop production. There was a dispute concerning whether either alternative would decrease the value of the land. The defendant challenged the soil conservation statute under which the county soil conservation district acted as unconstitutional – it amounted to a taking of private property without just compensation as the Fifth Amendment required. The defendant also claimed that the state law was an unreasonable and illegal exercise of the state’s “police power.”
The trial court agreed with the defendant and struck the state statute down. The law, the trial court said, placed an unreasonable burden on the defendant that was unduly oppressive and deprived them of their rights under the Fifth and Fourteenth Amendments of the U.S. Constitution and comparable provisions of state law.
On appeal, the Iowa Supreme Court reversed. The Supreme Court noted that the state had a vital interest in protecting its soil “as the greatest of natural resources” and that it has a right to do so based on the declared purpose of the statute at issue. Under that language, it is the duty of each landowner to establish and maintain soil and water conservation practices or erosion control practices, in accordance with soil conservation district regulations. Ultimately, the Supreme Court determined that the sate law was reasonably related to carrying out its announced purpose of soil control, and that control of soil erosion was a proper exercise of the state’s police power. The Supreme Court also noted that the state was willing to cost-share with the landowners to the tune of about three-fourths of the total bill. The Supreme Court said that the fact that a person must incur substantial expenditures to comply with valid regulations did not raise a constitutional issue. The defendants still had the use and enjoyment of their property.
The Iowa Supreme Court's opinion in Ortner upheld the neighbor's private property right to be free from damage caused by an adjacent farm's excessive water and soil erosion. In essence, the state can enact legislation to prevent a nuisance resulting from excessive soil and water erosion.
In Brown v. United States, No. 18-801L, 2019 U.S. Claims LEXIS 231 (Fed. Cl. Mar. 15, 2019), the plaintiff operated a sod farm on land the plaintiff owned in Oklahoma along a river. The river is south of a lake. In 1974, the federal government completed the lake dam, which has a spillway that releases water when it floods. The spillway discharges water and sediment downstream, directly across from plaintiff’s property. Since 1986 (the first use of the spillway) the spillway has been used 17 times. In 1990 the plaintiffs first complained of the water from the spillway eroding their property where they operate a sod farm. The plaintiff contacted the U.S. Army Corps of Engineers (COE) in 2003, 2004, 2007, 2008, 2009, 2011, 2015, and 2016 concerning the erosion. The COE continually maintained that it "will not—and cannot—mitigate the erosion," explaining that "there is no program that authorizes the “COE” to directly address the [plaintiff’s] situation.”
In 2015, the erosion rendered the plaintiff’s center pivot inoperable. The plaintiff spent approximately $10,000 on new irrigation equipment to continue business operations and approximately $15,000 on riprap to prevent further erosion. In 2018, the plaintiff filed sued, claiming that over eight acres of the plaintiff’s land had been lost due to erosion from the water released from the spillway. The plaintiff sought compensation under the Fifth Amendment as a compensable taking of their property.
The Government moved to dismiss this claim, but the court denied the motion on the basis that the “continuing claims” doctrine applied. Under that doctrine, the court concluded, each release of water through the spillway constituted a discreet takings claim. The Government claimed that the court lacked subject matter jurisdiction on the basis that the plaintiffs’ claim was barred by the statute of limitations as it accrued in 1990 when the plaintiffs first noticed the erosion. However, the plaintiffs asserted that the statute of limitations did not begin to run until 2015 when their operation had to be altered because of the erosion. Further, the plaintiffs asserted that the “continuing claims” doctrine should extend their claim because each use of the auxiliary spillway constituted a new breach of duty by the Government.
The court agreed with the plaintiff, and also pointed out that erosion-type takings involve an act of “taking” that occurs over a long period of time. Thus, the statute of limitations does not begin to run until the situation “stabilizes.” Ultimately, the court held that the record had not been developed sufficiently for the court to determine when the erosion stabilized. Hence, the Government’s motion to dismiss was denied for further development of the record.
Soil erosion issues loom large in agriculture. Sometimes, the Constitution gets involved in the mix. When it does, some interesting issues are involved.
Friday, April 12, 2019
The negligence concept is the great workhorse of tort law. To be liable for a negligent tort, the defendant's conduct must have fallen below that of a “reasonable and prudent person” under the circumstances. A reasonable and prudent person is what a jury has in mind when they measure an individual's conduct in retrospect - after the fact, when the case is in court.
But, what is a reasonable and prudent farmer? What is a farmer presumed to have knowledge of? These are important questions when the issue is negligence.
The reasonably prudent farmer – it’s the topic of today’s post.
Negligence – In General
More than 90 percent of all civil liability problems relate to negligence. The negligence system is a system designed to provide compensation to those who suffer personal injury or property damage. The negligence system is a fault system. For a person to be deemed legally negligent, certain conditions must exist. These conditions can be thought of as links in a chain. Each condition must be present before a finding of negligence can be obtained.
The first condition is that of a legal duty giving rise to a standard of care. If a legal duty exists, it is necessary to determine whether the defendant's conduct fell short of the conduct of a “reasonable and prudent person (or professional) under the circumstances.” This is called a breach, and is the second element of a negligent tort case. Once a legal duty and breach of that duty are shown to exist, a causal connection (the third element) must be established between the defendant's act and (the fourth element) the plaintiff's injuries (whether to person or property). In other words, the resulting harm to the plaintiff must have been a reasonably foreseeable result of the defendant's conduct at the time the conduct occurred. Reasonable foreseeability is the essence of causality (also known as proximate cause). For a plaintiff to prevail in a negligence-type tort case, the plaintiff bears the burden of proof to all four elements by a preponderance of the evidence (just over 50 percent).
The “Reasonably Prudent” Standard
The conduct of a particular tortfeasor (the one causing the tort) who is not held out as a professional is compared with the mythical standard of conduct of the reasonable and prudent person in terms of judgment, knowledge, perception, experience, skill, physical, mental and emotional characteristics as well as age and sanity. For those held out as having the knowledge, skill, experience or education of a professional, the standard of care reflects those factors. For example, the standard applicable to a professional veterinarian in diagnosing or treating animals is what a reasonable and prudent veterinarian would have done under the circumstances, not what a reasonable and prudent person would do.
The issue of what a farmer is presumed to know was at issue in a recent case. In Perkins v. Fillio, No. 18A-PL-2278, 2019 Ind. App. LEXIS 73 (Ind. Ct. App. Feb. 19, 2019), the defendant owned a small farm where she kept various animals including sheep and goats. The defendant spent roughly half her time at the farm and half her time in Florida. In 2016, the defendant was in Florida and left her half-brother (Slate) in charge of caring for her animals while she was gone, including feeding and watering them. While the defendant was in Florida, one of the goats (a ram) got sick, and because Slate had little experience with farm animals, he contacted a neighbor, the plaintiff, to come and help with the sick goat.
As the plaintiff bent over the ill goat head-butted her, causing her to fall and break her arm/wrist. The plaintiff then sued the defendant on three theories of negligence; premises liability, negligent entrustment and/or supervision, and vicarious liability. Under Indiana law, tort liability based on negligence requires that the defendant owe a plaintiff a duty; that the duty was breached; and that the plaintiff was injured as a result of the breach of the duty. At issue were whether a duty existed and whether the defendant had violated that duty. The plaintiff presented expert testimony to show that rams are generally territorial and tend to defend themselves, their territory, and the females that they perceive to be in their herd by headbutting unfamiliar animals or persons, and that tendency is generally known by farmers. The plaintiff claimed that when she went into the pen to care for the sick goat, she did not realize it was a ram because it had no horns, and she had never been warned that a ram might be protective and territorial.
Both parties moved for summary judgment on the liability question, and the trial court found in favor of the defendant because, in part, there was a lack of evidence indicating that the defendant knew the plaintiff would be on her real estate and, in particular, be inside the pen where the defendant kept the ram. There was also no evidence that the ram had been aggressive toward anyone in the past. Accordingly, the trial court found that the defendant had not violated a duty of care to the plaintiff. The plaintiff appealed.
On the premises liability question, the appellate court found that a duty to protect against harm caused by domestic animals could be established by either (1) a defendant’s knowledge that a particular animal has a propensity for violence and/or (2) a defendant’s ownership of a member of a class of animals that are known to have dangerous propensities, as the owner of such an animal is bound to have knowledge of that potential danger. The appellate court held that the plaintiff had presented sufficient evidence to establish that rams have dangerous tendencies as a class of animals, and the defendant was bound to have knowledge of that propensity. This evidence was enough to create a genuine issue of fact as to whether the defendant took reasonable measures to prevent the ram from causing harm to invitees, such as the plaintiff. Based on this standard, the appellate court held that the trial court had erred in granting summary judgment on the premise liability issue.
However, the plaintiff did not present sufficient evidence to create a genuine issue of material fact as to the remaining theories of negligence, and therefore the appellate court did not reverse on those rulings. Accordingly, the appellate court remanded to the trial court for further proceedings on the issue of premises liability.
Farmers have a great deal of skill and knowledge in many matters. For conduct that falls below the standard or reasonableness for a prudent farmer, tort liability may apply. That standard is difficult to determine and depends on the facts of each particular case. In the recent Indiana case, the farmer, even though part-time but as a keeper of animals (including sheep and goats) was presumed to know of the tendency of rams to butt.
Think through how the reasonably prudent person standard might apply in your situation.
Wednesday, April 10, 2019
The donation of a permanent conservation easement on farm or ranch land can provide a significant tax benefit to the donor. The rules are complex and must be carefully complied with to obtain the tax benefits that are possible – qualified farmers and ranchers can deduct up to 100 percent of their income (i.e., the contribution base). For others, the limit is 50 percent of annual income.
The IRS has a history of not showing a great deal of appreciation for the provision. After all, the donor is getting a significant tax deduction and can still farm or graze the property, for example. So, the technical requirements must be paid close attention to and strictly complied with.
Now legislation has been introduced that would eliminate the tax deduction associated with the donation of permanent conservation easements via a syndicated partnership. In addition, the IRS recently designated syndicated conservation easement transactions as being on its list of the “Dirty Dozen” tax scams of 2019.
The trouble with permanent conservation easement donations – it’s the topic of today post.
Permanent Conservation Easement Donations
In general. The donation of a permanent conservation easement is accomplished via a transaction that involves a legally binding agreement that is voluntarily entered into between a landowner and qualified charity – some form of land trust or governmental agency. Under the agreement, the landowner allows a permanent restriction on the use of the donated land so as to protect conservation characteristics associated with the tract. See I.R.C. §170(h). But, all of the applicable tax rules must be precisely complied with in order to generate a tax deduction. This is one area of tax law where a mere “foot-fault” can be fatal.
IRS Concerns. The key to securing a tax deduction for the donation of a permanent conservation easement is the proper drafting of the easement deed (as well as an accurate and detailed appraisal of the property). That’s the instrument that conveys the legal property interest of the easement to the qualified charity (qualified land trust, etc.). This document must be drafted very precisely. For example, the donor must not reserve rights that are conditioned upon the donee’s consent. This is termed a deemed consent provision and it will cause the donated easement to fail to be a perpetual easement – one of the requirements to get a charitable contribution deduction. See Treas. Regs. §§1.170A-14(e)(2); 1.170A-14(g)(1); 1.70A-14(g)(6)(ii).
Another requirement of securing a charitable deduction for a donated conservation easement is that the charity must be absolutely entitled to receive a portion of any proceeds received on account of condemnation or casualty or any other event that terminates the easement. This is required because of the perpetual nature of the easement. But, exactly how the allocation is computed is difficult to state in the easement deed. The basic point, however, is that the allocation formula cannot result in what a court (or IRS) could deem to be a windfall to the taxpayer. See, e.g., PBBM-Rose Hill, Ltd. v. Comr., 900 F3d 193 (5th Cir. 2018); Carroll v. Comr., 146 T.C. 196 (2016). In addition, the allocation formula must be drafted so that it doesn’t deduct from the proceeds allocable to the donee an amount that is attributable to “improvements” that the donor makes to the property after the donation of the permanent easement. If such a reduction occurs, the IRS presently takes the position that no charitable deduction is allowed because the specific requirements of the proceeds allocation formula are not satisfied. This seems counter-intuitive, but it is an IRS audit issue with respect to donations of permanent conservation easements.
If the donee acquires the fee simple interest in the real estate that is subject to the easement, the donee’s ownership of both interests would merge under state law and thereby extinguish the easement. This, according to the IRS, would trigger a violation of the perpetuity requirement. Consequently, deed language may be included to deal with the merger possibility. But, such language is problematic if it allows the donor and donee to contractually agree to extinguish the easement without a court proceeding. Leaving merger language out of the easement deed would seem to result in the IRS not raising the merger argument until the time (if ever) the easement interest and the fee interest actually merge.
The IRS also takes the position that the perpetuity requirement is not met if a mortgage on the property is not subordinated. For instance, in Palmolive Building Investors, LLC v. Comr., 149 T.C. 380 (2017), a charitable deduction was denied because the mortgages on the property were not subordinated to the donated façade easements as Treas. Reg. §1.170A-14(g)(2) requires. In addition, the deed at issue stated that the mortgagees had prior claims to extinguishment proceeds. That language violated the requirement set forth in Treas. Reg. §1.170A-14(g)(6)(ii). A savings clause in the deed did not cure the defective language because the requirements of I.R.C. §170 must be satisfied at the time of the easement is donated.
The caselaw also supports the IRS position that development rights and locations for development cannot be reserved on the property subject to the easement if it changes the boundaries for the easement. In other words, the IRS position is that the easement deed language must place a perpetual encumbrance on specifically defined property that is fixed at the time of the grant. However, if the easement only allows the boundary of potential development to be changed on a portion of a larger parcel that is subject to the easement restrictions and neither the acreage of potential development nor the easement is enhance, the perpetuity requirement remains satisfied. See, e.g., Bosque Canyon Ranch II, L.P. v. Comr., 867 F.3d 547 (5th Cir. 2017); Treas. Reg. §1.170A-14(f).
Another problem with easement deeds that the IRS watches for is whether the deed language allows the donor and donee to mutually agree to amend the deed. If this reserved right is present, the IRS takes the position that the easement is not perpetual in nature and does not satisfy the perpetuity requirement of I.R.C. §170(h)(2)(C). But, there is an exception. Amendment language is allowed if any subsequent transfer by the donee (via amendment language in the deed) facilitates the conservation purpose of the original transfer to the donee organization. Treas. Reg. 1.170A-14(c)(2); see also Butler v. Comr., T.C. Memo. 2012-72.
Syndicated Easement Donations
The IRS has also been aggressive at auditing donated conservation easements accomplished via a syndicated partnership. These transactions involve either an individual or an entity buying undeveloped property and then transferring it to a partnership. Partnership interests are then sold to “investors.” After the land appreciates in value, the partnership donates a conservation easement on the land to a qualified land trust with the charitable deduction flowing to the investors. This strategy made it on the 2019 IRS list of the “Dirty Dozen” tax scams and the Congress is taking action to eliminate the technique. In the U.S. Senate, The “Charitable Conservation Easement Program Integrity Act of 2019” has been introduced to end syndicated partnership easement donations. It also contains provisions that are effective retroactively and bars deductions when the value of the associated property has appreciated in value more than 2.5 times the initial investment.
I.R.C. §170(h) has been around for almost 40 years. It was enacted with the purpose of incentivizing landowners who wanted to bar development on their land and simultaneously provide a conservation benefit. It wasn’t designed with the intent that it become a profit-making venture. But, in recent years inappropriate and unsupportable property valuations have raised IRS and court scrutiny. In addition, the technical requirements for the deed language are very detailed and must be followed precisely. But, done correctly (and not via a syndicated partnership) the donation of a permanent conservation easement can provide substantial conservation benefits and a tax break for donors.
With the donation of permanent conservation easements it’s wise to remember that, “pigs get fat, but hogs get slaughtered.
Monday, April 8, 2019
Recently, I devoted a blog post to the benefits of a farming or ranching operation from the utilization of a cost segregation study. https://lawprofessors.typepad.com/agriculturallaw/2019/03/cost-segregation-study-do-you-need-one-for-your-farm.html. That post generated a great deal of nice comments and input and a request for another post looking at the risks of using a cost segregation study. Indeed, in 2018, the IRS issued a Chief Counsel Advice (CCA) discussing when the preparers of cost segregation studies could be subjected to penalties.
Issues and risks associated with cost segregation studies – that’s the topic of today’s post.
As pointed out in my prior post, cost segregation is the practice of taking a large asset (such as a building) and splitting its structural component parts into a group or groups of smaller assets that can be depreciated over shorter lives. See Treas. Reg. §1.48-1(e)(2)(provides guidance on the definition of a “structural component”). A primary emphasis of a cost segregation study is to classify assets as depreciable personal property rather than as depreciable real estate (or classify depreciable personal property (e.g., structures) separate from non-depreciable real estate). In tax lingo, the studies often result in the construction of rather detailed lists of individual assets that distinguish I.R.C. §1245 property with shorter depreciable recovery periods from I.R.C. §1250 property that has a longer recovery period. See, e.g., Hospital Corporation of America & Subsidiaries, 109 T.C. 21 (1997), acq. and non-acq. 1999-35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763. But see, Amerisouth XXXII, Ltd. v. Comr., T.C. Memo. 2012-67 (involving residential rental property). This technique will generate larger depreciation deductions in any particular tax year. The Tax Cuts and Jobs Act (TCJA) of late 2017, at least indirectly, makes the practice of cost segregation more beneficial by providing for the immediate expensing of up to $1 million ($1,020,000 for 2019) of most personal property that is found on a farm or ranch, and also by allowing first-year 100 percent “bonus” depreciation on used (in addition to new) assets. These changes make it more likely that a cost segregation study will provide additional tax benefits.
Because of the additional depreciation incentives included in the TCJA, the “placed-in-service” date of an asset is of primary importance. When is an asset deemed to be placed in service for depreciation purposes? The answer is when the asset is in a condition or state of readiness and availability for a specifically assigned function such as use in the taxpayer’s trade or business. See Treas. Reg. §1.167(a)-11(e)(1)(i); see also Treas. Regs. §§1.46-3(d)(1)(ii) and 1.46-3(d)(2); Von Kalinowski v. Comr., 45 F.3d 438 (9th Cir. 1994), rev’g. T.C. Memo. 1993-26. In practice, the determination of when an asset is placed in service is highly fact-dependent. In addition, the answer to the question can turn on the type of asset that is involved. As applied to commercial buildings, for example, the IRS tends to use the date on a certificate of occupancy as a factor in determining the placed-in-service date of the building or a portion of the building. But, in Stine, LLC v. United States, No. 2:13-03224, 2015 U.S. Dist. LEXIS 9850 (W.D. La. 2015), the court held that the two buildings of a retail operation at issue in the case were placed in service in the year when they were ready and available to store equipment and contained racks, shelving and merchandise. The court viewed it as immaterial that the certificates of occupancy for the buildings did not allow public access until the next year. The placed-in-service date was important in Stine because the taxpayer sought to have the buildings placed in service in 2008 (rather than 2009) to be eligible to deduct Gulf Opportunity Zone bonus depreciation on the buildings. The IRS issued a non-acquiescence in Stine. A.O.D. 2017-02 (Apr. 10, 2017). The IRS said that it will continue to litigate the placed-in-service issue on the basis of its position that a retail store isn’t placed in service until it is open for business.
IRS Audit Approach
The IRS has posted to its website a very detailed audit technique guide (ATG) concerning cost segregation studies. See https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-table-of-contents. The guide is useful in terms of the information it provides practitioners concerning its view on what constitutes a properly conducted cost segregation study. In the ATG, IRS auditors are advised to closely scrutinize cost segregation studies that are conducted on a contingency fee basis. The IRS believes that such fee structures incentivize the maximization of I.R.C. §1245 costs through “aggressive legal interpretations” or by inappropriate cost or estimation techniques. As a result, firms performing cost segregation studies may be better off billing the work based on the size of the project plus out-of-pocket expenses. Auditors are also advised to conduct in-depth reviews of cost segregation studies to determine the appropriateness of property depreciation classifications and determine if there are any land or non-depreciable land improvements that the study has classified as depreciable property. This could be a particularly important issue for cost segregation studies involving farm and ranch taxpayers.
In the ATG, IRS examiners are to closely look at the classification of I.R.C. §1245 and I.R.C. §1250 property. On this distinction, taxpayer records and documentation are critical. IRS will look to see whether a building component designated as I.R.C. §1245 can actually be used for other pieces of equipment. If it can, it will likely be classified as part of the building. The ATG also notes that IRS examiners can use sales tax records of the taxpayer as guidance on the proper allocation between I.R.C. §1245 and §1250 property. Other key points on the I.R.C. §1245/I.R.C. §1250 distinction involve whether the cost segregation study used cost estimates or actual cost records or a residual approach to determine the actual cost of I.R.C. §1245 items. What IRS is looking for is whether the cost of I.R.C. §1245 property has been set too high.
Another specific area of examination involves when depreciable and non-depreciable property are acquired in combination for a lump sum. The ATG points out to examiners that the basis for depreciation cannot exceed an amount which bears the same proportion to the lump sum as the value of the depreciable property at the time of the acquisition bears to the value of the entire property at that time. See Treas. Reg. §1.167(a)-5. Thus, examiners are to look at the fair market values of the properties at the time of acquisition. The fair market value of the land is to be based on its highest and best use as vacant land even if it has improvements on it. Thus, the ATG states that it is not correct for a cost segregation study to estimate land value by subtracting the estimated value of improvements from the lump sum acquisition price. Doing so, according to the IRS, results in an overstatement of the basis of depreciable improvements.
The ATG instructs examiners to reconcile total project costs (in terms of cost basis) in the taxpayer’s records with the total project costs in the cost segregation study. Thus, the IRS can be expected to request a copy of the taxpayer’s general ledger data. A key question will be whether costs that should have been in the taxpayer’s building account, for example, are showing up in another account or were expensed. Likewise, the ATG states that examiners should see if costs associated with site preparation, grading and land contouring have been properly (in the IRS view) allocated to land basis rather than being allocated to the overall building cost.
Preparer and Aiding and Abetting Penalties?
In 2018 the IRS issued a CCA taking the position that the preparers of cost segregation studies could be subjected to penalties. CCA 201805001(Oct. 26, 2017). The CCA involved a set of facts where an engineer/consultant prepared a cost segregation study without having any direct role in preparing tax returns. The engineer/consultant simply provided the completed study to the taxpayer so that the taxpayer could use it in the preparation of the taxpayer’s returns. The cost segregation study divided a 39-year property into component parts, many of which were assigned five-year MACRS lives. On audit, the IRS disagreed with the structural building components being classified as five-year property. Simply correcting the improper classification on the taxpayer’s returns was not enough. The IRS took the position that I.R.C. §6701 could serve as the basis for penalties against the study’s preparer for aiding and abetting the understatement of tax liability. The IRS position was that the engineer/consultant, by preparing the cost segregation study, was aiding or advising in the preparation of the taxpayer’s return. That satisfied I.R.C. §6701(a)(1). Accordingly, the engineer/consultant either knew or had reason to know that the study would be used “in a material matter relative to the IRC.” That satisfied I.R.C. §6701(a)(2). In addition, the IRS argued that the engineer/consultant had actual knowledge that the cost segregation study would result in an “understatement of the tax liability of another person” under I.R.C. §6701(a)(3). This last point is important. If the preparer of a cost segregation study knows that the study inflates depreciation deductions that will result in an understated tax liability, liability is present given that the fist two elements of potential liability under I.R.C. §6701 are practically presumed present.
The IRS determined that the engineer/consultant was liable for the $1,000 penalty for aiding and abetting the misstatement of individual tax forms. Had a misstated corporate form been involved, the penalty would have been $10,000. However, the IRS took the position that the $1,000 penalty should be imposed multiple times because the cost segregation study contributed to five returns misstating income as a result of the classification of 39-year property as five-year property. Why the IRS didn’t take the position that six $1,000 penalties should be imposed was not clear. Five-year MACRS property results in six-years of depreciation deductions (one-half year’s depreciation in each of year one year six under the one-half year convention). The IRS cited In re Mitchell, 977 F.2d 1318 (9th Cir. 1992) to support its position that multiple penalties should be imposed.
The favorable depreciation rules contained in the TCJA certainly create incentives for the greater use of cost segregation studies. In addition, care should be taken by the preparer(s) of a cost segregation study. The recent CCA indicates that the IRS is looking to establish that a study author has actual knowledge (under the preponderance of the evidence standard) that the study would result in an understatement of tax liability. See, e.g., Mattingly v. United States, 924 F.2d 785 (8th Cir. 1991). Actual knowledge must be shown. If a cost segregation study is prepared in accordance with the general guidance of Hospital Corporation of America & Subsidiaries, penalties should be avoided. But, ambiguities will very likely exist on the distinction between I.R.C. §1245 and I.R.C. §1250 property.
As Sergeant Esterhaus would say, ”Let’s be careful out there.”
Thursday, April 4, 2019
Last month, another jury has determined that Bayer-Monsanto was liable for damages caused by its Roundup weed killer. Roundup contains glyphosate, the most heavily used herbicide worldwide. According to the USDA, about 240 million pounds of glyphosate were sprayed in the U.S. in 2014, and traces of it can be found in air, water, soil and food products.
The most recent jury verdict awarding $81 million in damages to a plaintiff who developed non-Hodgkin lymphoma came about eight months after a different jury (also in California) awarded a different plaintiff almost $300 million for his claim that Roundup caused his cancer. In that 2018 case, however, the judge reduced the damages to about a third of what the jury awarded.
Do these verdicts and the thousands of other cases that have been filed in the Roundup litigation mean anything to a farming or ranching operation?
The implications of the Roundup litigation on a farming or ranching operation– that’s the topic of today’s post.
The Roundup Litigation
The Roundup litigation is an important matter for agriculture. Roundup is used heavily on genetically modified corn and soybeans as well as oats. It is presently sold in more than 160 countries. The patent on glyphosate expired in 2001 with generic versions being sold virtually worldwide. Presently, over 11,000 cases involving Roundup have been filed and are waiting trial and adjudication. The basic claim in each case is that the use of Roundup caused some sort of physical injury to the plaintiff. In many of the cases, the claim is that physical injury occurred after usage (usually over a long period of time) of Roundup. Indeed, both of the cases involving plaintiff jury verdicts involved the spraying of Roundup over many years.
Studies have reached differing conclusions on the safety of glyphosate. The Environmental Working Group (EWG) claims that glyphosate is present in many oat-based cereals and breakfast bars. The EWG believes that there is a causal connection between glyphosate and cancer, but others differ. In 2015, the International Agency for Research on Cancer classified glyphosate as a “probable human carcinogen.” That classification spurred lawsuits against Monsanto. But, the U.S. Environmental Protection Agency asserts that glyphosate is safe for humans when used in accordance with label directions. In addition, the World Health Organization has stated that glyphosate is “unlikely to pose a carcinogenic risk to humans from exposure through the diet.”
Vince Chhabria has been selected to oversee the Roundup lawsuits and has deemed the case resulting in last month’s jury verdict as one of the “bellweather” (test) cases. Judge Chhabria is a judge on the bench at the U.S. District Court for the Northern District of California. He was nominated to the bench by the President in 2013.
What Does the Litigation Mean For My Farm/Ranch?
While the temptation may be great to dismiss the recent verdicts as the result of raw emotion and passion by juries that don’t have much, if any, relation to or understanding of agriculture, that temptation should be resisted. It is true that juries tend to react based on emotion to a greater degree than do judges (indeed, the judge in the 2018 case significantly reduced the jury verdict), but that doesn’t mean that there aren’t some “take-home” implications for farming and ranching operations at this early stage of the litigation.
Things to ponder. Farming and ranching operations should at least begin to think about the possible implications of the Roundup litigation.
- What about lease agreements? Farmers and ranchers that lease out farmland and pasture may want to reexamine the lease terms. Consideration should be given as to whether the lease should incorporate language that specifies that the tenant assumes the risk of claims arising from the use of Roundup or products containing glyphosate. Relatedly, perhaps language should be included that either involves the tenant waiving potential legal claims against the landlord or provides for the landlord to be indemnified by the tenant for any and all glyphosate-related claims. Should language be included specifying that the tenant has the sole discretion to select chemicals to be used on the farm and that any such chemicals shall be used in accordance with label directions and any applicable regulatory guidance? How should the economics of the lease be adjusted to reflect this type of lease language? The tenant is giving up some rights and will want compensation for the loss of those rights. If the lease isn’t in writing, perhaps this is a good time to reduce it to writing.
- Is the comprehensive liability policy for the farm/ranch sufficient to cover glyphosate-related claims? Many farm comprehensive general liability policies contain “pollution exclusion” clauses. Do those clauses exclude coverage for glyphosate-related claims? How is “pollution” defined under the policy? Does it include pesticides and herbicides and associated claims? Does it cover loss to livestock that consume corn and/or soybeans that were grown with the usage of chemicals containing glyphosate? Can a rider be obtained to provide coverage, if necessary? These are all important questions to ask the insurance agent and an ag lawyer trained in reading farm comprehensive liability policies.
- If the farm employs workers, should that arrangement be modified from employer/employee to independent contractor status? If employee status remains and an employee sues the employer for alleged glyphosate-related damages, what can be done? Will enrolling the farm in the state workers’ compensation program provide sufficient liability protection for the farming/ranching operation?
What About Food Products?
To date, the cases have all involved the use of Roundup directly over a long period of time. At some point will there be cases where consumers of food products claim they were harmed by the presence of glyphosate in the food they ate? If those cases arise, given the use of production contracts in agriculture and the possibility of tracing back to the farm from which the grain in the allegedly contaminated food product was grown, does the farmer have liability? If you think this is far-fetched, remember that there is presently a member of the U.S. House that is proposing the regulation (if not elimination) of cows with flatulence. Relatedly, there are certain segments of the population that are opposed to the manner in which modern, conventional agriculture is conducted. These persons/groups would not hesitate in trying to pin liability all the way back down the chain to the farmer.
The Roundup litigation shouldn’t be ignored. It may be time to start thinking through possible implications and modifying certain aspects of the way the typical farm or ranch does business in order to provide the greatest liability protection possible.
Just some additional things to think about as you deal with low crop and livestock prices, flooding in the Midwest and Plains, and tax season! Also, a special “hat tip” to Jeremy Cohen, a lawyer in the Denver, Colorado area who put the bug in my ear about writing on this issue. Jeremy and I started our legal careers together in North Platte, NE nearly 30 years ago with Don Kelley – an iconic name in farm and ranch estate and business planning circles.
Tuesday, April 2, 2019
To be valid a will must satisfy certain requirements. One of those requirements is that the will is the product of the decedent’s intent. No one else can be allowed to unduly influence the decedent’s intent.
In ag settings, challenges to wills sometimes arise. The battles frequently involve the disposition of farmland that has been held in the family for many years or perhaps generations. As a result, tensions and emotions run high because the future of the family farm may be at stake. But, what does “undue influence” mean? In what situations may it be present?
Will challenges and undue influence – that’s the topic of today’s post.
Basic Will Requirements
Every state has statutory requirements that a will must satisfy in order to be recognized as valid in that particular jurisdiction. For example, in all jurisdictions, a person making a will must be of sound mind; generally must know the extent and nature of their property; must know who would be the natural recipients of the assets; must know who their relatives are; and must know who is to receive the property passing under the will. A testator lacking these traits is deemed to not have testamentary capacity and is not competent to make a will. These persons are more susceptible to being influenced by family members and others desirous of increasing their share of the estate of the decedent-to-be. If that influence rises to the level of being “undue,” the will resulting from such influence will not be validated.
Testamentary Capacity and Undue Influence
Cases involving will challenges are common where the testator is borderline competent or is susceptible to influence by others. However, the fact that the testator was old or in poor health does not, absent other evidence, give rise to a presumption that the testator lacked testamentary capacity or was subject to undue influence. For example, in a 2008 Wyoming case, Lasen v. Andersen, et al., 187 P.3d 857 (Wyo. 2008), the decedent’s daughter and her husband sued to quiet title to the decedent’s farm. Other family members asserted various defenses and also claimed an interest in the farm. A bank was also involved in the litigation. The trial court ruled against the daughter and granted the bank’s counterclaim. The trial court determined that the daughter and her husband had unduly influenced the decedent by continually pressing the decedent to change his will in their favor. The trial court also determined that the daughter and her husband had improperly pressured the decedent to change his power-of-attorney and execute the deed to the farm at issue in the case. The appellate court agreed, noting that the daughter was the party that executed the second deed involving the farm and that her husband did not obviate the first deed that had been executed and delivered.
But, undue influence was not established in In re Estate of Rutland, 24 So. 3d 347 (Miss. Ct. App. 2009). In this case, the court held that the trial court improperly set aside the decedent’s 2002 will which devised an 88-acre farm. The court determined that the decedent had testamentary capacity based on the evidence presented and that the evidence was insufficient to support a finding of undue influence and there was no abuse of a confidential relationship. If a confidential relationship had been present, a presumption of undue influence would have arisen.
In a 1993 Kansas case, In re Estate of Bennett, 19 Kan. App. 2d 154, 865 P.2d 1062 (1993), the court held that a person challenging the will must establish undue influence by clear and convincing proof and that the decedent possessed testamentary capacity despite being unable to comprehend the purchasing power of her estate. The surviving widow received approximately $50 million from her husband’s estate after they had lived as near paupers for many years. She changed her will after inheriting the vast sum and the disaffected family members sued on the basis that the subsequent will was the product of undue influence. It was not.
Recent case. In In re Estate of Caldwell, No. E2017-02297-COA-R3-CV, 2019 Tenn. App. LEXIS 114 (Tenn. Ct. App. Mar. 7, 2019), the decedent executed a will in 1999 that named the plaintiff, his son, as a devisee of his farm along with his nephew. At the time the will was executed, the plaintiff and nephew lived on the farm. Approximately nine years later the defendant, the decedent’s daughter, began to reestablish a relationship with the decedent and the plaintiff. The defendant did not learn that the decedent was her biological father until she was 35 years old and that she was a half-sister of the plaintiff by virtue of having the same father – the decedent.
In 2012 the decedent suffered a stroke that slowed his speech and resulted in limited mobility in one arm. The plaintiff took care of the decedent during the evenings and farmed during the day. The defendant often prepared meals and cleaned for the decedent. In November of 2012 the decedent executed a second will. The 2012 will revoked the 1999 will and devised the farm to the defendant. The 2012 will also named the defendant the executor of the estate. The defendant would drive the decedent to the attorney’s office but did not stay for the meetings. The attorney noted that the decedent spoke slower, but had no issue expressing his intent. The decedent wished to keep the property in the family and wanted the defendant and nephew to always have a place to live. The decedent also desired to make amends with the defendant for not playing a role in the first 35 years of her life. The 2012 will was properly witnessed and executed in late November. In January of 2013 the decedent quitclaim deeded the farm to the defendant. Again, at this time the attorney did not believe that the decedent had any mental capacity issues.
The decedent died in 2015 and the plaintiff submitted the 1999 will to probate. The defendant submitted the 2012 will to probate, and the plaintiff responded by bringing legal action for conversion; fraud; misrepresentation and deceit; unjust enrichment; and breach of fiduciary duty. The plaintiff sought punitive damages and injunctive relief that would prevent the defendant from taking any action against the estate. After a three-day bench trial, the trial court determined that the decedent had the requisite testamentary capacity and that the 2012 will was not a product of undue influence.
On appeal, the appellate court affirmed. The appellate court found that the evidence showed that decedent was of sound mind and had testamentary capacity at the time the 2012 will was executed – he knew what property he owned and understood how he wanted to dispose of it at his death. On the plaintiff’s undue influence claim, the appellate court determined that a confidential relationship did not exist between the defendant and the decedent based on a clear and convincing standard. As such, undue influence would not be presumed and the evidence demonstrated that the decedent received independent advice and was not unduly influenced in executing the 2012 will.
Family fights over the family farm are never a good thing. Sometimes the matter may involve claims of undue influence or lack of testamentary capacity to execute a will that is the linchpin of the estate plan. Care should be taken to avoid situations that can give rise to such claims.