Thursday, June 27, 2019
A significant amount of governmental regulation of agricultural activities is conducted by and through administrative agencies that promulgate regulations and make decisions. The rules for and scope of regulations is determined by unelected bureaucrats and often has the force of law. In addition, much of administrative law involves the administrative agency that developed the regulation at issue serving as judge and jury over disputed matters involving those same regulations. This raises fundamental questions of fairness.
In theory, governmental administrative agencies cannot exceed the authority provided by the legislative body. Ultimately, the courts serve as the check on the exercise of authority. But, how? Under what standard do the courts review administrative agency decisions? It’s an issue that was addressed by the U.S. Supreme Court yesterday, and it didn’t turn out the way that many in agriculture had hoped.
Today’s post takes a deeper look at administrative agencies, how farmers and ranchers can best deal with them, and review of administrative agency determinations by the courts. The deference provided to administrative agency decisions – that’s the topic of today’s post.
Administrative Agency Basics
At the federal level, the Congress enacts basic enabling legislation, but leaves the particular administrative departments (such as the USDA) to implement and administer congressionally created programs. As a result, the enabling legislation tends to be vague with the administrative agencies (such as the USDA) needing to fill in the specific provisions by promulgating regulations. The procedures that administrative agencies must follow in promulgating rules and regulations, and the rights of individuals affected by administrative agency decisions are specified in the Administrative Procedures Act (APA). 5 U.S.C. §§ 500 et seq. The provisions of the APA constitute the operative law for many of the relationships between farmers and ranchers and the government.
Administrative Agency Procedure
Usually, a farmer or rancher's contact with an administrative agency is in the context of participation in an agency-administered program, or being cited for failure to comply with either a statutory or administrative rule. So, it’s helpful for farmers and ranchers to have a general understanding of how administrative agencies work and the legal effects of their decisions. In general, disputed matters involving administrative agencies must first be dealt with in accordance with the particular agency's own procedural rules before the matter can be addressed by a court of law. This is known as exhausting administrative remedies. 7 U.S.C. §6912(e). See also Johnston v. Patterson, No. 4:14-CV-210-BO, 2014 U.S. Dist. LEXIS 172224 (E.D. N.C. Dec. 12, 2014). About the only exception to the rule of exhaustion occurs when a facial challenge is made to the regulation itself. See Gold Dollar Warehouse, Inc. v. Glickman, 211 F.3d 93 (4th Cir. 2000). Thus, participating carefully in administrative proceedings can be vitally important to a farmer or rancher, especially in terms of properly preserving a record for subsequent court review.
Going through the administrative process is critical because, typically, an appeal to a court of law is made only on the basis of the record generated in the administrative proceeding. Courts are limited in the extent to which they can substitute their judgment for that of an administrative agency regarding the facts of the dispute. Thus, it is critical to preserve all disputed factual and legal issues in the record of the administrative proceeding so that they can later be considered by a court. The exhaustion of administrative remedies, as a general rule, also requires that legal issues must be raised during the administrative process so as to be preserved for judicial review. If they are raised in the administrative process, then they will likely be precluded. Also, exhaustion is required as to each legal issue. See, e.g., Ballanger v. Johanns, 495 F.3d 866 (8th Cir. 2007).
What’s the Standard For Reviewing Agency Action?
Courts generally consider only whether the administrative agency acted rationally and within its statutory authority. Consequently, a particular farmer or rancher bears the burden of insuring that the record is adequate for the appeal of the issues involved before the matter leaves the administrative process. Otherwise, an appeal of an administrative agency's decision must be based solely on arguments that the agency acted arbitrarily, capriciously, beyond legal authority or that it abused its discretion.
In general, when dealing with administrative appeals from a federal agency such as the USDA, the court generally defers to the agency’s interpretation of its regulations as contained in the agency’s interpretive manuals. Prevailing in court on this type of a claim can be quite difficult. However, in Christensen v. Harris County, 529 U.S. 576 (2000), the U.S. Supreme Court ruled that statutory interpretations made by governmental agencies in pronouncements that do not have the force of law, such as opinion letters, policy statements, agency manuals, and enforcement guidelines, are not entitled to such great deference. Christensen is a significant case for the agricultural sector because the USDA often makes interpretations of the laws they administer in formats that do not have the force of law. Similarly, in Meister v. United States Department of Agriculture, 623 F.3d 363 (6th Cir. 2010), the court noted than an agency is not entitled to deference simply because it is a governmental agency. The case involved a claim that the U.S. Forest Service had failed to comply with its own regulations and a federal statute in developing its 2006 management plan for national forests in northern Michigan. The trial court granted the government’s motion for summary judgment, but the appellate court reversed. The appellate court noted that it was insufficient for the government to only identify the lands on which a particular activity (such as snowmobiling) could occur. Instead, the government had to identify the supply of lands on which participants in particular activities would experience a quality recreational experience. As a result, the issuance of the agency’s plan was arbitrary because the estimates of snowmobile and cross-country visitors to the forests were entirely arbitrary and there was no coordination with Michigan's recreational planning, and the agency did not minimize conflicts between off-road vehicle use and other uses and interests of the forests. The court specifically noted that agency deference was not automatic. Instead, the agency must apply the relevant statutory and regulatory authority.
On the deference issue, it was believed that a change might be in the wind. In 1997, the U.S. Supreme Court again reiterated the principle of agency deference. Auer v. Robbins, 519 U.S. 452 (1997). This so-called “Auer deference” involves a court deferring (or give “controlling weight”) to agency interpretations of its own ambiguous regulations. Another type of deference, known as “Chevron deference” involves a court deferring to an agency interpretation of ambiguous statutes that the agency administers. Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). However, the Court, in 2013 criticized the Court’s 1997 decision and suggested that it might be time to reconsider principles of agency deference. Decker v. Northwest Environmental Defense Center, 133 S. Ct. 1326 (2013).
The amount of deference a court gives to agency interpretations of its own regulations is important to agriculture. For example, the USDA administers the Packers and Stockyards Act (PSA). The PSA, bars packers (and others) from engaging in any “unfair, unjustly discriminatory, or deceptive practice.” 7 U.S.C. §192(a). The PSA also prohibits the making or giving of any “undue or unreasonable preference or advantage” to any person. 7 U.S.C. §192(b). The courts have construed this language to require harm to competition be shown to establish a violation. In late 2016, the USDA published an interim final rule removing the requirement to show harm to competition to establish a violation. But, the USDA later withdrew the rule. The withdrawal of the rule was challenged as arbitrary and capricious (the standard for overturning agency action). But, the Eighth Circuit denied the plaintiffs’ claims. Organization for Competitive Markets v. United States Department of Agriculture, 912 F.3d 455 (8th Cir. 2018). The court determined that the USDA, in abandoning the proposed rule, had provided a reasoned analysis based on principles that were “rational, neutral, and in accord with the agency’s proper understanding of its authority” – the USDA didn’t want to get sued. The case is an example of deference toward a governmental agency’s actions.
Yesterday, the U.S. Supreme Court addressed the issue of deference again in Kisor v. Wilkie, No. 18-15, 2019 U.S. LEXIS ___ (U.S. Sup. Ct. Jun. 26, 2019). The facts of the case didn’t involve agriculture. That’s not the important part. What is important is that the Court again reaffirmed (5-4, thanks to Chief Justice Roberts) Auer deference. However, the Court did appear to place some limitations on Auer deference for future cases. I say “appear” because the Court created a new multi-part test for review of agency action that could prove difficult for lower courts to apply and relatively easy for administrative agencies to skirt. According to the Court, a court that reviews agency action is to review the regulatory language at issue to determine whether the regulation is ambiguous. If it is, the court is to then apply Auer deference in determining whether the agency reached a reasonable conclusion resulting from the agency’s careful consideration and expertise after giving affected parties reasonable notice of the agency’s interpretation. From agriculture’s perspective, it was hoped that the Court would jettison Auer deference. That would have been the approach of Justice Gorsuch who would have eliminated the binding agency deference of Auer.
So, the battle between agriculture and administrative agencies will continue on numerous fronts, and the arguments over the reasonableness of agency interpretations will continue with the courts largely deferring to agency determinations. While there might be a dent in Auer deference, it still is a very functional defense to agency action.
The Equal Access to Justice Act (EAJA) (5 U.S.C. §§504 (2008); 28 U.S.C. §2412(d)(2)(A)) provides that a party who prevails administratively against government action can recover fees and expenses if the administrative officer determines that the government’s position was not substantially justified. However, the USDA’s longstanding position is that the EAJA does not apply to administrative hearings before the USDA’s National Appeals Division (NAD) because NAD proceedings are not adversarial adjudications that are held “under” the APA. But, the United States Court of Appeals for the Eighth Circuit rejected the USDA’s position in 1997. Lane v. United States Department of Agriculture, 120 F.3d 106 (8th Cir. 1997). The Ninth Circuit ruled similarly in 2007. Aageson Grain and Cattle, et al. v. United States Department of Agriculture, 500 F.3d 1038 (9th Cir. 2007). The Seventh Circuit ruled likewise in 2008. Five Points Road Venture, et al. v. Johanns, 542 F.3d 1121 (7th Cir. 2008).
Dealing with administrative agencies is a reality for the typical farmer or rancher. While ag didn’t get the clear victory it sought in Kisor, perhaps it’s a baby-step in the right direction. Only time will tell.
Tuesday, June 25, 2019
Last year, the U.S. Supreme Court decided South Dakota v. Wayfair, 138 S. Ct. 2080 (2018), upholding South Dakota’s ability to collect taxes from online sales by sellers with no physical presence in the state. That decision was the latest development in the Court’s 50 years of precedent on the issue. Based on that opinion, some states with an income tax took an aggressive stance against trust beneficiaries residing in their states. These states claimed that Wayfair meant that the mere presence in the state of a trust beneficiary allowed the state to tax the beneficiary’s trust income. North Carolina was one of those states.
The Supreme Court unanimously rejected North Carolina’s position. In so holding, the Court outlined Due Process limitations that apply to a state’s ability to tax.
The limitations on a state’s taxing authority – that’s the topic of today’s post.
The “Nexus” Requirement
In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided. Later, in Quill Corporation v. North Dakota, 504, U.S. 298 (1992), the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement.
In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. That’s what got North Carolina (and some other states) excited – the ability to tax trust income on the basis that a beneficiary’s presence in the state satisfied the nexus requirement. But, the key point is that the “substantial nexus” test of Brady remains. Likewise, the other three requirements of Brady remain – fair apportionment; no discrimination against interstate commerce, and; fairly related to services that the state provides. In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce. The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – limited application (based on transactions or dollars of sales); not retroactive; the state was a member of the Streamlined Sales and Use Tax Agreement; the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden.
Taxing an Out-Of-State Trust?
In the North Carolina case, the trust at issue was a revocable living trust created in 1992 with a situs of New York. The primary beneficiaries were the settlor’s descendants. None of the descendants lived in North Carolina at the time of the trust’s creation. The trust was divided into three separate trusts in 2002, one for each of the settlor’s children. The beneficiary of one of the sub-trusts was a North Carolina resident at that time. The trustee was replaced in 2005 with a successor trustee who resided in Connecticut. North Carolina tax returns were filed for tax years 2005-2008 for the accumulated trust income, that was distributed to the beneficiaries, including the non-North Carolina beneficiaries. In 2009, the trust filed a claim for a refund of North Carolina taxes in an amount slightly exceeding $1.3 million. The trust claimed that N.C. Gen. Stat. §105-160.2, which assesses tax on the amount of taxable income of the estate or trust that is for the benefit of a North Carolina resident, was unconstitutional on Due Process and Commerce Clause grounds. The defendant denied the claim, and the hearing officer later dismissed the case for lack of jurisdiction.
The trial court dismissed the request for injunctive relief with respect to the refund claim, but denied the defendant’s motion to dismiss the constitutional claims. The trial court then granted summary judgment for the trust on the constitutional claim and ordered the defendant to refund the taxes paid on its accumulated income.
On appeal, the appellate court affirmed. Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 248 N.C. 212, 789 S.E.2d 645 (N.C. Ct. App. 2016). The appellate court determined that the trust failed to have sufficient minimum contacts (as required by the Due Process Clause) with North Carolina to subject the trust to North Carolina income tax. The court cited both International Shoe Co. v. Washington, 326 U.S. 310 (1945) and Quill Corp. v. North Dakota, 504 U.S. 298 (1992) to support its position on this point. The trust did not have any physical presence in the state during the tax years at issue, contained no North Carolina property or investments, had no trust records that were created or kept in North Carolina, and the place of trust administration was not in North Carolina. Basing the imposition of state tax on a beneficiary’s domicile, by itself, did not establish sufficient minimum contacts with the state to satisfy the Due Process Clause and allow North Carolina to tax a non-North Carolina trust. The appellate court held that Brooke v. Norfolk, 277 U.S. 27 (1928) was controlling. In that case, a Maryland resident created a testamentary trust with a Maryland situs for a Virginia beneficiary. Virginia assessed tax on the trust corpus, but the Court held the assessment to be unconstitutional.
On further review, the state Supreme Court affirmed. Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 371 N.C. 133, 814 S.E.2d 43 (N.C. Sup. Ct. 2018). The state Supreme Court noted that a key to the case was that the trust beneficiary did not receive trust distributions during the years at issue. As such, the North Carolina statute violated the Due Process Clause of the U.S. Constitution.
The North Carolina Supreme Court’s decision was delivered 13 days before the U.S. Supreme Wayfair decision, and was based on the controlling U.S. Supreme Court decision at that time – Quill. Consequently, the North Carolina Department of Revenue, based on Wayfair, sought U.S. Supreme Court review. On January 11, 2019, the U.S. Supreme Court agreed to hear the case. North Carolina Department of Revenue v. Kimberley Rice Kaestner Trust 1992 Family Trust, 139 S. Ct. 915 (2019).
U.S. Supreme Court Decision
In a unanimous decision, the U.S. Supreme Court affirmed, holding that the North Carolina law violated Due Process. North Carolina Department of Revenue v. Kimberley Rice Kaestner Trust 1992 Family Trust, No. 18-457, 2019 U.S. LEXIS 4198 (U.S. Sup. Ct. Jun. 21, 2019). The Court noted that a taxpayer must have “some minimum connection” with the state, and that a rational relationship must exist between the income the state wants to tax and the state. There must be a fiscal relationship to benefits that the state provides. That’s a Due Process limitation. As applied to a trust, and based on Brooke v. Norfolk (cited above), the Court seemed to suggest that whether a trust beneficiary’s in-state contacts are relevant on the nexus question is tied to whether the beneficiary has a “right to control, possess, enjoy or receive trust assets.” Applying that rationale to the trust at issue, the court determined there was an insufficient nexus between the North Carolina beneficiary and the state for the state to have jurisdiction to tax the trust. The beneficiary never received an income distribution from the trust for the years at issue and didn’t have a right to demand trust distributions and had no power of assignment. It was the trustee, under the terms of the trust, that had the sole discretion over distributions. Indeed, the trust assets could ultimately end up in the hands of other beneficiaries. But, the Court did not foreclose the ability of a state to tax trust income where the trust gives the resident beneficiary a certain right to trust income.
Implications. The Court’s decision does leave in its wake considerations for drafters of trust instruments. For starters, a purely discretionary trust (e.g., a trust giving the trustee sole discretion over trust distributions) can bar a state from taxing a beneficiary’s income distribution. That’s especially true when combined with “spendthrift” language that bars the beneficiary from assigning their beneficial interest in the trust. This type of trust language typically works well when there is a need to place limitations on a beneficiary’s rights and access to trust assets. While the Court didn’t address the impact of a giving a beneficiary a power of appointment over trust assets in a discretionary trust, it would seem that if such a power is present and exercised, the state would have the ability to tax the beneficiary at least in the year the power is exercised.
The facts of the case indicated that the beneficiary had the right to receive either a share or all of the trust assets upon reaching a particular age, but the right was contingent. What if the trust language had made the future right not contingent? Would the Court have concluded that a state has the ability to tax the beneficiary then?
The Court also pointed out that nexus means something different depending on whether it is being applied to the grantor/settlor of the trust, the trustee or a beneficiary. A resident trustee satisfies the nexus requirement as does a resident grantor/settlor (with respect to a revocable trust). But, does that mean that a trust grantor/settlor can be taxed based solely on having created the trust in that particular state? Maybe that challenge will be forthcoming in the future.
State taxation of trusts varies greatly from state to state in those states that have a state income tax. A trust’s situs in a state certainly permits that state to subject the trust to the state’s income tax as a resident. But, a trust may be tied to a state in other ways via a grantor, trustee, assets, or a beneficiary. In addition, whether a trust is a revocable or irrevocable trust can make a difference. For instance, the Illinois definition of “resident” includes “an irrevocable trust the grantor of which was domiciled in this State at the time such trust became irrevocable.” 35 ILCS/1501(A)(20)(D); see also, Linn v. Department of Revenue, 2 N.E.3d 1203 (Ill. Ct. App. 2013). Indeed, a trust may have multiples states asserting tax on the trust’s income.
However, due process requires that before a state can tax a trust’s income, the trust must have a substantial enough connection (e.g., nexus) with the state. In addition, while a trust could be subject to state income tax based on its residency, the trust has grantors and trustees and beneficiaries and assets that can all be located in different states – and can move from state-to-state (at least to a degree). That last point makes the Court’s decision relevant even to those practitioners in states without an individual income tax.
Friday, June 21, 2019
It has taken the IRS and the Treasury almost 18 months to issue proposed regulations on how the new Qualified Business Income Deduction (QBID) works with respect to qualified agricultural cooperatives and their patrons. For background information on the QBID see https://lawprofessors.typepad.com/agriculturallaw/2018/01/the-qualified-business-income-qbi-deduction-what-a-mess.html Of course, the Congress didn’t help anything when the Tax Cuts and Jobs Act was passed by including a special deal for cooperatives that private grain elevators couldn’t avail themselves of. That got “fixed” in late March of 2018, but by that time the air and water in D.C. had become so polluted over the cooperative issue that I was told personally by Senator Grassley not to anticipate any proposed regulations until the middle of 2019. For commentary on the “fix” see https://lawprofessors.typepad.com/agriculturallaw/2018/03/congress-modifies-the-qualified-business-income-deduction.html The Senator was spot- on with that prediction.
Now that we have the proposed regulations, this will be a topic that will be addressed at the 2019 Summer National Farm Income Tax and Estate/Business Planning Seminar in Steamboat Springs, Colorado on August 13-14. That event is sponsored by Washburn University School of Law, the Department of Ag Econ at Kansas St. University and WealthCounsel. You can attend either in person or online. Registration information is available here: http://washburnlaw.edu/employers/cle/farmandranchtaxregister.html
A brief summary of the cooperative QBID regulations – that’s the topic of today’s post.
No Deduction for a Cooperative
Under I.R.C. §199A(a), a taxpayer is eligible for up to a 20 percent QBI deduction (QBID) attributable to qualified business income (QBI) derived from a domestic business that is other than a C corporation. Trusts and estates are eligible for the deduction. But, the QBID does not apply to wage income or to C corporate income. A cooperative is deemed to be a C corporation for federal income tax purposes and, thus, cannot claim a QBID. But, a cooperative determines its taxable income after the deduction for patronage dividend distributions and the like. I authored a BNA Tax Management Portfolio several years ago on cooperative taxation and noted there that such distributions are not taxed at the cooperative level. Instead, the distributions are taxed at the patron level. All cooperatives can deduct patronage distributions; exempt cooperatives can also deduct non-patronage distributions. I.R.C. §1382(c).
While a C corporation cannot utilize the QBID, I.R.C. §199A has a special rule for patrons that receive patronage dividends – they aren’t treated as an exclusion to the patron’s QBI. I.R.C. §199A(c)(3)(B)(ii). In addition, the Treasury has said that for purposes of the trade or business test of I.R.C. §162 (a pre-requisite for QBI), the income is tested at the trade or business level where the income is generated. T.D. 9847, Feb. 12, 2019. This all means that the QBID, if any, is at the patron level and not the cooperative level.
Special Rule for Patrons
As noted, I.R.C. §199A has special rules for patrons of ag cooperatives. These rules stem from the fact that farmers often do business with agricultural (or horticultural) cooperative. A farmer patron could have QBI that is not tied to patronage with a cooperative and QBI that is tied to patronage with a cooperative.
What are “patronage dividends”? Patronage dividends include money, property, qualified written notices of allocations, qualified per-unit retain certificates for which a cooperative receives a deduction under I.R.C. §1382(b), nonpatronage distributions paid in money, property, qualified written notices of allocation, as well as money or property paid in redemption of a nonqualified written notice of allocation for which an exempt cooperative receives a deduction under I.R.C. §1382(c)(2). But, dividends on capital stock are not included in QBI. Prop. Treas. Reg. §1.199A-7(c)(1).
Under Prop. Treas. Reg. §1.199A-7(c), patronage dividends or similar payments may be included in the patron’s QBI to the extent that these payments: (i) are related to the patron’s trade or business; (ii) are qualified items of income, gain, deduction, or loss at the cooperative’s trade or business level; and (iii) are not income from a specified service trade or business (SSTB) (as defined in I.R.C. §199A(d)(2)) at the cooperative level. But, they are only included in the patron’s income if the cooperative provides the required information to the patron concerning the payments. Prop. Treas. Reg. §199A-7(c)(2).
The patron’s QBID. The amount of a patron’s deduction that can be passed through to the patron is limited to the portion of the patron’s deduction that is allowed with respect to qualified production activities income to which the qualified payments (patronage dividends and per unit retains) made to the patron are attributable. I.R.C. §199A(g)(2)(E). In other words, the distribution must be of tax items that are allocable to the cooperative’s trade or business on behalf of or with a patron. The cooperative makes this determination in accordance with Treas. Reg. §1.199A-3(b). This is, essentially, the domestic production activities deduction computation of former I.R.C. §199, except that account is taken for non-patronage income not being part of the computation.
Note. There is a four-step process for computing the patron’s QBID: 1) separate patronage and non-patronage gross receipts (and associated deductions); 2) limit the patronage gross receipts to those that are domestic production gross receipts (likely no reduction here); 3) determine qualified production activities income from the domestic, patronage-sourced gross receipts; 4) apply a formula reduction (explained below). Prop. Treas. Reg. §1.199A-8(b).
As noted, the farmer-patron must reduce the “patron’s QBID” by a formula that is the lesser of 9 percent of QBI that relates to qualified payments from the cooperative, or 50 percent of the patron’s W-2 wages paid that are allocable to the qualified payments from the cooperative. I.R.C. §199A(b)(7)(A)-(B). In Notice 2019-27, 2019-16 IRB, the IRS set forth various methods for calculating W-2 wages for purposes of computing the patron’s QBID. See also Prop. Treas. Reg. §1.199A-11.
Because the test is the “lesser of,” a patron that doesn’t pay qualified W-2 wages has no reduction. Remember, however, under I.R.C. §199A(b)(4) and Prop. Treas. Reg. §1.199A-11(b)(1), wages paid in-kind to agricultural labor are not “qualified wages” but wages paid to children under age 18 by their parents are. For background information on that point, see https://lawprofessors.typepad.com/agriculturallaw/2018/08/the-qualified-business-income-deduction-and-w-2-wages.html
Note. I.R.C. §199A(b)(7) requires the formula reduction even if the cooperative doesn’t pass through any of the I.R.C. §199A(g) deduction (the deduction for a patron) to the patron for a particular tax year. If the patron has more than a single business, QBI must be allocated among those businesses. Treas. Reg. §1.199A-3(b)(5). Uncertainty remains, however, as to how the formula reduction functions in the context of an aggregation election. For example, if an aggregation election is made to aggregate rental income with income from the farming operation, must an allocation be made of a portion of the rental income as part of the formula reduction?
The formula reduction applies to the portion of a patron’s QBI that relates to qualified payments from a cooperative. If the patron has negative QBI that is associated with business done with the cooperative, the 9 percent amount will always be lower than the W-2 wage amount. Based on the draft form 8995-A, the QBID is to be increased by 9 percent of the AGI amount.
An optional safe harbor allocation method exists for patrons under the applicable threshold of I.R.C. §199A(e)(2) ($160,700 single/$321,400 MFJ for 2019) to determine the reduction. Under the safe harbor, a patron must allocate the aggregate business expenses and W-2 wages ratably between qualified payments and other gross receipts to determine QBI. Prop. Treas. Reg. §1.199A-7(f)(2)(ii). Thus, the amount of deductions apportioned to determine QBI allocable to qualified payments must be equal to the proportion of the total deductions that the amount of qualified payments bears to total gross receipts used to determine QBI. The same proportion applies to determine the amount of W-2 wages allocable to the portion of the trade or business that received qualified payments.
Note. The proposed regulations attempting to illustrate the calculation only mention gross receipts from grain sales. There is no mention of gross receipts from farm equipment, for example. Based on the language of Prop. Treas. Reg. §1.199A-7(f)(2)(ii), gross receipts from the sale of equipment and machinery should be included in the calculation and the farmer would have to allocate gross receipts from equipment sales between patronage and non-patronage income. Indeed, in prior years, depreciation may have been allocated between patronage and non-patronage income. Likewise, the example doesn't address how government payments received upon sale of grain are to be allocated.
The example contained in the Proposed Regulations not only utilizes an apparently unstated “reasonable method of allocation,” but uses an allocation of W-2 wage expense that doesn’t match the total expense allocation. That will have to be cleaned up in the final regulations. The example, as written, does not meet the requirement of the regulations to “clearly reflect income” without an explanation of how the cost allocation has been accomplished. A taxpayer using the approach of the example would certainly fail the requirement of the regulations upon audit.
This all means that the patron must know the qualified payments from the cooperative that were allocable to the patron that were used in computing the deduction for the patron at the cooperative level that could be passed through to the patron. This information is contained on Form 1099-PATR.
A higher income patron that receives patronage dividends (or similar payments) from a cooperative and is conducting a trade or business might be subject to the W-2 wages and “unadjusted basis immediately after acquisition” (UBIA) limitation. See https://lawprofessors.typepad.com/agriculturallaw/2018/08/qualified-business-income-deduction-proposed-regulations.html for a discussion of the limitation. In that instance, the patron is to calculate the W-2 wage and UBIA limitations without regard to the cooperative’s W-2 or UBIA amounts. Prop. Treas. Reg. §1.199A-7(e)(2). That means that the cooperative does not allocate its W-2 wages or UBIA to patrons. Id. Instead, a patron allocates (by election) W-2 wages and UBIA between patronage and non-patronage income using any reasonable method based on all the facts and circumstances that clearly reflects the income and expense of each trade or business. Prop. Treas. Reg. §1.199A-7(f)(2)(i). An example of an allocation might be by the number of bushels of grain that the patron sells during the year to various buyers – cooperatives and non-cooperatives. But, once an election is made with respect to an allocation approach, it applies to all subsequent years.
The patron’s QBID that is passed through from the cooperative (which is not limited by W-2 wages at the patron level) is limited to the patron’s taxable income taking into account the non-patron QBID which is limited to 20 percent of taxable income not counting net capital gains. Any unused patron-QBID is simply lost – there is not carryover or carryback provision that applies.
Identification by the cooperative. A cooperative must identify the amount of a patron’s deduction that it is passing through to a patron in a notice that is mailed to the patron via Form 1099-PATR during the “applicable payment period” – no later than the 15th day of the ninth month following the close of the cooperative’s tax year. I.R.C. §199A(g)(2)(A); Prop. Treas. Reg. §1.199A-8(d)(3); I.R.C. §1382(d).
A patron uses the information that the cooperative reports to determine the patron’s QBID. If the information isn’t received on or before the Form 1099-PATR due date, no distributions from the cooperative will count towards the patron’s QBI if the lack of reporting occurs after June 19, 2019. Prop. Treas. Reg. §1.199A-7(c)(3); Prop. Treas. Reg. §1.199A-7(d)(3).
Note. The Preamble to the proposed regulations states that these rules apply to both exempt and nonexempt cooperatives as well as patronage and nonpatronage distributions.
Is the Patron’s Business an SSTB? The proposed regulations indicate that a patron must determine whether the trades or businesses it directly conducts are specified service trades or businesses (SSTBs). Prop. Treas. Reg. §1.199A-7(d)(2). Why? Because the cooperative must report to the patron the amount of tax items from an SSTB that the cooperative directly conducts (based on the application of the gross receipts de minimis rule of Tress. Reg. §1.199A-5(c)(1)) that is used to determine if a trade or business is an SSTB. The patron is to then determine if the distribution from the cooperative can be included in the patron’s QBI (based on the patron’s taxable income and the phase-in range and threshold that applies to an SSTB). The cooperative must report to the patron the amount of SSTB income, gain, deduction, and loss in distributions that is qualified with respect to any SSTB directly conducted by the cooperative on an attachment to or on the Form 1099-PATR (or any successor form) that the cooperative issues to the patron, unless otherwise provided by the instructions to the Form.
Note. Again, the Preamble to the proposed regulations states that these rules apply to both exempt and nonexempt cooperatives as well as to patronage and non-patronage distributions.
Waiting well over a year for draft proposed regulations on the cooperative QBID issue has created many hassles for taxpayers, preparers and tax software companies for the 2018 tax season (which is still ongoing in many respects). The proposed regulations can be relied upon until final regulations are published. Written comments on the proposed regulations are due within 60 days of publication of the proposed regulations in the Federal Register – approximately August 17, 2019. Hard copy submissions of comments can be sent to: CC:PA:LPD:PR (REG-118425-18), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C., 20044.
Wednesday, June 19, 2019
Especially with respect to fruit and vegetable crops, seasonal ag workers are vital – particularly during harvest. But is a seasonal ag worker an employee or an independent contractor? What are the factors for determining the proper classification? Why does classification matter? Actually, it matters for several important reasons including withholding of income tax and the filing of the proper tax forms; whether minimum wage requirements apply; and applicable penalties for a misclassification.
During this spring’s academic semester at the law school, my students in agricultural law were required to write a paper on a particular ag law topic. Today’s post features the work of one of those students - Rebecca Bergkamp. Rebecca graduated last month, is presently preparing for the Bar exam, and will then join the Hinkle Law Firm in Wichita, Kansas. She is well-trained to enter the practice world to begin assisting agricultural clients (among others) with their legal issues.
The proper classification of seasonal ag workers – that’s the topic of today’s post.
Rules Governing Classification of Workers
Under the Fair Labor Standards Act (FLSA), a worker is presumed to be an employee, unless the worker is specifically classified as an independent contractor. The term “employee” is very expansive and means any individual employed by an employer. 29 U.S.C. §203(e)(1). This includes individuals who might not normally qualify as an “employee” under traditional agency principles. Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 112 S. Ct. 1344, 1350 (1992). Likewise, a contractual designation between a farmer and the worker that the worker is an independent contractor is not controlling for purposes of determining whether that worker is an employee or independent contractor. Rutherford Food Corp. v. McComb, 331 U.S. 722, 67 S. Ct. 1473, 1476-77 (1947). Moreover, the subjective intentions of the parties are not controlling in determining whether an employer-employee relationship exists; it does not matter whether the parties had any intention of creating an employment relationship. Brennan v. Partida, 492 F.2d 707, 709 (5th Cir. 1974).
Factors for Consideration
So how is it determined whether an ag worker is an employee or a independent contractor? An “economic realities” test is often used. Under this test, the courts look to various factors in assessing the economic realities of the situation to determine whether an individual is an employee, or an independent contractor. Those factors are: (1) the nature and degree of the worker’s control of the manner in which the work is to be performed (the less control the worker has, the more likely the worker is an employee); (2) the worker’s opportunity for profit or loss depending upon his or her managerial skill (the less opportunity, the more likely the worker is an employee); (3) the degree of the worker’s own investment in equipment or materials required for the work or employment of other workers (the greater degree, the more likely the worker is an independent contractor); (4) whether the service rendered requires a special skill, (if so, the more likely is independent contractor classification); (5) the degree of permanency and duration of the working relationship of the parties (the longer and more permanent the relationship, the more likely employee classification will be); and (6) the extent to which the services rendered are an "integral part" of the business (the greater the extent, the more likely is employee status). No single factor is determinative. See, e.g., Blair v. Transam Trucking, Inc., 309 F. Supp. 3d 977, 1002 (D. Kan. 2018); Real v. Driscoll Strawberry Associates, Inc., 603 F.2d 748 (9th Cir. 1979); In re Kokesch, 411 N.W.2d 559 (Minn. Ct. App. 1987); Mendez v. Brady, 618 F. Supp. 579 (W.D. Mich. 1985); Tobin v. Cherry River Boom & Lumber Co., 102 F. Supp. 763 (S.D. W. Va. 1952).
Although a farmer may have to classify many of its workers as employees due to the application of the economic realities test, a farmer is not required to classify immediate family members as employees. For the purposes of agriculture, the term “employee” does not include workers who are a parent, spouse, child, or other immediate family members. 29 U.S.C. §203(e)(3). This is an important exception for many family farming operations.
Why Classification Matters
There are various reasons for classifying a worker either as an employee or as an independent contractor.
- For many farmers, it’s simply easier to classify seasonal workers as independent contractors and pay them with a checks and issue Forms 1099 at year end. In addition, independent contractors are responsible for paying both the employer and employee portion of Social Security and Medicare taxes.
- For tax years beginning after 2017, the Tax Cuts and Jobs Act (TCJA) provides for a 20 percent deduction for the “qualified business income” of an independent contractor that is other than a C corporation. Wages of an employee don’t qualify.
- The staffing flexibly of independent contractors can be very beneficial and, if the farming operation is in a state that has at-will employment, employees can terminate the working relationship at any time for any reason. In contrast, an independent contractor’s ability to terminate a working relationship with a farmer is governed by a contract that the parties have negotiated.
- If a worker is an employee, the farmer-employer, has greater control over how, when, and which projects are completed at any given time. But, the use of an independent contractor provides the farm operation the flexibility of being able to acquire talent for a specific period of time without having to maintain an ongoing commitment, financial or otherwise.
What About Minimum Wage and Overtime Pay Requirements?
If a worker is an “employee,” the FLSA requires agricultural employers who use 500 “man-days” or more of “agricultural labor” in any calendar quarter of a particular year to pay the agricultural minimum wage to certain agricultural employees in the following calendar year. 29 CFR § 780.305. Man-days are those days during which an employee performs any agricultural labor for not less than one hour. The man-days of all agricultural employees count in the 500 man-days test, except those generated by members of an incorporated employer's immediate family. 29 U.S.C. § 203(e)(3). Five hundred man-days is roughly equivalent to seven workers working five and one-half days per week for thirteen weeks (5.5 x 7 x 13 = 501 man-days). Under the FLSA, “agriculture” is defined broadly. See 29 U.S.C. § 203(f). For related entities, where not all of the entities involve an agricultural trade or business, the question is whether the business operations are so intertwined that they constitute a single agricultural enterprise that is exempt from the minimum wage rules. See, e.g., Ares v. Manuel Diaz Farms, Inc., 318 F.3d 1054 (11th Cir. 2003).
Other agricultural exceptions from the minimum wage requirement include persons that are: (1) members of the employer's immediate family, unless the farm is incorporated; (2) local hand-harvest, piece-rate workers who come to the farm from their permanent residences each day, but only if such workers were employed less than 13 weeks in agriculture in the preceding year; (3) children age 16 and under whose parents are migrant workers, and who are employed as hand-harvest piece-rate workers on the same farm as their parents, provided that they receive the same piece-rate as other workers; and (4) employees engaged in range production of livestock. 29 U.S.C. § 213(a)(6). A higher monthly wage rate applies to a “ranch hand” who does not work in a remote location and works regular hours. See, e.g., Mencia v. Allred, 808 F.3d 463 (10th Cir. 2015).
If a worker is classified as an “employee,” the FLSA requires payment of at least one and one-half times an employee’s regular rate for work over 40 hours in a week. However, an exemption denies persons employed in agriculture the benefit of mandatory overtime payment. 29 U.S.C. § 213(b)(12). Again, for this purpose, “agriculture” is defined broadly, and the 500 man-days test is not relevant. There are also certain workers that are exempt from being paid for hours worked that exceed 40 hours in a week. Included in this category are those “executive” workers whose primary duties are supervisory, and the worker supervises two or more employees. Also included are workers that fall in the “administrative” category who provide non-manual work related to the management of the business. Also exempt are those workers defined as “professional” whose job is education-based and requires advanced knowledge. Many larger farming and ranching operations have employees that will fit in at least one of these three categories.
Income Tax Withholding
For employees, the employer must withhold federal (and state) income tax. The withholding of tax from an individual’s wages is “treatment” of the individual as an employee. See, e.g., Priv. Ltr. Rul. 8323004 (Feb. 21, 1983). Also, it’s not possible to retroactively change the “treatment” of the workers as employees by filing Forms 941c (the Form for correcting withholding information) and requesting a refund of FICA taxes. Even assuming the farmer could do so, the farmer would be prevented from claiming workers as nonemployees for years he did not file the proper federal information tax returns. Likewise, “Section 530 relief” is not available to those taxpayers who did treat workers as employees by filing Forms 943 and withholding FICA taxes. It also doesn’t apply to those who treated workers as employees as a result of past audits.
One of the biggest risks in hiring “independent contractors” is misclassification because it can result in violations of wage, tax, and employment laws. Penalties can also be imposed for failing to timely deposit payroll taxes. Fines from the U.S. Department of Labor (DOL), IRS, and state agencies could total thousands of dollars. Farmers can be held responsible for paying back-taxes and interest on employee’s wages as well as FICA taxes that were not originally withheld. Failure to make these payments can result in additional fines. If the misclassification is found to be intentional, criminal penalties can apply. In addition, for employees, an employer must keep Form I-9 on record for each employee to establish employment eligibility.
Careful thought must be given to the proper classification of ag workers. The issue is particularly acute with respect to seasonal ag workers. Misclassifying can lead to serious consequences.
Monday, June 17, 2019
Eminent domain is the power of a state to take private property for public use consistent with the state’s constitution. In many states, the power has been legislatively delegated to municipalities, government subdivisions, as well as private persons and private corporations. Sometimes, the exercise of eminent domain intersects with agriculture, particularly when a pipeline is being put in or a wind energy company wants to erect industrial wind towers and landowners object.
How broad is the power of eminent domain? How do the federal and state constitutions protect private property? What does “public use” mean? Can a private company exercise eminent domain?
The exercise of eminent domain at the state level and the impact on agriculture – that’s the focus of today’s post.
The Power to “Take” Property
The power to “take” private property for public use (or for a public purpose) without the owner's consent is an inherent power of the federal and state government. However, the United States Constitution limits the government's eminent domain power by requiring federal and state governments to pay for what is “taken.” U.S. Const. 5th Amend. The “takings” clause of the Fifth Amendment has been held to apply to the states since 1897. Chicago, Burlington and Quincy Railroad Co., v. Chicago, 166 U.S. 226 (1897).
The Fifth Amendment states in part “...nor shall private property be taken for public use without just compensation.” Just compensation” equals fair market value, generally in cash. For partial takings, “severance damages” may be awarded in addition to compensation for the part taken. See, e.g., Sharp v. United States, 191 U.S. 341 (1903). The clause has two prohibitions: (1) all takings must be for public use; and (2) even takings that are for public use must be accompanied by compensation.
What Does “Public Use” Mean?
Historically, the “public use” requirement operated as a major constraint on government action. For many years, the requirement was understood to mean that if property was to be taken, it had to be used by the public – the fact that the taking was “beneficial” was not enough. Eventually, however, courts concluded that a wide range of uses could serve the public even if the public did not, in fact, have possession. Indeed, so many exceptions were eventually built into the general rule of “use by the public” that the rule itself was abandoned. In 1954 and again in 1984, the U.S. Supreme Court demonstrated its willingness to define expansively “public use,” and confirmed the ability of a state to use eminent domain power to transfer property outright to a private party, so long as the exercise of the eminent domain power was rationally related to a conceivable public purpose.
In recent years, however, state courts have split on the issue of whether the government’s eminent domain power can be exercised to take private homes and businesses for the development of larger businesses by private companies. The argument is that the larger businesses enhance “economic development” that increases jobs and tax revenue in the area and that this satisfies the Fifth Amendment’s “public use” requirement. However, in Bailey v. Myers, 206 Ariz. 224, 76 P.3d 898 (Ariz. Ct. App. 2003), the court determined that the condemnation of private property for redevelopment and sale to private parties was unconstitutional because the proposed use of the property was not public. Similarly, the Michigan Supreme Court has ruled that the exercise of the eminent domain power is proper only if (1) the private entities involved are public utilities that operate highways, railroads, canals, power lines, gas pipelines, and other instrumentalities of commerce; (2) the property remains under the supervision or control of a governmental entity; or (3) the public concern is accomplished by the condemnation itself (i.e., blighted housing has become a threat to public health and safety). County of Wayne v. Hathcock, 684 N.W.2d 765 (Mich. 2004).
In 2005, the Supreme Court clarified the difference among the states by again ruling that the eminent domain power can be exercised on behalf of a private party for economic development that benefits the public by increasing jobs and the tax base in the area. Kelo, et al. v. City of New London, 545 U.S. 469 (2005). Thus, if the exercise of eminent domain for a private party is done in conjunction with a development plan and does not involve obvious corruption, the taking will be allowed (and compensation will have to be paid). While the Supreme Court’s Kelo decision was a landmark one, the Court clearly deferred to states on the issue. At the federal level, if the condemnation of property is rationally related to a legitimate purpose of government (rather low hurdle to overcome) the taking will be approved. But, any particular state could restrict the exercise of eminent domain on behalf of private parties if they so desired.
In the wake of Kelo, several states either amended the state statutory process for proceedings involving condemnation of private property, or have amended the state constitution. Shortly after the Kelo decision, the Ohio Supreme Court has held that a taking providing nothing other than an economic benefit violates the Ohio constitution. City of Norwood v. Horney, 853 N.E.2d 1115 (Ohio 2006). The Ohio Supreme Court has previously held that Ohio landowners have a property interest in the groundwater underlying their land such that governmental interference with that right can constitute a taking. McNamara v. City of Rittman, 838 N.E .2d 640 (Ohio 2005).
What Does “Property” Mean?
The term “property” in the context of eminent domain, connotes all types of ownership interests – fee simple; partial interests; future interests; surface interests and even, perhaps, sub-surface interests. For example, in The Edwards Aquifer Authority, et al. v. Day, et al. 369 S.W.3d 814 (Tex. Sup. Ct. 2012), the Texas Supreme Court unanimously held, on the basis of oil and gas law, that landownership in TX includes interests in in-place groundwater. As such, water cannot be taken for public use without adequate compensation guaranteed by Article I, Section 17(a) of the TX Constitution. In the case, the plaintiffs were farmers that sought permit to pump underground water for crop irrigation purposes. The underground water at issue was located in the Edwards Aquifer and the plaintiffs' land was situated entirely within the boundaries of the aquifer. A permit was granted, but water usage under the permit was limited to 14 acre-feet of water rather than 700 acre-feet that was sought because the plaintiffs could not establish "historical use." The Court determined that the plaintiff's practice of issuing permits based on historical use was an unjustified departure from the Texas Water Code permitting factors.
Recent Case – The Dakota Access Pipeline
A recent opinion issued by the Iowa Supreme Court involving a pipeline seeking to exercise eminent domain, illustrates the intersection of the concept with agriculture. In Puntenney, et al. v. Iowa Utilities Board, No. 17–0423, 2019 Iowa Sup. LEXIS 69 (Iowa Sup. Ct. May 31, 2019), the Court was faced with the Dakota Access Pipeline that sought to use eminent domain against farmland owners so that its pipeline could be completed. The pipeline was piping oil from the oil fields of northwest North Dakota to southern Illinois. In 2014, the pipeline company filed documents with the Iowa Utilities Board (IUB) signifying its intent to lay a pipeline. The pipeline would traverse Iowa from the northwest corner to the southeast corner of the state, passing through eighteen counties over approximately 343 miles. At the end of 2014, the pipeline company held meetings in all eighteen counties.
In 2015, the pipeline company petitioned the IUB to start construction and sought “the use of the right of eminent domain for securing right of way for the proposed pipeline project” due to several landowners in the path of the pipeline refusing to grant an easement. The pipeline asserted such authority as a “common carrier” (a public or private entity that carries goods or people). In November and December of 2015, the IUB held hearings on the petition. Hundreds of people were present to give testimony for both sides. On March 10, 2016, the IUB issued a 159-page final decision and order. This order found that the pipeline would promote the public convenience and necessity, involve a capital investment in Iowa of $1.35 billion, and generate $33 million in Iowa sales tax during construction and $30 million in property tax in 2017. The order also noted that the pipeline had utilized a software program to lay the pipeline’s path to avoid critical areas, and that state law gave the pipeline the power to exercise eminent domain where necessary. After the IUB’s issuance of the order, several motions for clarification and rehearing were filed, which the IUB denied. Numerous parties sought judicial review of the order, and the parties were consolidated into a single case. On February 15, 2017, the trial court denied the petitions for judicial review.
On further review, Iowa Supreme Court addressed numerous issues. The Court determined that the Iowa Chapter of the Sierra Club had standing under state law on behalf of its affected members. Those members, the Court noted under Iowa law, did not need to be landowners, just aggrieved or adversely affected by “agency action.” On the legal issues, the Court looked at the standing of the parties. While the pipeline had already largely been constructed, the Court determined that the matter was not moot because the IUB retained the authority to impose other “terms, conditions, and restrictions” in the petitioners’ favor. On the IUB’s authority to issue a construction permit to the pipeline company based on the promotion of public convenience and necessity, the Court determined that the IUB’s decision to grant the permit was not “[b]ased upon an irrational, illogical, or wholly unjustifiable application of law” and its factual determinations were supported by “substantial evidence.” The Court noted that the evidence showed that the pipeline would reduce oil transport costs which would provide a lower price for petroleum products; transport oil more safely than rail; and provide secondary economic benefits to the citizens of Iowa. However, the Court did conclude that private economic development, by itself, is not a valid “public use.” Thus, the Court rejected the U.S. Supreme Court’s holding in Kelo - joining Illinois, Michigan, Ohio and Oklahoma. The Court also did not find any violation of the statutory limit on the use of eminent domain with respect to farmland because the pipeline company was a common carrier under the IUB’s jurisdiction – an entity not statutorily limited on the use of eminent domain on farmland. Thus, the Iowa Constitutional provision on the use of eminent domain was not violated, nor was the Fifth Amendment of the U.S. Constitution. The Court also upheld the IUB’s determination that the pipeline route was proper and need not be rerouted based on speculative surface development, but did conclude that the pipeline be laid under existing field drainage tile where necessary.
The use of eminent domain at the state level and taking of private property at the federal level is a significant concern for many farmers and ranchers. Certainly, the government must pay for what it takes (the issue of compensation is a topic for another day), but the extent to which a public use must be present is a key issue. The recent Iowa decision sheds some light on the question – at least in Iowa.
Thursday, June 13, 2019
Weather conditions in the Midwest and the crop-growing regions of the Great Plains have made it likely that prevented planting payments will be utilized by a greater percentage of impacted farmers this summer. If that happens, what are the regulatory and legal rules that kick-in that the recipient-farmer becomes subject to?
Prevented Planting Payments
The crop insurance final planting dates for corn have passed, but many areas of the soybean growing region (basically south of Minnesota and east of Nebraska) still have final planting dates for soybeans that remain but will expire soon. A farmer must weigh options of changing crops, planting soybeans or simply not planting at all. The economics of the situation will dictate the outcome. Crop insurance companies can provide guidance on eligible acres and production practices and the applicable rules for prevented planting payments. It’s also important to know what neighboring farmers are doing. Being the only farmer in a particular area to utilize prevented planting payments is not a good thing. If that happens, crop insurance adjusters and underwriters may could suddenly become reluctant to allowing payment on the claim.
Legal and Regulatory Matters
The governing statute on prevented planting payments is 7 U.S.C. §1508a. The language contained in that statute defines such things as “first crop,” “second crop,” and “replanted crop.” It then lays out the options that a producer has when a “first crop” is lost and what the rules are when a “second crop” is planted. Also, specified is the effect on actual production history and the area conditions that are required for payment. Also, detailed are the exceptions for established double cropping practices, among other things.
As with participation in any federal government farm program, the participating farmer becomes subject to the regulatory and legal framework of the particular program. That means that any dispute must be appealed to a final decision through the administrative process before redress can be available in the judicial system. Failure to preserve the administrative record can result in a court being unable to provide a remedy even though it may be clear that the farmer should prevail. That’s not a good position to be in.
Recent Prevented Planting Court Decisions
It is common for a prevented planting dispute to end up in arbitration. Two recent federal court opinions have concerned the operation of the arbitration process with respect to prevented planting payments.
A case from Nebraska involved the statutory time limit for the notice of application to vacate a crop insurance arbitration award and whether that statutory time limit could be waived. In Karo v. NAU Country. Ins. Co., 901 N.W.2d 689, 297 Neb. 798 (2017), the plaintiffs farmed together in Holt County, Nebraska. They each obtained federally reinsured crop insurance policies that the defendant serviced. In 2012, the plaintiffs submitted “prevented planting” claims under their crop insurance policies, claiming they were unable to plant corn on certain acres due to wet conditions. The defendant denied the plaintiffs’ prevented planting claims, finding that excessive moisture was not general to the surrounding area and did not prevent other producers from planting acres with similar characteristics. Pursuant to the mandatory arbitration clause in the policies, the parties submitted their disputes to binding arbitration.
The arbitrator issued a final arbitration award in favor of the defendant on January 21, 2014. On May 15, 2014, the plaintiffs filed a petition for judicial review in the Holt County District Court seeking to vacate the arbitration award under §10 of the Federal Arbitration Act (FAA) which provides “the district court wherein the award was made may make an order vacating the award upon the application of any party to the arbitration. . . where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.” The district court granted the plaintiffs’ summary judgment motion and vacated the arbitration award finding that the arbitrator exceeded his powers and manifestly disregarded the law.
The defendant appealed, but failed to note in the appeal that the plaintiffs did not meet the three-month time limit for appealing. Consequently, because the defendant did not raise the issue of the violation of the three-month limit, the appellate court had to determine whether the time limit was jurisdictional in nature and, thus, could not be waived even if the parties do not raise the issue. According to the U.S. Supreme Court, absent such a clear statement, the restriction should be treated as non-jurisdictional in character. Section 9 of the FAA which enumerates the notice requirements for judicial confirmation expressly states that after service of proper notice “the court shall have jurisdiction over the adverse parties to the arbitration.” Consequently, the appellate court determined that this was a clear indication that Congress intended the statutory requirements for service notice of an application for expedited judicial review under the FAA to be jurisdictional in nature. The appellate court held that although different timeframes apply for serving notice under section 9 and section 12 of the FAA, there is no difference in the mandatory process by which the adverse party must be served with notice and no difference in the practical purpose for requiring such notice. Thus, it would make little sense for Congress to give clear jurisdictional weight to service notice in one context but not the other.
In addition, the appellate court saw no indication in the statute that Congress intended the notice requirements for expedited judicial review to be jurisdictional when a party seeks judicial confirmation, but not jurisdictional when a party seeks judicial vacatur or modification. Consequently, the court determined that whether an arbitrating party is applying for judicial review to confirm and award under section 9 or to vacate or modify an award under section 10 and 11, Congress intended that party’s failure to serve notice of the application within the mandatory time limits, would have jurisdictional consequences. Because the appellate court concluded that the three-month requirement is jurisdictional in nature and the plaintiffs failed to comply with the three-month requirement the district court did not have authority under the FAA to vacate the arbitration award. Because the district court didn’t have jurisdiction to enter a judgment vacating the arbitration award under the FAA, the district court’s judgment was void. That meant that the appeal from the district court’s judgment didn’t confer any appellate jurisdiction on the appellate court – the Nebraska Supreme Court. The district court’s judgment was vacated and the appeal was dismissed for lack of jurisdiction.
In a more recent case from North Carolina, an arbitrator’s award was vacated. In Williamson Farm v. Diversified Crop Insurance Services, No. 5:17-cv-513-D, 2018 U.S. Dist. LEXIS 49249 (E.D. N.C. Mar. 26, 2018), the plaintiff, a farming partnership, bought crop insurance from the defendant for the 2013 crop year. The plaintiff intended to buy full crop coverage on all planted acres, and the defendant’s agents represented that the coverage purchased was full coverage. The plaintiff incurred a loss on one parcel, and was prevented from planting on two other tracts. The plaintiff filed claims for the losses under the policy and the defendant denied coverage on the basis that one tract on which the claim was made was listed under the policy as being in a different county and the tracts on which the plaintiff was prevented from planting crops were improperly claimed on an Farm Service Agency report. The defendant conceded that the errors were the fault of the defendant’s agents.
The plaintiff sought arbitration pursuant to the policy and was awarded coverage on the claims and treble damages. The arbitrator’s award was based on legal theories of negligence, breach of fiduciary duty, constructive fraud and violation of state (NC) law. The defendant challenged the arbitrator’s award as beyond the scope and authority of the arbitrator insomuch as the arbitrator engaged in interpreting the meaning, scope and applicability of the crop insurance policy at issue rather than obtaining an interpretation from the Federal Crop Insurance Corporation (FCIC).
The court agreed, noting that 7 U.S.C. §1506(l) pre-empts the arbitrator’s award unless FCIC procedures had been followed. The court also noted that the treble damages were based on the arbitrator finding a violation of NC law involving unfair and deceptive trade practices without first seeking a ruling from the FCIC. Accordingly, the court vacated the award as being beyond the arbitrator’s authority. On appeal, the U.S. Court of Appeals for the Fourth Circuit affirmed. Williamson Farm v. Diversified Crop Ins. Services, 917 F.3d 247 (4th Cir. 2019).
The decision whether to plant a crop or simply file for prevented planting payments is an important one. In that decisionmaking process will be included the notion that this spring’s second round of market facilitation payments can only be received if a crop is planted. That’s a key point. But, once a claim is filed, the regulatory and administrative process kicks-in. Those rules can be complex and confusing. Another good reason to have an attorney specially trained in agricultural law matters at your side.
Tuesday, June 11, 2019
The organization of the farming business is important to those farm and ranch families that are wanting to transition the business to the next generation. Other families don’t have heirs that are interested in continuing the family business. For them organizational issues are important from a present tax and farm program payment limitation standpoint (perhaps), but not necessarily that critical for future business succession.
In today’ post, I take a look at some recent developments relevant to entity structuring. These developments point out just a couple of the various issues that can arise in different settings.
S Corporation Basis Required to Deduct Losses
An S corporation shareholder reports corporate income or loss on their personal income tax return for the year in which the corporate year ends. I.R.C. §1366(a). Losses or deductions passed through to the shareholder first reduce stock basis. After stock basis has been reduced to zero, remaining loss amounts are applied against debt basis. I.R.C. §1367(b)(2)(A). In a year where losses decrease stock and debt basis to zero, the losses can be deducted only if the shareholder increases basis before the end of the corporation’s tax year.
One way to increase basis is to lend money to the S corporation. But, the loan transaction must be structured properly for a basis increase to result. For example, in In Litwin v. United States, 983 F.2d 997 (10th Cir. 1993), the court allowed the principal shareholder and principal investor in a Kansas corporation involved in the provision and installation of certain fuel systems for motor vehicles a bad debt deduction for amounts loaned to the corporation. Why? Because the shareholder’s loan was tied to his desire to remain a shareholder/employee and he personally guaranteed the large loans that exceeded his investment. In other words, he was at-risk and his business motives outweighed his investment motives.
But, a couple of recent developments reveal the wrong way to structure loan transactions if a basis increase is desired. In Messina v. Comr., T.C. Memo. 2017-213, the petitioners, a married couple, formed an investment advisory firm. They also each owned 40 percent of the outstanding stock of an S corporation. The S corporation subsequently became the 100 percent owner of another business that elected to be a qualified subchapter S subsidiary (QSUB). The QSUB borrowed money from an unrelated third party to finance the acquisition of another business. The petitioners then formed another S corporation that they were the sole owners of. They then used that second S corporation to buy the debt of the QSUB. The petitioners claimed that they could use the QSUB debt that the second S corporation held to increase their tax basis in the first S corporation so that they could deduct losses that passed through to them from the first S corporation. The petitioners claimed that the second S corporation was to be ignored because it was merely acting as an agent or conduit of the petitioners (an incorporated pocketbook of the petitioners). Thus, the petitioners claimed that they had made an actual economic outlay with respect to the acquisition of the QSUB debt to their financial detriment. As such, the petitioners claimed that the second S corporation should be ignored, and its debt actually ran directly between the first S corporation and its shareholders, of which they owned (combined) 80 percent.
The IRS disallowed the loss deduction due to insufficient basis and the Tax Court agreed. The Tax Court determined that there was no evidence to support the claim that the second S corporation was operating as the petitioners’ incorporated pocketbook. The Tax Court noted that the second S corporation had no purpose other than to acquire the debt of the QSUB, and the petitioners did not use the second S corporation to pay their expenses of the expenses of the first S corporation. There also was no evidence that the second S corporation was the petitioners’ agent because the corporation operated in its own name and for its own account. The Tax Court also held that the petitioners had not made any economic outlay except to the second S corporation. As such, the second S corporation could not be ignored, and the petitioners could not use its debt to increase their tax basis. The Tax Court noted that 2014 IRS final regulations and I.R.C. §1366(d)(1)(B) require that shareholder loans must run directly between the S corporation and the shareholder.
More recently, another court determined that an S corporation shareholder failed to achieve a basis increase on loan transaction. In Meruelo v. Comr., No. 18-11909, 2019 U.S. App. LEXIS 13305 (11th Cir. May 6, 2019), the taxpayer was a shareholder in an S corporation that bought a condominium complex in a bankruptcy sale. To fund its operations, the S corporation accepted funds from numerous related entities. Ultimately, lenders foreclosed on the complex, triggering a large loss which flowed through to the taxpayer. The taxpayer deducted the loss, claiming that the amounts that the related entities advanced created stock basis (debt basis) allowing the deduction. The IRS disallowed the deduction and he Tax Court agreed. The appellate court affirmed on the grounds that the advances were not back-to-back loans, either in form or in substance. In addition, the related entities were not “incorporated pocketbooks” of the taxpayer. There was no economic outlay by the taxpayer that would constitute basis. There also was no contemporaneous documentation supporting the notion that the loans between the taxpayer and the related entities were back-to-back loans (e.g., amounts loaned to a shareholder who then loans the funds to the taxpayer), and an accountant’s year-end reclassification of the transfers was not persuasive. While the taxpayer owned many of the related entities, they acted as business entities that both disbursed and distributed funds for the S corporation’s business expenses. The appellate court noted the lack of caselaw supporting the notion that a group of non-wholly owned entities that both receive and disburse funds can be an incorporated pocketbook. To generate basis, the appellate court noted, a loan must run directly between an S corporation and the shareholder.
The Peril of the Boilerplate
The use of standard, boilerplate, drafting language is common. However, there rarely are situations where “one-size-fits-all” language in documents such as wills, trusts, and formative documents for business entities will work in all situations. That point was clear in another recent development.
In a recent IRS Private Letter Ruling (directed to a specific taxpayer upon the taxpayer’s request), a multi-member LLC elected to be treated for tax purposes as an S corporation. Later, the shareholders entered into an operating agreement that governed the rights of shareholders. Section 10 of the agreement provided that, “Upon dissolution…the proceeds from the liquidation of the Company’s assets shall be distributed…to the Members in accordance with their respective positive Capital Account Balances; and, the balance, if any, to the Members in accordance with their respective Percentage interests.” The language is “boilerplate” and was intended to meet the substantial economic effect provisions of Treas. Reg. §1.704-1(b)(1) and protect special allocations of the partnership.
Unfortunately, the language did not require that the distributions be equal to a “per share” basis in all situations. Instead, they could be disproportionate upon liquidation to the extent of differences in their capital accounts at the time of liquidation. That proved to be a problem. The LLC engaged in a reorganization and sought a ruling on whether the language created a second class of stock that would terminate the S election. The IRS determined that the fact that the rights were not strictly proportionate created more than a single class of stock in violation of I.R.C. §1362(b)(1)(D) and terminated the S election as of the date of the adoption of the operating agreement. However, the IRS determined that the termination was inadvertent, and the S status of the LLC was restored retroactively. Priv. Ltr. Rul. 201918004 (Nov. 15, 2018).
Trusts – Is the End in Sight?
When does a trust end? Either by its terms or when there is no longer any purpose for it. Those are two common ways for a trust to end. This was an issue in a recent case from Wyoming. In re Redland Family Trust, 2019 WY 17 (2019), involved a family trust. The case had been before the Wyoming Supreme Court on multiple occasions. The trust was created in 1989 and amended in 1995. The amendment provided for the appointment of a successor trustee; always required the service of two trustees; created a marital trust for the survivor of the settlors; and revised the buyout provision. The grantors and their five children made contributions to the trust. Upon the death of one of the grantors in 2007 one of the children was appointed as co-trustee. Ligation arose when the surviving grantor’s property was not conveyed to the trust and then again involving removal of the trustees, and an appointed trustee moved to have the trust terminated due to the administrative difficulties to administer, family dysfunction, and because the trust no longer served its purpose. The defendants, (including the co-trustee that resigned) asserted that termination was moot and moved to have the new co-trustee removed. The trial court did not remove the co-trustee and found that the trust was still valid. The trial court found that the co-trustee did not violate any fiduciary duties and that the defendants failed to show gross and willful misconduct to justify her removal. Further the trial court found that the co-trustee’s claims that the trust was invalid should have been raised in the original trust challenge. The trial court determined that the primary reason for the trust (to keep the lands and leases together for the Redland family) had not been frustrated and that the trust remained administratively functional and was not "unlawful, contrary to public policy, or impossible.
On appeal, the Wyoming Supreme Court affirmed. The Court determined that the trust still had a purpose - to keep the ranch holdings together to conduct business. Even though the other purpose of minimizing tax consequences had failed, consolidation of ranch holdings remained a legitimate purpose. The Court also determined that the co-trustee did not violate her fiduciary duties, her duties of impartiality or loyalty, and that her actions did not amount to gross and willful misconduct. In addition, the Court found that the duty of impartiality did not require the trustee to treat all beneficiaries fairly, but simply to act in the best interest of the beneficiaries and equally defend the intentions of the settlors. While the Court could find no precedent with respect to the duty of loyalty the Court held that merely seeking termination of the trust was not a breach of loyalty. In addition, the Court determined that hostility between parties did not warrant removal.
There are various ways to structure business arrangements. Not every structure is right for each family situation, but there’s a unique business plan that will do well for you – once you figure out what your goals and objectives are and have a solid understanding of your factual setting. But, peril lurks. Today’s post examined just a couple of the issues that can arise. Make sure to have good planners assisting.
Friday, June 7, 2019
Is a farmer that raises an ag commodity (or commodities) under a production contract engaged in the trade or business of farming or a rental activity? Is the farmer engaged in both activities with respect to the same contract? Self-employment tax is imposed on a taxpayer’s trade or business income, but not on rental income. Are there components of both in a contract production setting?
The self-employment tax treatment of contract production income – that’s the topic of today’s post.
There has been a dramatic increase in the contract production of agricultural products of the past 50 years. According to the USDA, as of 2017, 34 percent of U.S. farm output is produced under contract. https://www.ers.usda.gov/webdocs/publications/90985/eib-203.pdf?v=9520.4 That’s up from 12 percent in 1969. Over the past 20 years, the average has been 37 percent. Id. The percentage exceeds 50 percent for peanuts, tobacco (presently 90 percent), sugarbeets, hogs and poultry/eggs. Id. There are billions of dollars associated with ag production contracts annually.
There are two basic types of contracts involving the production of agricultural commodities. For crop farms, marketing contracts predominate. Under a marketing contract, the farmer retains ownership of the commodity while the commodity is being raised. The contract is entered into before harvest and establishes a price for a certain amount of commodity to be sold along with delivery date(s). This could also be termed a “forward” contract, and it may contain a payment or pricing clause that would make it a deferred contract for tax purposes. The other type of contract is a production contract. With this type of contract, the contracting firm owns the ag commodity during the production process, and the farmer is paid a fee for services rendered under the contract. The contract will set forth each party’s responsibilities with respect to the provision of inputs and services. Production contracts predominate in the poultry and hog industries.
The Self-Employment Tax Issue
Definition of self-employment income. I.R.C. §1402(a) of the Code, defines “net earnings from self-employment” as “the gross income derived by an individual from any trade or business carried on by such individual…”. Is an ag producer raising a commodity or commodities under a production contract engaged in a “trade or business.” If so, self-employment tax is owed on the contract income. Conversely, if the producer is merely an employee of the supplier under the contract, the supplier must withhold taxes on wages paid, and there is liability for Social Security and, perhaps, federal unemployment tax on both the producer and the supplier. To date, the IRS hasn’t pushed the employer/employee line of argument. However, the same cannot be said for the self-employment tax issue.
In Gill v. Comr., T.C. Memo. 1995-328, a farmer who contracted with a poultry supplier to raise poultry flocks in barns constructed on the farmer's property, but leased to the supplier, was liable for self-employment tax on payments received under the contract from the supplier because the farmer materially participated in raising the poultry That determination was made based on the services that the farmer was required to provide under the contract. They were extensive. Likewise, in Schmidt v. Comr., T.C. Memo. 1997-41, a dairy farmer who contracted with a vegetable cannery to raise beets on a portion of his farm was also found liable for self-employment tax on the contract payments. The contract required the farmer to supply the labor and equipment to produce the beets.
Exception for “rents.” I.R.C. §1402(a)(1) specifies that “there shall be excluded rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares.” That’s an important exception in the ag production contract setting. When an ag production contract also involves the rental of a building (particularly in livestock production settings), if the contract is structured properly the portion of the contract payment attributable to the building should not be subject to self-employment tax. If the contract calls for two separate checks to be issued to the producer (one for building rent and another for services rendered) the tax reporting is simplified – Schedule E for the building rent and Schedule F for the contract services payment. But, if a single check is issued the tax reporting is more difficult. In that situation, the producer will need supporting documentation and evidence of fair rental rates for comparable buildings as well as evidence supporting reasonable labor rates to be able to separate out the building rent portion from the services. Doing so will minimize self-employment tax.
What about W-2 wage income? As noted above, if the producer is merely an employee of the supplier under the contract, the supplier must withhold taxes on wages paid, and there is liability for Social Security and, perhaps, federal unemployment tax on both the producer and the supplier. That’s not likely to be the case – ag production (and marketing) contracts commonly recite that an employment relationship is not created. Even if there is no specific contract clause stating that the producer is not an employee, the typical contract language and producer requirements would likely not create one. In addition, the definition of self-employment income focuses on income derived from a “trade or business” that a taxpayer engages in on a regular and continuous basis. That is different than the definition of “wages” under I.R.C. §3121 which defines “wages” as “remuneration for employment.” I.R.C. §3121(a). In other words, the presence of an employer/employee relationship is the key. In contract production settings that is not present.
What about “nexus”? Income is self-employment taxable if there is a connection or “nexus” between the income a taxpayer receives, and the taxpayer’s conduct of a trade or business based on all of the facts and circumstances. See, e.g., Newberry v. Comr., 76 T.C 441 (1981); Groetzinger v. Comr., 480 U.S. 23 (1987). In an ag contract production situation, that would be broad enough to subject all of the contract income to self-employment tax. That’s where the real estate rental exception of I.R.C. §1402(a)(1) comes into play. That exception effectively severs the “nexus” with respect to building rents. Without that exception the nexus test has a broad application. See, e.g., Slaughter v. Comr., T.C. Memo. 2019-65.
Many ag products are produced via contract. The rental real estate exception can play an important role in minimizing self-employment tax. Proper structuring of the production arrangement economically and careful drafting of the contract for tax purposes can lead to a more profitable venture for the producer.
Wednesday, June 5, 2019
Centuries ago, the seas were viewed as the common property of everyone - they weren’t subject to private use and ownership. This concept was later adopted in English law, the Magna Carta, and became part of the common (non-statutory) law in the United States. Over the years, the doctrine has been primarily applied to access to the seashore and intertidal waters, but it can also be applied with respect to natural resources. A recent case involving seaweed involved the application of the public trust doctrine.
The public trust doctrine and the right to harvest seaweed – that’s the topic of today’s post.
The U.S. Supreme Court’s first application of the public trust doctrine was in 1842 in Martin v. Lessee of Waddell, 41 U.S.367 (1842). In the case, the issue was who had the right to submerged land and oyster harvesting off the coast of New Jersey. The Court, largely based on the language in the charter granted by the King to a Duke to establish a colony and for policy and economic reasons, determined that the land area in issue belonged to the state of New Jersey for the benefit of the people of the state. The Court dealt with the issue again in 1892 in a case involving a railroad that had been granted a large amount of the Chicago harbor. Illinois Central Railroad Company v. Illinois, 146 U.S. 387 (1892). The Court determined that the government cannot alienate (interfere with) the public’s right to access land under waters that are navigable in fact except for situations where the land involved wouldn’t interfere with the public’s ability to access the water or impair navigation.
As generally applied in the United States (although there are differences among the states), an oceanfront property owner can exclude the public below the mean high tide (water) line. See e.g., Gunderson v. State, 90 N.E. 3d 1171 (Ind. 2018). That’s the line of intersection of the land with the water's surface at the maximum height reached by a rising tide (e.g., high water mark). Basically, it’s the debris line or the line where you would find fine shells. However, traceable to the mid-1600s, Massachusetts and Maine recognize private property rights to the mean low tide line even though they do allow the public to have access to the shore between the low and high tide lines for "fishing, fowling and navigation. In addition, in Maine, the public can cross private shoreline property for scuba diving purposes. McGarvey v. Whittredge, 28 A.3d 620 (Me. 2011).
Other applications of the public trust doctrine involve the preservation of oil resources, fish stocks and crustacean beds. Also, many lakes and navigable streams are maintained via the public trust doctrine for purposes of drinking water and recreation.
The public trust doctrine was invoked recently in a Maine case. In Ross v. Acadian Seaplants, Ltd., 2019 ME 45 (2019), the defendants harvest rockweed with skiffs in the intertidal zones of Maine. Rockweed is a perennial plant that attaches to the rocks in the intertidal zones. Rockweed regulates the temperature of the area where it is located and is home to many organisms. Commercially, rockweed is used for fertilizer and feed. To harvest Rockweed, the defendant uses skiffs, rakes, and watercraft without physically stepping foot on the intertidal zone. The defendant annually harvests the statutory maximum 17 percent of eligible harvestable rockweed biomass in Cobscook Bay. The plaintiff, an intertidal landowner, sued seeking (1) a declaratory judgment that the plaintiff is the exclusive owner of the rockweed growing on and affixed to his intertidal property; and (2) injunctive relief that would prohibit the defendant from harvesting rockweed from the plaintiff’s intertidal land without his permission. The defendant sought a judgment declaring that harvesting rockweed from the intertidal water is a public right as a form of "fishing" and "navigation" within the meaning of the Colonial Ordinance. The trial court granted summary judgment for the plaintiff on the declaratory judgment claim, and on the defendants’ counterclaim. The trial court denied the defendant’s counterclaim.
On appeal, the state Supreme Court affirmed, holding that rockweed that is attached to and growing on rocks in the intertidal zone is private property owned by the adjacent landowner. The Court noted that the English common law tradition vested both “title” to and “dominion” over the intertidal zone in the crown. While title belonged to the crown, however, it was held subject to the public’s rights of “navigation,” “commerce,” and “fishing.” After the American colonies gained independence, the ownership of intertidal land devolved to the particular state where the intertidal area was located. See, e.g., Phillips Petroleum Co. v. Mississippi, 484 U.S. 469 (1988). But, the Court noted the uniqueness of rockweed. It takes specialized equipment and skills to harvest it, and harvesting didn’t “look like” the usual activities in the water of fishing and navigation. Instead, it was more like the other uses in the intertidal zone that have been held to be outside the public trust doctrine. Thus, the Court concluded that the harvesting of rockweed was not within the collection of rights held by the State for use by its citizens – the public couldn’t engage in rockweed harvest as a matter of right. The Court stated that, "rockweed in the intertidal zone belongs to the upland property owner and therefore is not public property, is not held in trust by the State for public use, and cannot be harvested by members of the public as a matter of right."
The application of the public trust doctrine has the potential to be quite broad. Environmental activists and others opposed to various agricultural activities often attempt to get courts to apply the doctrine in an expansive manner well beyond public access to that of preservation in general. The potential application of the doctrine can be rather expansive – nonpoint source pollution from farm field runoff; wetlands; dry sand areas; cattle ranching in areas of the West, etc. See, e.g., Mathews v. Bay Head Improvement Association, 471 A.2d 355 (N.J. 1984). The issue is acute in California where a private party can bring an independent action against a state agency under the public trust doctrine when that agency allegedly doesn’t follow the public trust in the conduct of its duties. See Citizens for Biological Diversity, Inc. v. FPL Group, Inc., 83 Cal. Rptr. 3d 588 (Cal Ct. App. 2008); San Francisco Baykeeper, Inc. v. State Lands Commission, 29 Cal. App. 5th 562, 240 Cal. Rptr. 3d 510 (2018).
In the recent Maine case, the public trust doctrine was not used to unnecessarily erode private property rights. The Court balanced the public’s rights against those of private property owners. It wasn’t enough for the plaintiff to simply assert the public trust doctrine.
Maybe there’s hope that the public trust doctrine will be properly balanced against the rights of private landowners. The recent Maine case weighs in on that side of the scale.
Monday, June 3, 2019
Earlier this spring I devoted two blog posts to the topic of cost segregation studies. In those, I mentioned that the purpose of such a study is to generate greater depreciation deductions by parsing out tangible personal property (that is depreciated over a shorter recovery period) from real estate when depreciable real estate is acquired in a transaction. But, one of the downsides of separating out tangible personal property from the real estate is the possibility of recapture – that dirty word in tax.
Cost segregation and the potential for recapture – that’s the topic of today’s post. I would also like to acknowledge Ken Wright’s assistance with today’s post. Ken is a lawyer in Chesterfield, MO and a lecturer on tax and estate planning topics. He brought to my attention the very real problem of recapture when a cost segregation study has been utilized and provided commentary for today’s post.
Cost Segregation Study - Why Do It?
According to the American Society of Cost Segregation Professionals, a cost segregation is "the process of identifying property components that are considered "personal property" or "land improvements" under the federal tax code." Cost segregation is the engineering and accounting process of identifying those items of personal property that are contained within real property, and separating out the items of personal property for MACRS purposes. Land is not depreciable, but structures associated with land are. From a depreciation standpoint, that means that there may be opportunities to allocate costs to personal property or land improvements that are depreciable.
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, a cost segregation study often results 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). That is what generates 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 commercial and business property (including property 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.
Potential Recapture Issue
When a component of I.R.C. §1250 property is reclassified as I.R.C. §1245 property, the total depreciation allowable on the reclassified item is the same. The benefit comes from the present value of the tax savings resulting from the acceleration of the depreciation deduction. However, depreciation recapture can occur on disposition. Depreciation on an I.R.C. §1245 asset is subject to ordinary income recapture in accordance with I.R.C. §1245 and is ineligible for long-term capital gain treatment under I.R.C. §1231. The impact of this result depends on the particular taxpayer’s marginal tax bracket at the time the recaptured amount is taxed. If the item of property had not been reclassified, gain on it would have been subject to a maximum rate of 25 percent as unrecaptured I.R.C. §1250 depreciation. Thus, the ordinary income penalty could be de minimis or it could be as much as 37 percent for individuals (but only 21% for C corporations).
The recapture issue may be more problematic if the disposition of the reclassified asset is via installment sale, like-kind exchange or involuntary conversion. Although gain from a sale of I.R.C. §1231 property can be reported on the installment basis, installment reporting is not permitted for I.R.C.§1245 depreciation recapture. Instead, all I.R.C. §1245 recapture is treated as cash received in the year of sale and must be reported. IRC § 453(i). The taxpayer’s basis in the property for purposes of calculating the gross profit ratio (part of the procedure for computing taxable gain on an installment sale transaction) is then increased by the amount of depreciation recapture and any remaining gain is taxed each year using the recomputed gross profit ratio.
Care should be taken in an installment sale transaction by a taxpayer who has reclassified a significant portion of a property’s basis as I.R.C. §1245 tangible personal property to get enough cash down to pay the tax liability resulting from the recapture along with any first-year payments. (This may also lead to some creative purchase price allocations in sales contracts.)
Ordinary income recapture under I.R.C.§1245 applies to any disposition of I.R.C. §1245 property notwithstanding any other provision of the Code unless there is an express exception contained in I.R.C. §1245. I.R.C. § 1245(a)(1). I.R.C. §1245(b)(4) provides a limited exception from the recapture rules for like-kind exchanges under I.R.C. §1031 and involuntary conversions under I.R.C. §1033. Under the exceptions, if property is disposed of and there is nonrecognition of gain under I.R.C. §1031 or I.R.C. §1033, then the amount of gain to be taken into account under I.R.C. §1245 by the seller is not to exceed the sum of the amount of gain recognized on the disposition determined without regard to I.R.C. §1245 (effectively boot received under I.R.C. §1031 and proceeds not reinvested under §1033), plus the fair market value of any property that is received and which is not I.R.C. §1245 property and has not already been taken into account as gain.
The application of the application rules in the event a portion of the real property is reclassified as §1245 property is illustrated by the following example that is based on Treas. Reg. §1.1245-4(d)(5).
Sam Sung owns I.R.C. §1245 property, with an adjusted basis of $100,000 and a recomputed basis of $116,000. The property is destroyed by fire and Sam receives $117,000 of insurance proceeds that triggers $16,000 of recapture.
Sam uses $105,000 of the proceeds to purchase I.R.C. §1245 property similar or related in service or use to his original property, and $9,000 of the proceeds to purchase stock in the acquisition of control of a corporation owning property similar or related in service or use to Sam’s original property. Both acquisitions qualify under the involuntary conversion rules. Sam properly elects to limit recognition of gain to the amount by which the amount realized from the involuntary conversion exceeds the cost of the stock and other property acquired to replace the converted property.
Since $3,000 of the gain is recognized (without regard to the I.R.C. §1245 recapture rules) under the involuntary conversion rules for failure to purchase sufficient replacement property (that is, $117,000 minus $114,000), and since the stock purchased for $9,000 is not I.R.C. §1245 property and was not taken into account in determining the gain under the involuntary conversion rules, the amount of the gain taken into account as I.R.C. §1245 recapture is limited to $12,000 (that is, $3,000 plus $9,000).
If, instead of purchasing $9,000 in stock, Sam purchases $9,000 worth of property which is I.R.C. §1245 property similar or related in use to the destroyed property, the recapture amount would be limited to $3,000. The result would have been the same had the transaction been structured as an I.R.C. §1031 exchange.
As noted above, a building containing items that have been reclassified as I.R.C. §1245 tangible personal property for MACRS purposes as the result of a cost segregation study does not change the classification of the property for purposes of the like-kind exchange provisions of I.R.C. §1031 or the involuntary conversion rules of I.R.C. §1033. Consider the following example:
Ray Ovac reclassifies 25 percent of the basis of items in a building as being 7-year MACRS property and claims accelerated depreciation. All of the items are otherwise structural components of the building and therefore classified as real property under state law. Ray later trades the building and associated land in a like-kind exchange for unimproved land. For purposes of applying the like-kind exchange rules of I.R.C. §1031, Ray is treated as having traded real property for real property. Ray will recognize gain under I.R.C. §1245, however, unless the FMV of the 25 percent of the basis that was reclassified as I.R.C. §1245 property is replaced by an equal or greater FMV of I.R.C. §1245 property. The point of this is to ensure that the I.R.C. §1245 recapture carries over to the replacement I.R.C. §1245 property and is not subsumed by the replacement I.R.C. §1250 property.
The recapture potential as the result of a cost segregation study should always be kept in mind.