Wednesday, July 31, 2019
My blog article of July 17 concerning the tax treatment of settlements and court judgments raised an interesting question by a reader. For review, you can read that post here: https://lawprofessors.typepad.com/agriculturallaw/2019/07/tax-treatment-of-settlements-and-court-judgments.html. The reader wanted to know how the tax rules would apply to the Roundup jury verdict that was reached this past May.
Applying the tax Code rules to the Roundup jury verdict (and others) - that’s the topic of today’s post.
Review of the Applicable Rules
As I noted in the July 17 article, proper categorization of a court award or settlement amount is critical. Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1. However, recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness.
Tax Application to the Roundup Jury Verdict
Impact on the plaintiffs. In May, Alva and Alberta Pilliod a California jury awarded $2 billion in punitive damages and $55 million for pain and suffering as a result of their use of the common weed-killer, Roundup. From accounts that I have read and persons that I have talked to, it is estimated that if the award stands up on appeal (no sure thing), attorney fees would amount to nearly $1 billion. So, how would the tax rules apply to the total award? What would be the Pilliod’s “take-home” amount from the jury award?
It’s important to segregate the jury award for pain and suffering from the award for punitive damages. For starters, the $55 million in pain and suffering is tax-free because it is to compensate for physical injury and/or physical sickness. As for the $2 billion, that's a different story – that amount is fully taxable. So how does this break-out on the tax return? Assuming that this is the only income that the Pilliod’s have for 2019, consider the following:
At the federal level, the $2 billion would be subject to the highest marginal income tax rate of 37 percent, yielding a tax of $740,000,000. There would be a very slight off-set for the standard deduction.
Added to the $740,000,000 of federal income tax is the California state income tax. The state-level tax is a bit more complicated to compute. The top marginal rate of 12.3 percent would apply. To that top rate, an additional 1 percent “millionaire tax” is added. A taxpayer with California taxable income (i.e. as calculated on Form 540, Line 19) exceeding $1,000,000 during a given tax year is subject to the “Mental Health Services Tax.” The amount of the tax is 1% of the amount of the taxpayer’s income that exceeds $1,000,000.
However, California does not couple with the federal government on the issue of the non-deductibility of legal fees. As a result, taxable income for California tax purposes will be substantially less than taxable income at the federal level. Based on a “mocked-up” California tax return, the following results:
Gross income: $2,000,000,000
Deduction for legal fees: 857,341,000
Taxable income: $1,142,659,000
Applying the top California tax rate to the $1,142,659,000; adding in the “Millionaire’s tax” and state-level alternative minimum tax; and factoring in the standard deduction for a married couple, the result is a state-level tax of $151,416,590.
Thus, the total tax bite (federal and state) for the Pilliod’s will be approximately $851,416,590 – very close to one-half of the punitive damage award.
The Pilliod’s will also be responsible for paying attorney fees. If the accounts are correct that the amount will approach the $1 billion amount, the remaining balance of the punitive damage award that the Pilliod’s will actually pocket will be somewhere between $149,000,000 and zero.
Application to the attorneys. The attorneys involved will also have to pay tax on the amount received from the settlement. This is income that is received in the ordinary course of a trade or business, so the amount is subject to tax at the federal and state levels and is also subject to self-employment tax, payroll tax, etc.
Assuming that the attorneys receive $1,000,000,000 in fees, here’s how the tax impact breaks out:
Fed. tax rate of 37%: $370,000,000
CA tax rate of 13.3%: $133,000,000
Total tax: $503,000,000
Balance remaining: $497,000,000
Less s.e. tax; payroll tax; medicare tax, etc. – (assuming 7%: $38,081,260)
Final balance remaining: $458,918,740
In summary, of the total jury award of $2,055,000,000, the total taxes paid (federal and state) amounts to $740,000 + $151,416,590 + 541,081,260, for a total tax bite of $1,432,497,850. That’s an effective rate of 71.6%! The Pilliod’s “take-home” is the $55,000,000 of actual damages and somewhere between zero and $149,000,000 of the punitive damage award. The attorneys “take-home” is $458,918.740. On balance the plaintiffs pocket approximately 2-10 percent of the total award, the attorneys pocket approximately 19-29 percent of the total award, and the government somewhere in excess of 70 percent.
What About Syngenta Payments?
Corn farmers participating in the nationwide class action against Syngenta may begin receiving settlement payments in 2020. None of those payments are attributable to physical injury or sickness. Instead, they are related to market damage/loss. Thus, the settlement payments are fully taxable, and any attorney fees will not be deductible on the federal return.
The taxation of court awards and settlements can be surprising. In addition, the inability to deduct legal fees post-TCJA enhances the tax impact.
Monday, July 29, 2019
Under 1986 amendments to the Bankruptcy Act of 1978, Congress created Chapter 12 bankruptcies for “family farmers.” Bankruptcy Judges, United States Trustees, and Family Farmer Bankruptcy Act of 1986, Pub. L. No. 99-554, 100 Stat. 3105 (1986), adding 11 U.S.C. § 1201 et seq. Chapter 12 became a permanent part of the Bankruptcy Code effective July 1, 2005. Numerous requirements must be satisfied for a debtor to qualify for Chapter 12 relief. One of those requirements, the “aggregate debt test” is the subject of a bill, H.R. 2336, that passed the U.S. House on July 25. The legislation increases the maximum aggregate debt a debtor can have and remain eligible for Chapter 12. It’s an important bill because of the economic struggles of many farming operations in certain parts of the country. I have discussed those problems in other posts, such as this one: https://lawprofessors.typepad.com/agriculturallaw/2018/03/chapter-12-bankruptcy-feasibility-of-the-reorganization-plan.html
The proposed increase in the Chapter 12 bankruptcy aggregate debt test - it’s the topic of today’s post.
To be eligible for Chapter 12 bankruptcy, a debtor must be a “family farmer” or a “family fisherman” with “regular annual income.” 11 U.S.C. §§101(19A) & (21). A “family farmer” is defined as an individual or individual and spouse who earned more than 50 percent of their gross income from farming either for the taxable year preceding the year of filing or during the second and third tax years preceding filing, and whose aggregate debts do not exceed $4,411,400. 11 U.S.C. §18). In addition, more than 50 percent of the debt must be debt from a farming operation that the debtor owns or operates. Id. H.R. 2336 proposes to increase the $4,411,400 amount to$10 million.
Changed Nature of Agricultural Production
As noted above, Chapter 12 was added to the Bankruptcy Code in 1986. At that time, much of agriculture was faced with a debt crisis when crop prices declined sharply, interest rates rose sharply, and farmland values, particularly in the Midwest, plummeted. That toxic mix resulted in many farmers, some of whom were very good managers, finding themselves in a precarious economic position. It was this environment that led to Chapter 12’s enactment and, at the time, it was estimated that 86 percent of farmers could qualify for relief under Chapter 12 . At time of enactment, the aggregate debt limit for Chapter 12 was $1,500,000. That debt limit did not increase until 2005 when it was increased to $3.237,000 via an inflation adjustment. The current limit of $4,411,400 is the present inflation-adjusted limit.
According to U.S.D.A. data, total real farm sector debt has now reached the level it was at during the depth of the farm debt crisis in the early 1980s. However, the increase has been particularly accelerated since 2009, with lenders shoring up their collateral positions by increasing debt on real estate to allow them to continue making loans to farmers. But that is only a short-term solution to a deeper problem. Presently, U.S.D.A. data indicates that the current ratio for agriculture (a measure of the ability to pay bill from current assets – it is total current assets divided by total current liabilities) is 1.31. That number indicates that many farmers are facing a liquidity crisis, and it is generally the position of ag economists that the ratio should be between 1.5 and 3.0.
In addition, U.S.D.A. data also indicates that the working capital compared to the value of farm production is at .09, further supporting the notion that a liquidity crisis is looming for even more farmers. Working capital is the amount of liquid funds that a business has available to meet short-term financial obligations. It is calculated by subtracting current liabilities from current assets, and it provides the short-term financial reserves that are available. In other words, it measures the ability of a farming operation to withstand a financial/economic downturn. For healthy farm businesses, ag economists generally take the position that ratio should be in the 15% to 25% range. The current number of nine-percent means that ag operations are “burning” through working capital and are more vulnerable to financial stress.
“Right-Sizing” the Farming Operation
With land increasingly used as collateral, if economic conditions in agriculture remain difficult, the ability of many farmers to stay in business will be further decreased. Some will be forced to “right-size” their farms by selling assets. But doing so has the very real potential of triggering significant taxes – both capital gain and ordinary income caused by depreciation recapture. Historically, this was a very real problem for farmers filing Chapter 12. The sale of farm assets to make the operation economically viable triggered gain which, as a priority claim, had to be paid in full before payment could be made to general creditors. Even though the priority tax claims could be paid in full in deferred payments, in many instances the debtor did not have sufficient funds to allow payment of the priority tax claims in full even in deferred payments.
Congress addressed this problem with the 2005 Bankruptcy Act overhaul. That law contained a provision allowing a Chapter 12 debtor to treat claims arising out of “claims owed to a governmental unit” as a result of “sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation” to be treated as an unsecured claim that is not entitled to priority under Section 507(a) of the Bankruptcy Code, provided the debtor receives a discharge. The provision is now contained in 11 U.S.C. §1232, and it is immaterial whether the tax is triggered pre or post-petition.
Back to the Debt Limit
For the above-mentioned reasons, eligibility for Chapter 12 essential for a farmer to be able to deprioritize taxes associated with the sale of farm assets used in the farming operation and ultimately put together a reorganization plan that will allow the farmer to stay on the farm to continue production activities, make restructured loan payments and have some debt written off.
While the Chapter 12 debt limit has only adjusted for inflation since 1986, farms have increased in size and capital needs faster than the rate of inflation. This means that far less than 86 percent of farmers can satisfy the aggregate debt limit of Chapter 12 – the percentage estimated to qualify for Chapter 12 when it was enacted. While Chapter 11 is an alternative reorganization provision, it does not contain the favorable tax rule of a Chapter 12, is more costly to file, has different “timing” rules, and contains an “absolute priority” rule that can severely limit the ability of a farmer to reorganize debts and remain in farming. I discussed the absolute priority rule here: https://lawprofessors.typepad.com/agriculturallaw/2019/07/farmers-bankruptcy-and-the-absolute-priority-rule.html. In addition, for a farm debtor that has aggregate debt over the $4,411,400 limit, it’s not possible to file a Chapter 11, pay debt down beneath the threshold, and convert to Chapter 12.
H.R. 2336 (and the companion Senate bill S. 987) is important legislation designed to restore the availability of Chapter 12 to farmers (but not family fisherman) that were intended to benefit from it when it was enacted in 1986. If the original policy reasons justifying the enactment of Chapter 12 in 1986 remain, the debt ceiling should increase to reflect that rationale. Senate rules are different than those in the House and a Senator’s objection to a bill can cause a bill to stall much more easily than in the House. Presently, Senator Feinstein (D-CA) is objecting to the legislation on the basis that hearings have not been held. However, she is mistaken on that point. Hearings were held last year – on both the House and Senate bills. Senator Durbin (D-IL) is also objecting for other reasons, and Senator Warren (D-MA) is believed to follow whatever Sen. Durbin does.
At this point, interested farmers and others are encouraged to contact their Senators via email before Thursday of this week. After Wednesday, the Senate is recessed. This week will be a key week for many family farmers.
Thursday, July 25, 2019
Agriculture is a heavily regulated industry. Land ownership; production activities; marketing of ag products; and food products that are in the consumer (and livestock) food supply are subject to federal and state regulations. What are the major federal rules? How do they apply to producers of food products?
The regulation of food products – it’s the topic of today’s post.
The government agencies with primary responsibility for ensuring the safety of the U.S. food supply are the USDA (through the Food Safety and Inspection Service (FSIS)) and the Food and Drug Administration (FDA). While neither agency has the authority to mandate a recall of unsafe food, they have developed general oversight procedures and protocol for voluntary food recalls by private companies. The USDA is generally responsible for the regulation of meat, poultry and certain egg products, while the FDA has responsibility for the regulation of all other food products including seafood, milk, grain products, fruits and vegetables, and certain canned, frozen and otherwise packaged foods that contain meat, poultry and eggs that USDA does not otherwise regulate.
Food Adulteration and Misbranding
The regulations generally proscribe the adulteration and misbranding of food. In general, a food is considered adulterated if it contains a harmful substance that may pose a safety risk, contains an added harmful substance that is acquired during production or cannot be reasonably avoided, contains a unapproved substance that has been intentionally added to the food, or if it has been handled under unsanitary conditions that presents a risk of contamination that may pose a safety threat. Under the Federal Food, Drug, and Cosmetic Act (FFDCA) (21 U.S.C. §§ 301-399), the manufacture, delivery, receipt or introduction of adulterated food into interstate commerce is prohibited. However, the USDA regulations did not prevent the introduction into the human food chain of meat from downed livestock. In Baur v. Veneman, 352 F.3d 625 (2d Cir. 2003), a beef consumer argued that the USDA should label all downed livestock as “adulterated,” and that the consumption of meat from downed animals created a serious health risk of disease transmission and that elimination of downed cattle from the human food stream was necessary to protect the public health. In late 2003, the United States Court of Appeals for the Second Circuit held that the beef consumer had standing to challenge the USDA policy. Shortly thereafter, the presence of “Mad-Cow” disease was discovered in the U.S., and the USDA announced on December 30, 2003, that it was changing its regulations to ban the meat from downed animals from the human food chain. FSIS issued a series of three interim rules in early 2004. The final rule is effective October 1, 2007, and prohibits the slaughter of non-ambulatory cattle in the United States (except that veal calves that cannot stand due to fatigue or cold weather may be set apart and held for treatment and re-inspection). 72 Fed. Reg. 38699 (July 13, 2007). Also, the final rule specifies that spinal cord must be removed from cattle 30 months of age and older at the place of slaughter, and that records must be maintained when beef products containing specific risk materials are moved from one federally inspected establishment to another for further processing. Under the final rule, countries that have received the internationally recognized BSE status of “negligible risk” are not required to remove specific risk materials.
While neither the USDA nor the FDA can order a private company to recall unsafe food products, they can issue warning letters, create adverse publicity, seize unsafe food products, seek an injunction or begin prosecuting criminal proceedings.
For food products over which the FSIS has jurisdiction, upon learning that a misbranded or adulterated food item may have entered commerce, the FSIS will conduct a preliminary investigation to determine whether a voluntary recall is warranted. If a recall is deemed necessary, a determination is made as to the degree of the recall and the public is notified. For food products subject to the FDA’s jurisdiction, a similar procedure is utilized.
Organic foods are produced according to certain production standards. For crops, “organic” generally means they were grown without the use of conventional pesticides, artificial fertilizers, human waste, or sewage sludge, and that they were processed without ionizing radiation or food additives. For animals, “organic” generally means they were raised without the use of antibiotics and without the use of growth hormones. In most countries, organic produce must not be genetically modified.
Historically, organic farms have been relatively small family-run farms with organic food products only available in small stores or farmers' markets. More recently, organic foods have become much more widely available, and organic food sales within the United States have grown by 17 to 20 percent a year in recent years while sales of conventional food have grown at only about 2 to 3 percent annually. This large growth is predicted to continue, and many companies (including Wal-Mart) are beginning to sell organic food products.
An organic food producer must obtain certification in order to market food as organic. Under the Organic Food Production Act (OFPA) of 1990 (7 U.S.C. §§ 6501-23), the USDA is required to develop national standards for organic products. USDA regulations are enforced through the National Organic Program (NOP) governing the manufacturing and handling of organic food products. As enacted, the statute provides that an agricultural product must be produced and handled without the use of synthetic substances in order to be labeled or sold as “organic”. But, under USDA regulations, a “USDA Organic” seal can be placed on products with at least 95% organic ingredients. The 95 percent rule was challenged by a Maine organic blueberry farmer as being overly tolerant of non-organic substances and inconsistent with the statute, and the United States Court of Appeals for the First Circuit agreed, invalidated several of the regulations while scaling back the scope of other regulations. Harvey v. Veneman, 396 F.3d 28 (1st Cir. 2005). In response to the court’s opinion (and while the case was on appeal) the Congress amended OFPA. Upon further review, the court determined that OFPA, as amended, permitted the use of synthetics as both ingredients in and processing aids to organic food. Harvey v. Johanns, 494 F.3d 237 (1st Cir. 2007).
Produce Safety Rule
In early 2011, the President signed into law the Food Safety Modernization Act (FSMA) of 2010. 21 U.S.C. §301, et seq. The FMSA gives the FDA expansive power to regulate the food supply, including the ability to establish standards for the harvesting of produce and preventative control for food production businesses. Beginning in 2018, the new rules will significantly impact many growers and handlers of fresh produce.
The FMSA also gives the FDA greater authority to restrict imports and conduct inspections of domestic and foreign food facilities. To implement the requirements of the FMSA, the FDA had to prepare in excess of 50 rules, guidance documents, reports under a short time constraint. Indeed, the timeframe was so short FDA complained that they didn’t have enough time to do the job appropriately. That led to lawsuits being filed by activist groups to compel the FDA to issue several rules that were past-due. A federal court agreed with the activists in the spring of 2013 and, as a result, the FDA issued four proposed rules with comment periods that ended in November of 2013. Center for Food Safety v. Hamburg, 954 F. Supp. 2d 965 (N.D. Cal. 2013). One of the most contentious issues involved the rule FDA was supposed to develop involving intentional adulteration of food. FDA said it needed two more years to develop an appropriate rule, but the Court ordered them to develop it immediately. The hope, at that time, was that the Congress would step in and modify the deadlines imposed on the FDA so that reasonable rules could be developed rather than being simply rushed through the regulatory process for the sake of meeting an arbitrary deadline.
In late 2015, the FDA issued its Final Produce Safety Rule that has application to growers and fresh produce handlers (those that pack and store fresh produce). The rule is designed to reduce the instances of foodborne illnesses. Effective, January 16, 2016, the rule generally covers the use of manure or compost as fertilizer, allowing (at least for the present time) a 90 to120-day waiting period between the application of untreated manure on land and the time of harvest. That timeframe is in accordance with USDA National Organic Program Standards. Relatedly, the rule requires that raw manure and untreated biological soil amendments of animal origin must be applied without contacting produce and post-application contact must be minimized. Also, the rule addresses water quality and establishes testing for water that is used on the farm such as for irrigation or handwashing purposes. Under the rule, there must be no detectible generic E coli in water that has the potential to contact produce. The rule establishes a timeframe for noncompliant growers to come into compliance with the water requirements. The rule also addresses scenarios that could involve contamination of food products by animals, both domestic and wild, and establishes standards for equipment, tools and hygiene. As for potential contamination by wild animals, the rule requires farmers to monitor growing areas for potential contamination by animals and not harvest produce that has likely been contaminated. In addition, the rule establishes requirements for worker training, health and hygiene, and particular rules for farms that grow sprouts.
Under the rule, farms that sell an average of $25,000 or less of produce over the prior three years are exempt. Similarly, exempt are farms (of any size) whose production is limited exclusively to food products that are cooked or processed before human consumption. For producers whose overall food sales average less than $500,000 annually over the prior three years where the majority of the sales are directly to consumers or local restaurants or retail establishments, a limited exemption from the rule can apply. However, these producers must maintain certain required documentation (effective Jan. 16, 2016) and disclose on the product label at the time the product is purchased the name and location of the farm where the food product originated. In addition, the rule also allows commercial buyers to require that the farms from which they purchase produce follow the rule on their own accord.
Food products – yet another aspect of agriculture that is substantially regulated.
Tuesday, July 23, 2019
In last Friday’s post, I examined what an Employee Stock Ownership Plan (ESOP) is, the basic structure of an ESOP, and the benefits of using an ESOP. In Part Two today, I look at an ESOP’s potential pitfalls, how the U.S. Department of Labor might get involved (in not a good way), and the impact of the Tax Cuts and Jobs Act (TCJA) on ESOPs.
ESOPs and ag businesses – part two. It’s the topic of today’s post.
What the DOL Looks For
The U.S. Department of Labor (DOL) has a national enforcement project focused on ESOPS. The Employee Benefits Security Administration (EBSA) is an agency within the DOL that enforces the Employee Retirement Income Security Act of 1974 (ERISA) and is charged with protecting the interests of the plan participants. One of the primary concerns of the DOL is the belief that ESOPs suffer chronically from bad appraisals. As a result, the EBSA has increased its level of scrutiny of ESOP appraisals, and litigates cases it believes are egregious and could not be settled or otherwise resolved. In these situations, the basic allegation is that the fiduciaries of the ESOP didn’t exercise adequate diligence in obtaining and reviewing the appraisals as part of the transaction process.
Appraisals that are based on projections that are too optimistic can result in an overpayment by the ESOP in the transaction. This can be a particular problem when the appraisal is prepared by a party to the transaction – the same people that are selling the stock to the ESOP or who are subordinates of the sellers. I.R.C. §401(a)(28)(C) requires that all employer securities which are not readily tradeable on an established securities market must be valued by an “independent appraiser.” An “independent appraiser” is a “qualified appraiser” as defined by Treas. Reg. §1.170A-13(c)(5)(i). For example, in Churchill, LTD. Employee Stock Ownership Plan & Trust v. Comr., T.C. Memo. 2012-300, pet. for rev. den., No. 13-1295, 2013 U.S. App. LEXIS 11046 (8th Cir. May 29, 2013), the appraiser did not satisfy the requirements to be a qualified appraiser. The court also upheld the IRS determination to revoke the ESOP as a disqualified plan from 1995 forward (total of 15 years) for failure to meet certain statutory requirements (i.e., failure to timely amend plan documents necessitated by tax law changes and failure in addition to not having a qualified appraiser) to which ESOPs are subject.
If the ESOP fiduciaries simply accept the projections without determining whether the projections are realistic that will likely constitute a breach of their fiduciary duties. So, simply plugging management projections into the ESOP appraisal without a critical review by the fiduciaries is problematic. Clearly, an ESOP’s fiduciaries should be communicating with the appraisers about the projections and asking questions. Similarly, if the appraisal incorporates a control premium when the ESOP is not really buying control, that will bring scrutiny from the EBSA. The reason for the scrutiny is that the result will be an enhanced stock value over what it should be in reality. Relatedly, an issue can arise where the ESOP pays full value for the stock but does not get all of the upside potential because of dilution caused by warrants, options, or earn-outs that are not considered in determining adequate consideration. That results in overpayment for the stock. The EBSA is also concerned about the use of out-of-date financials on which the appraisals are based which don’t reflect current corporate reality.
Also, EBSA looks for situations where the plan effectively owns the company, but is not exercising any of its ownership rights in the company. In other words, in this situation the claim is that company management is effectively “looting” the company of its value and the ESOP fiduciaries are doing little or nothing to protect the value of the corporate stock.
The Cactus Feeders Case
Basic facts. The concerns of the DOL and the EBSA were illustrated recently in a matter involving Cactus Feeders, Inc. (CFI), a large cattle feeding business. In early March of 2016, the DOL filed a lawsuit in federal district court in Amarillo, TX, against CFI and various fiduciaries to the CFI ESOP for allegedly causing the ESOP to pay tens of millions of dollars more than the DOL claims it should have paid for company stock. The court filing points out ESOPs require care in their implementation and usage to avoid government scrutiny and the possible fines and penalties, and revocation that can accompany failing to meet all of the technical requirements.
The DOL alleged that Lubbock National Bank (the ESOP trustee) violated its fiduciary obligations under the (ERISA) when it caused the ESOP to overpay for company stock. The DOL also claimed that CFI, as the ESOP administrator and acting through its board of directors and designated ESOP committee members, knew of the trustee’s breaches of duty and didn’t stop them. The ESOP, which already owned 30 percent of corporate stock, bought the remaining 70 percent for $100 million which DOL claims was too high of a price to pay because it failed to account for warrants and stock options that would dilute the ESOP’s equity from 100 percent to 55 percent when exercised; a lack of marketability discount; and a price adjustment for an investors’ rights agreement that allowed the selling shareholders to retain control over CFI for a 15-year period.
Settlement. On May 4, 2018, the DOL and CFI settled. The settlement also involved CFI’s insurers, certain parties involved with the ESOP committee, and the ESOP trustee. The settlement involved the payment of an additional $5.4 million into the CFI ESOP. Acosta v. Cactus Feeders, Inc., et al., No. 2:16-cv-00049-J-BR (N.D. Tex. May 4, 2018). In addition, the settlement placed additional requirements on the ESOP trustee that are comparable to an agreement the DOL reached in 2014 with GreatBanc Trust Co. Basically, the agreement requires the CFI ESOP trustee to follow specified procedures when serving as a trustee or other fiduciary of an ESOP that is subject to ERISA when non-publicly traded employer securities are involved. But, it did not require the CFI ESOP trustee to do a number of things that the DOLwas seeking – such as reviewing financing options for ESOPs; obtaining “fairness” opinions; obtain sufficient insurance to provide liability coverage as a fiduciary; perform oversight of a valuation advisor; and maintain documentation of when control is given up via an ESOP transaction.
Impact of the TCJA
The TCJA retained the existing tax benefit when an ESOP owns an S corporation. In that situation, the portion of ESOP earnings that are attributable to the S corporation are exempt from federal (and most state) income tax. In other words, the flow-through tax status of the S corporation is recognized. However, when an ESOP owns a C corporation or less than 100 percent of an S corporation, the TCJA will have an impact. Under the TCJA, the C corporate tax rate was changed to a flat 21 percent, effective January 1, 2018. Depending on the prior applicable tax rate for the corporation, this could be a benefit. As for interest expense deductibility (which could be an issue for an ESOP where the company borrowed funds to finance the acquisition), the TCJA limits the deduction for business interest to the sum of business interest income; 30% of the taxpayer’s adjusted taxable income for the tax year; and the taxpayer’s floor plan financing interest for the tax year. Any disallowed business interest deduction can be carried forward indefinitely (with certain restrictions for partnerships). But, the limitation doesn’t apply to a taxpayer with gross receipts of $25 million or less. A “farming business” can elect out of the limitation (with some “pain” incurred on the depreciation side of things).
On the ESOP valuation issue, the reduction in the top C corporate tax rate (federal) from 35 percent to 21 percent may result in enhanced after-tax corporate earnings. If so, it will trigger higher valuations when the ESOP is valued using the discounted cash-flow method (which is a common ESOP valuation approach). This rate reduction could also result in higher ESOP repurchase obligations.
If an ESOP transaction is treated seriously, is minimally complex (e.g., the plan buys shares of common stock at fair market value), and the trustee considers how the structure of the transaction can either help or hurt plan participants, it is likely that the ESOP will avoid scrutiny. Clearly, the trustee should be communicating with the appraisers, analyzing company projections by comparing them with industry competitors and historical numbers, and determining whether the plan should be paying for control (it shouldn’t when the plan can’t control who manages the company or how it is managed). In addition, the use of an independent appraiser is required.
Certainly, ESOPS are useful primarily as a management succession vehicle for a closely held business. Also, they tend to work better for lower income, relatively younger employees compared to the typical company retirement plan. But, they are very complex and potentially dangerous. They do require meticulous compliance to avoid catastrophic results, and should never be used as a tax shelter for a closely-held business when the owner wants to maintain control. They require compliance with complex qualification rules on an annual basis, which requires significant legal and consulting bills. So, in the right situation, an ESOP can be useful and may even outperform a more traditional retirement plan. But, that’s to be expected given the greater inherent compliance costs and risks.
Is an ESOP a good tool for your farming or ranching operation? It depends.
Friday, July 19, 2019
What Is An ESOP?
In existence since the 1970s, an employee stock ownership plan (ESOP) is a type of qualified retirement plan that is designed to provide employees with ownership in the company by investing (primarily) in shares of stock of the employer-company. According to data from the National Center for Employee Ownership, there are about 7,000 ESOPs in the United States covering approximately 14 million employees.
Does an ESOP work for employees of a farming/ranching operation or an agribusiness? In part one of a two-part series, today’s post lays out the basics of an ESOP – how it’s established and the potential benefits. In part two next week I will examine potential problem areas as well as how the new tax law (as of the beginning of 2018) impacts the use of an ESOP.
ESOPs in agriculture – it’s the topic of today’s blog post.
An ESOP involves employee ownership of the business. There are several ways that an employee can obtain ownership in the business. One is to buy stock in the company. Other ways involve an employee being gifted stock, receiving stock as a bonus or obtaining it via a profit-sharing plan. But, the most common way for an employee to obtain ownership in the business is by use of an ESOP.
In the typical ESOP transaction, the company establishes the plan by means of a trust fund – an “employee benefit trust” (hopefully with competent tax and legal counsel) and appoints an ESOP trustee. The trustee then negotiates with a selling shareholder to establish the terms of the sale of the shareholder’s stock to the ESOP. The company borrows the necessary funds from a third-party lender on the ESOP’s behalf and loans the funds to the ESOP which uses the funds to buy the stock from the selling shareholder with the seller receiving cash and taking a note for the balance. The company will make annual (tax-deductible) contributions of cash to the ESOP which the ESOP uses to repay the inside loan. The company uses the payment received from the ESOP to make payments on the third-party loan.
An alternative approach is for the company to have the trust borrow money to buy stock with the company making contributions to the plan so that the loan can be paid back. Unlike other retirement plans, an ESOP can borrow money to buy stock. Consequently, an ESOP can buy large percentages of the company in a single transaction and repay the loan over time using company contributions. The trustee is appointed by the company’s board of directors to manage the trust and can be an officer or other corporate insider. Alternatively, the trustee can be an independent person that is not connected to the corporation as an officer or otherwise. It is advisable that an external trustee be used to negotiate the terms and execute the transaction involving the purchase of shares of stock from a selling shareholder. The trustee has the right to vote the shares acting in a fiduciary capacity. However, the ESOP may require that certain major corporate transactions (i.e., mergers, reorganizations, and significant asset sales) involve the participation of ESOP participants in terms of instructing the trustee with respect to voting the stock shares that are allocated to their accounts. I.R.C. §409(e)(3). ESOP participants do not actually own the shares, the trust does. Thus, an ESOP participant has only the right to see the share price and number of shares allocated to their account on an annual basis. They have no right to see any internal financial statements of the company.
The ESOP shares are part of the employees’ remuneration. The shares are held in the ESOP trust until an employee either retires or otherwise parts from the company. The trust is funded by employer contributions of cash (to buy company stock) or the contributions of company shares directly.
Retirement Plan Characteristics
An ESOP is a qualified retirement plan that is regulated by I.R.C. §4975(e)(7) as a defined contribution plan. As such, ESOPs are regulated by ERISA which sets minimum standards for investment plans in private industry. Only corporations can sponsor an ESOP, but it is possible to have non-corporate entities participate in an ESOP. An ESOP must include all full-time employees over age 21 in the plan and must base stock allocations on relative pay up to $265,000 (2016 level) or use some type of level formula. ESOPs are provided enhanced contribution limits, which may include the amount applied to the repayment of the principal of a loan incurred for the purposes of acquiring employer securities. Employers are allowed to deduct up to an additional 25 percent of the compensation paid or accrued during the year to the employees in the plan as long as the contributions are used to repay principal payments on an ESOP loan. I.R.C. §404(a)(9)(A).
In addition, an employer with an ESOP may deduct up to another 25 percent of compensation paid or accrued to another defined benefit contribution plan under the general rule of I.R.C. §404(a)(3).
In addition, contributions made to the ESOP applied to the repayment of interest on a loan incurred for the purpose of acquiring qualifying employer securities are also deductible, even though in excess of the 25 percent limit. I.R.C. §404(a)(9)(B). But, these two provisions, do not apply to an S corporation. I.R.C. §404(a)(9)(C). As a qualified retirement plan, an ESOP must satisfy I.R.C. §401(a) to maintain its tax-exempt status. While an ESOP is not subject to the normal ERISA rules on investment diversification, the fiduciary has a duty to ensure that the plan’s investments are prudent. In addition to basic fiduciary duties designed to address the concern of an ESOP concentrating retirement assets in company stock, it is not uncommon for a company with an ESOP to also have a secondary retirement plan for employees.
What Happens Upon Retirement or Cessation of Employment?
When one the employee retires or otherwise parts from the company, the company either buys the shares back and redistributes them or voids the shares. An ESOP participant is entitled to a distribution of their account upon retirement or other termination of employment, but there can be some contingencies that might apply to delay the distribution beyond the normal distribution time of no later than the end of the plan year. For plan participants that terminate employment before normal retirement age, distributions must start within six years after the plan year when employment ended, and the company can pay out the distributions in installments over five years, with interest. If employment ceased due to death, disability or retirement, the distribution must start during the plan year after the plan year in which the termination event occurred, unless elected otherwise. If the ESOP borrowed money to purchase employer securities, and is still repaying the loan, distributions to terminating employees are delayed until the plan year after the plan year in which the loan is repaid. In addition, no guarantee is made that the ESOP will contain funds at the time distributions are required to begin to make the expected distributions.
What Are The Benefits of an ESOP?
For C corporations with ESOPS, the selling shareholder avoids the “double tax” inherent in asset sales because the sale is a stock sale. As such, gain can be potentially deferred on the sale of the stock to the ESOP. To achieve successful deferral, the technical requirements of I.R.C. §1042 must be satisfied and the ESOP, after the sale, must own 30 percent or more of the outstanding stock of the company and the seller must reinvest the sale proceeds into qualified replacement property (essentially, other securities) during the period beginning three months before the sale and ending 12 months after the sale. If the replacement property is held until the shareholder’s death, the gain on the sale of the stock to the ESOP may permanently avoid tax.
Corporate contributions to the ESOP are deductible if the contributions are used to buy the shares of a selling shareholder. As a result, an ESOP can be a less costly means of acquiring a selling shareholder’s stock than would be a redemption of that stock. Also, the ESOP does not pay tax on its share of the corporate earnings if the corporation is an S corporation. Thus, an S corporation ESOP is not subject to federal income tax, but the S corporation employees will pay tax on any distributions they receive that carry out the resulting gains in their stock value.
From a business succession/transition standpoint, an ESOP does provide a market for closely-held corporate stock that would otherwise have to be sold at a discount to reflect lack-of marketability of the stock, although the lack of marketability must be considered in valuing the stock. Indeed, one of the requirements that an ESOP must satisfy is that it must allow the participants to buy back their shares when they leave the company (a “repurchase obligation”).
Compared to a traditional 401(k) retirement plan, ESOP company contribution rates tend to be higher, and ESOPS tend to be less volatile and have better rates of return.
In part two next week, I will look at the potential drawbacks of an ESOP and why the U.S. Department of Labor (DOL) gets concerned about them. That discussion will include a recent DOL ESOP investigation involving a major ag operation. It will also involve a look at how the Tax Cuts and Jobs Act impacts ESOPs.
Wednesday, July 17, 2019
Many legal cases are settled out-of-court. Cases could involve divorce, wrongful death, securities fraud, false advertising, civil rights, sexual harassment, product liability, reverse discriminations, or damages for a spilled cup of hot coffee just to name a few. But, if a recovery from a lawsuit or out-of-court settlement is obtained, the tax consequences must be considered. A recent case involving damages that a dairy sustained as a result of stray voltage illustrates this point.
The tax treatment of settlements and court judgments, that’s today’s topic.
Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). Thus, amounts received on account of sickness or mental distress may be received tax-free if the sickness or distress is directly related to personal injury. For instance, settlement proceeds from a wrongful termination suit that are allocable to mental distress are excludible from income where the mental distress is caused directly by the wrongful termination. See, e.g., Barnes v. Comr., T.C. Memo. 1997-25. Those amounts that are allocated to punitive damages are not excludible. Id.
As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1 (1970). The IRS has determined, for example, that excludible damages include damages for wrongful death (Priv. Ltr. Rul. 9017011 (Jan. 24, 1990)); payments to Vietnam veterans for injuries from Agent Orange (Priv. Ltr. Rul. 9032036 (May 16, 1990)); and damages from gunshot wounds received during a robbery (Priv. Ltr. Rul. 8942083 (Jul. 27, 1989)).
Categorization of a settlement or award is also highly dependent on how the wording of the legal complaint, settlement and release are drafted. Wording matters. This point was evident in a recent Tax Court case. In Stepp v. Comr., T.C. Memo. 2017-191, the petitioners, a married couple, could not exclude payments received in settlement of the wife’s Equal Employment Opportunity Commission complaint in which she alleged disability and gender-based discrimination, retaliatory harassment for a job reassignment. The Tax Court noted that each of the complaint, settlement and release provided for emotional and financial harms. There wasn’t mention of any physical injury or sickness. Perhaps those documents were drafted without much thought given to the tax consequences of any eventual award or settlement.
1996 Legislation and the Aftermath
1996 legislation specified that recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness. Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1605(a). See, e.g., O'Gilvie v. United States, 519 U.S. 79 (1996); Whitley v. Comr., T.C. Memo. 1999-124. But punitive damages that are awarded in a wrongful death action are not taxable if applicable state law in effect on September 13, 1995, provides (by judicial decision or state statute) that only punitive damages may be awarded. In that case, the award is excludible to the extent it was received on account of personal injury or sickness. Small Business Job Protection Act, P.L. 104-188, § 1605(d)). The enactment also made it clear that damages not attributable to physical injury or physical sickness are includible in gross income.
In 2006, the U.S. Circuit Court of Appeals for the District of Columbia ruled that the distinction drawn in the 1996 amendment was unconstitutional. Murphy v. United States, 460 F.3d 79 (D.C. Cir. 2006). In the case, the plaintiff sued her former employer and was awarded $70,000 ($45,000 for mental pain and anguish and $25,000 for “injury to professional reputation”). The plaintiff originally reported the entire $70,000 as taxable and then filed amended returns excluding the income. The IRS maintained that the entire $70,000 was taxable, and the trial court agreed. On appeal, the court held that the $70,000 was not excludible from income under the statute, but that I.R.C. §104(a)(2) was unconstitutional under the Sixteenth Amendment since the entire award was unrelated to lost wages or earnings, but were, instead, payments for the restoration of the taxpayer’s human capital. Thus, the entire $70,000 was excludible from income. However, in late 2006, the court vacated its opinion and set the case for rehearing. Upon rehearing, the court reversed itself and held that even if the taxpayer’s award was not “income” within the meaning of the Sixteenth Amendment, it is within the reach of the power of the Congress to tax under Article I, Section 8 of the Constitution. In addition, the court reasoned that the taxpayer’s award was similar to an involuntary conversion of assets – the taxpayer was forced to surrender some part of her mental health and reputation in return for monetary damages.” Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), reh’g. den., 2007 U.S. App. LEXIS 22173 (D.C. Cir. Sept. 14, 2007), cert. den., 553 U.S. 1004 (2008).
What About Lost Profit?
In many lawsuits, there is almost always some lost profit involved, and recovery for lost profit is ordinary income. See, e.g., Simko v. Comm’r, T.C. Memo. 1997-9. For recoveries in connection with a business, if the taxpayer can prove that the damages received were for injury to capital, no income results except to the extent the damages exceed the income tax basis of the capital asset involved. The recovery is, in general, a taxable event except to the extent the amount recovered represents a return of basis. Recoveries representing a reimbursement for lost profit are taxable as ordinary income.
What if Contingent Fees are Part of an Award?
If the amount of an award or court settlement includes contingent attorney fees, the portion of the award representing contingent attorney fees is includible in the taxpayer’s gross income. Comr. v. Banks, 543 U.S. 426 (2005), rev’g and rem’g sub. nom., Banks v. Comr., 345 F.3d 373 (6th Cir. 2003). For fees and costs paid after October 22, 2004, with respect to a judgment or settlement occurring after that date, legislation enacted in 2004 provides for a deduction of attorney’s fees and other costs associated with discrimination in employment or enforcement of civil rights. I.R.C. § 62(a)(19).
Interest on Judgments
Statutory interest imposed on tort judgments, however, must be included in gross income under I.R.C. § 61(a)(4), even if the underlying damages are excludible. See, e.g., Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996).
Under I.R.C. § 104(a), amounts received under workmen’s compensation as compensation for personal injuries or sickness are excludible. However, the exclusion is unavailable to the extent the payment is determined by reference to the employee’s age or length of service.
Impact of the Tax Cuts and Jobs Act (TCJA)
Under the TCJA, some settlement recoveries will cause the full amount of the award (the gross recovery) to be subjected to taxation. Due to the TCJA’s limitation on itemized deductions, the award is included in income without an offset for attorney fees. However, the TCJA does not impact awards that are on account of qualified personal physical injury. Those awards are tax-free as noted above. Also not impacted are employer-related claims – attorney fees for these type of cases remain an “above-the-line” deduction. The TCJA does, however, modify the tax rules involving sexual harassment cases.
Facts. The issue of the proper tax treatment of a jury award and interest was at issue recently in a case involving a Wisconsin dairy operation what suffered affected by stray voltage. In Allen v. United States, 331 F. Supp. 3d 852 (E.D. Wisc. 2018), the plaintiff received a jury award of damages, plus interest, as a result of his lawsuit against a utility company. Stray voltage had harmed his cattle and dairy operation causing decreased milk production, damage to his property and dairy herd, lost profits and increased veterinary bills from 1976 to 2000. The plaintiff’s expert testified that the inflation-adjusted economic losses to the dairy and cattle operation were almost $14 million. The jury returned a verdict for the plaintiff in the amount of $1,750,000 with $750,000 to economic damages and $1,000,000 to tort damages. In 2005, after the jury’s award was affirmed on appeal, the plaintiff received the funds along with $519,233,35 in accrued interest. The plaintiff also paid attorney fees, costs and expenses of $1,230,384.38.
On the plaintiff’s 2005 return, the plaintiff reported the $750,000 of economic damages as ordinary income on Schedule F and the $519,233.35 of interest as capital gain on Schedule B. $548,736 of legal expenses were reported on Schedule F as farm business expense. The $1,000,000 of tort damages was not reported, nor was Form 8275 filed explaining why the tort damages were not reported on the return. The 2005 return showed a tax liability of $124,827 which the plaintiff paid. The IRS audited and treated the $750,000 of economic damages, $1,000,000 of tort damages and $519,233.28 of interest as ordinary income on Schedule F. The IRS also assessed an accuracy-related penalty for the $1 million of underreported income. The IRS assessed an additional $145,836.89 in tax, interest and penalties. The plaintiff then filed an amended 2005 return with the IRS seeking a refund of $130,215. On the amended return, the plaintiff claimed $119,408 of legal expenses as an itemized deduction on Schedule A, categorized the $519,233.25 of interest as capital gain income on Schedule B, and claimed the $1,000,000 tort damage award as a nontaxable recovery of capital on Schedule B, Form 4797. The plaintiff also did not include the $750,000 of economic damages, but later agreed that it constituted ordinary income as reported on the original 2005 return. The plaintiff then sued in federal district court for a refund.
Interest. The court determined that the interest award was properly includible in the plaintiff’s gross income as arising directly from the plaintiff’s damage award for loss to the cattle and dairy business. The court noted that the plaintiff had failed to rebut the determination of the IRS that the interest award was ordinary income. As such, the interest award was also subject to self-employment tax – there was a nexus between the interest on the damage award for loss to the plaintiff’s cattle and dairy business and the underlying business.
Tort damages. The court also held that the $1 million of tort damages constituted ordinary income, based on the origin of the claim and because the facts did not show that the plaintiff was asserting any recovery for interfering with (and devaluing) his real property as a capital asset. The plaintiff had exclusively presented evidence on economic damages - lost profits from milk production and the sale of both dairy and beef cattle. The court noted that the plaintiff had advised the jury to base the amount of the tort damages on economic damages. The plaintiff’s lawyers made no attempt to establish that the plaintiff was seeking recovery for interference with the plaintiff’s real property as a capital asset.
Penalty. The court also upheld the accuracy-related penalty on the basis that the plaintiff did not disclose his position with respect to the non-reporting of the tort damages and because he was advised by an accountant that his treatment of the tort damages was not correct. Thus, the plaintiff did not qualify for the reasonable cause exception to the I.R.C. §6662 penalty contained in I.R.C. §6664(c)(1).
Jury awards and cases where an award is received as a result of a settlement can result in some tricky tax consequences. As Allen illustrates, ag cases can involve a mix of damages with numerous and unique tax consequences.
Monday, July 15, 2019
Major weather events beginning early in 2019 and continuing through May and June in many parts of the Midwest and Great Plains have impacted agricultural producers. A “bomb cyclone” hit parts of Colorado, Kansas, Nebraska and South Dakota in March, leaving billions of dollars of devastation to agricultural livestock, crops, land, equipment and everything else in its path. Rains have been excessive in many places, mirroring the flooding of 1993 that hit the Midwest. Downstream flooding of the Missouri River has impacted parts of Nebraska, Iowa and Missouri.
Some of the impacted ag producers may feel that the need for tax planning is not necessary for 2019. After all, crops and livestock have been lost and other property has been destroyed. What’s there to plan for? Actually, there may be a lot to plan for. Income may actually end up higher than anticipated.
What tax planning considerations are there for farmers and ranchers impacted by weather events in 2019? It’s the topic of today’s blog post.
"What’s Past is Prologue"
The Shakespeare quote from The Tempest is certainly appropriate in the context of today’s topic. The very first Extension meeting that I held was in Topeka, Kansas, in the fall of 1993 and the topic was “Tax and Legal Issues Associated with the 1993 Flood.” I should dust that one off and update it. Many of the concepts will be the same. I remember telling the assembled crowd that evening that tax planning is still very important in what seems like a bad year. But, what are those issues and concepts?
What was experienced in 1993 that is likely to be the experience in 2019? For starters, many ag producers defer income into the following year. Thus, grain and livestock that were sold in 2018 might have been sold under a deferred payment contract that effectively deferred the income to 2019. I discussed the requirements of deferred payment contracts in a prior post here: https://lawprofessors.typepad.com/agriculturallaw/2017/08/deferred-payment-contracts.html. Many producers are also likely to have less crop input expense in 2019 compared to 2018 and prior years. That could be caused by prepaid input expenses in 2018 that aren’t fully utilized in 2019 due to land not in production in 2019 due to flooding, etc. But, to the extent the inputs that were pre-paid in 2018 aren’t used in 2019, that presents another tax/accounting issue. I have discussed the pre-paid expense rules here: https://lawprofessors.typepad.com/agriculturallaw/2017/10/the-tax-rules-involving-prepaid-farm-expenses.html. In addition, a producer may have lower operating expenses (e.g. fuel expense and equipment repairs) in 2019 because fewer acres may be farmed. Similarly, some producers may have little to no equipment purchases in 2019. But, it’s also possible that there could be greater equipment purchases in 2019 due to the need to replace equipment that was destroyed. There may also be a relatively large crop insurance payout in 2019. Also, don’t forget to add in a Market Facilitation Program (MFP) payment(s). While not weather-related, it is something new for 2018 and 2019.
Many farmers may fit this profile in 2019. For them, tax planning is an absolute necessity. Different tools in the tax practitioner’s toolbox may have to be used, but planning is still necessary.
As noted above, the receipt of crop insurance proceeds could be significant for some producers in 2019. I discussed the crop insurance deferral rules here: https://lawprofessors.typepad.com/agriculturallaw/2016/08/proper-reporting-of-crop-insurance-proceeds.html. In general, the proceeds from insurance coverage on growing crops are includible in gross income in the year actually or constructively received. But, taxpayers on the cash method of accounting may elect to include crop insurance and disaster payments in income in the taxable year following the crop loss if it is the taxpayer's practice to report income from sale of the crop in the later year. I.R.C. §451(d). Included are payments made because of damage to crops or the inability to plant crops. The deferral provision applies to federal payments received for drought, flood or “any other natural disaster.”
Another item that I noted in that post is the “50 percent test.” Based on Rev. Rul. 74-145, 1974-1 C.B. 113, for a farmer on the cash method of accounting to be eligible to make an election, the taxpayer must establish that a substantial part of the crops (more than 50 percent) has been carried over into the following year. If multiple crops are involved, the “substantial portion” test must be met with respect to each crop if each crop is associated with a separate business of the taxpayer. Otherwise, the 50 percent test is computed in the aggregate if the crops are reported as part of a single business. Also, a taxpayer may not elect to defer only a portion of the insurance proceeds to the following year. It’s an all or nothing election.
Also included in my crop insurance post is a suggested methodology on how to determine the deductible portion of crop insurance related to policies that pay-out for events other than just physical crop loss.
Also, as for crop insurance, if payment is made in 2020 for a 2019 claim, deferral has already occurred. The proceeds can’t be deferred until 2021. Similarly, unless the crop insurance proceeds were somehow constructively received in 2019 (I can’t see how that would be possible), proceeds paid in 2020 relating to a 2019 crop are reported in 2020.
With respect to deducting input costs, be wary of deducting those that are financed via promissory note or vendor-financed. I discussed that matter here: https://lawprofessors.typepad.com/agriculturallaw/2017/06/input-costs-when-can-a-deduction-be-claimed.html.
For a casualty loss to be deductible, the loss must be of a sudden, unexpected and unusual nature. My blog post on the casualty loss rules and the comparable involuntary conversion rules is here: https://lawprofessors.typepad.com/agriculturallaw/2017/03/farm-related-casualty-losses-and-involuntary-conversions-helpful-tax-rules-in-times-of-distress.html. Can a casualty loss be claimed on land? That’s an important question given that some land in southeastern Nebraska and southwestern Iowa (and elsewhere) is completely covered in sand as a result of the flooding this spring.
The Tax Court dealt with a case in 2016, that can provide assistance in answering this question. In Coates v. Comr., T.C. Memo. 2016-197, the petitioners, a married couple, owned 700 acres. One tract consisted of 80 acres and comprised their home and two barns. Another tract contained 440 acres of woodland. In May of 2010, a tornado flattened most of the trees on the 440-acre tract and also damaged property on the other tract. The petitioners reported a $127,731 casualty loss for 2010 based primarily on their estimate of the tract’s fair market value before and after the tornado, with insurance reimbursements subtracted out of the calculation. The IRS disallowed the entire loss and tacked-on an accuracy-related penalty. The IRS took issue with the fact that the petitioners provided their own property valuation rather than that of a disinterested certified appraiser. The Tax Court wasn’t troubled by the petitioners’ valuation of their property and the IRS didn’t challenge it in its opening brief filed after trial. The Tax Court upheld the amount of the casualty with respect to the 80-acre tract. However, the Tax Court held that the petitioners did not establish that they had any tax basis in the timber tract, and the IRS had challenged the basis that the petitioners had assigned to it. There was also a discrepancy as to whether the petitioners had purchased the property or whether it was gifted to them. Ultimately, the Tax Court allowed a total casualty loss deduction for 2010 of $39,731, entirely attributable to the 80-acre tract. That amount represented the drop in the property value after the tornado, less insurance reimbursements and the statutory reduction of $100 and 10 percent of gross income. The Tax Court also refused to uphold the accuracy-related penalty that the IRS had imposed.
Of course, tax provisions exist for weather-related sales of livestock. If they were killed in a disaster such as the flooding brought on by the “bomb cyclone” or blizzard or prairie fire, the USDA Livestock Indemnity Program (LIP) provides financial assistance. With that financial assistance comes tax consequences. I covered LIP payments here: https://lawprofessors.typepad.com/agriculturallaw/2017/03/livestock-indemnity-payments-what-they-are-and-tax-reporting-options.html.
Another thought for consideration is the possibility of extending the planning horizon over both 2019 and 2020 together. That brings up the possible need to consider an income averaging election. For more details on the income averaging election and planning points to consider see: https://lawprofessors.typepad.com/agriculturallaw/2017/03/using-schedule-j-as-a-planning-tool-for-clients-with-farm-income.html
Just because 2019 may seem like a low-income year due to weather-related events, does not mean that tax planning is not necessary. More thought might be necessary. 2019 might actually turn out to be a better year than first-thought. In any event, the tax planning for 2019 could be different that it has been in prior years. This all means that year-end tax planning may need to be engaged in sooner rather than later. Now might be a good time to start if the process hasn’t already begun.
Thursday, July 11, 2019
My post last fall on what constitutes real estate for purposes of a like-kind exchange under I.R.C. §1031 generated a great deal of interest among readers, lots of good questions and lengthy discussion. https://lawprofessors.typepad.com/agriculturallaw/2018/10/what-is-like-kind-real-estate.html In light of that, it’s worth expanding the topic a bit to address some rather interesting scenarios that can arise in the context of like-kind exchanges.
That’s the topic of today’s post – a deeper dive on like-kind exchanges.
I.R.C. §1031 provides for tax deferred treatment of real property that is exchanged for real property of “like-kind.” Personal property trades were eligible for tax-deferred treatment before 2018, but now the provision only applies to real estate trades. Thus, real estate that is used in the taxpayer’s trade or business or held for investment can be “traded” for any other real estate that the taxpayer will hold for use in the taxpayer’s trade or business or for investment. It’s a broad standard. For example, eligible real estate can be rental properties; farmland; office buildings; retail real estate properties; storage units; bare land held for investment; golf courses; conservation easements; partial interests in property; water rights (in some states (as pointed out in the prior post); and even vacation homes (if certain requirements are satisfied). In addition, the rules don’t require real property trades to be by type. Any type of real estate can be traded with any other type. Treas. Reg. §1.1031(a)-1(b). What matters is the reason the taxpayer held the relinquished property and the replacement property.
What About Property That Doesn’t Produce Income?
A permissible reason for trading real estate is to hold the replacement property on the hopes that it will appreciate in value. Thus, real estate that is held for appreciation purposes without producing income can be traded for other real estate. The replacement real estate can also be held for value-appreciation purposes. Basically, this is a favorable tax rules for those that speculate on a tract of real estate appreciating in value. It also means, for example, that a farmer can defer tax on a trade of farmland that the farmer uses in the farming operation for farmland that is not farmed but used for hunting or fishing purposes, etc. The farmer is deemed to hold the replacement property for investment purposes. But, whenever real estate is traded for real estate that will be held for investment purposes, depending on the real estate market, the replacement property should be held long enough to sufficiently illustrate the investment purpose of holding the replacement property. There is no bright line to determined how long is long enough.
But, there is a distinction to note with respect to property held for investment purposes. I.R.C. §1031 treatment does not apply to real estate that is held for resale or as inventory. This is a rule that is of particular importance to land developers and building contractors. That’s because the real estate that such parties hold constitute inventory. The same result occurs for a taxpayer that acquires an apartment complex with the intent at the time of the acquisition of selling the complex to current occupants as condominiums. The IRS views such deals as a “resale” transaction.
The line between property that is held for investment purposes and property that is held for resale can be rather fine. For example, what about a taxpayer that buys homes, renovates them and then as soon as the home has been renovated (i.e., updated) list the homes for sale at a profit? You may have seen the television shows featuring parties that do this. Rather than being sold, can these homes qualify for I.R.C. §1031 treatment? It’s not likely. In these situations, the IRS has a legitimate claim that the homes were acquired and “held” for the intent and purpose of selling them (resale) and not for investment purposes. To qualify for I.R.C. §1031 treatment at some point in the future, the homes would need to be rented out for a period of time (the longer the better) or be clearly held for appreciation.
Mixed-Use Real Estate
Quite often, the question arises as to how to handle a like-kind exchange of farmland when a personal residence is involved. Indeed, I had this question come up at a tax seminar in Missouri earlier this week. It’s a great question. Many exchanges of farmland involve more than just bare farmland. Buildings, structures, and the farm residence may also be involved in the transaction. As for the personal residence, I.R.C. §121 allows the exclusion of gain of up to $500,000 on a joint return ($250,000 on a single return) if the taxpayer owned the home and used it as the taxpayer’s principal residence for at least two of the immediately previous five years. If the residence gain can qualify for the I.R.C. §121 exclusion, the residence portion of the real estate should be parceled out from the other real estate that will qualify for a like-kind exchange? Keeping in mind that an exclusion from income is better from a tax standpoint than is income tax deferral, as much real estate as possible should be included with the residence. But, how much? The maximum benefit is obtained if enough real estate along with the residence can be combined to “max-out” the $500,000 exclusion. Certainly, land that is adjacent to the residence that is functionally used along with and as part of the residence counts as the “residence” for purposes of the I.R.C. §121 exclusion. The caselaw is all over the board on this issue. It’s a very fact-specific issue with the question being how much land can reasonably be claimed to be used along with the residence. For additional guidance on the matter see Rev. Proc. 2005-14, 2005-1 C.B. 528.
From a transactional and practice standpoint, the documents supporting the exchange (known as the “exchange agreement”) should detail only the real estate that qualifies for tax deferral under I.R.C. §1031. To this end, it may be helpful to include in the documentation a map of the property that distinguishes the property that will be treated as the personal residence for purposes of I.R.C. §121 from the I.R.C. §1031 property with the exchange agreement only listing the I.R.C. §1031 property. A closing statement can then be utilized for the I.R.C. §121 property, and then a separate statement can be used for the I.R.C. §1031 property. Indeed, separate closing statements can be used in any transaction involving mixed-use properties – not just when a principal residence is involved. This is of particular importance post-2017 because personal property involved in a trade of real-property no longer qualifies for I.R.C. §1031 treatment.
Also, the IRS position is that property that is used for both business and personal purposes cannot be treated as two separate properties for purposes of the holding requirement – that the property be held for the productive use in a trade or business or for investment. See, e.g., C.C.A. 201605017 (Jan. 29, 2016).
Do Vacation Homes Qualify?
The upfront answer is, “no” – a vacation home doesn’t qualify for I.R.C. §1031 treatment. It’s not qualifying property unless it is held for the right reason – as trade or business property or for investment purposes. So, while a vacation home wouldn’t normally meet the test, it may be possible to convert the home to a qualified use to eventually allow it to qualify as part of an I.R.C. §1031 exchange. That can be accomplished by the taxpayer renting the vacation home out and either limiting or eliminating personal use. For example, in a case involving the exchange of two vacation houses, Moore, et ux. v. Comr., T.C. Memo. 2007-134, the Tax Court determined that the vacation homes at issue failed to qualify for I.R.C. §1031 treatment because the taxpayer failed to prove that they were held for primarily for investment. Instead, the evidence revealed that the taxpayer basically used the home as a second residence and for personal vacation retreats for family. The Tax Court also pointed out that the taxpayer did not rent or attempt to rent the properties; didn’t offer the replacement property for sale until forced to do so by liquidity needs; spent a great deal of time fixing up the property; kept a boat at the lake for personal use; didn’t claim any deductions for depreciation or maintenance expenses; claimed home mortgage interest deductions; and failed to maintain the relinquished property during the last two years of ownership (i.e., failed to protect the taxpayer’s investment in the property).
But, Moore doesn’t stand for the proposition that a vacation home cannot qualify as part of an I.R.C. §1031 transaction. Under an I.R.S. safe harbor (that was issued after Moore was decided), if the relinquished and/or the replacement property is owned for two years either immediately before or after the exchange; the taxpayer rents out the property at fair market value for 14 days or more during the tax year; and the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period during which the property is rented at fair market rental, the safe harbor applies. See, Rev. Proc. 2008-16, 2008-1 C.B. 547. In addition, the safe harbor is just that – a safe harbor. A transaction involving a vacation home can still qualify under I.R.C. §1031 without being in the safe harbor, but it could be subject to IRS challenge.
Like-kind exchanges are tricky. While the rules presently in place only allow deferred tax treatment on real estate trades, the appropriate reason for holding the properties exchanged must be satisfied. In addition, mixed use properties can present special problems. Again, it’s best to seek out competent counsel. And, one thing I didn’t address, is that often a “qualified intermediary” (Q.I.) must be involved in the exchange to make sure that deferred tax treatment is preserved. One such Q.I. is a firm in Iowa operated by a colleague of mine (and his wife) that were in law school with me. They do a fine job. Let me know if you need assistance on trades and I can point you in the right direction.
Tuesday, July 9, 2019
Agriculture and the law intersect in many ways. Of course, tax and estate/business planning issues predominate for many farmers and ranchers. But, there are many other issues that arise from time-to-time. Outside of tax, leases and fences are issues that seem to come up repeatedly. Other issues are cyclical. Bankruptcy is one of those issues that has increased in importance in recent months. Of course, legal issues associated with the administration of federal farm programs is big too. In addition, legal issues associated with market structure and competition in various sectors of agriculture are of primary importance particularly in the poultry and cattle sectors.
Periodically, I step away from the technical article aspect of this blog and do a survey of some recent ag-related developments in the courts. That’s what today’s post is about – it’s “ag in the courtroom” day today – at least with respect to a couple of recent cases.
Abandoned Rail Lines
One matter that is a big one in ag for those farms and ranches impacted by it involves the legal issues associated with abandoned rail lines. It’s often a contentious matter, and it doesn’t help that the Congress changed the rules several decades ago to, in the view of many impacted adjacent landowners, diminish private property rights.
Recently, another abandoned rail line case was decided. This time the decision was rendered by the Kansas Court of Appeals. In Central Kansas Conservancy, Inc., v. Sides, No.119,605, 2019 Kan. App. LEXIS 29 (Kan. Ct. App. May 17, 2019), the Union Pacific Railroad acquired a right-of-way over a railroad corridor that it abandoned in the mid-1990s. At issue in the case was a 12.6-mile length of the abandoned line between McPherson and Lindsborg, Kansas. A Notice of Interim Trail Use (NITU) was issued in the fall of 1995. The corridor was converted into a trail use easement under the National Trails System Act. In 1997, Union Pacific gave the plaintiff a "Donative Quitclaim Deed" to the railroad’s easement rights over the corridor, with one-quarter mile of it running through the defendant’s property at a width of 66 feet. Pursuant to a separate agreement, the plaintiff agreed to quit claim deed its rights back to the railroad if the railroad needed to operate the line in the future. By virtue of the easement, the plaintiff intended to develop the corridor into a public trail.
In 2013, the plaintiff contacted the defendant about developing the trail through the defendant’s land. The defendant had placed machinery and equipment and fencing in and across the corridor which they refused to remove. In 2015, the plaintiff sued to quiet title to the .75-mile corridor strip and sought an injunction concerning the trail use easement over the defendant’s property. The defendant admitted to blocking the railway with fencing and equipment, but claimed the right to do so via adverse possession or by means of a prescriptive easement. The defendant had farmed, grazed cattle on, and hunted the corridor at issue since the mid-1990s. The defendant also claimed that the plaintiff had lost its rights to the trail because it had failed to complete development of the trail within two years as the Kansas Recreational Trail Act (KRTA) required.
In late 2016, the trial court determined that the two-year development provision was inapplicable because the Interstate Commerce Commission had approved NITU negotiations before the KRTA became effective in 1996. The trial court also rejected the defendant’s adverse possession/prescriptive easement arguments because trail use easements are easements for public use against which adverse possession or easement by prescription does not apply.
During the summer of 2017 the plaintiff attempted work on the trail. When volunteers arrived, the defendant had placed equipment and a mobile home on the corridor preventing any work. The plaintiff sought a "permanent prohibitory injunction and permanent mandatory injunction." The defendant argued that he had not violated the prior court order because "[a]ll the Court ha[d] done [was] issue non-final rulings on partial motions for summary judgments, which [were], by their nature, subject to revision until they [were] made final decisions." Ultimately, the trial court granted the plaintiff’s request for an injunction, determined that the defendant had violated the prior summary judgment order, but also held that the plaintiff had not built or maintained fencing in accordance with state law.
On appeal, the appellate court partially affirmed, partially reversed, and remanded the case. The appellate court determined that the defendant did not obtain rights over the abandoned line via adverse possession or prescriptive easement because such claims cannot be made against land that is held for public use such as a recreational trail created in accordance with the federal rails-to-trails legislation. The appellate court also determined that the plaintiff didn’t lose rights to develop the trail for failing to comply with the two-year timeframe for development under the KRTA. The appellate court held that the KRTA two-year provision was inapplicable because a NITU was issued before the effective date of the KRTA. However, the appellate court determined that the plaintiff did not follow state law concerning its duty to maintain fences. The appellate court held that Kan. Stat. Ann. §58-3212(a) requires the plaintiff to maintain any existing fencing along the corridor and maintain any fence later installed on the corridor. In addition, any fence that is installed on the corridor must match the fencing maintained on the sides of adjacent property. If there is no fencing on adjacent sides of a landowner’s tract that abuts the corridor, the plaintiff and landowner will split the cost of the corridor fence equally. The appellate court remanded the case for a determination of the type and extent of fencing on the defendant’s property, and that the plaintiff has the right to enter the defendant’s property to build a fence along the corridor. Any fence along the corridor is to be located where an existing fence is located. If no existing fence exists along the corridor, the corridor fence is to be located where the plaintiff’s trail easement is separated from the defendant’s property. The appellate court remanded to the trial court for a reconsideration of its ruling on fence issues.
Feasibility of Chapter 12 Plan
As I mentioned at the beginning of the post, bankruptcy is one of those ag legal issues that has increased in relevancy in recent months. In certain parts of the country Chapter 12 (farm) bankruptcy has been on the rise. Once a farmer qualifies for Chapter 12 (not always an easy task), the reorganization plan was be proposed in good faith and be feasible. Those issues were at stake in a recent case from Iowa.
In In re Fuelling, No. 18-00644, 2019 Bankr. LEXIS 1379 (Bankr. N.D. Iowa May 1, 2019), the debtor was a farmer that granted the bank a first priority lien on all farm assets other than a truck and cash proceeds to the 2017 crop. To pay for the 2017 inputs, the debtor secured financing though another creditor (not the bank). The creditor obtained a subordination agreement from the bank, giving the creditor a $151,000 first priority lien in the 2017 crop sale proceeds. However, the proceeds from the 2017 crop were not enough to repay the creditor or continue making payments to the bank. The debtor filed Chapter 12 bankruptcy in May of 2018. The debtor sold the 2017 crops and various equipment to repay secured creditors. The creditor’s remaining claim was $107,506.45, $66,625.37 of which is secured by the remaining 2017 crop sale proceeds that the debtor still held.
The parties agreed that the bank's secured claim was $214,093.86 for purposes of plan confirmation. The creditors filed a motion for relief that would allow them to collect the remainder of the 2017 crop proceeds. The debtor filed a motion to use cash collateral to start a cattle feeding operation and grant the creditor a lien in the cattle and feed. The debtor also proposed to use rental payments from the grain bins on the property to make interest payments to the creditor and the bank for five years. The entire principal of the loans would come due as a balloon payment at the end of the plan period.
The bank, the Chapter 12 Trustee, the Iowa Department of Revenue, and the creditor objected to the debtor’s plan. The bankruptcy court denied the debtor’s proposed plan and motion to use cash collateral. The creditors’ motion for relief of stay was granted due to the court finding that the debtor’s plan was not feasible. The court denied the plan for multiple reasons. First the plan improperly substituted the creditor’s lien in the crop with a lien in cattle. Second the plan impermissibly utilized rental payments covered by the bank lien for payments towards the other creditors. The court also determined that the debtor’s proposed interest rate was not correct. The court agreed with the bank and the creditor that the plan was not feasible based on the information in the record. The debtor’s health issues, overly optimistic rental rates for the grain bins, and the balloon payment all factored in the court’s decision of lack of feasibility, even though the plan was submitted in good faith. Since the debtor’s plan to feed cattle was impermissible and not feasible, the court did not need any additional analysis to deny the debtor’s motion to use cash collateral. The debtor claimed that the remaining proceeds were necessary for reorganization, but the court concluded that the debtor’s proposed use of the proceeds impermissibly substituted the creditors. In the end, the court simply could not find a permissible way for the funds to be utilized in reorganization.
These are just two recent cases involving ag legal issues. There are many more. This all points out the need for well-trained lawyers in the legal issues that face farmers and ranchers.
Friday, July 5, 2019
It’s costly to start a business – especially a farming or ranching business. From a tax standpoint are the start-up costs deductible? As with many tax questions, that answer is that it “depends.” One item that the answer depends upon is when the business begins. That’s a key determination in properly deducting business-related expenses.
Deducting costs associated with starting a business – that’s the topic of today’s post.
Categorization – In General
The tax Code allows deductions for various expenses that are related to a taxpayer’s investments that don’t amount to a business if the expenses are ordinary and necessary for the production or collection of income or are for the management, conservation or maintenance of property held for the production of income. I.R.C. §212.
Once the business begins, all of the ordinary and necessary expenses of operating the business (on a basis that is regular, continuous and substantial) that are paid or incurred during the tax year are deductible. I.R.C. §162. But, business start-up costs are handled differently. I.R.C. §195.
I.R.C. §195(a) generally precludes taxpayers from deducting startup expenditures. However, by election, a taxpayer can deduct business start-up expenses on the return for the year that the business begins. I.R.C. §195(b). The election is irrevocable. Treas. Reg. §1.195-1(b). The deduction is the lesser of the amount of start-up expenses for the active trade or business, or $5,000 reduced (but not below zero) by the amount by which the start-up expenses exceed $50,000. I.R.C. §195(b)(1)(A); I.R.C. §195(b)(1)(A)(i). Once the election is made, the balance of start-up expenses are deducted ratably over 180 months beginning with the month in which the active trade or business begins. I.R.C. §195(b)(1)(B); Treas. Reg. §1.195-1(a). This all means that in the tax year in which the taxpayer’s active trade or business begins, the taxpayer can deduct the $5,000 amount (if that’s the lesser of, etc.) and the ratable portion of any excess start-up costs.
The election is normally made on a timely filed return for the tax year in which the active trade or business begins. However, if the return that year was timely filed without the election, the election can be made on an amended return that is filed within six months of the due date for the return (excluding extensions). The amended return should clearly indicate that the election is being made and should state, “Filed pursuant to section 301.9100-2” at the top of the amended return. Without the election, the start-up costs should be capitalized.
What are start-up expenses? Amounts paid or incurred in connection with creating an active trade or business are startup expenditures. I.R.C. §195(c). More specifically, start-up costs are amounts that the taxpayer pays or incurs for: investigating the creation or acquisition of an active trade or business; creating an active trade or business; or activities that the taxpayer engages in for profit and for the production of income before that day on which the active trade or business begins, in anticipation of the activities becoming an active trade or business, and which would be deductible in the year paid or incurred if in connection with an active trade or business. I.R.C. §§195(c)(1)(A)(i-iii); 195(c)(1)(B). Common types of start-up expenses include advertising costs; salaries and wages; and expenses related to travel. See, e.g., IRS Field Service Advice 789 (1993). But, interest expense, state and local taxes, and research and experimental expenses are not start-up expenses. I.R.C. §195(c)(1).
Start-up expenses are limited to expenses that are capital in nature rather than ordinary. That’s an important point because it means that I.R.C. §195 does not bar the deductibility of ordinary and necessary expenses a taxpayer incurs in an ongoing activity for the production of income under I.R.C. §212. In addition, it makes no difference that the activity is later transformed into a trade or business activity under I.R.C. §162. For example, in Toth v. Comr., 128 T.C. 1 (2007), the taxpayer started operating a horse boarding and training facility for profit in 1998. The activity showed modest profit the first few years, but had really taken off by 2004. For 1998 and 2001, the taxpayer claimed expenses from the activity on Schedule C as ordinary and necessary business expenses deductible in accordance with I.R.C. §162, but she later determined that the expenses should be deducted in accordance with I.R.C. §212 as miscellaneous itemized deduction on Schedule A (which are presently suspended through 2025). However, the IRS took the position that the taxpayer anticipated that the horse activity would become an active trade or business and, as such, her expenses had to be capitalized under I.R.C. §195. The Tax Court agreed with the taxpayer. Start-up expenses, the Tax Court said, were capital in nature rather than ordinary. Thus, once her income producing activity began her expense deductions were not barred by I.R.C. §195. It didn’t matter that the activity later became a trade or business activity under I.R.C. §162.
When does the business begin? A taxpayer cannot deduct or amortize startup expenditures if the activities to which the expenditures relate fail to become an “active trade or business.” See I.R.C. §§195(a), (c). There are no regulations that help define when a trade or business begins, so the question is answered based on the facts and circumstances of a particular situation. To be engaged in a trade or business, a taxpayer must: (1) undertake an activity intending to make a profit, (2) be regularly and actively involved in the activity, and (3) actually have commenced business operations. See, e.g., McManus v. Comr., T.C. Memo. 1987-457, aff’d., 865 F.2d 255 (4th Cir. 1988). In addition, the courts have held that a taxpayer is not engaged in a trade or business “until such time as the business has begun to function as a going concern and performed those activities for which it was organized.” Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965). Likewise, an activity doesn’t have to generate sales or other revenue for the business to be deemed to have begun. Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 620 (7th Cir. 1995), aff’g., in part, rev’g. in part, and remanding T.C. Memo. 1994-316; Jackson v. Commissioner, 864 F.2d 1521, 1526 (10th Cir. 1989), aff’g., 86 T.C. 492 (1986). However, merely researching or investigating a potential business is not enough. Dean v. Commissioner, 56 T.C. 895, 902-903 (1971).
Earlier this week, the U.S. Tax Court dealt with I.R.C. §195 and the issue of when the taxpayer’s business began. In Smith v. Comr., T.C. Sum. Op 2019-12, the Tax Court was convinced that the taxpayer had started his vegan food exporting business. The Tax Court noted that the taxpayer had been peddling his vegan food products in Jamaica, the Dominican Republic, Brazil Argentina and Columbia. However, he was having trouble getting shelf space. Thus, for the tax year at issue, he showed expenses associated with the activity of about $41,000 and gross sales of slightly over $2,000. The IRS largely disallowed the Schedule C expenses due to lack of documentation, and tacked on an accuracy-related penalty. After issuing the statutory notice of deficiency, the IRS said the expenses were not deductible because they were start-up expenditures. Because IRS raised the I.R.C. §195 issue at trial, the IRS bore the burden of proof on the issue. The Tax Court determined that the taxpayer was, based on the facts, engaged in a trade or business. He had secured products to sell, actively marketed those products, attended food shows and other meetings around the Caribbean and South America and had established a network to find potential customers. Thus, I.R.C. §195 did not apply to limit the deduction of the expenses – they would be deductible under I.R.C. §162. Or would they?
Substantiation. To be deductible under I.R.C. §162 as an ordinary and necessary business expense on Schedule C (or Schedule F), the taxpayer must substantiate the expenses. Here’s where the IRS largely prevailed in Smith. The Tax Court determined that the taxpayer had not substantiated his expenses. Thus, the expenses were not deductible beyond (with a small exception) what the IRS allowed. The Tax Court also upheld the accuracy-related penalty.
When a business is in its early phase, it’s important to determine the proper tax treatment of expenses. It’s also important to determine if and when the business begins. The Tax Cuts and Jobs Act makes this determination even more important. Once these hurdles are cleared, the recent Tax Court case illustrates the importance of substantiating expenses to preserve their deductibility.
Wednesday, July 3, 2019
On August 13-14 Washburn University School of Law along with co-sponsors Kansas State University Department of Agricultural Economics and WealthCounsel, LLC will be conducting the 2019 National Summer Farm Income Tax/Estate and Business Planning Conference in Steamboat Springs, CO. This is a great opportunity for practitioners with agricultural clients as well as agricultural producers to get two days of in-depth education/training on issues that impact the agricultural sector.
The Steamboat Springs seminar, it’s the topic of today’s post.
Speakers and Agenda
This is the 15th summer that I have been conducting a national event, with that first one held in beautiful Ely, Minnesota. Sometimes there is more than one during the summer, with the event usually held at a very nice location so that attendees can enjoy the area with their families if they choose to do so. This summer is no exception. Steamboat Springs is a lovely place on the western side of the Rocky Mountain National Park.
The speakers this year in addition to myself are Paul Neiffer, Stan Miller and Timothy O’Sullivan. Paul has taught with me for several years at this event (and others) and many of you are familiar with him. Stan is a partner in a law firm in Little Rock, Arkansas and the founder of WealthCounsel, LLC. Stan will be speaking on the second day and will be addressing the necessary planning steps to assist farm and ranch families keep the business going into the future. Also, on the Day 2, Tim O’Sullivan will provide the key details on long-term care planning, and dealing with family disharmony and its impact on the tax and estate planning/business succession planning process. Tim has an extensive estate planning practice with Foulston Siefkin, LLP in Wichita, Kansas. He is particularly focused and has expertise in the areas of Elder Law and Trusts and Estates.
On the first day, Paul and myself will go through the current, key farm income tax issues. Of course, the I.R.C. §199A deduction will be a big topic. Just a couple of weeks ago, the Treasury released the draft proposed regulations on how the deduction applies in the context of agricultural/horticultural cooperatives and patrons. We will take a deep dive into that topic, for sure. Many questions remain. We will also numerous other topics and provide insight into discussions in D.C. on specific issues and the legislative front. It will be a full day.
You can see the full agenda here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
The event will be held at the beautiful Steamboat Grand Hotel. A roomblock is established for the conference. Information on the hotel can be found here: https://steamboatgrand.com/ For those brining families, there are many sights to see and places to visit in the town and the surrounding area.
You can register for both days or just a single day. Also, the conference is live streamed in the event you are not able to attend in person. Just click on the conference link provided above to learn more. You can register here: http://washburnlaw.edu/employers/cle/farmandranchtaxregister.html
On Monday, August 12 I will be participating in another conference at the Steamboat Grand Hotel focusing on conservation easements. That event is sponsored by several land trusts. Contact me personally about that conference if you are interested in learning more.
I hope to see you in Steamboat Springs next month! If you can’t attend in person, we trust you will benefit from watching the live presentation online.
Monday, July 1, 2019
Financial and economic continue to predominate in numerous parts of the ag economy. Current statistics show that economic woes are the most difficult in the dairy sector and other areas on a regional basis – particularly parts of the Great Plains and the Upper Midwest.
Initially passed in the midst of the farm debt crisis of the 1980s, Chapter 12 bankruptcy is uniquely tailored to address the needs of farmers in financial distress. That’s particularly true because of a special tax rule and the ability to avoid something known as the “absolute priority” rule of Chapter 11. However, appropriate planning must be utilized for a farmer to take advantage of Chapter 12.
The peril of a farmer not being eligible for Chapter 12 bankruptcy – that’s the topic of today’s post.
I was asked during a recent radio interview what I would tell a farmer or rancher facing potential financial problems if there was only one piece of advice I could give. My response – “listen to your wife.” Why? In many farming and ranching operations, the operating spouse simply works in the business of farming or ranching rather than working on it. There is a big difference between the two. The spouse that works on the business is the one keeping the books and records, tracking income and expense and monitoring the financial strength of the business. The operating spouse often is not tuned-in to these important aspects of the business. Instead, if lenders will continue to lend, the farmer can continue doing what they do best – farm, ranch and… sign lending documents without having legal counsel review them. But, this can lead to ignoring financial problems until it’s too late. Then, it might be necessary to liquidate assets.
This is the problem that Chapter 12 was designed to address. Chapter 12 allows a farmer to downsize the operation so that it can continue. The business gets reorganized, not liquidated. While the sale of assets to “right-size” the operation can trigger significant taxes, Congress added 11 U.S.C. §1222(a)(2)(A) with the overhaul of the Bankruptcy Code in 2005. Under that provision (and an amendment to it that took effect for new Chapter 12 cases on or after October 26, 2017), a Chapter 12 debtor can treat claims arising out of “claims owed to a governmental unit” as a result of “sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation” to be treated as an unsecured claim that is not entitled to priority under Section 507(a) of the Bankruptcy Code, provided the debtor receives a discharge. The amendment addressed a major problem faced by many family farmers filing under Chapter 12 where the sale of farm assets to make the operation economically viable triggered gain which, as a priority claim, had to be paid in full before payment could be made to general creditors. Even though the priority tax claims could be paid in full in deferred payments under prior law, in many instances the debtor operation did not generate sufficient funds to allow payment of the priority tax claims in full even in deferred payments. That was the core problem that the 2005 provision attempted to address.
Among other eligibility requirements, a farmer must have aggregate debt not exceeding $4,411,400. That is presenting a very real problem for many farmers at the present time. If Chapter 12 is not available because a farmer has debt exceeding the limit, what are the options? In terms of bankruptcy, the only viable options are a Chapter 7 liquidation bankruptcy and a Chapter 11 reorganization. But, in terms of reorganization, Chapter 11 is not nearly as favorable to the farm debtor as is Chapter 12 for the reasons noted below. Thus, for a farmer with excessive debt the strategy would be to identify and liquidate underperforming assets; repay creditors; and get the debt limit beneath the $4,411,400 threshold. That will allow the farmer to file Chapter 12 and get a stronger bargaining position in negotiating a debt settlement with creditors and get favorable tax treatment upon sale, etc., of farm assets.
The Perils of Chapter 11
Chapter 11 is the general reorganization provision for individuals and firms operating a business. There is no debt limit associated with Chapter 11, but major drawbacks of Chapter 11 include the relatively short time the debtor has to overcome existing financial problems, and an absolute priority rule that prohibits debtors from retaining ownership of their property unless unsecured creditors receive 100 percent of their claims.
The absolute priority rule. Under 11 U.S.C. §1129(b)(1), a creditor's plan objection will be upheld if the plan: (1) discriminates unfairly; or (2) is not fair and equitable with respect to each non-accepting class of claims or interests that is impaired under the plan. In this context, "impaired" means that the plan alters the rights of a class of creditors compared to the contractual rights prior to bankruptcy. The rule arose from several railroad case about a century ago. For example, in Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913), the debtor’s reorganization plan proposed to not pay the claims of junior creditors. The Court refused to approve the plan. Instead, the Court concluded that an “absolute priority rule,” as applied to a dissenting class of impaired unsecured creditors, must result in a plan being "fair and equitable." As codified, the “fair and equitable” test (i.e., the “absolute priority rule”) is satisfied only if the allowed value of the claim is to be paid in full, or if the holder of any claim or interest that is junior to the dissenting creditors will not receive or retain any property under the plan on account of such junior claim or interest. See 11 U.S.C. §1129(b)(2)(B)(ii).
The absolute priority rule came up in a recent Wisconsin bankruptcy case involving a dairy. In In re Schroeder Bros. Farms of Camp Douglas LLP, No. 16-13719-11, 2019 Bankr. LEXIS 1705 (Bankr. W.D. Wisc. May 30, 2019), a dairy was structured as a limited liability partnership (LLP). The LLP filed Chapter 11 in late 2016. At the time the Chapter 11 petition was filed, the debtor was ineligible to file Chapter 12 because aggregate debts exceeded the limit for Chapter 12 eligibility. The bankruptcy court confirmed the debtor’s reorganization plan in mid-2018. The debtor became unable to make plan payments and the committee of unsecured creditors motioned for the appointment of a liquidating trustee. The debtor objected on the basis that the sale of any assets would trigger capital gain taxes, and the combination of those taxes, the liquidating trustee’s fees, attorney fees and committee attorney fees would completely consume the sale proceeds of the encumbered real estate, farm equipment and cattle rendering the estate insolvent and leaving the individuals subject to pay the unpaid income taxes.
The debtor subsequently claimed that total debts had fallen beneath the debt limit for a Chapter 12 filing and sought to convert the Chapter 11 case to Chapter 12. Doing so would allow the debtor to take advantage of 11 U.S.C. §1222(a)(2)(A) (the predecessor to current 11 U.S.C. §1232) so that capital gain taxes could be treated as an unsecured claim. The committee of unsecured creditors asserted that the non-priority treatment of capital gain taxes was a non-issue because the debtor, as a pass-through entity, had no liability for any taxes. Instead, it would be the partners of the LLP that would have personal liability for taxes arising from asset sales. The debtor claimed it could elect to be taxed as a corporation via IRS Form 8832 upon making an election. Doing so, the debtor claimed, would result in the capital gain taxes being discharged as an unsecured claim. The committee claimed that the debtor was ineligible to convert to Chapter 12 because it was ineligible at the time the petition was filed.
The bankruptcy court agreed with the committee of unsecured creditors. The original petition date of the debtor’s Chapter 11 filing is the measuring date for the debtor’s Chapter 12 eligibility. However, when the debtor filed Chapter 11, the debtor was ineligible for Chapter 12. The bankruptcy court also pointed out that the debtor’s bankruptcy filing did not impact the debtor’s tax status. The bankruptcy court reasoned that allowing the debtor to make an election to be treated for tax purposes as a corporation would violate the absolute priority rule of 11 U.S.C. §1129(b)(2)(B) – a mainstay of Chapter 11. The absolute priority rule, the court noted, bars a court from approving a plan that gives a holder of a claim anything unless objecting classes have been paid in full. Thus, the proposed conversion of tax status would dilute the class of unsecured creditors and shift unfavorable tax treatment to the detriment of creditors. Accordingly, the bankruptcy court determined that the proposed tax election was not in the best interests of the debtor, the bankruptcy estate or the creditor and denied the tax election. The bankruptcy court approved the appointment of a liquidating trustee.
For farmers and ranchers, proper planning is the key to dealing with financial distress so they can utilize the advantages of Chapter 12. In the In re Schroeder Bros. case, a suggested approach for the dairy would have been to file the election to be treated as a C corporation at least one year before filing the bankruptcy petition. Then a pre-petition partial liquidation could have been utilized to get the debt level within the Chapter 12 limit. If the LLP couldn’t be treated taxwise as a C corporation, the farmer would have needed to file Chapter 12 individually to utilize the tax provisions of 11 U.S.C. §1232. In the alternative, two jointly administered petitions could have been filed.
Chapter 11 has serious limitations and is clearly disadvantageous compared to Chapter 12. It’s never too early to seek out competent legal counsel. A great deal of advance planning is often required to obtain the best possible result in a difficult situation.