Friday, August 30, 2019
The fall academic semester has begun at the law school and at K-State. That means that my campus teaching duties are done for the year, and now I am fully devoted to speaking at ag law and ag tax events across the country. Actually, I finished up the calendar year’s teaching in late July and have been on the road ever since in Lawrence, Kansas, Illinois, Colorado, Montana, South Dakota and Nebraska. So where does the ag law and tax road take me this fall? What opportunities are there for you this fall to gain additional CLE/CPE credits?
Fall ag law and ag tax seminars – it’s the topic of today’s post.
In the next couple of months, the trail starts with the Washburn Law School/Kansas State University Agribusiness Symposium. This year’s event will be held in Hutchinson, Kansas on September 13 in conjunction with the state fair. Sessions this year include discussions of the legal issues association with precision agriculture and technology; water rights and how to evaluate risks that might reduce value and usefulness; tax planning issues for farmers and ranchers in light of the Tax Cuts and Jobs Act; the details of what happening in the farm economy both from a macroeconomic sense and a microeconomic one; agricultural trade issues; farm bill issues; and ethics. You can learn more about the event and register here: https://www.kfb.org/Article/2019-Kansas-State-UniversityWashburn-University-School-of-Law-Agribusiness-Symposium. This event is also available online for those that aren’t able to travel to Hutchinson.
After the Symposium, I head to Lexington, Kentucky for the presentation of an ag tax seminar and then to Illinois for ag tax seminars in Rock Island and Champaign. You can lean more about the Illinois seminars and register here: https://taxschool.illinois.edu/merch/2019farm.html. For my Iowa friends, particularly those in eastern Iowa, the Rock Island school may be a convenient location for you.
When the calendar flips to October, I will be found in Fresno, California. On October 1 I will providing four hours of ag tax content at the California CPA Society’s “Farmers Tax and Accounting Conference.” The conference is also webcast. For more information, click here: http://conferences.calcpa.org/farmers-tax-accounting-conference/.
The following two weeks show me on the road in Kansas and Nebraska with CPA firm in-house CPE training events.
Late October – Mid-December
Beginning on October 29 are the Kansas State University Tax Institutes that I am a part of. Those begin in western Kansas and move east across the state, finishing in Pittsburg on Dec. 11 and 12. The Pittsburg event is also live simulcast over the web. On December 13, Prof. Lori McMillan (also of Washburn Law) and myself will conduct a 2-hour tax ethics session live in Topeka and over the web. You can learn more about the KSU tax institutes here: https://agmanager.info/events/kansas-income-tax-institute.
I will be conducting additional two-days tax seminars in November. On November 5-6, I will be in Sioux Falls, South Dakota and on November 7-8 I will be in Omaha, Nebraska. You can learn more about those events here: https://astaxp.com/seminars/. On November 20, I will be teaching the second day of a tax seminar in Fargo, North Dakota and then doing the same again in Bismarck on November 22. These are for the University of North Dakota. More information can be obtained about these events here: https://und.edu/conferences/nd-tax-institute/.
When the calendar turns to December, I will be in San Angelo, Texas doing an all-day ag tax seminar for the Texas Society of CPAs on December 3. The next day I will be kicking off the Iowa Bar Bloethe Tax School in Des Moines with a four-hour session on farm taxation. December 6 finds me in Omaha teaching farm tax at the Great Plains Federal Tax Institute. More information about the event can be found here: https://greatplainstax.org/. As mentioned above, the two-hour tax ethics seminar will be in Topeka, Kansas on December 13. That ethics session will also be webcast.
Other events may be added in over the coming weeks. When the calendar flips to 2020, I will be in Nashville, Tennessee; San Antonio, Texas; and Boise, Idaho just to name a few locations. Make sure to check my calendar that is posted on www.washburnlaw.edu/waltr. I update the calendar often.
I hope to see you at one or more of the events this fall!
Wednesday, August 28, 2019
One of the most difficult concepts for law students, and practicing lawyers for that matter, is the Rule Against Perpetuities (RAP). The rule bars a person from using a deed or a will (or other legal instrument) to control the ownership of property well beyond their death – known as “control by the dead hand.” It’s an ancient rule of property law that is intended to enhance the marketability of property by limiting the ability to tie-up the ownership of property for too long of a time period. Wedel v. American Elec. Power Service Corp., 681 N.E.2d 1122 (Ind. Ct. App. 1997). The RAP is, essentially, grounded in public policy. See, e.g., Symphony Space, Inc. v. Pergola Properties, Inc., 88 N.Y.2d 466, 669 N.E.2d 799 (N.Y. 1996).
The RAP often comes into play in estate planning situations with respect to wills and trusts, particularly in large estates where the desire is to keep land in the family for many generations into the future. But, it can also be involved when real estate is transferred and oil production is present or might be in the future. But the Rule has been applied to oil, gas, and mineral leases, too. If some future interest in a mineral deed is granted, the RAP requires the interest to vest (the point in time when a person becomes legally entitled to what has been promised) within 21 years of the lifetimes of those living at the time of the grant. If it is possible for the vesting to happen beyond that 21 years, then the Rule voids the contingent future interest.
Indeed, in 2018, the Texas Supreme Court modified the application of the rule in the context of oil and gas, and recently the Kansas Supreme Court refused to apply the RAP to a defeasible term mineral interest (an interest that is capable of being terminated/voided) – a very common form of mineral ownership.
The implications of not applying the RAP to oil and gas interests - that’s the topic of today’s post.
The RAP originated In the late 17th century in England. In the Duke of Norfolk’s Case, 3 Ch. Cas. 1, 22 Eng. Rep. 931 (Ch. 1682), Henry, the 22nd Earl of Arundel, created an estate plan that sought to pass a portion of his property to his oldest son (who was mentally disabled) and then to his second son. Other property would pass to his second son, and then to his fourth son. Henry’s estate plan also contained provisions for shifting property many generations later if certain conditions should occur. When Henry’s second son succeeded to his older brother’s property, he didn’t want the property to pass to his younger brother. The younger brother sued to enforce his interest as created by Henry’s estate plan. The House of Lords held that the shifting condition that the estate plan created could not have an indefinite existence. The Court was of the view that tying up the ability to transfer property for too long of a time period beyond the lives of the persons that were alive at the time of the initial transfer was impermissible. Just how long was too long was not determined until 1833 in Cadell v. Palmer, 1 Cl. & Fin. 372, 6 Eng. Rep. 936 (H.L. 1832, 1833) where the court set the time limit at lives in being plus 21 years.
A similar property law concept to the RAP is the rule barring unreasonably restraints on alienation. Both concepts are based on the common law’s general distaste of restrictions on the ability to transfer property. See, e,g, Cole v. Peters, 3 S.W.3d 846 (Mo. Ct. App. 1999). But, the concepts are not identical – it is possible for an unreasonable restraint on alienation to occur without triggering the RAP.
2018 Texas Case
In Conoco Phillips Co. v. Koopmann, 547 S.W.3d 858 (Tex. Sup. Ct. 2018), the Texas Supreme Court held that the RAP did not void a 15-year non-participating royalty interest that was reserved in a deed. Accordingly, the Court changed the application of the RAP such that, at least in Texas, it will not void an oil, gas and mineral deed if, regardless of the grant or reservation (it no longer makes a difference whether the interest is created by grant or reservation), the holder of the future remainder interest is at all times ascertainable and the preceding estate was/is certain to terminate. Thus, according to the Texas Supreme Court the RAP will not apply if the future contingent interest is transferable and/or inheritable; the holder of the future interest is known or knowable at all time; and the previous estate is certain to end at some point.
Recent Kansas Case
As noted above, a recent Kansas Supreme Court decision, Jason Oil Company v. Littler, No. 118,387, 2019 Kan. LEXIS 204 (Kan. Sup. Ct. Aug. 16, 2019), involved the application of the RAP to a defeasible term mineral interest. The Court refused to apply the rule.
A defeasible term mineral interest is a durational estate that involves a mineral, royalty or nonexecutive mineral interest for a fixed term of years and for an indefinite period of time thereafter, usually so long as oil or gas is produced. That’s what was it issue in Jason Oil.
In late 1967, a grantor executed two deeds conveying tracts of real estate in the same section of the county. The east half of the section was conveyed to one grantee and the a quarter of the section was conveyed to another grantee. Both deeds stated, “"EXCEPT AND SUBJECT TO: Grantor saves and excepts all oil, gas and other minerals in and under or that may be produced from said land for a period of 20 years or as long thereafter as oil and/or gas and/or other minerals may be produced therefrom and thereunder." The grantor died a few years later and the local probate court distributed set percentages of the residue of the grantor’s estate, including the reserved mineral interest, to the grantor’s descendants.
The 20-year term expired on December 30, 1987. From that time until May 31, 2017, there was no drilling activity on either tract and no gas or mineral production. In 2016, the plaintiff sued to quiet title to both tracts. The plaintiff claimed that it held valid and subsisting oil and gas leases. One set of the grantor’s heirs claimed that they owned an interest in the minerals via the grantor’s will – the grantor owned a fee simple determinable in the mineral rights and that, as a result, they were devised an interest in the minerals. However, another set of the grantor’s heirs claimed that those mineral interests were subject to an invalidated by the RAP because they were “springing executory interests.”
Note: A springing executory interest is an interest in an estate in land created by the conditions of a grant wherein the grantor cuts short the grantor's own interest in the property in favor of the grantee, contingent upon the occurrence of a specific condition. It’s an executory (future) interest that follows an interest that the grantor held upon the happening of a stated event.
If the RAP applied to invalidate their interests, those heirs claimed that their interests should be reformed under the Uniform Statutory RAP contained in Kan. Stat. Ann. §59-3405(b) to conform to the parties’ intent and avoid violating the RAP. The other set of heirs continued to maintain that the RAP invalidated the other heirs’ interest and that the Uniform Statutory RAP was void for violating the Kansas Constitution. As a result, they claimed that they owned the minerals by virtue of the residuary clause of the grantor’s will.
The trial court held that a defeasible term mineral interest is a future estate reserved to the grantor and a reversion. As a reversion remaining to the grantor, the court concluded, it wasn’t subject to the RAP. In addition, the trial court determined that the grantor’s reserved right had not alienated the surface and mineral estates of the tracts.
The Supreme Court agreed with the trial court that the decedent reserved a defeasible term interest. However, the Supreme Court opined that the trial court “…veered off course” by finding (1) the future estate kept by the decedent in the mineral estate was a reversion and (2) the reservation of the defeasible mineral interest was a reversion and not subject to the RAP. However, the Supreme Court declined to apply the RAP concluding that the application of the RAP would be counterproductive to the purpose behind the RAP and create “chaos.” The Supreme Court held that when a grantor (the decedent in this case) creates a defeasible term (plus production) mineral interest by exception that leaves a future interest in an ascertainable person, the future interest in the minerals is not subject to the RAP. In sum, the Supreme Court held that the RAP did not apply because the interest vested during a lifetime, however it reverted back to the surface estate because of the lack of production.
Defeasible term mineral interests are prevalent with oil and gas properties. If the RAP were to apply to these interests, the RAP would invalidate the grantee’s interest. That would often be contrary to the parties’ intent. In fact, had the Kansas court applied the RAP, the future right to the on-half mineral interest upon termination would be void and the landowner (and heirs) would own it forever. Clearly, the parties in Jason Oil did not intend that result. Thus, the Court’s refusal to apply the RAP advanced the underlying public policy of protecting the transferability of interests in land.
The Kansas Supreme Court’s opinion is significant. When application of the RAP would fail to promote transferability of interests in land, it should not be applied. In addition, when a a particular form of property interest (such as a defeasible term mineral interest) has a long history of usage within a particular industry, it is not a good idea to have the RAP apply. In that situation, it would have the serious potential of disrupting titles and impairing commerce in property rights. These points are true even though the Kansas Supreme Court said it was creating a “narrow exception” to the RAP for defeasible term mineral interests. That means the public policy implications of the Court’s decision could apply in future cases.
Monday, August 26, 2019
For agricultural labor, only cash wages are subject to Social Security tax. Wages paid in-kind to agricultural labor are not subject to FICA tax, FUTA (Federal Unemployment Tax Act) tax, or income tax withholding, but they are subject to income tax. I.R.C. §§ 3121(a)(8), 3306(b)(11). In 1994, an IRS Task Force produced guidelines that set forth several factors as relevant in determining when a particular in-kind payment qualifies for the exemption. Those guidelines are still relevant in structuring in-kind wage payment arrangements.
Payment in the form of grain, soybeans, cotton or other commodities usually qualifies for the exemption. Payments in the form of livestock or livestock products cause problems but, with careful attention to the rules, should qualify for the special treatment for wages paid in-kind. Payments in a form equivalent to cash are ineligible for the in-kind wage treatment.
But, are commodity wages subject to Form W-2 reporting? They are if they are “wages.” But, are commodity wages really “wages” for W-2 reporting purposes? I got into this issue in an earlier post with respect to whether wages paid to children under age 18 are within the definition of “wages” for purposes of the 20 percent pass-through deduction of I.R.C. §199A here: https://lawprofessors.typepad.com/agriculturallaw/2018/08/the-qualified-business-income-deduction-and-w-2-wages.html.
Commodity wages and W-2 reporting: revisiting the definition of “wages” – it’s the topic of today’s post.
I.R.C. §6051(a)(3) requires the reporting of “wages” as that term is defined in I.R.C. §3401(a). I.R.C. §3401(a) defines “wages” as “all remuneration” including all remuneration paid in a medium other than cash. That’s an all-inclusive definition. However, I.R.C. §3401(a)(2) provides an exception to that broad definition. Ag labor that is defined in I.R.C. §3121(g) is not a “wage” if it meets the definition of a “wages” under I.R.C. §3121(a). I.R.C. §3121(a) specifies that the cash value of all remuneration paid in any medium other than cash is included in the definition of “wages,” except that the term does not include (among others) wages defined in I.R.C. §3121(a)(8). That’s a key exception - it excepts remuneration paid in any medium other than cash for agricultural labor (i.e., commodity wages).
“Wages” as defined by I.R.C. §3121(a)(8)(B) provides another exception from the definition of “wages” for W-2 reporting purposes. This exception applies if the amount paid to the employee is less than $150 AND the total expenditures for ag labor is less than $2,500 for the year. Stated another way (and how the statute actually reads), cash remuneration for ag labor is exempt unless the wage amount to the payee is at least $150 or the total expenditures for ag labor is at least $2,500. The farmer doesn’t need to report any W-2 if all employees are less than $150 and the total to all employees is less than $2,500. That’s because if the exemption of I.R.C. §3121(a)(8)(B) is triggered, all cash wages paid to ag employees satisfy the definition of “wages” that are excluded from the definition of wages for W-2 reporting purposes.
Why File Form W-2?
Even though Form W-2 need not be filed to report commodity wage payments, there are good reasons to complete the Form and file it. For example, W-2 filing is necessary to allow the taxpayer to e-file the tax return. But, even if the commodity wage is not reported on Form W-2, it is reported as other income on Form 1040 if not supported by Form W-2. E-filing would still be allowed.
In addition, Form W-2 filing helps the recipient determine the correct amount of wages to report on line 1. Also, without Form W-2, the recipient may not know the value of the commodity on the date of payment. Similarly, Form W-2 helps the recipient determine the correct income tax basis of the grain sold when calculating gain or loss on the subsequent sale of the commodity that is received in lieu of wages. In addition, if the recipient does not receive a Form W-2, it will be easy for the recipient of the commodity wages to forget to report the fair market value of the commodity wages on their tax return. Also, properly reporting the commodity wages on Schedule F could qualify the taxpayer for “farmer” status if the taxpayer doesn’t have enough gross farm income to satisfy the two-third’s test for estimated tax purposes.
Commodity Wages – A Caution
A further consideration when deciding whether to pay agricultural wages in-kind is that the payment of in-kind wages may threaten an agricultural employee's eligibility for disability benefits and may reduce or eliminate the employee's retirement benefits. Agricultural employees receiving wages in-kind do not build up retirement or disability credit under the Social Security system. For that reason, many employers agree to pay part of the wages in cash and part in-kind. The cash portion would be credited for purposes of the quarters of coverage needed for disability benefits and for purposes of retirement benefits.
Also, payments in-kind for agricultural labor are not considered wages for purposes of determining the amount of earnings in retirement.
Although reporting the income on Form W-2 might be helpful to the employee, the farmer paying the commodity wage does not have a duty to do so. Value is inherently subjective. A bushel of corn in a livestock farmer’s hands, at the farm, may be valued differently when viewed from the perspective of the employee, who is responsible for handling and later selling that commodity. It is not, therefore, the farmer’s responsibility to determine the value of the commodity transferred to the employee and report that value on Form W-2.
Clearly, the Code does not require Form W-2 reporting for commodity wage payments. This comports with the Code’s longtime exclusion of agriculture from the need to determine the value of commodities that are transferred. For example, Form 1099-Misc need not be issued for crop share rents and the landlord need not report the value of the rent received in income as a crop share until it is converted to cash (or used to satisfy a liability).
Thus, while Form W-2 reporting is not required for in-kind wage payments to agricultural labor as noted above, it might be a good idea to do so in particular circumstances.
Friday, August 23, 2019
Farmers have various sources of income. Of course, grain sales and livestock sales are common and the tax rules on the treatment of such sales are generally well understood. Farmers also have other miscellaneous sources of income from such things as the sale of timber and soil and natural resources. Another source of income for some farmers and ranchers is from breeding fees.
The proper tax reporting of income from breeding fees – it’s the topic of today’s post.
Sale or Lease?
Perhaps the starting point in determining the proper tax treatment of breeding fees from the perspective of both the buyer and the seller is to properly analyze the transaction that the parties have entered into. The key question is whether a breeding fee arrangement is a lease or a sale. This is not only important from a tax standpoint, but also from a financing and secured transaction standpoint. See, e.g., In re Joy, 169 B.R. 931 (Bankr. D. Neb 1994).
The courts and the IRS have, at least to a small extent, dealt with the proper tax treatment of breeding fees. A breeding or stud fee is classified as either a cost of raising or a cost of acquiring an animal, depending on which party bears the risk of loss that the breeding process may be unsuccessful. See, e.g., Jordan v. Comr., T.C. Memo. 2000-206. For example, in Duggar v. Comr., 71 T.C. 147 (1978), acq., 1979-1 C.B. 1, the petitioner entered into a “management agreement” with a cattle breeder. Under the agreement, the petitioner leased 40 brood cows and paid a fee for the artificial insemination of each brood cow as the initial step in developing a purebred herd. The agreement specified that the petitioner owned each calf at the time of birth, but did not have possession of any particular calf until after weaning – about a year after birth. The petitioner also paid a “calf maintenance” fee for each calf until the calf was weaned. After weaning and gaining possession of a calf, the petitioner could either sell the calf or pay an additional annual maintenance fee to the cattle breeder for the care of the heifers during the pre-breeding timeframe.
On his tax return, the petitioner deducted the cost of leasing the cows and maintenance fee associated with each calf for both the pre-weaning and pre-breeding stages. The IRS denied the deductions and the Tax Court agreed. The Tax Court concluded that the transaction between the petitioner and the cattle breeder was essentially the purchase of weaned calves. It couldn’t be properly characterized as the rental and care of breeding cows because the risk of loss with respect to any particular calf didn’t pass to the petitioner until after the calf was weaned. Thus, the costs that the petitioner incurred for the leasing of the cows and the maintenance of the calves before weaning had to be capitalized. However, the Tax Court did conclude that the expenses that the petitioner incurred to maintain the calves post-weaning were currently deductible.
Shortly after the Tax Court decided Duggar, the IRS issued a Revenue Ruling on the subject. The facts of the ruling are similar to those of Duggar. In Rev. Rul. 79-176, 1979-1 C.B. 123, a taxpayer on the cash method of accounting entered into a cattle breeding service agreement with another party. The agreement was specifically referred to as a lease. The agreement specified that the taxpayer “leased” cows from the herd owner. Under the agreement, any calf that was produced within a year of mating was to remain with its mother for a year after birth. When a calf was weaned the agreement termination and the calf was to be healthy and ready for breeding. Only after a calf was weaned did the taxpayer gain possession of the calf. Upon gaining possession, the taxpayer could sell the calf or place it in a herd management program.
Based on these facts, the IRS took the position that the arrangement amounted to a sales contract for the purchase of a live calf. Thus, the costs attributable to the cattle breeding, including the breeding fee and the initial cost of caring for the cow and calf until the calf was weaned, were non-deductible capital expenditures under I.R.C. §263. The calf could be depreciated over its useful life.
In contrast to the facts of Duggar and Rev. Rul. 79-176, if a taxpayer pays a breeding fee an animal bred that the taxpayer owns, the fee is deductible.
For a taxpayer that is on accrual accounting, breeding fees must be capitalized and allocated to the cost basis of the animal.
What About Embryo Transplanting?
An amount paid for embryo transplanting, including the cost of buying the embryo and costs associated with preparing the animal for transplantation and the transplant fees are deductible as “breeding fees.” Priv. Ltr. Rul. 8304020 (Oct. 22, 1982). But, if the taxpayer buys a pregnant cow the purchase price is to be allocated to the basis of the cow and resulting calf in accordance with the fair market value of the cow and the calf. In this situation, there is no current deduction for the purchase price of the cow or the portion of basis that is allocated to the calf.
What About the Owner of the Breeding Cattle?
Neither the Tax Court in Duggar, nor the IRS in Rev. Rul. 79-176 discussed the tax consequences to the owner of the breeding cattle. But, as noted above, both the Tax Court and the IRS treated that transactions involved as a sale. Because of that characterization, the owner of the breeding cattle should treat receipt of breeding fees as income from the sale of calves. If part of all of the fee is later refunded because the animal did not produce live offspring (or for any other reason) any breeding fees received should still be treated as income in the year received with a later deduction for the year that a refund is made.
Farmers and ranchers generate income in unique ways. Breeding fees arrangements are just one of those ways. Most likely, any such arrangement should be treated as a sale on the tax return. But, as noted, the correct answer is highly fact dependent.
Tuesday, August 20, 2019
Through 2016, the U.S. Treasury Department was pushing for the elimination of valuation discounts for federal estate and gift tax purposes. However, as part of the elimination of “non-essential” regulations under the Trump Administration, the Treasury announced in 2017 that it would no longer push for the removal of valuation discounts to value minority interests in entities or for interests that aren’t marketable. That means that the concept of valuation discounting is back in vogue – for those that need it. Of course, with the increase in the federal estate and gift tax applicable exclusion amount to $11.4 million (for deaths occurring and gifts made in 2019), the practice of valuation discounting is only used in select instances.
But, one area in which valuation discounting remains rather prominent is in the context of entity valuation when built-in gain (BIG) tax is involved. Can a discount be claimed for BIG tax? If so, what’s the extent of the discount? These are the topics of today’s post.
Illustration of the problem
Assume that Sam is interested in buying a tract of real estate. Sam finds two identical tracts – tract “A” and tract “B.” Sid owns tract A outright, and tract B is owned by a C corporation. Both tracts are worth $2 million and each have a cost basis of $200,000. If Sam buys tract A from Sid for $2 million and sells it five years later for $4 million, the capital gain triggered upon sale will be $2 million and the resulting tax (assuming a 20 percent effective capital gain tax rate) will be $400,000. So, the result is that Sam invested $2 million and five years later received $3.6 million when he “cashed-in” his investment.
However, if Sid owns tract B inside of a C corporation and Sam were to pay $2 million to buy 100 percent of the C corporate stock, he would receive the corporation’s stock with the land at the low $200,000 basis. Thus, upon sale of the land five years later for $4,000,000, the capital gain inside the corporation is $3.8 million). Based on a hypothetical capital gain tax rate of 20 percent, the capital gains tax liability inside the corporation is $760,000. This leaves $3,240,000 left to distribute from the corporation to Sam. Assuming Sam’s basis in the corporate stock is $2,000,000 (the amount he originally paid for the stock), Sam has additional capital gain at the shareholder level of $1,240,000. Assuming a capital gain tax rate of 20 percent, Sam must pay an additional $248,000 in capital gain tax at the shareholder level. So, the total tax bill to Sam is $1,008,000. The result is that Sam received $2,992,000 when he cashed his investment in five year later.
So, in theory, would Sam pay the same amount Sam for tract “A” as he would for tract “B”? The answer is “no.” Sam would pay an amount less than fair market value to reflect the BIG tax he would have to pay to own tract “B” outright and not in the C corporate structure. That’s the basis for the discount for the BIG tax – to reflect the fact that the taxpayer in Sam’s position would not pay full fair market value for the asset. Rather, a discount from fair market value would be required to reflect the BIG tax that would have to be paid to acquire the asset outright and not in the C corporate structure.
BIG Tax Discount - The IRS and the Courts
IRS position and early cases. The IRS maintained successfully (until 1998) that no discount for BIG tax should apply, but the courts have disagreed with that view. That all changed in 1998 when the Tax Court decided Estate of Davis v. Comr., 110 T.C. 530 (1998) and the U.S. Court of Appeals for the Second Circuit decided Eisenberg v. Comr., 155 F.3d 50 (1998). In those cases, the court held that, in determining the value of stock in a closely held corporation, the impact of the BIG tax could be considered. In Eisenberg, the appellate court directed the Tax Court (on remand) that some reduction in value to account for the BIG tax was appropriate. Ultimately, the Tax Court did not get to decide the amount of the discount, because the case settled. The IRS acquiesced in the Second Circuit’s opinion and treats the applicability of the discount for BIG tax as a factual matter to be determined by experts using generally applicable valuation principles. A.O.D. 1999-001 (Jan. 29, 1999).
The level of the discount. Initially, the courts focused on the level of the discount. But, in 2007, the United States Court of Appeals for the Eleventh Circuit in Estate of Jelke III v. Comr., 507 F.3d 1317(11th Cir. 2007), held that in determining the estate tax value of holding company stock, the company's value is to be reduced by the entire built-in capital gain as of the date of death. In 2009, the U.S. Tax Court followed suit and essentially allowed a full dollar-for-dollar discount in a case involving a C corporation with marketable securities. Estate of Litchfield v. Comr., T.C. Memo. 2009-21. In 2010, the Tax Court again allowed a full dollar-for-dollar discount for BIG tax in Estate of Jensen v. Comr., T.C. Memo. 2010-182.
The Tax Court, in 2014, held that a BIG tax discount was allowable. Estate of Richmond v. Comr., T.C. Memo. 2014-26. Ultimately, the Tax Court determined that the BIG tax discount was 43 percent of the tax liability (agreeing with the IRS) rather than a full dollar-for-dollar discount, but only because the potential buyer could defer the BIG tax by selling the securities at issue over time. That meant, therefore, that the BIG tax discount was to be calculated in accordance with the present value of paying the BIG tax over several years.
Implications for Divorce Cases
While the rulings in Jelke III, Litchfield and Jensen are important ones for estate tax valuation cases, they may not have a great amount of practical application given that very few estates are subject to federal estate tax, and of those that are taxable, only a few involve a determination of the impact of BIG tax on valuation. However, the impact of BIG tax in equitable distribution settings involving divorce may have much greater practical application. Many states utilize the principles of equitable distribution in divorce cases. Under such principles, the court may distribute any assets of either the husband or wife in a just and reasonable manner. Any factor necessary to do equity and justice between the parties is to be considered. Technically, the tax consequences to each spouse are to be considered. However, the amount (or even the allowance) of a discount for built-in capital gains tax is not well settled.
In divorce settings, courts tend to be reluctant to deduct potential tax liability from the distribution of the underlying assets. For example, a Pennsylvania court, in a 1995 opinion, refused to deduct the potential tax liability associated with the distribution of defined benefit pension plans. Smith v. Smith, 439 Pa. Super. 283, 653 A.2d 1259 (1995). The court held that potential tax liability could be considered in valuing marital assets only where a taxable event has occurred or is certain to occur within a time frame such that the tax liability can be reasonably predicted. The North Carolina Court of Appeals has ruled likewise in Weaver v. Weaver, 72 N.C. App. 409 (1985), as have courts in New Jersey (see, e.g., Stern v. Stern, 331 A.2d 257 (N.J. 1975); Orgler v. Orgler, 237 N.J. Super. 342, 568 A.2d 67 (1989); Goldman v. Goldman, 275 N.J. Super. 452, 646 A.2d 504 (1994), cert. den., 139 N.J. 185, 652 A.2d 173 (1994)), Delaware (Book v. Book, No. CK88-4647, 1990 Del. Fam Ct. LEXIS 96 (1990)), West Virginia Hudson v. Hudson, 399 S.E.2d 913 (W. Va. 1990); Bettinger v. Bettinger, 396 S.E.2d 709 (W. Va. 1990)) and South Dakota (See, e.g., Kelley v. Kirk, 391 N.W.2d 652 (1986)). But, the Oregon Court of Appeals, has indicated that a reduction for taxes should be allowed in divorce cases subject to equitable distribution rules. In re Marriage of Drews, 153 Ore. App. 126, 956 P.2d 246 (1998).
The courts have largely dismissed the IRS view that generally opposed a BIG tax discount. It’s simply not the way that buyers operate in actual transactions. In any event, when a discount for BIG tax is sought, hiring a tax expert and a valuation expert can go along way to establishing a full dollar-for-dollar discount for the BIG tax.
Friday, August 16, 2019
The conservation-compliance provisions of the 1985 Farm Bill introduced the concept of “swampbuster.” Swampbuster was introduced into the Congress in January of 1985 at the urging of the National Wildlife Federation and the National Audubon Society. It was originally presented as only impacting truly aquatic areas and allowing drainage to continue where substantial investments had been made. Thus, there was virtually no opposition to Swampbuster.
But, the “dirt is in the details” as it is often said. Just how does the USDA determine if a tract of farmland contain a wet area that is subject to regulation? That’s a question of key importance to farmers. That process was also the core of a recent court opinion, in which the court painted a rather bleak and embarrassing picture of the USDA bureaucrats.
Swampbuster and the USDA’s process for determining land subject to the Swampbuster rules – that’s the topic of today’s post.
The legislation charged the soil conservation service (SCS) with creating an official wetland inventory with a particular tract being classified as a wetland if it had (1) the presence of hydric soil; (2) wetland hydrology (soil inundation for at least seven days or saturated for at least 14 days during the growing season); and (3) the prevalence of hydrophytic plants under undisturbed conditions. In other words, to be a wetland, a tract must have hydric soils, hydrophytic vegetation and wetland hydrology. The presence of hydrophytic vegetation, by itself, is insufficient to meet the wetland hydrology requirement and the statute clearly requires the presence of all three characteristics. B&D Land & Livestock Co. v. Schafer, 584 F. Supp. 2d 1182 (N.D. Iowa 2008).
Under the June 1986 interim rules, wetland was assumed to be truly wet ground that had never been farmed. In addition, “obligation of funds” (such as assessments paid to drainage districts) qualified as commenced conversions, and the Fish and Wildlife Service (FWS) had no involvement in ASCS or SCS decisions. In September of 1986, a proposal to exempt from Swampbuster all lands within drainage districts was approved by the chiefs of the ASCS, SCS, FmHA, FCIC and the Secretary of Agriculture. However, the USDA proposal failed in the face of strong opposition from the FWS and the EPA.
The final Swampbuster rules were issued in 1987 and greatly differed from the interim rules. The final Swampbuster rules eliminated the right to claim prior investment as a commenced conversion. Added were farmed wetlands, abandoned cropland, active pursuit requirements, FWS concurrence, a complicated “commenced determination” application procedure, and special treatment for prairie potholes. Under the “commenced conversion” rules, an individual producer or a drainage district is exempt from Swampbuster restrictions if drainage work began before December 23, 1985 (the effective date of the 1985 Farm Bill). If the drainage work was not completed by December 23, 1985, a request could be made of the ASCS on or before September 19, 1988, to make a commencement determination. Drainage districts must satisfy several requirements under the “commenced conversion” rules. A project drainage plan setting forth planned drainage must be officially adopted. In addition, the district must have begun installation of drainage measures or legally committed substantial funds toward the conversion by contracting for installation or supplies.
The final rules defined “farmed wetlands” as playa, potholes, and other seasonally flooded wetlands that were manipulated before December 23, 1985, but still exhibited wetland characteristics. Drains affecting these areas can be maintained, but the scope and effect of the original drainage system cannot be exceeded. 7 C.F.R. § 12.33(b). Prior converted wetlands can be farmed, but they revert to protected status once abandoned. Abandonment occurs after five years of inactivity and can happen in one year if there is intent to abandon. A prior converted wetland is a wetland that was totally drained before December 23, 1985. Under 16 U.S.C. §3801(a)(6), a “converted wetland” is defined as a wetland that is manipulated for the purpose or with the effect of making the production of an agricultural commodity possible if such production would not have been possible but for such action. See, e.g., Clark v. United States Department of Agriculture, 537 F.3d 934 (8th Cir. 2008). If a wetland was drained before December 23, 1985, but wetland characteristics remain, it is a “farmed wetland” and only the original drainage can be maintained.
Identifying a Wetland – The Boucher Saga
The process that the USDA uses to determine the presence of wet areas on a farm that are subject to the Swampbuster rules (known as the “on-site” wetland identification criteria) are contained in 7 C.F.R. §12.31. The application of the rules was at issue in the most recent opinion in a case involving an Indiana farm family’s longstanding battle with the USDA.
Facts and administrative appeals. The facts of the litigation reveal that the plaintiff (and her now-deceased husband) owned the farm at issue since the early 1980s. The farmland has been continuously used for livestock and grain production for over 150 years. The tenants that farm the land participated in federal farm programs. In 1987, the plaintiffs were notified that the farm might contain wetlands due to the presence of hydric soils. This was despite a national wetland inventory that was taken in 1989 that failed to identify any wetland on the farm. In 1991, the USDA made a non-certified determination of potential wetlands, prior converted wetlands and converted wetlands on the property. In 1994, the plaintiff’s husband noticed that passersby were dumping garbage on a portion of the property. To deter the garbage-dumping, the plaintiff’s husband cleaned up the garbage, cleared brush, and removed five trees initially and four more trees several years later. The trees were upland-type trees that were unlikely to be found in wetlands, and the tree removal impacted a tiny fraction of an acre. The USDA informed the landowners that the tree removal might have triggered a wetland/Swampbuster violation and that the land had been impermissibly drained via field tile (which it had not).
Because the land at issue was farmed, the USDA’s Natural Resources Conservation Service (NRCS) used an offsite comparison field to compare with the tract at issue for a determination of the presence of wetland. The comparison site chosen was an unfarmed depression that was unquestionably a wetland. In 2002, an attempt was made to place the farm in the Conservation Reserve Program, which triggered a field visit by the NRCS. However, a potential wetland violation had been reported and NRCS was tasked with making a determination of whether a wet area had been converted to wetland after November 28, 1990. The landowners requested a certified wetland determination, and in late 2002 the NRCS made a “routine wetland determination” that found all three criteria for a wetland (hydric soil, hydrophytic vegetation and hydrology) were present by virtue of comparison to adjacent property because the tract in issue was being farmed. The landowners were notified in early 2003 of a preliminary technical determination that 2.8 acres were converted wetlands and 1.6 acres were wetlands. The NRCS demanded that the landowners plant 300 trees per acre on the 2.8 acres of “converted wetland.”
The landowners requested a reconsideration and a site visit. Two separate site visits were scheduled and later cancelled due to bad weather. The landowners also timely notified NRCS that they were appealing the preliminary wetland determination and requested a field visit, asserting that NRCS had made a technical error. A field visit occurred in the spring of 2003 and a written appeal was filed of the preliminary wetland determination and a review by the state conservationist was requested. The appeal claimed that the field visit was inadequate. The husband met with the State Conservationist in the fall of 2003. No site visit occurred, and a certified final wetland determination was never made. The landowners believed that the matter was resolved.
The husband died, and nine years later a new tenant submitted a “highly erodible land conservation and wetland conservation certification” to the FSA. Permission was requested from the USDA to remove an old barn and house from a field to allow farming of that ground. In late 2012, the NRCS discovered that a final wetland determination had never been made and a field visit was scheduled for January of 2013 shortly after several inches of rain melted a foot of snow on the property. At the field visit, the NRCS noted that there were puddles in several fields. The NRCS used the same comparison field that had been used in 2002, and also determined that underground drainage tile must have been present (it was not).
Based on the January 2013 field visit, the NRCS made a final technical determination that one field did not contain wetlands, another field had 1.3 acres of wetlands, another field had 0.7 acres of converted wetlands and yet another field had 1.9 acres of converted wetlands. The plaintiff (the surviving spouse) appealed the final technical determination to the USDA’s National Appeals Division (NAD). At the NAD, the plaintiff asserted that either tile had been installed before the effective date of the Swampbuster rules in late 1985 or that tiling wasn’t present (a tiling company later established that no tiling had been installed on any of the tracts); that none of the tracts showed water inundation or saturation; that none of the tracts were in a depression; and that the trees that were removed over two decades earlier were not hydrophytic, were not dispositive indicators of wetland, and that improper comparison sites were used. The NRCS claimed that the tree removal altered the hydrology of the site. The USDA-NAD affirmed the certified final technical determination. The plaintiff appealed, but the NAD Director affirmed. The plaintiff then sought judicial review.
Trial court decision. The trial court affirmed the NAD Director’s decision and granted summary judgment to the government. Boucher v. United States Department of Agriculture, No. 1:13-cv-01585-TWP-DKL, 2016 U.S. Dist. LEXIS 23643 (S.D. Ind. Feb. 26, 2016). The court based its decision on the following:
- The removal of trees and vegetation had the “effect of making possible the production of an agricultural commodity” where the trees once stood and, thus, the NRCS determination was not arbitrary or capricious with respect to the converted wetland determination.
- The NRCS followed regulatory procedures found in 7 C.F.R. §12.31(b)(2)(ii) for determining wetland status on the land that was being farmed by comparing the land to comparable tracts that were not being farmed.
- Existing regulations did not require site visits during the growing season.
- “Normal circumstances” of the land does not refer to normal climate conditions but instead refers to soil and hydrologic conditions normally present without regard to the removal of vegetation.
- The ten-year timeframe between the preliminary determination and the final determination did not deprive the plaintiff of due process rights.
The appellate court reversed the trial court decision and remanded the case for entry of judgment in the plaintiff’s favor and award her “all appropriate relief.” Boucher v. United States Dep’t of Agric., No. 16-1654, 2019 U.S. App. LEXIS 23695 (7th Cir. Aug. 8, 2019). On the comparison site issue (the USDA’s utilization of the on-site wetland identification criteria rules), the USDA claimed that 7 C.F.R. § 12.31(b)(2)(ii) allowed them to select a comparison site that was "on the same hydric soil map unit" as the subject property, rather than on whether the comparison site has the same hydrologic features as the subject tract(s). The appellate court rejected this approach as arbitrary and capricious, noting that the NRCS failed to try an "indicator-based wetland hydrology" approach or to use any of their other tools when picking a comparison site. In addition, the appellate court noted a COE manual specifies that, “[a] hydrologist may be needed to help select and carry out the proper analysis" in situations where potential lack of hydrology is an issue such as in this case. However, the NRCS did not send a hydrologist to personally examine the plaintiff’s property, claiming instead that a comparison site was not even necessary. Based on 7 C.F.R. §12.32(a)(2), the USDA claimed, the removal of woody hydrophytic vegetation from hydric soils to permit the production of an agricultural commodity is all that is needed to declare the area "converted wetland."
The appellate court concluded that this understanding of the statue was much too narrow and went against all the other applicable regulatory and statutory provisions by completely forgoing the basis of hydrology that the provisions are grounded in. Accordingly, the appellate court reasoned that because hydrology is the basis for a change in wetland determination, the removal of trees is merely a factor to determine the presence of a wetland, but is not a determining factor. In addition, the appellate court pointed out that the NRCS never indicated that the removal of trees changed the hydrology of the property during the agency appeal process – a point that the USDA ignored during the administrative appeal process. The appellate court rather poignantly stated, “Rather than grappling with this evidence, the hearing officer used transparently circular logic, asserting that the Agency experts had appropriately found hydric soils, hydrophytic vegetation, and wetland hydrology…”.
The USDA-NRCS was brutalized (rightly so) by the appellate court’s decision for its lack of candor and incompetence. Those same agency characteristics were also illustrated in the Eighth Circuit decision of Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999). Perhaps much of the USDA/NRCS conduct relates to the bureaucratic unilateral decision in 1987 to change the rules to include farmed wetland under the jurisdiction of Swampbuster. That decision has led to abuse of the NAD process and delays that have cost farmers untold millions. Hopefully, the clean-out of some USDA bureaucrats as a result of the new Administration that began in early 2017 will result in fewer cases like this in the future.
Thursday, August 8, 2019
The Tax Cuts and Jobs Act of 2017 (TCJA) changed the landscape of tax-deferred exchanges under I.R.C. §1031. Personal property trades are no longer eligible for tax-deferred treatment. But, the rules governing tax-deferred exchanges of real estate didn’t change. That makes the definition of “real estate” of utmost importance. In prior posts I have addressed the issue of what constitutes like-kind “real estate” for I.R.C. §1031 purposes. See, e.g., https://lawprofessors.typepad.com/agriculturallaw/2018/10/what-is-like-kind-real-estate.html. But, what about an easement? Or, more specifically, what about a perpetual conservation easement? Do they qualify as “like-kind” to real estate such that the proceeds received from a donation/sale transaction can be used to acquire replacement real estate and the transaction be tax-deferred?
Conservation easements and the like-kind exchange rules – it’s the topic of today’s post
The Definition of “Real Estate”
Under the I.R.C. §1031 rules, “real estate” is defined very broadly. Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment purposes. The regulations define “like-kind” in terms of reference to the nature or character of the replacement property rather than its grade or quality. Treas. Reg. §1.1031(a)-1(b); see also C.C.M. 201238027
In addition, it doesn’t matter whether the real estate involved in a tax-deferred exchange is improved or unimproved. Treas. Reg. §1.1031(a)-1(b), (c). Thus, agricultural real estate may be traded for residential real estate. However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are “I.R.C. §1245 property.” For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in the exchange. Also, remember, post-2017, the value of personal property associated with the real estate that does not fit within the definition of “real estate” is no longer eligible for tax-deferral under I.R.C. §1031.
Easements. Defined broadly, an easement is a nonpossessory interest in another party’s land that entitles the holder of the easement the right to use the land subject to the easement in the manner that the easement specifies. Conservation easements involve development rights. There is support for the notion that development rights in land are like-kind to real estate. For instance, in Rev. Rul. 55-749, 1955-2 CB 295, the IRS determined that land was like-kind to perpetual water rights. The IRS also has taken the position that a leasehold interest in a producing oil lease that extended until the exhaustion of the oil deposit was like-kind to a fee interest in a ranch. Rev. Rul. 68-331, 1968-1 CB 352.
In addition, Rev. Rul. 59-121, 1959-1 CB 212, the IRS took the position that an easement sold was an interest in real property. Under the facts of the ruling, the taxpayer granted easements to an industrial company over his ranchland that he used for grazing livestock that were raised for sale. The easements granted were for an indefinite duration and he was paid for the easement grants. The easements provided for the construction of a dam across a creek located on the taxpayer's property in order to create a reservoir and impound water and as a depository for waste material produced as a byproduct of the company's industrial process. The easements specified that the taxpayer retained all rights to explore for and produce oil, gas, or other minerals on the land subject to the easements and he could use the land and buildings on it if he didn’t interfere with the easement rights granted. The IRS said that the funds the taxpayer received for the easement grants constituted proceeds from the sale of an interest in real property. Thus, the amount received could be applied to reduce the basis of the land subject to the easement, with any excess (recognized gain) being eligible for investment in like-kind real estate.
Later, in 1972, the IRS determined that a right-of-way easement was like-kind to real estate. Rev. Rul. 72-549, 1972-2 CB 352. In 1971, under threat of condemnation the taxpayer granted an electric power company an easement and right-of-way over part of the taxpayer’s property that he used in his trade or business. The amount received for the easement and right-of-way triggered gain to the taxpayer. The easement and right-of-way were permanent and exclusive, and the company obtained the right to construct, maintain, operate, and repair power transmission lines and electrical towers on the right-of-way. The taxpayer used the funds acquired from the easement and right-of-way grant to acquire other real estate that he would use in his trade or business. The IRS ruled that the acquired property qualified as like-kind replacement property under I.R.C. §1031.
More closely aligned with conservation easements, the U.S. Supreme Court held in 1958 that when a right or interest arises out of real estate and is for a term short of “perpetuity” (which also means a land lease of less than 30 years) and the interest is defined in terms of money, the right or interest is not like-kind to a fee simple interest in real estate. The case was the consolidation of five cases involving the conversion of future income from oil leases into present income in the form of real estate. Comr. v. P.G. Lake, Inc, et al., 356 U.S. 260 (1958). Also, in Priv. Ltr. Rul. 200901020 (Oct. 1, 2008), the IRS determined that development rights that a taxpayer transferred were like-kind to a fee interest in real estate; a real estate lease with at least 30 years remaining at the time of the exchange; and land use rights for hotel units.
On conservation and agricultural easements, the following IRS rulings are helpful guidance:
- Ltr. Rul. 9851039 (Sept. 15, 1998) – The taxpayers sought to convey a perpetual agricultural conservation easement on their farms to the state in exchange for property of like-kind. Under state law, an ag conservation easement constituted an interest in land and was deemed to be the same as covenants that ran with the land. In other words, the easement was deemed to be like-kind to a fee simple and the proceeds received from the easement grant could be reinvested in like-kind real estate under the I.R.C. §1031 rules.
- Ltr. Rul. 200201007 (Oct. 2, 2001) - The IRS concluded that a perpetual conservation easement on a ranch could be exchanged for a fee interest in other ranch property that was subject to a (negative) perpetual conservation easement. Again, one of the keys to the IRS conclusion was that under applicable state law, a perpetual conservation easement constituted an interest in real property.
- Ltr. Rul. 9232030 (May 12, 1992) – The IRS determined that the exchange of a perpetual agricultural conservation easement on a farm for a fee simple interest in other real property qualified as a tax-deferred exchange under I.R.C. §1031.
- Ltr. Rul. 9621012 (Feb. 16, 1996) – In this private ruling, a county sought to acquire a perpetual scenic conservation easement over a ranch to protect a coastline viewshed that the state wanted to protect in perpetuity. While the taxpayer retained the right to use the ranch for ranching and grazing purposes, the portion of the ranch subject to the easement could not be developed. The taxpayer was willing to make the conveyance, but only in return for property of like-kind that qualified for non-recognition treatment under I.R.C. §1031. The IRS determined that the exchange of the easement for a fee simple interest in timberland, farm land or ranch land qualified as an exchange of property that qualified for tax deferral under I.R.C. §1031.
- Ltr. Rul. 200649028 (Sept. 8, 2006) – This private ruling involved transferable rural land use credits under state law. The state was concerned about controlling development and developed a system whereby the owner of credits could develop property in a manner that otherwise wasn’t permissible without the credits (termed “stewardship credits”). Any use or transfer of the credits had to be publicly recorded as an easement that ran with the land in favor of the county, qualified state agency or state land trust. The credits were perpetual in nature, and state law specified that a “stewardship easement” was an interest in real property. The taxpayer involving in the private ruling sought to sell the credits to a buyer and use the proceeds of sale to buy replacement real estate via a qualified intermediary. The taxpayer would use the replacement property for productive use in the taxpayer’s trade or business or for investment purposes. The IRS determined that the transaction qualified for tax deferral under I.R.C. §1031.
- Ltr. Rul. 200805012 (Oct. 30, 2007) -Here, the IRS privately ruled that development rights were like kind, to a fee interest in property that a taxpayer relinquished in an exchange. The trade transaction was quite complex and was accomplished via a qualified intermediary
The IRS has been aggressive at auditing donated conservation easements accomplished via a syndicated partnership. These transactions involve either an individual or an entity buying undeveloped property and then transferring it to a partnership. Partnership interests are then sold to “investors.” After the land appreciates in value, the partnership donates a conservation easement on the land to a qualified land trust with the charitable deduction flowing to the investors. This strategy made it on the 2019 IRS list of the “Dirty Dozen” tax scams and the Congress is taking action to eliminate the technique. In the U.S. Senate, The “Charitable Conservation Easement Program Integrity Act of 2019” has been introduced to end syndicated partnership easement donations. It also contains provisions that are effective retroactively and bars deductions when the value of the associated property has appreciated in value more than 2.5 times the initial investment
The use of proceeds from a conservation easement donation in a transaction that will qualify as an I.R.C. §1031 exchange can be handled in a rather straightforward manner. In addition, separate exchanges can occur as to the easement and the residual interest in the real estate. Issues, if any present themselves, could occur with respect to the Natural Resource Conservation Service and its option and funding process. But those are separate matters from the deferred tax treatment of the transaction qualifying as an I.R.C. §1031 exchange.
Tuesday, August 6, 2019
In 2018, the U.S. Supreme Court, in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), handed South Dakota a narrow 5-4 win in its quest to collect taxes from online sales. The Court held that the Constitution’s Commerce Clause did not bar South Dakota from statutorily requiring remote sellers without a physical presence in the state to collect and remit sales tax on goods and services that are sold to buyers for delivery inside the state of South Dakota. In so doing, the Court distinguished and at least partially overruled 50 years of Court precedent on the issue.
But, did the Court open the floodgates for the states to tax every dollar of sales in a state from an out-of-state seller? That’s a hard case to make because the Court ruled specifically on a South Dakota statute that contained a de minimis sales requirement before state sales tax kicked-in. However, the Kansas Department of Revenue (KDOR) has now taken the position that any amount of sales by a remote seller (a seller without any physical presence in Kansas) to a Kansas buyer triggers the need of the remote seller to register with the state and pay Kansas sales tax.
The Kansas position concerning sales taxation of remote sellers and implications – the focus of today’s blog post.
Online Sales - Historical Precedent
The core constitutional issues concerning a state’s ability to impose sales (and/or use) tax on a seller with no physical presence in the state involve interstate commerce and due process. In 1967, the U.S. Supreme Court determined that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States” in holding that Illinois could not subject a mail order seller located in Missouri to use tax where the seller had no physical presence in Illinois. National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967). In holding the law unconstitutional, the Court reasoned that subjecting the seller’s interstate business to local “variations in rates of tax…and record-keeping requirements” would violate the purpose of the Commerce Clause “to ensure a national economy free from…unjustifiable local entanglements.”
Twenty-five years later, the Court reaffirmed the limitations of the Commerce Clause on state regulatory authority in Quill Corporation v. North Dakota, 504, U.S. 298 (1992). In Quill, the Court held that a mail order house with no physical presence in North Dakota was not subject to North Dakota use tax for “property purchased for storage, use, or consumption within the State.” The Court followed closely its holding in National Bellas Hess, Inc. because doing so “encourage[d] settled expectations and …foster[ed] investment by businesses and individuals.” As applied to internet sales, Quill (which predated the internet) does not exempt all internet sales from state sales taxes – just sales by sellers who don’t have a physical presence in a particular state. National retailers have a presence in many states.
More recently, in 2015, the Court examined a Colorado “tattletale” law that required out-of-state sellers with no physical presence in the state “to notify…customers of their use tax liability and to report” sales information back to Colorado. Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2013). The trial court enjoined enforcement of the law on Commerce Clause grounds. On appeal, the Tenth Circuit held that it couldn’t hear the challenge to the law because the Tax Injunction Act (28 U.S.C. §1341) divested it of jurisdiction and the matter belonged in state court and, ultimately, the U.S. Supreme Court. The Tenth Circuit remanded the case for dismissal of the Commerce Clause claims and dissolution of the permanent injunction. The U.S. Supreme Court reversed and remanded the decision of the Tenth Circuit on the jurisdiction issue and, on remand, the Tenth Circuit, invalidated the Colorado law on Commerce Clause grounds. Direct Marketing Association v. Brohl, 814 F.3d 1129 (10th Cir. 2016).
In the U.S. Supreme Court’s reversal and remand of the Tenth Circuit’s decision in Direct Marketing Association, Justice Kennedy wrote a concurring opinion that essentially invited the legal system to find an appropriate case that would allow the Court to reexamine the Quill and National Bellas Hess holdings. Hence, the South Dakota legislation.
South Dakota Legislation and Litigation
S.B. 106 was introduced in the 2016 legislative session of the South Dakota legislature. It requires the collection of sales taxes from certain remote sellers – those with “gross revenue” from sales in South Dakota of over $100,000 per calendar year or with 200 or more “separate transactions” in the state within the same timeframe.
S.B. 106 was signed into law on March 22, 2016, and the state Department of Revenue soon thereafter began issuing notices to sellers that it thought were in violation of the law. Several out-of-state sellers that received notices did not register for sale tax licenses as the law required. Consequently, the state brought a declaratory judgment action against the sellers in circuit court, and sought a judicial declaration that the S.B. 106 requirements were valid and applied to the sellers. The state also sought an order enjoining enforcement of S.B. 106 while the action was pending in court, and an injunction that required the sellers to register for licenses to collect and remit sales tax.
The sellers tried to remove the case to federal court based on federal question jurisdiction, but the federal court rejected that approach and remanded the case to the South Dakota Supreme Court. South Dakota v. Wayfair, Inc., 229 F. Supp. 3d 1026 (D. S.D. 2017). On remand, the South Dakota Supreme Court invalidated S.B. 106 on Commerce Clause grounds based on the U.S. Supreme Court precedent referenced above. State v. Wayfair, Inc., et al., 901 N.W.2d 754 (S.D. 2017). The state of South Dakota filed a petition for certiorari with the U.S. Supreme Court and the Court granted the petition.
U.S. Supreme Court Decision – The Importance of “Substantial Nexus”
Article I, Section 8 of the U.S. Constitution says that, “The Congress shall have the power...to regulate commerce…among the several states…”. That was the key point of the Court’s 1967 Bellas Hess, Inc. decision. As noted above, in that case the Court stated that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States.” In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided. Later, in the Quill case, the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement.
In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. But, the key point is that the “substantial nexus” test of Brady remains. Likewise, the other three requirements of Brady remain. A state can only impose sales (or use) tax on a remote seller without a physical presence in the state if the tax is fairly apportioned; does not discriminate against interstate commerce; and is fairly related to services that the state provides. In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce. The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – it had only a limited application due to the requirement of a de minimis a dollar amount of sales or transactions in the state; it was not applied retroactively; South Dakota was a member of the Streamlined Sales and Use Tax Agreement (SSUTA); the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden.
On August 1, 2019, the KDOR issued Notice 19-04 designed to provide “guidance” to remote sellers doing business in Kansas. https://www.ksrevenue.org/taxnotices/notice19-04.pdf In the Notice, the KDOR noted that Kansas law (Kan. Stat. Ann. §79-3702(h)(1)(F)) defines a “retailer doing business in this [Kansas]” as: “any retailer who has any other contact with this state that would allow this state to require the retailer to collect and remit tax under the provisions of the constitution and the law of the United States.” The KDOR also noted that the Kansas requires online (and other remote) sellers with no physical presence in Kansas to collect and remit “the applicable” sales and use tax on sales delivered into Kansas. KDOR indicated that remote sellers are to register and begin collecting and remitting Kansas sales and/or use tax by October 1, 2019.
The Notice, as strictly construed, is correct. The state can require a remote seller to register with the state and collect and remit sales and/or use tax “under the provisions of the constitution and the laws of the United States.” That would mean as the applicable law has been defined by the U.S. Supreme Court, including the Court’s most recent Wayfair decision – which involved a state law that contained a de minimis requirement based on amount of sales or number of transactions. However, the KDOR Notice did not specify any level of de minimis sales before sales tax was triggered. Indeed, the Director of Research and Analysis for KDOR was quoted in the Bloomberg Daily Tax Report (online) on August 1 as stating that KDOR “does not believe it needs a de minimis threshold” based on Kan. Stat. Ann. §79-3702. This is an inaccurate statement that will likely invite a legal challenge to the KDOR’s position. There simply is no protection in the Wayfair decision for KDOR’s position. The “substantial nexus” test still must be satisfied – even with a remote seller. Indeed, during the 2019 session of the Kansas legislature, a major tax bill contained de minimis requirements that mirrored the South Dakota legislation, but the Governor vetoed the bill and the Kansas House failed to override the veto. Presently, no other state has taken the position that the KDOR has taken.
The KDOR’s position amounts to a frontal assault on the Commerce Clause post-Wayfair. Presently, 23 states are “full members” of the SSUTA. For those states, Wayfair at least implies that membership in the SSUTA has the effect of minimizing the impact on interstate commerce. But, that doesn’t mean that SSUTA membership eliminates the “substantial nexus” requirement. Indeed, South Dakota was an SSUTA member and the Court still went through the “substantial nexus” analysis. Thus, it appears that any state legislation must have exceptions for small businesses with low volume transactions and sales revenue. Whether a series LLC (in some states such as Iowa) or subsidiaries of a business could be created, each with sales below the applicable threshold, remains to be seen.
On a related note, could the KDOR (or any other state revenue department) go after a portion of business income of the out-of-state business via income tax? That seems plausible. However, the Interstate Income Act of 1959 (15 U.S.C. §381-384), requires that a business (or individual – the business form does not matter because corporations have long held personhood status under the Constitution (see, Bank of the United States v. Deveaux, 9 U.S. 61 (1809); Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014)) have some sort of connection with a state before its income can be taxed (at least with respect to the solicitation of orders for tangible personal property). Is that legislation now unconstitutional too? Or, is there a distinction remaining between taxing receipts as opposed to income? That may be at issue in a future Supreme Court case.
For now, it’s practically a sure bet that, unless the Kansas legislature passes a bill containing de minimis thresholds that can withstand the Governor’s veto, the state will be devoting taxpayer resources to defending a lawsuit that will challenge the state’s (as of now) unsupportable position.
Friday, August 2, 2019
It’s been about a month since I devoted a blog post to court litigation involving agricultural producers and businesses. So, it’s time to devote another post to the matter as an illustration of how often the law and the business of agriculture intersect. These posts have proven to be quite popular and instructive.
“Ag in the Courtroom” – the most recent edition. It’s the topic of today’s post.
More Bankruptcy Developments
As I have noted in numerous posts over the past couple of years, the difficult economic conditions in much of agriculture in the Great Plains and the Midwest have made bankruptcy law rise in importance. Fortunately, legislation is headed to the President’s desk that will increase the debt limit in Chapter 12 bankruptcy to $10 million and place some of the existing Chapter 12 provisions in Chapter 11 for use by non-farm small businesses. Those were needed pieces of legislation.
A recent Alabama bankruptcy case illustrates the peril of selling loan collateral without the creditors notice and consent. It’s a unique set of facts because the debtor sold the collateral, a tractor, to bail her boyfriend out of jail. In In re Reid, 598 B.R. 674 (Bankr. S.D. Ala. 2019), the Farm Service Agency (FSA) attached itself as a creditor in the debtor’s chapter 7 bankruptcy proceeding. In March of 2016 the debtor took out two FSA loans for a total of $50,000. A security agreement was also executed at the same time granting the FSA a security interest in "All farm equipment . . . and inventory, now owned or hereafter acquired by the Debtor, together with all replacements, substitutions, additions, and accessions thereto, including but not limited to the following which are located in the State of Alabama." A specific list of assets was attached, including a New Holland tractor, ten beef breeding cows, and nine calves. The debtor used the loan proceeds to purchase the equipment and livestock that was listed as collateral.
In June of the same year, the debtor was notified that she could not have cattle on the land she purchased with another loan not at issue in the case. However, the debtor was never notified of the restriction and it was not stated in the purchase contracts. Ultimately, the debtor was given thirty days to vacate the premises. Around this time, the debtor’s equipment and cattle started to go missing. The debtor was also becoming aware that her boyfriend (and father of her children) had a drug problem, and she began to suspect that he was selling the equipment and cattle for drugs. Later, the debtor attempted to stop a man from taking cattle from the property and the man said to take it up with her boyfriend. The debtor did not report the cattle or equipment as stolen. The debtor’s boyfriend was arrested about the same time for drug crimes and eluding the police. The debtor vacated the property with the only collateral remaining at the property being the New Holland tractor, which the debtor listed for sale on Facebook. The debtor testified that she sold the New Holland tractor to an unknown purchaser for between $6,000.00 and $8,000.00. But the exact price and identity of the purchaser could not be found as the debtor deleted her Facebook account. The proceeds of the tractor sale were put towards bail money for the boyfriend. The debtor never made a payment on the loans and vacated the property before the first payment was due.
The FSA attempted to recover the tractor but was unsuccessful. The FSA sought to have the bankruptcy court find the debt owed to the FSA in the amount of $52,048.56 plus interest to be non-dischargeable for fraud; fiduciary defalcation; embezzlement; and willful and malicious injury. The court averaged the alleged selling price of the tractor and rendered $7,000 non-dischargeable. The court also determined that the debtor did not fraudulently obtain the FSA loans, and did not embezzle the collateral because fraud wasn’t present. Because willful and malicious injury was present upon the debtor’s sale of the tractor without notice to the FSA and use of the proceeds for the debtor’s personal benefit, the $7,000 that the debtor received upon sale of the tractor was non-dischargeable.
The Intersection of State and Federal Regulation
Agriculture is a heavily regulated industry. Sometimes that regulation is apparent and sometimes it occurs an a rather unique manner. Sometimes it comes from the federal government and sometimes it is purely at the state and local level. In yet other situations, the regulation is an interesting (and frustrating for those subject to it) blend of federal and state/local regulation.
In 2009, the defendant in Carroll Airport Comm'n v. Danner, No. 17-1458, 2019 Iowa Sup. LEXIS 57 (May 10, 2019), planned to construct a grain leg (bucket elevator) and grain bins. In 2013, the defendant obtained the proper county zoning permits but was told of the need to comply with the airport zoning ordinances. The grain leg stands within 10,000 feet horizontally from the end of plaintiff’s runway. The structure reaches a height of 127 feet off the ground. The parties agree the grain leg intrudes within the airport's protected airspace by approximately sixty feet. After construction began it was evident that there would be issues with the airport zoning ordinances and the plaintiff asked the Federal Airport Administration (FAA) to perform an aeronautical study of the grain leg and its impact on aviation safety. The FAA issued a letter stating, "This aeronautical study revealed that the structure does exceed obstruction standards but would not be a hazard to air navigation." It also warned, “This determination concerns the effect of this structure on the safe and efficient use of navigable airspace by aircraft and does not relieve the sponsor (i.e., the defendant) of compliance responsibilities relating to any law, ordinance, or regulation of any Federal, State, or local government body.” Lastly the FAA requested that the defendant paint the structure and add red lights to the top of it. The defendant did so. The FAA also adjusted the flight patterns in and out of the airport to accommodate this structure. The plaintiff did not seek review under this determination.
Two years later, the plaintiff (the local airport commission) sued alleging the grain leg violated certain building ordinances; city and county zoning ordinances; airport commission regulations; and constituted a nuisance and hazard to air traffic. The plaintiff sought equitable relief—an injunction requiring the defendant to modify or remove the grain leg. The defendant raised an affirmative defense of federal preemption. In June 2017, the trial court found that the grain leg violated state and local zoning ordinances and constituted a nuisance and an airport hazard. The trial court found that the grain leg did not fall within the agricultural exemption to certain zoning laws and rejected the defendants’ affirmative defense that the no-hazard letter preempted state and local zoning ordinances. The appellate court affirmed, concluding that the doctrines of express, implied, and conflict preemption did not apply to the FAA no-hazard determination. On further review, the state Supreme Court affirmed. The Supreme Court concluded that the FAA no-hazard determination did not preempt local zoning ordinances, was not legally binding, and contained language notifying the defendant that compliance with local rules was required.
Rights involving surface water vary from state-to-state. In some parts of the U.S., however, a party owning land adjacent to a watercourse has what are known as “riparian” rights to the water. But, do those rights apply to man-made lakes, or just natural lakes? The issue came up recently in Incline Village Board of Trustees v. Edler, No. SC97345, 2019 Mo. LEXIS 178 (Mo. Sup. Ct. Apr. 30, 2019).
The defendants owned properties in subdivisions around a lake. One of the properties of the second subdivision abutted the lake. The properties they owned in the first subdivision did not abut the lake. During the creation of the first subdivision, restrictions were added to the land. One such restriction stated, “No structures or other improvements shall be made on or to any common area, including any body of water, other than such structures or improvements which are made by the trustees for the benefit of all lot owners. Except that, the owner of each lot which abuts any body of water, may construct one boat dock on such body of water, provided that, said boat dock extends from said lot and is first approved in writing by the trustees.” All landowners in the first subdivision were entitled to use the lake, even if they did not abut the lake. The second subdivision was not joined with the first one, but it was clear that the second subdivision was excluded from use rights on the lake. Lots in the first subdivision were subject to assessments to maintain the lakes.
The defendants built a dock on the property on the second subdivision. The trustees of the first subdivision defendants sued seeking a declaratory judgment, damages for trespass, and the removal of the dock. The district court ordered removal of the dock and determined that special circumstances existed supporting the award of attorney's fees of $70,000 in favor of the trustees.
On appeal, the appellate court determined that the lake was clearly artificial and, thus, the defendants were not riparian owners. Riparian rights are only extended to landowners adjacent to natural lakes. The appellate court also rejected the defendants’ reliance-based argument. The appellate court noted that the defendants had never had use of the lake for dock purposes or paid assessments for its maintenance. In addition, the defendants’ predecessor in title's deed to the adjacent land explicitly excepted the lake from the transfer. In addition, the plaintiffs had told the defendants of the property restrictions before the dock was built. As for attorney fees, the appellate court determined that there was not any special circumstance to merit an award of attorney fees. The plaintiff had not given any formal warning about not building the dock and the defendants had sought legal advice.
It’s never a dull moment in ag law involving ag producers, agribusinesses and rural landowners. The cases keep on rolling in.