Friday, September 27, 2019

The Family Limited Partnership – Part Two

Overview

In Tuesday’s Part One of a two-part series on family limited partnerships (FLPs), I looked at where an FLP might fit as part of a business or succession plan for a farm or ranch operation.  Today, in Part Two, I examine the relative advantages and disadvantages of the FLP form.

The pros and cons of the FLP – that’s the topic of today’s blog post.

Advantages of an FLP

Income taxation.  An FLP is generally taxed like a general partnership.  There is no corporate-level tax and taxes are not imposed on assets passing from the FLP to the partners (unlike an S corporation).  Thus, the FLP is not recognized as a taxpayer, and the income of the FLP passes through to the partners based on their ownership interest.  The partners report the FLP income on their individual income tax returns and must pay any tax owed.  Income is allocated to each partner to the extent of the partner’s share attributable to their capital (or pro rata share). 

This tax feature of the FLP can be an attractive vehicle if a transfer of interests to family members in a lower tax bracket is desired.  Transfers of FLP interests can also be made to minor children if they are competent to manage their own property and participate in FLP activities.  But, such transfers are typically made in trust on behalf of the minor.  Also, unearned income of children under age 18 (and in certain cases up to age 23) may be subject to the “kiddie tax” and thus be taxable at the parents’ income tax rate. 

Avoidance of transfer taxes.  Another advantage of an FLP is that it can help avoid transfer taxes - estate tax, gift tax and generation skipping transfer tax.  Transfer tax avoidance is accomplished in three ways: 1) by the removal of future asset appreciation; 2) the utilization of the present interest annual exclusion for gift tax purposes; and 3) the use of valuation discounts for both gift and estate tax purposes.  Of course, the federal estate and gift tax is not much concern for very many at the present time with the applicable exclusion amount set at $11.4 million for deaths in and gifts made in 2019.  But, the present high level of the exclusion is presently set to expire after 2025.  Depending on politics, it could be reduced before 2025.

Transfer of assets yet maintenance of control.  Another advantage of an FLP is that it allows the senior generation of the family to distribute assets currently while simultaneously maintaining control over those assets by being the general partner with as little as a 1% interest in the FLP.  This can allow the general partner to control cash flow, income distribution, asset investment and all other management decisions. 

But, a word of caution is in order.  I.R.C. §2036(a)(1) provides that a decedent’s gross estate includes the value of property previously transferred by the decedent if the decedent retained the possession or enjoyment of, or the right to the income from, the transferred property. I.R.C. §2036(a)(2) includes in the gross estate property previously transferred by the decedent if the decedent retained the right, either alone or in conjunction with any person, to designate the persons who are to possess or enjoy the transferred property or its income. Thus, pursuant to §2036(a)(2), the IRS may claim that because a general partner controls partnership distributions, a transferred partnership interest should be taxed in the general partner’s estate.

In the typical FLP scenario, the parents establish the FLP with themselves as the general partners and gift the limited partnership interests to their children. In this situation, if the general partners have the discretionary right to determine the amount and timing of the distributions of cash or other assets, rather than the distributions being mandatory under the terms of the partnership agreement, the IRS could argue that the general partners (who have transferred interests to the limited partners) have retained the right to designate the persons who will enjoy the income from the transferred property.  An exception exists for transfers made pursuant to a bona fide sale for adequate and full consideration.

Consolidation of family assets.  An FLP also keeps the family business in the family, with the limited partner interests restricted by the terms of the partnership agreement.  Such restrictions typically include the inability of the limited partner to transfer an FLP interest unless the other partners are first given the opportunity to purchase (or refuse) the interest.  This virtually guarantees that non-family members will not own any of the business interests.  These agreements (buy-sell agreements and rights of first refusal) must constitute a bona fide arrangement, not be a device to transfer property to family members for less than full and adequate consideration, and have arm’s length terms.  An agreement structured in this manner will produce discounts from fair market value for transferred interests that are subject to the agreement.

Provision for non-business heirs.  The FLP can also provide for children not in the family business and allow for an even distribution of the estate among all family members, farm and non-farm.  The limited partner interest of a non-farm heir can allow that heir to derive an economic benefit from the income distributions made from time to time without being involved in the day-to-day operation of the business. 

Asset protection.  The FLP can also serve as an asset protection device.  This is particularly the case for the limited partners.  A limited partner has no ownership over the assets contributed to the FLP, thus the creditor’s ability to attach those assets is severely limited.  In general, a court order (called a “charging order”) would be required to reach a limited partner interest, and even if the order is granted, the creditor only receives the right to FLP income to pay the partner’s debt until the debt is paid off.  The creditor still does not reach the FLP assets.  The limited partnership agreement and state law are crucial with respect to charging orders.  Also, a charging order could put a creditor in a difficult position because tax is owed on a partner’s share of entity profits even if they are not distributed.  Thus, a creditor could get pinned with a tax liability, but no income flowing from the partnership to pay the obligation.   However, a general partner does not receive the same creditor protection unless the general partner interest is structured as a corporation. 

Establishing a corporation as the general partner should be approached with care.  It cannot be established as merely a sham to avoid liability.  If it is, IRS and/or the courts could ignore it and pierce the corporate veil.  To avoid this from happening, the corporation must be kept separate from the FLP.  Funds and/or assets must not be commingled between the FLP and the corporation, and all formalities must be observed to maintain the corporate status such as keeping records and minutes, holding directors and shareholders’ meetings and filing annual reports. 

Other advantages.

  • The FLP can also provide flexibility because the FLP agreement can be amended by vote in accordance with the FLP agreement.    
  • Consolidation of assets. The assets of both the general and limited partners are consolidated in the FLP.  That can provide for simplification in the management of the family business assets which could lead to cost savings.  In addition, the management of the assets and related investments can be managed by professional, if desired. 
  • Minimization or elimination of probate. Assets may be transferred to the FLP and the ownership interests may be transferred to others, with only the FLP interest owned at death being subject to probate.  Upon death, the FLP continues to operate under the terms of the FLP agreement, ensuring continuity of the business without any disruption caused by death of an owner.  Relatedly, an FLP will also typically avoid the need for an ancillary probate (probate in the non-domiciliary state) at the FLP interest owner’s death.  Most states treat FLP interests as personal property even if the FLP owns real estate.  To the extent probate is avoided, privacy is maintained.
  • Partnership accounting rules. The rules surrounding partnership accounting, while complicated, are relatively flexible.
  • Ease of gifting. The FLP structure does provide a mechanism that can make it easier for periodic gifting to facilitate estate and tax planning goals.

Disadvantages of an FLP 

While there are distinct advantages to using an FLP in the estate and business succession planning context, those advantages should be weighed against potential drawbacks.  The disadvantages of using an FLP can include the following:

  • An FLP is a complex form of business organization that requires competent legal and tax consultation to establish and maintain. Thus, the cost of formation could be relatively higher than other forms of doing business.
  • Unlimited liability of the general partners. However, slightly over one-half of states have enacted legislation allowing the formation of a limited liability limited partnership (LLLP), which is typically accomplished by converting an existing limited partnership to an LLLP.  In an LLLP, any general partner has limited liability for the debts and obligations of the limited partnership that arise while the LLLP election is in place.  In addition, some states (such as California) that do not have a statute authorizing on LLLP will recognize LLLPs formed under the laws of another state.  Also, while Illinois does not authorize LLLPs by statute, it does allow the formation of an LLLP under the Revised Uniform Limited Partnership Act.   
  • Ineligibility of FLP members for many of the tax-free fringe benefits that employees are eligible for.
  • The gifts of FLP interests must be carefully planned to not trigger unexpected estate, gift or GSTT liability.
  • Establishing and FLP can be costly in terms of the legal work necessary to draft the FLP agreement, changing title to assets, appraiser fees, state and local filing fees, and tax accounting fees.
  • There could be additional complications in community property states. In community property states, guaranteed payments (compensation income) from an FLP are treated as community property.  However, FLP income distributed at the discretion of the general partner(s) is classified as separate property. 

Conclusion

The FLP can be a useful business organizational form for the farm or ranch business.  Careful considerations of the pros and cons of the entity choice in accordance with individual goals and objectives is essential.

September 27, 2019 in Business Planning, Income Tax | Permalink | Comments (0)

Wednesday, September 25, 2019

The Family Limited Partnership – Part One

Overview

A family limited partnership (FLP) is a limited liability business entity created and governed by state law.  It is generally composed of two or more family members and is typically utilized to reduce income and transfer taxes, act as a vehicle to distribute assets to family heirs while keeping control of the business, ensure continued family ownership of the business, and provide liability protection for all of the limited partners. 

What are the key distinguishing characteristics of an FLP?  How is an FLP formed?  What are the important points to consider upon formation?  These are the topics of today’s post, Part One of a two-part series.  In Part Two, I will examine some of the basic advantages and disadvantages of the FLP.

Distinguishing characteristics and formation considerations of an FLP – these are the topics of today’s post.

Distinguishing Characteristics

Interests in an FLP interests are usually held by family members (or entities controlled by family members). These typically include spouses, ancestors, lineal descendants, and trusts established on behalf of such family members.  A member holding a general partner interest is entitled to reasonable compensation for work done on behalf of the FLP.  These payments are not deemed to be distributions and are beyond the reach of judgment creditors.  Limited partners take no part in FLP decision making and cannot demand distributions, can only sell or assign their interests with the consent of the general partners and cannot force a liquidation.

An FLP is a relatively flexible entity inasmuch as income, gain, loss, deductions or credits can be allocated to a partner disproportionately in whatever manner the FLP desires. It is not tied to the capital contributions of any particular partner.

Formation

It’s important to form the FLP with a clear business purpose and the entity should hold only income-producing family business property or investment property.  Personal assets should not be placed in the entity.  If personal assets are transferred to the entity, the temptation will be for the transferor to continue to use the assets as their personal assets without respecting the fact that the FLP is the owner.  That could cause the IRS to disregard the entity and claim that the transferor retained the enjoyment and economic benefit of the transferred assets for life.  See, e.g., Estate of Thompson, 382 F.3d 367 (3d Cir. 2004).

All formalities of existence must be observed.  These include executing a written agreement that establishes the rights and duties of the partners; filing all the necessary certificates and documents with the state; obtaining all necessary licenses and permits; obtaining a federal identification number; opening new accounts in the FLP’s name; transferring title to the assets contributed to the FLP; amending any existing contracts to reflect the FLP as the real party in interest; filing annual federal, state and local reports; maintaining all formalities of existence; not commingling partnership assets with the personal assets of any individual partner; keeping appropriate business records; including income from the FLP interest on personal income tax returns annually. 

As noted above, an FLP is formed by family members who transfer property in return for an ownership interest in the capital and profits of the FLP.  At least one family member must be designated as the general partner (or a corporation could be established as the general partner).  The general partner manages and controls the FLP business and decides if and when FLP income will be distributed and in what amount.  In return for that high degree of control, the general partner(s) is (are) personally liable for any creditor judgment that is not satisfied from FLP assets.  Thus, income is retained in the FLP at the sole discretion of the general partner(s) and the general partner(s) have complete control over the daily operations of the business.  Conversely, because a limited partner has no say in how the business is operated, the personal liability of the limited partner is limited to the value of that partner’s capital account (generally, the amount of capital the partner contributed to the FLP). 

There are a couple of common approaches in FLP formation and utilization.  Often, an FLP is formed by the senior generation with those persons becoming the general partners and the remaining interests being established as limited partner interests.  Those interests are then typically gifted to the younger generation.  As an alternative, an FLP could be created by spouses transferring assets to the entity in return for FLP interests.  Under this approach, one spouse would receive a 99 % limited partnership interest and the other spouse a 1% general partner interest.  The general partner should own at least 1 percent of the FLP.  Anything less will raise IRS scrutiny.  The spouse holding the limited partnership interest could then make annual exclusion gifts of the limited partnership interests to the children (or their trusts). The other parent would retain control of the “family assets” while the parent holding the limited partnership interest is the transferor of the interests.

Consider the following example:

Bob is 55 and owns a farming operation.  His wife, Stella, died in 2014.  All of the assets were titled in Bob’s name.  Thus, Stella’s estate was very small and the unused exclusion of $5 million was “ported” over to Bob.  The farming business has expanded over the years and now is comprised of 1,000 acres of farmland valued at $10,000,000, and other assets (livestock, buildings and equipment, etc.) valued at $3,000,000.  His three sons (ages 27, 24 and 18) work with him in the farming business.  Bob’s objective is for the farming operation to continue to be operated by the family into subsequent generations.  He would like to transfer ownership of some of the farming business to his sons, now before the assets appreciate further in value.  However, Bob does have some concern that his son’s may not be fully experienced and ready to manage the farming operation.  Bob also wants to protect the sons against personal liability that could arise in connection with the business.  After consulting with his attorney, Bob decides to have the attorney draw up an FLP agreement.  

The terms of the FLP agreement designate Bob as the general partner with a 1% ownership interest.  The sons are designated as the limited partners, each having a 33% limited partner interest.  Bob transfers the land, farm equipment and some livestock to the FLP, and each son contributes cash and additional livestock and equipment.  All other formalities for formation of the FLP are completed.  Bob then gifts 99% of the FLP to his sons (33% to each son), reports the gifts and pays the gift tax (using exclusion and unified credit to substantially offset the gift tax).  Bob continues to run the farming operation until he is 65, at which point he is comfortable that the sons can manage the farming operation on their own.  Up until age 65, Bob filed the required annual reports with the state and followed all necessary FLP formalities.  Bob, distributed FLP income annually – 1% to himself and 33% to each son.  By shifting most of the income to the sons that are in a lower tax bracket than Bob, the family (on a collective basis) saves income tax. 

Upon turning age 65, the partners vote to name the oldest son (now age 37) as the general partner and Bob’s interest is changed to be a limited partner interest.  Bob then retires.  The value of the business continued to increase over the years, but that appreciation in value would escape taxation in Bob’s estate inasmuch as only 1% of the FLP value at the time of Bob’s death would be included in Bob’s estate for estate tax purposes. 

Conclusion

The FLP can be a useful entity form for the transition of a family business such as a farm or ranch.  It can also be a good entity choice for transferring that value at a discount.  That is particularly important when the exemption for federal estate and gift tax purposes is relatively low (which could be the case again at some future point in time).  But, attention to details on formation are important.  In Part Two, I will examine the relative advantages and disadvantages of the FLP.

September 25, 2019 in Business Planning | Permalink | Comments (0)

Monday, September 23, 2019

Shareholder Loans and S Corporation Stock Basis

Overview

Receiving income tax basis for a contribution of debt to an S corporation is an important issue.  Tax basis allows a shareholder to determine the tax effect of transactions with the corporation.  It’s a measure of the shareholder’s investment in the corporation and is adjusted upward by the shareholder’s share of corporate income and downward by the portion of the corporation’s losses (and nondeductible expenses) allocated to the shareholder.  Similarly, any expenses that the shareholder transfers to the corporation will increase basis and expenses the shareholder receives from the corporation will decrease basis. 

But, what if the shareholder loans money to the corporation?  Will that increase the shareholder’s stock basis?  The answer is that “it depends.” 

Shareholder loans and stock basis – it’s the topic of today’s blog post.

Debt Basis Rules

A fundamental principle is that debt basis has no impact on the determination of gain or loss on the sale of stock.  It also doesn’t impact the taxability of an S corporation’s distributions.   Two fundamental principles apply:  1) debt basis has only one purpose – to “soak up” losses that are allocated to a shareholder; and 2) a shareholder in an S corporation gets basis only for those debts made directly from the shareholder to the S corporation.   That means for a shareholder to get debt basis, the shareholder must make the loan directly to the S corporation rather than through a related party (entity) that the shareholder owns.  There must be an “economic outlay” that (as the courts have stated) makes the shareholder “poorer in a material sense.”  See, e.g., I.R.C. §1366(d)(1)(B). 

Regulations and Cases

In 2014, the Treasury adopted regulations on the matter.  The regulations, known as the “bona fide debt” provisions appeared to replace the “actual economic outlay” test set forth by the judicial decisions on the matter.  Under the regulations, the debt must satisfy two requirements: 1) the debt must run directly from the shareholder to the S corporation; and 2) the debt must be bona fide as determined under general federal tax principles based on the facts and circumstances.  Treas. Reg. §1.1366-2(a)(2). 

In Oren v. Comr., 357 F.3d 854 (8th Cir. 2004), a case decided by the U.S. Court of Appeals for the Eighth Circuit in 2004 (a decade before the 2014 regulations) the court held that a taxpayer lacked enough stock basis to deduct losses passed through to him from his S corporations.  He had created loans between himself and his commonly owned S corporations.  The transactions were designed to create stock basis so that he could deduct corporate losses.  The taxpayer’s S corporation loaned $4 million to the taxpayer.  He then loaned the funds to another S corporation in which he was also an owner.  The second S corporation then loaned the funds back to the first S corporation.  All of the transactions were executed on the same day with notes specifying that the interest was due 375 days after demand.  Annual interest was set at 7 percent.  The taxpayer claimed that he could use the debt basis created in the second S corporation to deduct the passthrough losses on his individual return.  The IRS disagreed and the court agreed with the IRS – he wasn’t poorer in any material sense after the loans were made and he had no economic outlay.  The only thing that happened was that there were offsetting bookkeeping entries.  There were also other problems with the way the entire transaction was handled. 

In Meruelo v. Comr., No. 18-11909, 2019 U.S. App. LEXIS 13305 (11th Cir. May 6, 2019), a case involving a tax year after the 2014 regulations became effective, the taxpayer was a shareholder in an S corporation that bought a condominium complex in a bankruptcy sale. To fund its operations, the S corporation accepted funds from numerous related entities. Ultimately, lenders foreclosed on the complex, triggering a large loss which flowed through to the taxpayer. The taxpayer deducted the loss, claiming that the amounts that the related entities advanced created stock basis (debt basis) allowing the deduction. The IRS disallowed the deduction and the Tax Court agreed.

The appellate court affirmed on the grounds that the advances were not back-to-back loans, either in form or in substance. In addition, the related entities were not “incorporated pocketbooks” of the taxpayer. There was no economic outlay by the taxpayer that would constitute basis. There was no contemporaneous documentation supporting the notion that the loans between the taxpayer and the related entities were back-to-back loans (e.g., amounts loaned to a shareholder who then loans the funds to the taxpayer), and an accountant’s year-end reclassification of the transfers was not persuasive. While the taxpayer owned many of the related entities, they acted as business entities that both disbursed and distributed funds for the S corporation’s business expenses. The appellate court noted the lack of caselaw supporting the notion that a group of non-wholly owned entities that both receive and disburse funds can be an incorporated pocketbook. To generate basis, the appellate court noted, a loan must run directly between an S corporation and the shareholder. 

Conclusion

Some had thought that the 2014 regulations had materially changed the way that debt basis transactions would be looked at in the S corporation context.  Indeed, the preamble to the regulations did lead to the conclusion that the IRS was moving away from the “economic outlay” test to a “bona fide indebtedness” test (except in the context of shareholder guarantees).  See also Treas. Reg. §1.1366-2(a)(2). That lead some to believe that debt basis could be created without an economic outlay.  Meruelo establishes that such a belief may not be true. 

The lesson of Meruelo (and prior cases) is clear.  Debt basis won’t result with a loan from a related party, and it won’t result from simply a paper transaction entered into near the end of the tax year.  Don’t cut corners.  Pay the money yourself or borrow it from a third party (such as a bank) and then loan the funds directly to the S corporation.  Also, make sure that the transaction is booked as a loan.  Interest should be charged, and a maturity date established.  Make a duck look like a duck.

September 23, 2019 in Business Planning, Income Tax | Permalink | Comments (0)

Thursday, September 19, 2019

Refund Claim Relief Due To Financial Disability

Overview

The Internal Revenue Code (Code) suspends the statutory timeframe for claiming a tax refund for the period of time that an individual is suffering a financial disability. I.R.C. §6511(h).  It’s an important statutory provision that can provide relief in the event of unforeseen circumstances.  But definitions matter and there is a key exception to the statutory time suspension.

The suspension of the timeframe for claiming a tax refund – it’s the topic of today’s post.

The Statute

Under I.R.C. §6511 for all taxes for which a return must be filed, a claim or refund must be filed within: (1) three years of the time the return was filed, except, if the return was filed before it was due, then the claim must be filed within three years of the return's due date; (ii) two years from the time the tax was paid, if that period ends later; or, (iii) two years from the time the tax was paid, if no return's filed by a taxpayer required to file a return.  I.R.C. §6511(b)(2). 

However, those timeframes are suspended for the time period that an individual is “financially disabled.”  An individual is “financially disabled” if the individual cannot manage his financial affairs by reason of his medically determinable physical or mental impairment, and the impairment can be expected to result in death, or has lasted, or can be expected to last, for a continuous period of not less than 12 months.  I.R.C. §6511(h)(2)(A).   Upon the individual’s death, the suspension period ends, and if a joint return is filed, each spouse’s financial disability must be separately determined.  C.C.A. 200210015 (Nov. 26, 2001). 

The statute has no application to corporations because it, by its terms, applies to an “individual.”    That’s the case even for a solely owned corporation where the owner is financially disabled.  See, e.g., Alternative Entertainment Enterprises, Inc. v. United States, 277 Fed. Appx. 590 (6th Cir. 2008).   The statute also only applies to the limitation periods that are listed in the provision.  That means, for example, that it won’t extend the limitations periods for other provisions of the Code such as for net operating losses or loss carrybacks (now only for farmers), etc.  See, e.g., McAllister v. United States, 125 Fed. Cl. 167 (2016). 

The statute also doesn’t apply to an estate.  This point was made clear in a recent case.  In Carter v. United States, No. 5:18-cv-01380-HNJ, 2019 U.S. Dist. LEXIS 134035 (N.D. Ala. Aug. 9, 2019) a decedent’s estate sought relief on the basis that the estate’s personal representative was financially disabled for a period of time entitling the estate to file a claim for refund after the time period set forth in I.R.C. §6511(a). The estate claimed that it should be treated as in individual for relief purposes. The estate sought a refund of federal estate tax tied to the value of bank stock that the decedent held at the time of death which made up 45 percent of the gross estate value. Unknown at the time of death was that a fraud had been committed against the bank which ultimately led to the bank being shut down and the stock rendered worthless. The personal representative was traumatized by the events, suffering emotional distress which rendered her unable to manage the estate which was substantiated by a physician who maintained that the representative’s disabilities triggered I.R.C. § 6511(h)’s equitable tolling provision so as to excuse the untimely filing of the refund claim.

The court disagreed with the estate’s position, holding that the term “individual” in I.R.C. §6511(h)(1) did not apply to an estate. The court pointed out that I.R.C. §7701(a)(1) defines a person as “an individual, a trust, estate, partnership, association, company or corporation.” The court reasoned that this made it clear that the Congress saw individuals and estates as distinct types of taxpayers, and the use of the term individual in I.R.C. §6511(h) limited the relief to natural persons. The court also noted that even if the estate’s claim weren’t time-barred, it would fail on its own merits because estate tax value is based on the value as of the date of death or the alternate valuation date of six months after death. Simply because the fact of the bank fraud arose post-death didn’t change the fact that it wasn’t known at the time of death and the stock was being actively traded at death, the measuring date for federal estate tax purposes. 

In all situations, as you probably could guess, a taxpayer is not considered to be financially disabled unless the taxpayer can prove that the statutory requirements are met to the satisfaction of the government.  I.R.C. §6511(h)(2)(A).

More Cases

The courts have fleshed-out the edges on the statute.  For example, in Brosi v. Comr., 120 T.C. 5 (2003), the petitioner claimed that the reason he didn’t file was because he was too busy providing care to his mother working for an airline.  The Tax Court held he wasn’t entitled to relief because he didn’t personally suffer any physical or mental impairment.  The same result occurred in Pleconis v. Internal Revenue Service, No. 09-5970 (SDW) (ES), 2011 U.S. Dist. LEXIS 88471 (D. N.J. 2011).  In that case, the taxpayer failed to show that he was financially disabled from 2001-2007 because the evidence showed that even during the periods when he underwent surgeries, he was able to manage his finances, and his conditions had improved by January of 2006.  In another case, a taxpayer that missed 60 days of work due to high blood sugar didn’t qualify as “financially disabled. Bhattacharyya v. Comr., 180 Fed. Appx. 763 (9th Cir. 2006). 

Authorized “agent”?  The statute clearly states that an individual cannot satisfy the statute to be treated as “financially disabled” when there is a spouse or an authorized agent that can handle the individual’s financial affairs for the individual, whether they choose to do so or not.  I.R.C. §6511(h)(2)(B)See also, Pull v. Internal Revenue Service, No. 1:14-cv-02020-LJO-SAB, 2015 U.S. Dist. LEXIS 39562 (E.D. Cal. 2015); Plati v. United States, 99 Fed. Cl. 634 (2011).  This is the case even when the power to act on the individual’s behalf exists under a durable power of attorney, but the agent has not acted and has agreed not to act on the individual’s behalf until the individual wants the agent to act or otherwise becomes “disabled.”  See, e.g., Bova v. United States, 80 Fed. Cl. 449 (2008)

The issue of the presence of an authorized agent came up again in a recent case.  In Stauffer v. Internal Revenue Service, No. 18-2105, 2019 U.S. App. LEXIS 27827 (1st Cir. Sept. 16, 2019), an individual who filed suit on behalf of his father’s estate claimed that the IRS had improperly denied his 2013 claim for his father’s 2006 tax refund as untimely.  He claimed that the tax refund claim time limitation was suspended because of his father’s financial disability.  The trial court dismissed the claim because the son held a durable power of attorney that authorized him to act on his father’s behalf with respect to his father’s financial matters.  It made no difference whether he ever actually had acted on his father’s behalf.  The mere fact that the durable power of attorney had been executed and was in effect was enough to bar the application of the statute.  On appeal, the appellate court agreed. 

Conclusion

Financial hardship brings its own set of complications to other areas of life.  The Code provides some relief from the filing deadlines.  But, the relief only applies to an “individual” and only if that individual is suffering from a financial disability.  If someone else is authorized to act on the financial affairs of the individual, the individual cannot be financially disabled.  These points should be kept in mind. 

September 19, 2019 in Income Tax | Permalink | Comments (0)

Tuesday, September 17, 2019

Irrigation Return Flows and the Clean Water Act

Overview

The Clean Water Act (CWA) has often been in the agricultural news in recent years.  Most of that attention has focused on the Waters of the United States” (WOTUS) rule, including the recent regulatory redefinition of the rule.  But there’s another issue that’s been lurking in the background, and it involves farm field drainage.

Are return flows to a watercourse from agricultural drainage activities exempt from the CWA permit requirements?  It’s the topic of today’s post.

Background

With the enactment of the federal water pollution control amendments of 1972 (more commonly known as the CWA, the federal government adopted a very aggressive stance towards the problem of water pollution. 

The CWA essentially eliminates the discharge of any pollutants into the nation's waters without a permit. The CWA recognizes two sources of pollution. Point source pollution is pollution which comes from a clearly discernable discharge point, such as a pipe, a ditch, or a concentrated animal feeding operation. Point source pollution is the concern of the federal government.  Nonpoint source pollution, while not specifically defined under the CWA, is pollution that comes from a diffused point of discharge, such as fertilizer runoff from an open field. Control of nonpoint source pollution is to be handled by the states through enforcement of state water quality standards and area-wide waste management plans.

Importantly, in 1977, the Congress amended the CWA to exempt return flows from irrigated agriculture as a point source pollutant. Thus, irrigation return flows from agriculture are not considered point sources if those “...discharges [are] composed entirely of return flows from irrigated agriculture.”   See, e.g., 33 U.S.C. §1342(l)(1); 40 C.F.R. §122.3.  See also, Hiebenthal v. Meduri Farms, 242 F. Supp. 2d 885 (D. Or. 2002).  This statutory exemption was elaborated in a 1994 New York case, Concerned Area Residents for the Environment v. Southview Farm, 34 F.3d 114 (2d Cir. 1994). In that case, the court noted that when the Congress exempted discharges composed “entirely” of return flows from irrigated agriculture from the CWA discharge permit requirements, it did not intend to differentiate among return flows based on their content.  Rather, the court noted, the word “entirely” was intended to limit the exception to only those flows which do not contain additional discharges from activities unrelated to crop production. 

Current Case

In Pacific Coast Federation of Fishermen’s Associations v. Glaser, No. 17-17310, 2019 U.S. App. LEXIS 26938 (9th Cir. Sept. 6, 2019), the plaintiffs (various fishing activist groups) filed a CWA citizen suit action claiming that the defendant’s (U.S. Bureau of Reclamation) Grasslands Bypass Project in the San Joaquin Valley of California was discharging polluted water (water containing naturally-occurring selenium from soil) into a WOTUS via a subsurface tile system under farmland in California’s Central Valley without a CWA permit.  The plaintiffs directly challenged the exemption of tile drainage systems from CWA regulation via “return flows from irrigated water” on the basis that groundwater discharged from drainage tile systems is separate from any irrigation occurring on farms and is, therefore, not exempt.  After the lower court initially refused to grant the government’s motion to dismiss, it later did dismiss the case noting that the parties agreed that the only reason the project existed was to enable the growing of crops requiring irrigation, and that the drainage of contaminated water only occurred due to irrigated agriculture.  The lower court noted that the plaintiffs failed to plead sufficient facts to support a claim that some discharges were unrelated to agricultural crop production.  Later, the plaintiffs retooled their complaint to claim that not all of the irrigated water that was discharged through the tile systems came from crop production. Rather, the plaintiffs claimed that some of the discharges that flowed into groundwater were from former farmlands that now contained solar panels.  It was this “seepage” from the non-farmland that the plaintiffs claimed was discharged in the farm field tile system and caused the system to contain pollutants that didn’t come exclusively from agricultural crop irrigation.  The lower court found the tile system to be within the exemption for “return flows from irrigation,” noting that “entirely” meant “majority” because (in the court’s view) a literal interpretation of the amended statutory language would produce an “absurd result.”

The appellate court reversed.  The appellate court held that discharges that include irrigation return flows from activities “unrelated” to crop production are not exempt from the CWA permit requirement.  To the appellate court, “entirely” meant just that – “entirely.”  It didn’t mean “majority” as the lower court had determined. 

Conclusion

What’s the impact of the appellate court’s decision?  After all, shouldn’t the appellate court be praised for construing a statute in accordance with what the law actually says?  What was the concern of the lower court of a literal interpretation of the statute?  For starters, think of the burden of proof issue.  Does the appellate court’s decision mean that a plaintiff must prove that some discharges come from non-agricultural irrigation activities, or does it mean that upon an allegation that irrigation return flows are not “entirely” from agricultural crop production that the farmer must prove that they all are?  If the latter is correct, that is a next-to-impossible burden for a farmer.  Such things as runoff from public roadways and neighboring farm fields can and do often seep into a farmer’s tile drainage system. If that happens, at least in the Ninth Circuit (Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington), a farmer’s discharges will require a CWA permit.  This is the “absurd result” that the lower court was trying to avoid by construing “entirely” as “majority.”  

The appellate court remanded the case to the lower court for further review based on the appellate court’s decision.  However, the point remains that the appellate court determined that the exception for return flows from agriculture only applies when all of the discharges involved comes from agricultural sources.  That’s why the case is important to any farmer that irrigates crops and should be paid attention to.

September 17, 2019 in Environmental Law | Permalink | Comments (0)

Friday, September 13, 2019

Ag Contracts – What if Goods Don’t Conform to the Contract?

Overview

Not all contractual transactions for agricultural goods function smoothly and without issues.  From the buyer’s perspective, what rights does the buyer have if the seller breaches the contract?  One of the ways in which a breach can occur is if the contracted-for goods fail to conform to the contract requirements.  That can be a particularly important issue for contracts involving agricultural goods.  Ag goods, such as crops and livestock, are not standard, “cookie-cutter” goods.  They vary in quality; size; shape; germination rate; and moisture content, for example.  All of those aspects can lead to possible non-conformity issues. 

Non-conforming agricultural goods – when is a nonconformity significant enough to constitute a breach.  Contracts and non-conforming ag goods – it’s the topic of today’s post.

Non-Conformity and the Right of Rejection

A buyer has a right to reject goods that do not conform to the contract.  Under the Uniform Commercial Code (UCC), a buyer may reject nonconforming goods if such nonconformity substantially impairs the contract.  A buyer usually is not allowed to cancel a contract for only trivial defects in goods.  Triviality is highly fact dependent.  It is tied to industry custom, past practices between the parties and the nature of the goods involved in the contract. 

For example, in Hubbard v. UTZ Quality Foods, Inc., 903 F. Supp. 444 (W.D. N.Y. 1995), a manufacturer of potato chips rejected shipments of potatoes for failure to conform to the contract based on the color of the potatoes. The contract provided that the potatoes had to meet certain quality standards.  The buyer was entitled to reject the potatoes if they failed to do so. The potatoes had to meet USDA standards for No. I white chipping potatoes. They had to have a minimum size and be free from bruising, rotting and odors which made them inappropriate for use in the processing of potato chips.  The main issue was the color of the potatoes.  That issue was decided in accordance with industry custom.  Based on industry custom, the court held that the failure to conform substantially impaired the contract and justified the manufacturer’s refusal to accept the potatoes.  The defect was not merely trivial.     

In a more recent case, Albrecht v. Fettig, 27 Neb. App. 371 (2019), the plaintiff raised Red Angus cattle with operations touching every stage of cattle production, including a feedyard. The plaintiff contacted the defendant (who was not the plaintiff’s usual cattle buyer) to purchase calves for the yard. In May of 2015 the defendant purchased cattle for the plaintiff, with the load consisting mostly of black cattle. The plaintiff accepted the load but stated that he would reject any subsequent load if it consisted primarily of black cattle. Two months later, the defendant purchased another batch of cattle for the plaintiff, promising that there would only be “five or so black hides this time.” The contract for this transaction stated "APPROX 150 - HD," that would be "80% Red Angus cross [and] 20% Bl[ac]k Angus cross steers" at a base average weight of 780 pounds. The price was specified as “$235 per hundredweight with a $0.15 slide.” The contract specified a delivery window of between October 10 and 25, 2015. In early October the defendant contacted the plaintiff with an additional 10 head at $185 per hundredweight. The defendant felt that these 10 head would fall under the “approx” in the contract but notified the plaintiff out of courtesy. The plaintiff never looked at the cattle before delivery.

The cattle were delivered to the plaintiff late at night on October 14, after it was dark outside. The next morning, the plaintiff saw the cattle in the daylight and observed that there were many black-hided steers.  The plaintiff stated that he "knew there was more than 20 percent without even counting them...” From a video taken of the cattle the Plaintiff counted 88 red steers, 68 black steers, and 4 “butterscotch” steers. That amounted to 160 head of cattle that were 55 percent red hided, 42.5 percent black hided, and 2.5 percent Charolais influenced. The plaintiff called the defendant on October 15, expressing frustration and displeasure at receiving so many black steers. The defendant offered to take back the black steers, leaving the plaintiff with 88 head of red steers. The plaintiff rejected the offer. The next day, after discussions with family and an attorney, the plaintiff rejected the load. The defendant sent trucks to pick up the rejected cattle on October 17, and the plaintiff requested the $6,000 deposit back. Another agreement for the deposit and trucking costs to be covered by the defendant was also signed on October 17. The defendant never attempted to cure the issue before the specified October 25 date. The defendant kept and fed the cattle himself and later sold them for a loss. On November 9, the plaintiff texted the plaintiff to inquire about the $6,000 deposit refund. The defendant replied that he had filed a lawsuit and that his attorney instructed him not to discuss the matter.

On November 11, the plaintiff sued for breach of the July 15 contract to recover the $6,000 deposit, yardage fees, feed costs and labor and miscellaneous costs associated with loading the cattle for the return trip. The defendant counterclaimed that the plaintiff breached the July 15 contract by refusing to accept delivery of cattle. The defendant requested that the court award damages in the amount of the value lost on the cattle between their delivery and their eventual sale on December 5, 2015, along with associated costs and expenses. The trial court found that the plaintiff did not breach the sale contract and could reject all or part of the delivery. The trial court also found that the defendant failed to cure under the contract before October 25th and the only cure attempted, to take the black calves, would have breached the quantity amount of the contract. The trial court ordered the defendant to refund the $6,000 deposit and 12 percent prejudgment interest on the $6,000 deposit from October 17, 2015, and 12 percent post-judgment interest. The trial court also ordered the defendant to pay incidental damages based on the costs incurred in caring for the cattle on his property from October 14-17, totaling $449.53, and post-judgment interest at the rate of 3.61 percent until paid in full. The defendant filed a motion to alter or amend arguing that prejudgment interest was inappropriate and that a post judgment interest rate of 12 percent was also inappropriate. After a hearing the trial court agreed, dropping the prejudgment interest and setting post-judgment interest at 3.61 percent. Both parties appealed.

The appellate court affirmed the award of the refund of the $6,000 deposit to the plaintiff, and incidental damages for the cost of caring for the cattle between the time of delivery and their return. The appellate court also awarded court costs to the plaintiff, and the denial of prejudgment interest. The appellate court determined that the plaintiff was entitled to reject delivery notwithstanding the contract's additional ground for rejection if the cattle were unmerchantable. The contract, the appellate court noted, was specific as to quantity and weight but the hide colors were more than a trivial variation and the defendant had time post-rejection to correct the error and deliver the correct color of cattle. The appellate court took the issue of interest under advisement. 

Inspecting Nonconforming Goods

A buyer has a right before acceptance to inspect delivered goods at any reasonable place and time and in any reasonable manner.  The reasonableness of the inspection is a question of trade usage and past practices between the parties. If the goods do not conform to the contract, the buyer may reject them all within a reasonable time and notify the seller, accept them all despite their nonconformance, or accept part (limited to commercial units) and reject the rest. Any rejection must occur within a reasonable time, and the seller must be notified of the buyer's unconditional rejection.  For instance, in In re Rafter Seven Ranches LP v. C.H. Brown Co., 362 B.R. 25 (B.A.P. 10th Cir. 2007), leased crop irrigation sprinkler systems failed to conform to the contract.  However, the buyer indicated an attempt to use the systems and did not unconditionally reject the systems until four months after delivery.  As a result, the buyer was held liable for the lease payments involved because the buyer failed to make a timely, unconditional rejection.

The buyer’s right of revocation is not conditioned upon whether it is the seller or the manufacturer that is responsible for the nonconformity. UCC § 2-608. The key is whether the nonconformity substantially impairs the value of the goods to the buyer.

A buyer rejecting nonconforming goods is entitled to reimbursement from the seller for expenses incurred in caring for the goods. The buyer may also recover damages from the seller for non-delivery of suitable goods, including incidental and consequential damages.  If the buyer accepts nonconforming goods, the buyer may deduct damages due from amounts owed the seller under the contract if the seller is notified of the buyer’s intention to do so.  See, e.g., Gragg Farms and Nursery v. Kelly Green Landscaping, 81 Ohio Misc. 2d 34; 674 N.E.2d 785 (1996).

Timeframe for Exercising Remedies

The UCC allows buyers a reasonable time to determine whether purchased goods are fit for the purpose for which the goods were purchased, and to rescind the sale if the goods are unfit.  Whether a right to rescind is exercised within a reasonable time is to be determined from all of the circumstances. UCC §1-204.  The buyer’s right to inspect goods includes an opportunity to put the purchased goods to their intended use.  Generally, the more severe the defect, the greater the time the buyer has to determine whether the goods are suitable to the buyer.

Statute Of Limitations

Actions founded on written contracts must be brought within a specified time, generally five to ten years.  For unwritten contracts, actions generally must be brought within three to five years.  In some states, however, the statute of limitations is the same for both written and oral contracts.  A common limitation period is four years.  Also, by agreement in some states, the parties may reduce the period of limitation for sale of goods but cannot extend it.

Conclusion

Most contractual transactions for agricultural goods function smoothly.  However, when there is a problem, it is helpful to know the associated rights and liabilities of the parties.

September 13, 2019 in Contracts | Permalink | Comments (0)

Wednesday, September 11, 2019

Ag Law and Tax In The Courts

Overview

This month’s installment of court developments concerning agriculture in the courts covers recent developments involving the valuation of a timber enterprise; obtaining a tax refund for an estate due to a financial disability; the calculation of a casualty loss; and the growing of hemp.

Ag law and tax developments in the courts – it’s the topic of today’s post.

Estate Tax Valuation

At issue in Estate of Jones v. Comr., T.C. Memo. 2019-101 were the proper valuations, as of May 28, 2009, of limited partner units in a timber business and stock shares in a sawmill. The decedent died in 2014, having established the sawmill business in 1954 and expanding it substantially since then. The decedent bought about 25,000 acres of timber in 1989 and an additional 125,00 acres in 1992. Later in 1992, the decedent formed the limited partnership to invest in, acquire, hold and manage timberlands and real estate and incur debt. The decedent transferred the timberland, which was considered to be the sawmill’s inventory, to the limited partnership in exchange for an interest in the entity.

The decedent began doing some succession planning in 1996 with the intent of keeping the business in the family as a successful operation. That plan included making gifts of interests in the businesses to family members, including significant blocks of stock. Upon the decedent’s death, the IRS challenged the valuation for gift tax purposes of the 2009 transfers of limited partnership interests and interests of the S corporation that owned the sawmill. Transfer of the limited partnership units was also restricted via a buy-sell agreement that contained a right-of-first refusal. Thus, the determination of fair market value of the 2009 transfers had to account for lack of marketability, lack of control, lack of voting rights of an assignee and reasonably anticipated cash distributions allocable to the gifted interests.

The IRS valued the transfers utilizing a net asset value approach and the estate’s expert used a discounted cash flow approach for both the timberland and the mill. The Tax Court agreed with the valuation arrived at by the estate’s expert, a far lower amount than what the IRS had arrived at. 

There are many underlying details concerning the valuation approaches that I am not discussing here.  The major point is, however, that taking care to follow well-established valuation procedures and keeping good records is essential.  The Tax Court will often adopt the approach that is most precise and is substantiated.

Refund Claims Due To Financial Disability

I.R.C. §6511(h) establishes a statute of limitations for filing a claim for refund due to financial disability. The provision provides “an individual is financially disabled if such individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment of the individual which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.” I.R.C. §6511(a)-(c) specifies that, “In the case of an individual, the running of the periods specified in subsections (a), (b), and (c) shall be suspended during any period of such individual’s life that such individual is financially disabled.”  In Carter v. United States, No. 5:18-cv-01380-HNJ, 2019 U.S. Dist. LEXIS 134035 (N.D. Ala. Aug. 9, 2019) a decedent’s estate sought relief on the basis that the estate’s personal representative was financially disabled for a period of time entitling the estate to file a claim for refund after the time period set forth in I.R.C. §6511(a). The estate claimed that it should be treated as in individual for relief purposes. The estate sought a refund of federal estate tax tied to the value of bank stock that the decedent held at the time of death which made up 45 percent of the gross estate value. Unknown at the time of death was that a fraud had been committed against the bank which ultimately led to the bank being shut down and the stock rendered worthless. The personal representative was traumatized by the events, suffering emotional distress which rendered her unable to manage the estate which was substantiated by a physician who maintained that the representative’s disabilities triggered § 6511(h)’s equitable tolling provision so as to excuse the untimely filing of the refund claim.

The court disagreed with the estate’s position, holding that the term “individual” in I.R.C. §6511(h)(1) did not apply to an estate. The court pointed out that I.R.C. §7701(a)(1) defines a person as “an individual, a trust, estate, partnership, association, company or corporation.” The court reasoned that this made it clear that the Congress saw individuals and estates as distinct types of taxpayers, and the use of the term individual in IRC §6511(h) limited the relief to natural persons. The court also noted that even if the estate’s claim weren’t time-barred, it would fail on its own merits because estate tax value is based on the value as of the date of death or the alternate valuation date of six months after death. Simply because the fact of the bank fraud arose post-death didn’t change the fact that it wasn’t known at the time of death and the stock was being actively traded at death, the measuring date for federal estate tax purposes. 

Calculating a Casualty Loss

While the casualty loss deduction rules have been modified for tax years beginning after 2017, the underlying manner in which a casualty loss is to be computed remains largely the same.  Those rules involve documenting the value of the property before the casualty; determining the value after the casualty; income tax basis; and the amount of insurance proceeds received.  It’s a big issue for agriculture particularly because of the exposure of agricultural property to weather.  A recent Tax Court case illustrates how a casualty loss is computed.

In Taylor II v. Comr., T.C. Memo. 2019-102, the petitioner claimed a casualty loss on his 2008 return for damage from a hurricane. An insurance company paid over $2.3 million in claims, and the claimed deduction was $888,345. The petitioner reported a basis in the property of $6.5 million, insurance reimbursement of $2.3 million and a pre-casualty fair market value of $15,442,059 and a post-casualty fair market value of $12,250,000. The pre-casualty FMV was based on the 2009 listing price of the property reduced for time spent on the market. No testimony was provided as to post-casualty FMV.

The Tax Court (Judge Paris) noted that to compute a casualty loss deduction, the pre and post-FMV values of the impacted property must be computed and the property basis must be established. The Tax Court noted that decline in value can alternatively be established via the regulations under I.R.C. §165 if the taxpayer has repaired the property damage resulting from the casualty, the taxpayer may use the cost of repairs to prove the loss of value to the property from the casualty. In that instance, the taxpayer must show that (a) the repairs are necessary to restore the property to its condition immediately before the casualty, (b) the amount spent for such repairs is not excessive, (c) the repairs do not care for more than the damage suffered, and (d) the value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty. The Tax Court noted that the record did not establish that the valuations were based on competent appraisals, and didn’t indicate how the petitioner’s CPAs determined the pre or post-casualty FMV of the property, even though the pre-casualty FMV was consistent with the value reported to the insurance company. The Tax Court concluded that the appraisals were not reliable measures of the taxpayer's casualty loss and didn’t rely on them. In addition, the taxpayer received insurance payments that exceed the cost of repairs. That meant that a casualty loss deduction couldn’t be claimed based on the regulations. The Tax Court disallowed any casualty loss deduction. 

Growing of Hemp

The 2018 Farm Bill allows for hemp (not marijuana) production and allows states and Indian tribes to opt for either primary regulatory authority, or USDA authority over any proposed hemp production. Under the primary authority option, a state may submit its own plan to the U.S. Secretary of Agriculture (Secretary). Once a plan is submitted, the Secretary has 60 days to approve or deny the plan. Under the “USDA option,” hemp can be produced under a plan established by the USDA, but the plan must still be submitted to and approved by the Secretary. The Farm Bill provides that the Secretary has explicit authority to set regulations and guidelines that relate to the implementation to both the primary regulatory authority option or the USDA option. On February 27, 2019, the USDA issued a notice that the agency had begun gathering information to promulgate rules and regulations related to the 2018 Farm Bill and the production of hemp in the United States.

In Flandreau Santee Sioux Tribe v. United States Department of Agriculture, No. 4:19-CV-04094-KES, 2019 U.S. Dist. LEXIS 95188 (D. S.D. Jun. 6, 2019), the plaintiff, an Indian tribe, submitted its own proposed hemp production plan in March of 2019.  The Secretary issued a letter in stating that the plan would be approved or denied within 60 days after hemp production regulations were finalized – likely in the fall of 2019. On May 6, the plaintiffs submitted a letter to USDA requesting a waiver of regulatory requirements so that the plaintiff could plant hemp during the 2019 growing season. A meeting was held to discuss the waiver. Later that month the plaintiff sued for a temporary restraining order or preliminary injunction seeking to force the USDA to grant the hemp planting waiver.

A hearing on the temporary restraining order was held in June. After the hearing, the court denied the plaintiff’s motion. The court determined that the plaintiff’s motion was not yet ripe and that the plaintiff was not likely to ultimately succeed on the merits of its claim. The court noted that the Farm Bill gave the Secretary broad discretion with respect to hemp production. In addition, the 60-day window to approve or reject plans did not begin until the USDA finalized regulations. The court also noted that there was no monetary remedy built into the law because the USDA was not required to pay compensation for economic losses. The court also determined that the plaintiff’s potential economic losses did not outweigh the impact on the USDA if the injunction were to be granted. The court noted that the issuance of an injunction would force the USDA to act before it could carefully lay out the regulations on hemp production. Such haste in allowing production could have detrimental long-term effects. 

Conclusion

There’s never a dull moment in ag law and tax. 

September 11, 2019 in Business Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Monday, September 9, 2019

Are Taxes Dischargeable in Bankruptcy?

Overview

When facing financial trouble and bankruptcy, don’t forget about the taxes.  While Chapter 12 bankruptcy contains a provision allowing for the deprioritization of taxes, there is no comparable provision for other types of bankruptcies.  But, for Chapter 7 and 11 filers, there is a possibility that taxes could be dischargeable in bankruptcy.  That’s because under those bankruptcy code provisions, a new tax entity is created at the time of bankruptcy filing. 

But, discharging taxes in bankruptcy is a tricky thing.  It involves timing and, perhaps, not filing successive cases.

The discharge of tax liability in bankruptcy – it’s the topic of today’s post.

The Bankruptcy Estate as New Taxpayer

As noted, for Chapter 7 (liquidation bankruptcy) or Chapter 11 (non-farm reorganization bankruptcy), a new tax entity separate from the debtor is created when bankruptcy is filed.  That’s not the case for individuals that file Chapter 12 (farm) bankruptcy, or Chapter 13 bankruptcy, and for partnerships and corporations under all bankruptcy chapters.  In those situations, the debtor continues to be responsible for the income tax consequences of business operations and disposition of the debtor's property.  Thus, payment of all the tax triggered in bankruptcy is the responsibility of the debtor.  The only exception is that Chapter 12 filers can take advantage of a special rule that makes the taxes a non-priority claim.  11 U.S.C. §1232.

Categories of taxes.  The creation of the bankruptcy estate as a new taxpayer, separate from the debtor, highlights the five categories of taxes in a Chapter 7 or Chapter 11 case.

  • Category 1 taxes are taxes where the tax return was last timely due more than three years before filing. If an extension was filed, an individual’s return can last be timely filed on October 15th.  In this case, the tax is dischargeable provided the bankruptcy is filed on or after October 16th three years after the year the tax return was filed. These taxes are dischargeable unless the debtor failed to file a return or filed a fraudulent return. 
  • Category 2 taxes are the taxes due within the last three years. These taxes are not dischargeable but are entitled to an eighth priority claim in the bankruptcy estate, ahead of the unsecured creditors. 
  • Category 3 taxes are the taxes for the portion of the year of bankruptcy filing up to the day before the day of bankruptcy filing. If the debtor's year is closed as of the date of filing, the taxes for the first year, while not dischargeable, are also entitled to an eighth priority claim in the bankruptcy estate.  If the debtor's year is not closed, the entire amount of taxes for the year of filing are the debtor's responsibility.
  • Category 4 taxes are the taxes triggered on or after the date of filing and are the responsibility of the bankruptcy estate. Taxes due are paid by the bankruptcy estate as an administrative expense.  If the taxes exceed the available funds, the tax obligation remains against the bankruptcy estate but does not return to the debtor.  Most bankruptcy trustees abandon assets if the taxes incurred will make the bankruptcy estate administratively insolvent.
  • Category 5 taxes are for the portion of the year beginning with the date of bankruptcy filing (or for the entire year if the debtor's year is not closed) and are the responsibility of the debtor.

The election to close the debtor’s tax year.  In general, the bankrupt debtor’s tax year does not change upon the filing of bankruptcy.  But, debtors having non-exempt assets that will be administered by the bankruptcy trustee may elect to end the debtor’s tax year as of the day before the bankruptcy filing.

Making the election creates two short tax years for the debtor.  The first short year ends the day before bankruptcy filing and the second year begins with the bankruptcy filing date and ends on the bankrupt’s normal year-end date.  If the election is not made, the debtor remains individually liable for income taxes for the year of filing.  But, if the election is made, the debtor’s income tax liability for the first short year is treated as a priority claim against the bankruptcy estate, and can be collected from the estate if there are sufficient assets to pay the bankruptcy estate’s claims through the eighth priority.  If there are not sufficient assets to pay the income tax, the remaining tax liability is not dischargeable, and the tax can be collected from the debtor at a later time.  The income tax the debtor owes for the years ending after the filing is paid by the debtor and not by the bankruptcy estate.  Thus, closing the debtor’s tax year can be particularly advantageous if the debtor has substantial income in the period before the bankruptcy filing.  Conversely, if a net operating loss, unused credits or excess deductions are projected for the first short year, a short year election should not be made in the interest of preserving the loss for application against the debtor’s income from the rest of the taxable year.  Even if the debtor projects a net operating loss, has unused credits or anticipates excess deductions, the debtor may want to close the tax year as of the day before bankruptcy filing if the debtor will not likely be able to use the amounts, the items could be used by the bankruptcy estate as a carryback to earlier years of the debtor (or as a carryforward) and,

But, in any event, if the debtor does not act to end the tax year, none of the debtor’s income tax liability for the year of bankruptcy filing can be collected from the bankruptcy estate.  Likewise, if the short year is not elected, the tax attributes (including the basis of the debtor’s property) pass to the bankruptcy estate as of the beginning of the debtor’s tax year.  Therefore, for example, no depreciation may be claimed by the debtor for the period before bankruptcy filing.  That could be a significant issue for many agricultural debtors.

Consider the following example:

Sam Tiller, a calendar year/cash method taxpayer, on January 26, 2019, bought and placed in service in his farming business, a new combine that cost $400,000.  Sam is planning on writing off the entire cost of the new combine in 2019.  However, assume that during 2019, Sam’s financial condition worsens severely due to a combination of market and weather conditions.  As a result, Sam files Chapter 7 bankruptcy on September 5, 2019.

If Sam does not elect to close the tax year, the tax attributes (including the basis of his property) will pass to the bankruptcy estate as of the beginning of Sam’s tax year (January 1, 2019).  Therefore, Sam would not be able to claim any of the depreciation for the period before he filed bankruptcy (January 1, 2016, through September 4, 2019).

The Timing Issue - Illustrative Cases

As you have probably already figured out, timing of the bankruptcy filing is critical to achieving the best possible tax result.  Unfortunately, it’s often the case that tax considerations in bankruptcy are not sufficiently thought out and planned for to achieve optimal tax results.  Unfortunately, this point is illustrated by a couple of recent cases. 

Filing too soon.  In Ashmore v. Comr., T.C. Memo. 2017-233, the petitioner claimed that his 2009 tax liability, the return for which was due on April 15, 2010, was discharged in bankruptcy.   He filed Chapter 7 on April 8, 2013. That assertion challenged whether the collection action of the IRS was appropriate.  As indicated above, the Tax Court noted that taxes are not dischargeable in a Chapter 7 bankruptcy if  the return can last be timely filed within three years before the date the bankruptcy was filed.  Because the petitioner filed bankruptcy a week too soon, the Tax Court held that his 2009 taxes were not dischargeable and could be collected.  As a result, the IRS settlement officer did not abuse discretion in sustaining the IRS levy.  In addition, the Tax Court, held that the IRS did not abuse the bankruptcy automatic stay provision that otherwise operates to bar creditor actions to collect on debts that arose before the bankruptcy petition was filed. 

The Tax Court’s conclusion in Ashmore is not surprising.  The three-year rule has long been a part of the bankruptcy code.  Indeed, in In re Reine, 301 B.R. 556 (Bankr. W.D. Mo. 2003), the debtor filed the Chapter 7 bankruptcy petition more than three years after filing the tax return, but within three years of due date of return.  The court held that the debtor’s tax debt was not dischargeable.

The peril of multiple filings.  In Nachimson v. United States, No. 18-14479-SAH, 2019 Bankr. LEXIS 2696 (Bankr. W.D. Okla. Aug. 23, 2019), the debtor filed Chapter 7 on October 25, 2018 after not filing his tax returns for 2013 through 2016. Immediately after filing bankruptcy, the debtor filed an action claiming that his past due taxes were discharged under 11 U.S.C. §523(a)(1).  After extension, the debtor’s 2013 return was due on October 15, 2014.  His 2014 return was due April 15, 2015.  The 2016 return was due on April 15, 2016.  The 2016 return was due April 15, 2017.  The debtor had previously filed bankruptcy in late 2014 (Chapter 13), but the case was dismissed on January 14, 2015 after lasting 80 days.  He then filed a Chapter 11 case on November 5, 2015, but it was dismissed on April 13, 2016 after 160 days.  After that dismissal, he filed another Chapter 11 case on October 20, 2016, but it was dismissed on December 30, 2016 after 71 days.  He filed the present Chapter 7 case, as noted, on October 25, 2018.  Thus, as of October 25, 2018, he had been in bankruptcy proceedings from October 15, 2014 through October 25, 2018 -311 days. 

11 U.S.C. §523(a)(1)(A) provides, in general, that a discharge of debt in bankruptcy does not discharge an individual debtor from any income tax debt for the periods specified in 11 U.S.C. §507(a)(8). One of the periods contained in 11 U.S.C. §507(a)(8)(A)(i), is the three-year period before the bankruptcy petition is filed.  Importantly, 11 U.S.C. §507(a)(8)(A)(ii)(II) specifies that an otherwise applicable time period specified in 11 U.S.C. §507(a)(8) is suspended for any time during which a governmental unit is barred under applicable non-bankruptcy law from collecting a tax as a result of the debtor’s request for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days; plus any time during which the stay of proceedings was in effect in a prior bankruptcy case or during which collection was precluded by the existence of one or more confirmed bankruptcy plans.

So, what does all this mean?  It means that when a debtor files multiple, successive bankruptcy cases, the ordinary operation of the automatic stay 11 U.S.C. § 507(a)(8) and the three-year look-back rule is altered by 11 U.S.C. § 362(c)(3)(A) which specifies that if a debtor had a case pending within the preceding one-year period that was dismissed, then the automatic stay with respect to any action taken with respect to a debt or property securing that debt terminates with respect to the debtor on the 30th day after the filing of the later case.

Here, the debtor sought to have his 2013 and 2014 tax liabilities discharged in the present bankruptcy case under 11 U.S.C. §523(a)(1)(A) on the basis that the filing dates for those returns were outside the three-year look-back period.  He wanted a rather straightforward application of the three-year rule.  However, the IRS took the position that the three-year “look-back” period was extended due to the debtor's bankruptcy filings. The court agreed with the IRS, noting that the three-year look-back period began on October 25, 2015. But the court determined that the real issue was whether the look-back period extended back 401 (311 plus 90) days, or only for the first 30 days following each bankruptcy filing as provided by 11 U.S.C. § 362(c)(3)(A).

The court noted that the Congress, in 2005, amended 11 U.S.C. §507(a)(8) to codify the U.S. Supreme Court decision of Young v. United States, 535 U.S. 43 (2002) where the Supreme Court concluded that the tolling provision of 11 U.S.C. § 507(a)(8) was not impacted by the automatic nature of 11 U.S.C. § 362(c)(3)(A). Instead, for purposes of the tolling provision, the stay of proceedings was in effect in each of debtor's three previous cases until each was dismissed. In addition, the Congress amended the statute to tack-on another 90 days to the extension.  See, In re Kolve, 459 B.R. 376 (Bankr. W.D. Wisc. 2011).  The look-back period automatically tolls upon the filing of a previous case.  See, e.g., In re Clothier, 588 B.R. 28 (Bankr. W.D. Tenn. 2018).  Thus, instead of suspending the look-back period, it extends it and allows the priority and nondischargeability of tax claims to reach further into the past.  Thus, the court in the present case determined that the look-back period extended back three years plus 401 days. Since the debtor filed the bankruptcy petition in the present case on October 25, 2018, the three-year plus 401-day look-back period (80 + 160 + 71 +90) reached back to September 19, 2014. Because the debtor's 2013 and 2014 tax liabilities were due after that date (including the extension for the 2013 liability), neither was dischargeable in the current bankruptcy case. 

Conclusion

Bankruptcy planning should necessarily account for taxes.  The cases point out that timing of the filing of the bankruptcy petition is critical, and that successive filings can create tremendous complications.  Competent legal and tax counsel is a must, in addition to competent bankruptcy counsel. 

September 9, 2019 in Bankruptcy, Income Tax | Permalink | Comments (0)

Thursday, September 5, 2019

Regulatory Changes to the Endangered Species Act

Overview

The Endangered Species Act (ESA) establishes a regulatory framework for the protection and recovery of endangered and threatened species of plants, fish and wildlife. 16 U.S.C. § 1531, et seq.  The ESA has the potential to restrict substantially agricultural activities because many of the protections provided for threatened and endangered species under the ESA extend to individual members of the species when they are on private land where many endangered species have some habitat.

In late July of 2018, the U.S. Fish and Wildlife Service (USFWS) and the National Marine Fisheries Service (NMFS) issued three proposed rules designed to modify certain aspects of the ESA. Public comment on the proposed rules was accepted until September 24, 2018.  On August 12, 2019, the agencies announced the finalization of the regulations.

The ESA regulatory changes and their relevance to agriculture – that’s the topic of today’s post.

Background

The regulatory modifications to the ESA stem from early 2017 when President Trump signed an executive order (Exec. Order 13777, “Enforcing the Regulatory Reform Agenda”) requiring federal agencies to revoke two regulations for every new rule issued.  The order also required federal agencies to control the costs of all new rules within their budget. In addition, the order barred federal agencies from imposing any new costs in finalizing or repealing a rule for the remainder of 2017 unless that cost were offset by the repeal of two existing regulations.  Exceptions were included for emergencies and national security.  Beginning in 2018, the order required the director of the White House Office of Management and Budget to give each agency a budget for how much it can increase regulatory costs or cut regulatory costs.  The order was touted as the “most significant administrative action in the world of regulatory reform since President Reagan created the Office of Information and Regulatory Affairs (OIRA) in 1981."

The ESA has long been considered critical to species protection, but it has also been one of the most contentious environmental laws largely because of its impact on the usage of private as well as public land.  The judicial and legal costs of enforcing the ESA are quite high, as both environmental and industry groups have historically brought litigation to protect their interests on account of the ESA. 

As for private land, about half of ESA listed species have at least 80 percent of their habitat on private lands.  This has given concern to landowners that the presence of a listed species on their land will result in land use restrictions, loss in value, and possible involvement in third-party lawsuits.  

Under the ESA, “fish and wildlife” species are defined as any member of the animal kingdom, including without limitation any mammal, fish, bird...amphibian, reptile, mollusk, crustacean, arthropod, or other invertebrate. 16 U.S.C. § 1532(8). “Plants” are defined as any member of the plant kingdom. 16 U.S.C. § 1532(14).  An “endangered species” is a species which is in danger of extinction throughout all or a significant part of its range other than a species determined by the USFWS to constitute a pest whose protection under the provisions of the Act would present an overwhelming and overriding risk to humans. 16 U.S.C. § 1532(6). A “threatened species” is a species which is likely to become endangered within the foreseeable future throughout all or a significant portion of its range. 16 U.S.C. § 1532(20).  The term “species” includes any subspecies of fish or wildlife or plants and any distinct population segment of any species of vertebrate fish or wildlife which interbreeds when mature. 16 U.S.C. § 1532(16).

The Secretary of the Interior (Secretary) determines when a species is to be listed as either threatened or endangered.  Presently, there are about 1,700 species listed under the ESA as either endangered or threatened.  The listing decision historically has been made on the basis of the best available scientific and commercial data without reference to possible economic or other impacts after the USFWS conducts a review of the status of the species. 16 U.S.C. § 1533(b)(1)(A); 50 C.F.R. 424.11. There is, however, no statutory threshold definition or quantification of the level of data necessary to support a listing decision. Indeed, the information supporting a listing decision need not be credible; only the “best available.”

The USFWS considers species for listing on its own initiative, but the ESA also provides a listing petition process for “interested persons” to force evaluation and listing of a species. Within 90 days of receiving a petition for listing, the USFWS must determine whether the petition presents substantial information to warrant listing of the species.  If the USFWS concludes that the petitioned action is warranted, it then conducts a review of the species' status and must determine within one year of the receipt of the petition whether to propose formally the species for listing. The Secretary's decision to list a species as endangered or threatened is based upon the presence of at least one of the following factors; (1) the present or threatened destruction, modification, or curtailment of a species' habitat or range; (2) the over-utilization for commercial, sporting, scientific or educational purposes; (3) disease or predation; (4) the inadequacy of existing regulatory mechanisms; or (5) other natural or manmade factors affecting a species' continued existence. The USFWS may decline to list a species upon publishing a written finding either that listing is unwarranted or that listing is warranted, but that the USFWS lacks the resources to proceed immediately with the proposal.  Under the ESA, all USFWS decisions to decline listing a species are subject to judicial review.

When a species is listed as endangered or threatened, the Secretary must consider whether to designate critical habitat for the species.   “Critical habitat” is the specific area within the geographical range occupied by the species at the time of listing that is essential to the conservation of the species. Critical habitat may also include specific areas outside the geographical area occupied by the species at the time it is listed if the USFWS determines that such areas are essential for conservation of the species. However, critical habitat need not include the entire geographical range which the species could potentially occupy.  16 U.S.C. § 1532(5).   In making a critical habitat determination, the USFWS must consider economic impacts and other relevant impacts, as well as best scientific data. See, e.g., New Mexico Cattle Growers Association. v. United States Fish and Wildlife Service, 248 F.3d 1277 (10th Cir. 2001).   The USFWS may exclude any area from critical habitat if the benefits of the exclusion outweigh the benefits of specifying the area as critical habitat, unless the USFWS determines on the basis of best scientific and commercial data available that the failure to designate an area as critical habitat will result in the extinction of the species.

The Final Rules

In general.  The final rules are entitled, “Endangered and Threatened Wildlife and Plants; Revision of the Regulations for Listing Species and Designating Critical Habitat.”  83 Fed. Reg. 35,193 (Aug. 12, 2019).  The final rules will be codified at 50 C.F.R. pt. 424 and clarify the procedures and criteria that are used to add or remove species from the endangered and threatened species lists and how their critical habitat is designated.  The new rules also eliminate the rule that, by default, extended many prohibitions on endangered species to those species that only had threatened stats.  In addition, the final rules further define the procedures for interagency cooperation. 

The listing process.  The final rules modify the ESA listing process.  The final rule allows for economic impacts of the potential listing, delisting or reclassifying of a species to be accounted for.  The findings of anticipated economic impact must be publicly disclosed.  In addition, the Secretary must evaluate areas that are occupied by the species, and unoccupied  areas will only be considered “essential” where a critical habitat designation that is limited only to the geographical areas that a species occupies would be inadequate to ensure conservation of the species.  In addition, for an unoccupied area to be designated as critical habitat, the Secretary must determine that there is a reasonable certainty that the area will contribute to the conservation of the species and that the area contains one or more physical or biological features essential to the conservation of the species.  Also, a “threatened” listing for a species is to be evaluated in accordance with whether the species is likely to become endangered in the “foreseeable future” (as long as a threat is probable). 

The final rules also require any critical habitat for a listed species designation to first take into account all areas that a species occupies at the time of listing before considering whether any unoccupied areas are necessary for the survival or recovery of the species. On that point, a determination must be made that “there is a reasonable likelihood that the area will contribute to the conservation of the species” before designating any unoccupied area as critical habitat.  This is consistent with the U.S. Supreme Court opinion in Weyerhaeuser Co. v. United States Fish & Wildlife Service, 139 S. Ct. 361(2018), where the Court held that an endangered species cannot be protected under the ESA in areas where it cannot survive. 

The “blanket rule.”  The ESA statutory protections, including the prohibition on an “unauthorized take” of a species apply only to endangered species. However, the USFWS has automatically extended those protections to all species listed as threatened through a broad regulation known as the “blanket 4(d) rule.” The final rules remove these automatically provided protections to threatened species that are given to endangered species.  As a result, the USFWS will be required to develop additional regulations for threatened species on a case-by-case basis to extend the protections given endangered species.    

Agency cooperation.  The final rules also provide alternative mechanisms intended to improve the efficiency of ESA consultations conducted by the USFWS and federal agencies. The revisions include a process for expedited consultation in which a federal agency and the USFWS may enter into upon mutual agreement. A 60-day limit is included for completion of informal consultations with the option to extend the consultation to no more than 120 days.

Conclusion

The ESA has been termed the “pit bull” of environmental law.  It has a history since its enactment in 1973, and the landmark Supreme Court case of Tennessee Valley Authority v. Hill, 437 U.S. 153 (1978), of being the nation’s most controversial environmental law because of its impact on landowners and others.   The final regulations are an attempt to inject additional common-sense into the application of the ESA and align it to a greater extent to its original purpose.  Another intended impact is a decreased burden on farmers and ranchers.  Only time will tell if these goals are actually accomplished. 

September 5, 2019 in Environmental Law | Permalink | Comments (0)

Tuesday, September 3, 2019

Tax Consequences of Forgiving Installment Payment Debt

Overview

During this time of financial stress in parts of the agricultural sector, a technique designed to assist a financially troubled farmer has come into focus.  When farmland is sold under an installment contract, it’s often done to aid the farmer-buyer as an alternative to more traditional debt financing.  But what if the buyer gets into financial trouble and can’t make the payments on the installment obligation and the seller forgives some of the principal on the contract?  Alternately, what if the principal is forgiven as a means to pass wealth to the buyer as a family member and next generation farmer?  What are the tax consequences of principal forgiveness in that situation?

The Tax consequences of forgiving principal on an installment obligation – it’s the topic of today’s post.

The Deal Case

In 1958, the U.S. Tax Court decided Deal v. Comr., 29 T.C. 730 (1958).  In the case, a mother bought a tract of land at auction and transferred it in trust to her three sons-in-law for the benefit of her daughters.  Simultaneously, the daughters (plus another daughter) executed non-interest-bearing demand notes payable to their mother.  The notes were purportedly payment for remainder interests in the land.  The mother canceled the notes in portions over the next four years.  For the tax year in question, the mother filed a federal gift tax return, but didn’t report the value of the cancelled notes on the basis that the notes that the daughters gave made the transaction a purchase rather than a gift.  The IRS disagreed, and the Tax Court agreed with the IRS. The notes that the daughters executed, the Tax Court determined, were not really intended to be enforced and were not consideration for their mother’s transfers.  Instead, the transaction constituted a plan with donative intent to forgive payments.  That meant that the transfers were gifts to the daughters.  Even though the amount of the gifts was under the present interest annual exclusion amount each year, they were gifts of future interests such that the exclusion did not apply and the full value of the gifts was taxable. 

Subsequent Tax Court Decisions

In 1964, the Tax Court decided Haygood v. Comr., 42 T.C. 936 (1964).  Here, the Tax Court upheld an arrangement where the parents transferred property to their children and took back vendor’s lien (conceptually the same as a contractor’s lien) notes which they then forgave as the notes became due.  Each note was secured by a deed of trust or mortgage on the properties transferred.  The Tax Court believed that helped the transaction look like a sale with the periodic forgiveness of the payments under the obligation then constituting gifts. 

What did the Tax Court believe was different in Haygood as compared to Deal?  In Deal, the Tax Court noted, the property was transferred to a trust and on the same day the daughters (instead of the trust) gave notes to the mother.  In addition, the notes didn’t bear interest, and were unsecured.  In Haygood, by contrast, the notes were secured, and the amount of the gift at the time of the initial transfer was reduced by the face value of the notes. 

A decade later the Tax Court ruled likewise in Estate of Kelley v. Comr., 63 T.C. 321 (1974).  This case involved the transfer of a remainder interest in property and the notes received (non-interest- bearing vendor’s lien notes) were secured by valid vendor’s liens and constituted valuable consideration in return for the transfer of the property.  The value of the transferred interests were reported as taxable gifts to the extent the value exceed the face amount of the notes.  The notes were forgiven as they became due.  The IRS claimed that the notes lacked “economic substance” and were just a “façade for the principal purposes of tax avoidance.” 

The Tax Court disagreed with the IRS position.  The Tax Court noted that the vendor’s liens continued in effect as long as the balance was due on the notes.  In addition, before forgiveness, the transferors could have demanded payment and could have foreclosed if there was a default.  Also, the notes were subject to sale or assignment of any unpaid balance and the assignee could have enforced the liens.  As a result, the transaction was upheld as a sale.

The IRS Formally Weighs In

In Rev. Rul. 77-299, 1977-2 C.B. 343, real property was transferred to grandchildren in exchange for non-interest-bearing notes that were secured by a mortgage.  Each note was worth $3,000.  The IRS determined that the transaction amounted to a taxable gift as of the date the transaction was entered into.  The IRS also determined that a prearranged plan existed to forgive the payments annually.  As a result, the forgiveness was not a gift of a present interest. 

The IRS reiterated its position taken in Rev. Rul. 77-299 in Field Service Advice 1999-837.  In the FSA, two estates of decedents held farm real estate.  The executors agreed to a partition and I.R.C. §1031 exchange of the land.  After the exchange, the heirs made up the difference in value of the property they received by executing non-interest-bearing promissory notes payable to one of the estates.  The executors sought a court order approving annual gifts of property to the heirs.  They received that order which also provided that the notes represented valid, enforceable debt.  The notes were not paid, and gift tax returns were not filed.  Tax returns didn’t report the annual cancellation of the notes.  The IRS determined that a completed gift occurred at the time of the exchange and that each heir could claim a single present interest annual exclusion ($10,000 at the time).  The IRS determined that the entire transaction was a prearranged plan to make a loan and have it forgiven – a sham transaction.  See also Priv. Ltr. Rul. 200603002 (Oct. 24, 2005).

The IRS position makes it clear from a planning standpoint where the donor intends to forgive note payments that the loan transaction be structured carefully.  Written loan documents with secured notes where the borrower has the ability to repay the notes and actually does make some payment on the notes would be a way to minimize “sham” treatment. 

1980 Legislation

The Congress enacted the Installment Sales Revision Act of 1980 (Act).  As a result of the Act, several points can be made:

  • Cancelation of forgiveness of an installment obligation is treated as a disposition of the obligation (other than a sale or exchange). R.C. §453B(f)(1).
  • A disposition or satisfaction of an installment obligation at other than face value results in recognized gain to the taxpayer with the amount to be included in income being the difference between the amount realized and the income tax basis of the obligation. R.C. §453B(a)(1)
  • If the disposition takes the form of a “distribution, transmission, or disposition otherwise than by sale or exchange,” the amount included in income is the difference between the obligation and its income tax basis. R.C. §453B(a)(2).
  • If related parties (in accordance with I.R.C. §267(b)) are involved, the fair market value of the obligation is considered to be not less than its full face value. R.C. §453B(f)(2).

Other Situations

Impact of death.  The cancellation of the remaining installments at death produces taxable gain.  See, e.g., Estate of Frane v. Comr., 98 T.C. 341 (1992), aff’d in part and rev’d in part, 998 F.2d 567 (8th Cir. 1993).  In Frane, the Tax Court decided, based on IRC §453(B)(f), that the installment obligations of the decedent’s children were nullified where the decedent (transferor) died before two of the four could complete their payments.  That meant that the deferred profit on the installment obligations had to be reflected on the decedent’s final tax return.  But, if cancelation is a result of a provision in the decedent’s will, the canceled debt produces gain that is included in the estate’s gross income.  See, e.g., Priv. Ltr. Rul. 9108027 (Nov. 26, 1990).  In that instance, the obligor (the party under obligation to make payment) has no income to report. 

If an installment obligation is transferred on account of death to someone other than the obligor, the transfer is not a disposition.  Any unreported gain on the installment obligation is not treated as gross income to the decedent and no income is reported on the decedent's return due to the transfer.  The party receiving the installment obligation as a result of the seller's death is taxed on the installment payments in the same manner as the seller would have been had the seller lived to receive the payments.

Upon the holder’s death, the installment obligation is income-in-respect-of-decedent.  That means there is no basis adjustment at death. I.R.C. §691(a)(4) states as follows:

“In the case of an installment obligation reportable by the decedent on the installment method under section 453, if such obligation is acquired by the decedent’s estate from the decedent or by any person by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent—

(A)

an amount equal to the excess of the face amount of such obligation over the basis of the obligation in the hands of the decedent (determined under section 453B) shall, for the purpose of paragraph (1), be considered as an item of gross income in respect of the decedent; and

(B)

such obligation shall, for purposes of paragraphs (2) and (3), be considered a right to receive an item of gross income in respect of the decedent, but the amount includible in gross income under paragraph (2) shall be reduced by an amount equal to the basis of the obligation in the hands of the decedent (determined under section 453 B).”

But, disposition (sale) at death to the obligor is a taxable disposition.  I.R.C. §§691(a)(4)-(5).  Similarly, if the cancelation is triggered by the holder’s death, the cancellation is treated as a transfer by the decedent’s estate (or trust if the installment obligation is held by a trust).  I.R.C. §691(a)(5)(A). 

No disposition.  Some transactions are not deemed to be a “disposition” for tax purposes.  Before the Act became law, the IRS had determined that if the holder of the obligation simply reduces the selling price but does not cancel the balance that the obligor owes, it’s not a disposition.  Priv. Ltr. Rul. 8739045 (Jun. 30, 1987).  Similarly, the modification of an installment obligation by changing the payment terms (such as reducing the purchase price and interest rate, deferring or increasing the payment dates) isn’t a disposition of the installment obligation.   The gross profit percentage must be recomputed and applied to subsequent payments.  Also, where the original installment note was replaced, the substitution of a new promissory note without any other changes isn’t a disposition of the original note.  See, e.g., Priv. Ltr. Ruls. 201144005 (Aug. 2, 2011) and 201248006 (Aug. 30, 2012).

There is also no disposition if the buyer under the installment obligation sells the property to a third party and the holder allows the third party to assume the original obligor’s obligation.  That’s the case even if the third party pays a higher rate of interest than did the original obligor. 

Conclusion

Debt forgiveness brings with it tax consequences.  Installment obligations are often used to help the obligor avoid traditional financing situations, particularly in family settings.  It’s also used as a succession planning tool.  But, it’s important to understand the tax consequences for the situations that can arise.

September 3, 2019 in Business Planning, Income Tax | Permalink | Comments (0)