Friday, March 13, 2020
Periodically on this blog I write about recent caselaw and IRS developments that farmers, ranchers and others should be aware about. The courts are constantly churning out cases that are important to agriculture and tax developments are always non-stop. It’s amazing how broad the reach is of the issues the courts and IRS address that touches agriculture in one way or another. Many of these issues may not be given much thought on a daily basis, but perhaps they should.
In today’s post, I look at a few more recent developments of relevance to agriculture – it’s the focus of today’s post.
IRS Loses Valuation Case
Grieve v. Comr., T.C. Memo. 2020-28
When interests in closely-held businesses are transferred, either by death or gift, and either federal estate or gift tax is involved, the valuation issue becomes highly relevant. For farms and ranches, blocks of non-controlling stock may be involved and the IRS may seek to apply a premium to the value of the stock to increase estate or gift taxes owed. Recently, the U.S. Tax Court shot down an IRS attempt to attach a premium to a gift of non-controlling stock among family members.
In the case, after the petitioner’s wife died, he formed two LLCs (Rabbit and Angus) for financial management and estate planning purposes. He then transferred some of the Class B shares of Rabbit to a grantor-retained annuity trust (GRAT) and the Class B shares of Angus to an irrevocable trust. The petitioner filed a 2013 gift tax return (Form 709) and attached appraisal reports that reported a taxable gift of nearly $10 million. The IRS rejected that valuation, claiming that the proper valuation was $17.8 million, and issued a notice of deficiency.
The Tax Court examined both appraisal reports, noting that the petitioner’s appraisal reports included independent analysis of the LLC shares using a combination of market and income approaches to determine the total value. Conversely, the Tax Court noted that the IRS included an assumption that selling the Class B share would encourage the petitioner’s daughter (who solely owned the Class A shares) to sell her 0.2 percent interest in the entities, which would increase the petitioner’s interests. However, the daughter testified that she would not be inclined to sell her interest, and if she were to sell, would seek a much higher premium that the IRS estimated. The Tax Court also determined that the IRS appraisal also relied on additional hypothetical scenarios that were inconsistent and insufficient to consider a change to the petitioner’s appraisal and the discounts concluded in the report. In addition, the Tax Court noted that the IRS appraiser failed to provide support for the valuations, and also did not provide evidence that his appraisal methodology was subject to peer review.
The Tax Court concluded that the IRS failed to provide sufficient evident to support its expert appraiser’s conclusion that the interests of the LLCs were undervalued and that the petitioner’s gifts of the assets to the two trusts were likewise undervalued. The Tax Court rejected the IRS position that the petitioner had underreported gift tax by $4.4 million and also rejected the IRS penalties of $600,000.
IRAs and the Constitution
Conard v. Comr., 154 T.C. No. 6 (2020)
So that people are disincentivized from using their retirement savings for things other than retirement, the IRS hits withdrawals before age 59-1/2 with a 10 percent penalty. Exceptions to the penalty apply, but even if a taxpayer fits within an exception the amount withdrawn still must be reported into income. Exemptions include distributions made post-death; because the account owner is total and permanently disabled, to cover qualified post-secondary education expenses; distributions made after being called to active military duty for 180 days; or within a year of a child’s birth or adoption.
The U.S. Tax Court recently dealt with a constitutional challenge to such penalty exemptions. In the case, the petitioner had not yet reached age 59-1/2 at the time the she received a distribution from a qualified retirement plan. Consequently, the IRS assessed the 10 percent early withdrawal penalty of I.R.C. §72(t). She sought review of the asserted tax deficiency and challenged the additional tax on the basis that the application of the tax to her early distribution violated the Constitution’s Fifth Amendment Due Process Clause because exceptions exist to the penalty that are applicable to taxpayers that haven’t reached age 59-1/2, such as for disability, etc.
The Tax Court disagreed, applying the rational basis test (low-level scrutiny) to evaluate the constitutionality of the Code provision. The Tax Court determined that test applied because the provision did not invade a substantive constitutional right or freedom or involve a suspect classification. As a result, the constitutionality of the provision could only be overcome by an explicit demonstration that the statute established hostile and oppressive discrimination against particular persons and classes. The Tax Court noted that the petitioner did not claim that the penalty provision concerned a substantive constitutional right or freedom or involved a suspect classification. Age is not a suspect classification for purposes of equal protection. Thus, the provision was presumed constitutional if it had a legitimate governmental purpose. The Tax Court noted that Committee Reports concerning the provision provided that the statute aimed “to provide means for financing retirement” and that penalties for early withdrawals were “designed to insure that retirement plans will not be used for other purposes.” An exemption from the penalty for disability, for example, satisfied a legitimate objective of encouraging taxpayers to provide for times of inability to work.
Huge FBAR Penalty Imposed
In recent years, some farmers and ranchers have started operations in locations other than the United States. Others may have bank accounts in foreign jurisdictions. Still others may serve as an agent under a power of attorney for someone that has a bank account in a foreign jurisdiction. In that event, every year, under the Bank Secrecy Act, anyone that owns or has an interest in or signature authority over certain foreign accounts such as bank accounts, brokerage accounts and mutual funds, must report the account(s) by filing a Report of Foreign Bank and Financial Accounts (FBAR) on FinCEN Form 114. The proper box must also be checked on Schedule B of Form 1040. Failure to do so can trigger a penalty. Willful failure to do so can result in a monstrous penalty. A recent case points out how bad the penalty can be for misreporting.
In the case, the taxpayer had a foreign bank account with aggregate highest balance of $1.9 million, $770,000 and $1.76 million for the three tax years at issue. Form 1040, Schedule B contains a question with a box to be checked asking whether the taxpayer had a financial interest in or signature authority over a financial account located in a foreign country. The box on Schedule B was checked “No” which was the default in the software that the return preparer used. The taxpayer also did not file an FBAR Form for any of the three years. The FBAR Form is required to be filed when the aggregate account balance exceeds $10,000.
The IRS claimed that the taxpayer had constructive knowledge of his reporting requirements by signing his tax returns which included a reference to the FBAR on Schedule B, and that the naming his sister's Canadian address on the accounts was an act of concealment. The taxpayer argued that he was simply negligent and there was no will failure to file the FBARs. The Court examined the definition of willfulness for purposes of FBAR filing and concluded that the taxpayer could have easily determined the need to file the FBAR. Accordingly, the court held that the taxpayer willfully failed to file the FBAR Form and assessed penalties for the years at issue in the amount of $988,245.
Lakes Have Constitutional Rights?
Drewes Farms Partnership v. City of Toledo, No. 3:19 CV 434, 2020 WL 966628 (N.D. Ohio Feb. 27, 2020) No. 3:19 CV 434 2020 U.S. Dist. LEXIS 36427 (N.D. Ohio Feb. 27, 2020)
The genesis of this case actually began in a bar in Toledo (no word on whether the bar was across from the depot). Apparently, the inebriated were commiserating over the pollution of Lake Erie. Ultimately, the ideas of that night got formulated into a ballot question at a special election for the citizens of Toledo concerning whether Lake Erie should be granted legal rights that people have. It was the first rights-based legislation in the U.S. aimed at protecting an ecosystem – Lake Erie, its tributaries and the species that live there.
When election time came, sufficient Toledo citizens voted to add the “Lake Erie Bill of Rights” (LEBOR) to the city’s charter in early 2019. The LEBOR prohibited any infringement of the “rights” of Lake Erie to “exist, flourish, and naturally evolve” without explaining the kind of conduct that would infringe those “rights.” The plaintiff, a farming operation that grows crops in four counties near Toledo and Lake Erie, sued to invalidate the LEBOR on constitutional grounds for lack of due process as being void for vagueness. The court agreed and vacated the LEBOR in its entirety.
There are always developments involving agriculture. It’s good to stay informed.