“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 8 and 7

Overview

As I pointed out in Sunday’s article, agricultural law and agricultural tax law intersect with everyday life of farmers and ranchers in many ways.  Some of those areas of intersection are good, but some are quite troubling.  In any event, it points to the need for being educated and having good legal and tax counsel that is well-trained in the special rules that apply to agriculture.

This is the second installment in my list of the “Top Ten” agricultural law and tax developments of 2021.  The list is comprised of what are, in my view, the most important developments in agricultural law (which includes taxation that impacts farmers and ranchers) to the sector as a whole.  The developments primarily are focused on the impact to production agriculture, but the issues involved will also have effects that spillover to rural landowners and agribusinesses as well as consumers of agricultural products.

The Eighth and Seventh most important agricultural law and tax developments of 2021 – it’s the topic of today’s post.

8.  Ag Nuisance Litigation in North Carolina.  In recent years, North Carolina has been the focus of much ag nuisance litigation, particularly targeted at large-scale hog confinement operations.  Legal developments flowing from the various cases has influenced the North Carolina legislature as well as legislatures in other states (such as Florida and Indiana) to modify their Right-To-Farm (RTF) laws in an attempt to provide greater legal protection to agricultural operations.  In 2021, there were further developments in North Carolina involving nuisance and that state’s RTF law.

The North Carolina RTF law was originally enacted in 1979 with the state policy goal to: "[R]educe the loss to the State of its agricultural and forestry resources by limiting the circumstances under which an agricultural or forestry operation may be deemed a nuisance." After many nuisance suits were filed against confinement hog operations, the legislature amended the RTF in 2013. The amendment specified that an ag operation that has been in business for at least a year and has not fundamentally changed is protected from a nuisance action as a result of changed conditions surrounding it if the ag operation was not a nuisance at the time it began. The plaintiffs refiled their suits in 2014 in federal district court based on the amended law. The federal court held that the RTF law did not apply to shield hog producers and five juries rendered verdicts for the plaintiffs. The legislature again amended the RTF law in 2017 and 2018 to expand its protection for agricultural operations.

There were two additional court opinions in 2021 involving the North Carolina RTF law.  In Barden v. Murphy-Brown, LLC, No. 7:20-CV-85-BR, 2021 U.S. Dist. LEXIS 47809 (E.D. N.C. Mar. 15, 2021), the plaintiff sued the defendant in 2020 for trespass, negligence, civil conspiracy and unjust enrichment arising from odor, dust, feces, urine and flies from a neighboring hog facility that housed 20,000-head of the defendant’s hogs. The plaintiff sought compensatory and punitive damages. The defendant sought to dismiss the complaint for failure to join to the lawsuit the farmer that operated the hog facility via a contact with the defendant as an indispensable party. The court disagreed, as the farmer’s conduct was likely irrelevant to the outcome of the litigation and any impact that an adverse judgment against the defendant might have on the farmer’s interests at the farm was speculative. The defendant also sought dismissal on the basis that the plaintiff’s complaint failed to state a claim for relief that was other than speculative. The defendant cited the North Carolina RTF law as barring all of the plaintiff’s claims.

The federal trial court disagreed with the defendant, noting that conditions constituting a nuisance can also constitute a trespass (and other causes of action). Thus, the plaintiff’s complaint was not restricted to allegations of a nuisance cause of action which the RTF law would bar. The court noted that the RTF law was different from other state RTF laws that covered non-nuisance tort claims related to farming operations along with nuisance claims. The RTF law only covered nuisance-related claims and had no application to non-nuisance claims. As to whether the plaintiff adequately alleged the non-nuisance claims, the court concluded that the plaintiff sufficiently alleged, at a minimum, a claim for unintentional trespass by not consenting to dust, urine and fecal matter from entering its property. On the plaintiff’s negligence claim, the court determined that it was reasonably foreseeable that if the defendant did not act reasonably in managing the facility that dust and animal waste would be present on the plaintiff’s property. As such, the defendant owed the plaintiff a duty and there was a causal link with any potential breach of that duty. Thus, the plaintiff properly stated a claim for negligence. The plaintiff also alleged that the defendant conspired with its corporate parent to mislead the public about the science of hog manure removal and various constitutional violations. The court rejected this claim because any conspiracy was between the defendant and its corporate parent and not with any independent party. The plaintiff also claimed that the defendant unjustly enriched itself by using the plaintiff’s property for a de facto easement without paying for it. The court rejected the claim because the plaintiff had conferred no benefit on the plaintiff which gave rise to any legal or equitable obligation on the defendant’s part to account for the benefit received. However, the court refused to strike the plaintiff’s allegations relating to the defendant’s Chinese ownership, influence and exploitation as well as the defendant’s financial resources. The court determined that such allegations had a bearing on the defendant’s motivation, extent of harm and ability to implement alternative technology. 

A second court opinion involving the North Carolina RTF law was issued in late 2021.  In Rural Empowerment Association for Community Help v. State, No. COA21-175, 2021 N.C. App. LEXIS 733 (N.C. Ct. App. Dec. 21, 2021), the plaintiffs filed suit in 2019 challenging the constitutionality of the RTF law. The plaintiffs sued in 2019 challenging the constitutionality of the RTF law on its face because they claimed the law exceeded the scope of the state’s police power. The defendants moved to dismiss the case and the trial court granted the defendant's motion to dismiss and denied the plaintiffs’ motion for summary judgment. On appeal, the appellate court affirmed. The state appellate court agreed with the trial court that limiting the potential nuisance liability from ag, forestry, and related operations furthered the state’s goal of protecting ag activities and encouraging the availability and continued production of agricultural products. The appellate court also determined that the RTF law amendments were a valid exercise of legislative and state police powers and did not violate the state Constitution’s Law of the Land Clause or the Due Process Clause. The appellate court also determined that the amendments were not a special or private law, and didn’t deprive any prospective plaintiff of the right to a jury trial. 

Note:   It is anticipated that the state appellate court opinion, if upheld on any appeal, will provide further guidance to other states and RTF laws. 

7.  Federal Court Determines Whether Withheld Taxes and Other Pre-Paid Taxes Can Be Deprioritized in Chapter 12 Bankruptcy. As originally enacted, Chapter 12 did not create a separate tax entity for Chapter 12 bankruptcy estates for purposes of federal income taxation.  That shortcoming precludes debtor avoidance of potential income tax liability on disposition of assets as may be possible for individuals who file Chapter 7 or 11 bankruptcy.  But, an amendment to Chapter 12 in 2005 made an important change.  As modified, tax debt associated with the sale of an asset used in farming can be treated as unsecured debt that is not entitled to priority and ultimately discharged.  Without this modification, a farmer faced with selling assets to satisfy creditors could trigger substantial tax liability that would impair the chance to reorganize the farming business under Chapter 12.  Such a farmer could be forced into liquidation.

A question that was addressed by a federal trial court in Indiana in 2021 was how taxes that the debtor had already paid are to be treated.  Can previously paid or withheld taxes be pulled back into the bankruptcy estate where they are “stripped” of their priority (i.e., deprioritized)?  That is a very significant question for a Chapter 12 farm debtor that also has off-farm income of a spouse that helps support the farming operation.

In United States v. Richards, No. 1:20-cv-02703-SEB-MG, 2021 U.S. Dist. LEXIS (S.D. Ind. Sept. 30, 2021), the debtors, a married farm couple, filed Chapter 12 bankruptcy in 2018 after suffering losses from negative weather events and commodity market price declines during 2013 through 2015. The primary lender refused to renew the loan which forced liquidation of the farm’s assets in the spring of 2016. During 2016, the debtors sold substantially all of the farm equipment, vehicles and other personal property assets as well as grain inventory. The proceeds were paid to the primary lender as well as other lenders with purchase money security interests in relevant assets. After filing Chapter 12, the debtors sold additional farmland. The asset sales triggered substantial income tax obligations for 2016, 2017 and 2018 tax years. The debtors Chapter 12 plan made no mention concerning whether off-farm earnings, tax withholdings or payments the debtors voluntarily made to the IRS, or a claim or refund would remain property of the bankruptcy estate after Plan confirmation. The plan did, however, divide the debtors federal tax obligations into 1) tax liabilities for income arising from the sale, transfer, exchange or other disposition of any property used in the debtors’ farming operation “Section 1232 Income”; and 2) tax liabilities arising from other income sources – “Traditional income.” Tax liabilities associated with Traditional Income would retain priority status, but taxes associated with Section 1232 Income would be de-prioritized (regardless of when the liability was incurred) and treated as general unsecured claims that would be discharged upon Plan completion if not paid in full. Under the reorganization Plan, the debtors would pay directly the tax liability associated with Traditional Income incurred after the Chapter 12 filing date. Under the Plan, unsecured claims would be paid on a “pro rata” basis using the “marginal method” along with other general unsecured claims. The Section 1232 taxes would be computed by excluding the taxable income from the disposition of assets used in farming from the tax return utilizing a pro forma tax return. The Plan was silent concerning how the Debtors’ withholding payments and credits for each tax year were to be applied or allocated between any particular tax year’s income tax return and the corresponding pro forma return.

The IRS filed a proof of claim for the 2016 and 2017 tax years in the amount of $288,675.43. The debtors objected to the IRS’s claim, but did seek to reclassify $5,681 of the IRS claim as general unsecured priority status. The IRS failed to respond, and the bankruptcy court granted the debtors approximately $280,000 in tax relief for 2016 and 2017. The debtors then submitted their 2018 federal and state returns showing a tax liability of $58,380 and their pro forma return for 2018 excluding the income from the sale of farm assets which showed a tax liability of $3,399. The debtors, due to withholding and estimated tax, inadvertently paid $9,813 to the IRS during 2018. They claimed $6,414 was an overpayment and listed that amount on the Pro Forma return as a refund. The IRS amended its proof of claim and asserted a general unsecured claim of $42,200 for the 2018 tax year (excluding penalties and interest). The IRS claimed that none of the debtors’ tax liability qualified for non-priority treatment under 11 U.S.C. §1232, and that it had a general unsecured claim for $42, 220 for the 2018 tax year. To reach that amount, the IRS allocated tax withholdings and credits of $9,813 to the assessed tax due on the debtors’ pro forma return which reduced that amount to zero, and then allocated the remaining $6,414 of withholdings, payments and credits to the outstanding tax liability of $48,634. IRS later added $6,347 of net investment income tax that the debtors had reported on their return but IRS had excluded due to a processing error. The debtors objected to the IRS’s claim and asserted it should not be increased by either the $6,414 overpayment or the $6,347 of net investment income tax. The debtors sought to adjust the IRS claim to $54,981 and have the court issue a refund to them of $6,414 or reduce distributions to the IRS until the refund obligation had been satisfied. The IRS objected on the basis that the court lacked jurisdiction to compel the issuance of a refund or credit of an overpayment, and that the debtors were not entitled to the refund or credit of the overpayment shown on the pro forma return as a matter of law.

The bankruptcy court sustained the debtors’ objection to the extent the 2018 refund was applied to the IRS’s claim in a manner other than provided for under the confirmed plan. Specifically, the bankruptcy court held that the IRS had exercised a setoff that was not permitted under 11 U.S.C. §553 which violated the plan’s bar against any creditor taking any action “to collect on any claim, whether by offset or otherwise, unless specifically authorized by this Plan.” But, the bankruptcy court held that it lacked jurisdiction to compel the issuance of a refund or credit of an overpayment and that the debtors were not entitled to the refund or credit of overpayment as a matter of law. This was because, the court determined, the refund was not “property of the estate” under 11 U.S.C. § §542 and 541(a). Later, the bankruptcy court held that the overpayment reflected on the pro forma return was “property of the estate” and withdrew its prior analysis of 11 U.S.C. §§542 and 505(a)(2)(B). Thus, the bankruptcy court allowed the IRS’s 2018 general unsecured tax claim in the amount of $54,981 and ordered the Trustee to pay distributions to the debtors until the overpayments had been paid to the debtors.

The IRS appealed, claiming that the bankruptcy court erred in allowing the IRS’s proof of claim in the amount of $54,981 rather than $48,567, and ordering the IRS to issue the debtors a refund or credit of any overpayment in the amount of $6,414. Specifically, the IRS asserted that 11 U.S.C. §1232 did not provide the debtors any right to an “overpayment” or “refund” because it only applies to “claims” - tax liability after crediting payments and withholdings. The IRS based its position on Iowa Department of Revenue v. DeVries, 621 B.R. 445 (8th Cir. B.A.P. 2020). However, the trial court noted distinctions with the facts of DeVries. Here, the sale of property at issue occurred post-petition and involved a claim objection after the Plan had already been confirmed. The appellate court noted that the IRS did not object to the terms of the Plan, and under 11. U.S.C. §1232 the debtors can deprioritize all post-petition Sec. 1232 liabilities, not just a portion. The application of the marginal method resulted in a tax liability of $54,981 to be paid in accordance with 11 U.S.C. §1232. The non-§1232 tax liability was $3,399. The debtors inadvertently paid $9,813 to the IRS and were entitled to a refund of $6,414, and the IRS could not apply that amount against the Sec. 1232 liabilities in calculating its proof of claim. The refund amount was “property of the estate” under 11 U.S.C. §1207(a)(2).

Note:   On November 30, 2021, an appeal was docketed with the U.S. Circuit Court of Appeals for the Seventh Circuit.

Devries and Richards are important cases for practitioners helping farmers in financial distress.  11 U.S.C. §1232 is a powerful tool that can assist making a farm reorganization more feasible.  The Indiana case is a bit strange.  In that case, the debtors were also due a refund for 2016.  A pro-forma return for that year showed a refund of $1,300.  Thus, the issue of a refund being due for pre-petition taxes could have been asserted just as it was in the Iowa case.  Another oddity about the Indiana case is that the 2018 pro-forma (and regular) return was submitted to the IRS in March of 2019.  Under 11 U.S.C. §1232, the “governmental body” has 180 days to file its proof of claim after the pro forma tax return was filed.  The IRS timely filed its proof of claim and later filed an amended proof of claim which was identical to the original proof of claim.  The IRS filed an untimely proof of claim in one of the other jointly administered cases.

Procedurally, in the Indiana case, a Notice regarding the use of 11 U.S.C. §1232 should have been filed with the court to clarify the dates of Notice to the IRS (and other governmental bodies) of the amount of the priority non-dischargeable taxes and 11 U.S.C. §1232 taxes to be discharged under the plan.  That is when the issue of the refund would have been raised with the IRS.  However, there was no Notice of the filing of the pro-forma return with the court.  It will be interesting to see how the U.S. Court of Appeals handles the Indiana case on appeal.

Note:   Going forward, Chapter 12 reorganization plans should provide that if a pro-forma return shows that the debtor is owed a refund the governmental bodies will pay it.  

Conclusion

The next article will detail the Sixth and Fifth most important ag law and tax developments of 2021.  Stay tuned.