Saturday, February 5, 2022
Purchase and Sale Allocations Involving CRP Contracts
It is not unusual for farmland enrolled in the Conservation Reserve Program (CRP) to be sold with several years remaining on the CRP contract. Also, economic conditions may exist which provide an incentive for a landowner to terminate the contract early and put the land back into production or lease it to another farmer for a higher rent amount. But, what are the economic and tax consequences when these situations occur?
The economic and tax consequences of selling land subject to a CRP contract and early contract termination – it’s the topic of today’s post.
Under the typical CRP contract, farmland is placed in the CRP for a ten-year period. Contract extensions are available. Crops cannot be grown on the enrolled land, and enrolled land cannot be grazed unless the USDA authorizes it in special situations (such as drought). The landowner is required to maintain a grass cover on the ground which may involve planting appropriate wild grasses and other vegetation and to perform mid-contract maintenance of the enrolled land in accordance with USDA/FSA specifications.
If the landowner terminates the contact early, an early termination “penalty” applies. In reality, however, the “penalty” really amounts to liquidated damages. The question, however, from a tax standpoint, is whether the amount the landowner must pay is a nondeductible as a fine or penalty imposed by a governmental entity for the violation of a law. See I.R.C. §162(f). Likewise, if land that is enrolled in the CRP is sold, the seller must pay back to the USDA all CRP rents that they have already received, plus interest, and liquidate damages (which might be waived) unless the buyer agrees to continue to have the land enrolled in the CRP. If the buyer does not agree to continue to keep the land in the CRP, what are the tax consequences to the seller?
Purchase Price Allocation to CRP Contract
The requirement that an owner of CRP land pay a penalty in the form of reimbursing the USDA all CRP rents received, plus interest and damages, is synonymous with a lessee’s termination of a lease when the obligations under the lease exceed the benefits. For a lessee that terminates a lease and pays a cancellation fee to do so, the lessee is generally allowed a deduction. The rationale for allowing a deduction is that the lessee does not receive a future benefit, as long as the lease cancellation payment is not integrated in some manner with the acquisition of another property right. If, on the other hand, the termination payment is part of a single overall plan involving the acquisition of an affirmative benefit, the payment must be capitalized. See Priv. Ltr. Rul. 9607016 (Nov. 20, 1995).
Note: While not involved in the CRP setting, when a lessee terminates an existing lease by purchasing the leased property, I.R.C. §167(c)(2) bars an allocation of a portion of the cost to the leasehold interest. The taxpayer must allocate the entire adjusted basis to the underlying capital asset.
Selling a CRP Contract - Price Allocation
The IRS has ruled that a taxpayer who sold the right to 90 percent of the revenue from three CRP contracts that had approximately 11 years remaining was required to report the lump sum payment as ordinary gross income in the year of receipt. In Priv. Ltr. Rul. 200519048 (Jan. 27, 2005), The taxpayer relinquished all rights to the CRP payments that were sold but agreed to comply will all of the provisions of the CRP contract, including the damage provisions that would apply if he breached the CRP contract terms. The taxpayer’s return for the year of sale reported the entire amount received for the sale on Form 4835. On the following year’s return, the taxpayer included the annual CRP payment from the remaining 10 percent on Form 4835 and claimed a deduction for the part which sold the prior year. On the next year’s return, the taxpayer included the total CRP payment and did not offset it with the amount he received from the buyer. The taxpayer later filed amended returns to remove the amount reported as income on Form 4835 in the year of sale, and to remove the expense deduction that was claimed on the following year’s return. The taxpayer claimed that the lump-sum was not income in the year of sale because he did not have the unrestricted right to the funds (due to the damage clause applying in the event of noncompliance), and only held them as a conduit. The IRS disagreed, noting that the taxpayer had received the proceeds from the sale of the CRP contracts, with the risk of nonpayment by the USDA shifted to the purchaser. The IRS also stated that amounts received under a claim of right are includable in income, even though the taxpayer may have to repay some portion at a later date. In addition, the IRS noted that a lump sum payment for the right to future ordinary income generally results in ordinary income in the year of receipt. On this point, the IRS cited Cotlow v. Comr., 22 T.C. 1019 (1954), aff’d., 228 F.2d 186 (2nd Cir. 1955). In Cotlow, a life insurance agent bought the rights to assigned commissions for renewals of life insurance from other insurance agents and had ordinary income in the year of receipt from those assigned renewal commissions.
Note: The purchasing party may pay the early termination costs. In such event, the payment should be considered part of the land, as an additional cost incurred to acquire full rights in the property (i.e., a payment made to eliminate an impediment to full use of the property).
Early Termination Payments
Generally. A landlord that makes a payment to the tenant to obtain early cancelation of a lease, where the payment is not considered an amount paid to renew or renegotiate a lease, is considered a capital expenditure that the landlord can amortize. Treas. Reg. §1.263(a)-4(d)(7). The amortization period depends on the intended use of the property subject to the canceled lease, but normally the amount paid is capitalized and amortized over the lease’s remaining term. Rev. Rul. 71-283, 1971-2 C.B. 168. That certainly is the case if the landlord is regaining possession of the land, but if the payment is to allow the sale of the farm, the cost should be added to the landlord’s basis in the farmland and deducted as part of the sale.
As applied to CRP contracts. A landlord paying early CRP termination costs to enter into a new lease of farmland with another farmer should capitalize and amortize the costs over the remaining term of the CRP contract that is being terminated. See, e.g., Miller v. Comr., 10 B.T.C. 383 (1928). That’s the case where a lease cancelation is not tied to substantial improvements that are to be made to the property. See, e.g., Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir.1981). However, the IRS might claim that such costs should be amortized over the term of the new lease if the new lease is for a longer period that the remaining term of the CRP contract. See Montgomery v. Comr., 54 T.C. 986 (1970). The U.S. Court of Appeals for the Ninth Circuit has questioned this position, noting that the Tax Court decision seeming to bolster the IRS position relied on court cases that seemed to alternate between using the unexpired lease term versus the new lease term. Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir. 1981). The Ninth Circuit established the Miller case as the general rule that lease cancelation costs should typically be written off over the unexpired term of the canceled lease.
Over 20 million acres are presently enrolled in the CRP. Sometimes a landowner enrolling land in the CRP wants to sell the land or simply terminate the contract early due to economic conditions. It’s important to know the tax consequences when engaging in those transactions.