Wednesday, November 6, 2019
Monday’s post discussed some basic estate and business planning considerations for farm and ranch operations. When an intergenerational transfer of the business is desired, often entity structuring is a part of the design. Should there be one entity or more than one? What types of leases should be involved? What type of entities should be utilized? What about an S corporation?
Considerations about the use of S corporations – it’s the topic of today’s post.
S Corporation Issues
Reasonable compensation. An S corporation shareholder-employee cannot avoid payroll taxes by not being paid a salary. This is a “hot button” audit issue with the IRS and, fortunately, recent caselaw does provide helpful guidance on how to structure salary arrangements for S corporation shareholder-employees and the methodology that the IRS (and the courts) uses in determining reasonable compensation. While the incentive in prior years has been to drive compensation low and remove corporate earnings in the form of distributions to avoid employment-related taxes, the advent of the qualified business income deduction may incentivize increasing wages in certain situations, the key is to determine an acceptable range for reasonable compensation and stay within it to avoid IRS scrutiny.
Sales of interests. Obamacare potentially impacts the sale of interests in entities, including S corporations. Gain on sale might be subject to an additional tax of 3.8 percent if the gain is deemed to be “passive” – not related to a trade or business. This means that the stockholder selling an interest in an S corporation must be engaged in the business of the S corporation. There is a somewhat complex procedure that is used to determine the portion of the gain on sale that is passive and the portion that is deemed to be attributable to a trade or business. In many small, family-run S corporations much of the gain may not be subject to the health care law’s “passive” tax. That will be the case if all of the assets of the entity are used in the entity’s business operations and the selling owner materially participates in the business. There are income thresholds that also apply, so if income is beneath that level, then the “passive” tax doesn’t apply in any event.
Redemptions. If interests are redeemed, the IRS issued a private letter ruling in 2014 that can be helpful in succession planning contexts. In Priv. Ltr. Rul. 201405005 (Oct. 22, 2013), The facts of the ruling involved a proposed transfer of ownership of an S corporation from two co-equal owners to key employees. The IRS determined that the profit on the redemption of the co-owners' shares in return for notes would be treated as capital gain in the co-owners' hands and would be spread-out over the term of the notes. The IRS also said that there would be no gain to the S corporation, and that the S corporation was entitled to a deduction for interest paid on the notes. Also, the IRS said that the notes did not constitute a disqualifying second class of S corporate stock. To get these results requires careful drafting.
S corporation stock held by trusts. Trusts may also be a useful planning tool along with an S corporation as part of an estate/succession plan. But, while a decedent’s estate can hold S corporate stock for the period of time that the estate needs for reasonable administration, grantor trusts and testamentary trusts can only hold S corporate stock after an S corporation shareholder dies for the two-year period immediately following death. I.R.C. §1361(c)(2)(A). If that two-year limitation is violated, the S election is terminated, and the corporation is no longer a “small business corporation.” Thus, grantor and testamentary trusts should not hold S corporate stock beyond the two-year period. Clearly, the issue is to make sure the passage of the stock to a trust doesn’t jeopardize the S corporation’s status. During the time that the decedent’s estate holds the stock, there should be no problem in maintaining S status unless the administration of the estate is unreasonably extended. Once a testamentary trust is funded, it must take steps to be able to hold the S corporation stock for no more than two years. After that, the trust must qualify as a trust that is eligible to hold S corporation stock. The types of trusts that might cause issues with holding S corporate stock include credit shelter trusts (a.k.a. “bypass trusts”), grantor retained annuity trusts (GRATS), dynasty trusts (often structured as grantor trusts), self-settled trusts (a.k.a. domestic asset protection trusts), intentionally defective trusts and insurance trusts. If the testamentary trust is an irrevocable trust, the trust language will be the key to determining whether the trust can be appropriately modified to hold S corporation stock.
However, certain types of trusts can own S corporation stock without jeopardizing the S status of the corporation. Thus, proper structuring of trusts in conjunction with S corporations is critical. The basic options are a qualified subchapter S trust (QSST) and an electing small business trust (ESBT). Each of these types of trusts require precise drafting and careful maintenance to ensure that it can hold S corporation stock without causing the S corporation to lose its S status.
Issues associated with the death of a shareholder. Upon an S corporation shareholder’s death, the S corporation’s income is typically prorated between the decedent and the successor shareholder. The proration occurs on a daily basis both before and after death. Income that is allocated to the pre-death period is reported on the decedent’s final income tax return, and income that is allocated to the post-death period is reported on the successor’s income tax return. But an S corporation can make an election to divide the S corporation’s tax year into two separate years. The first of those years would end at the close of the day of the shareholder’s death.
Drawbacks of S Corporations
While S corporations can be beneficial in the planning process, they do have their drawbacks. While the following is not intended to be a comprehensive list of the limitations of utilizing S corporations, each of these points needs to be carefully considered.
Limitations on stock ownership. As indicated above, only certain types of trusts can hold S corporation stock. Also, corporations (except for Qualified S Corporation Subsidiary Corporations (Q-Subs)), LLCs and partnerships cannot be S corporation shareholders. In addition, there is an overall limitation on the number of S corporation shareholders (but it’s high enough that it won’t hardly ever cause problems for family-operated S corporations). But, the limits on trust and entity ownership of S corporation stock could prove to be a limiting factor for estate, business and succession planning purposes.
Special allocations for tax purposes. An S corporation must allocate all tax items pro rata. Special allocations are not permitted. But special allocations are permitted in an LLC or any other entity that has partnership tax treatment. So, for example, an entity taxed as a partnership can allocate (with some limitations) capital gain or loss as well as ordinary income or loss to those members that can best utilize the particular tax items. The special allocation rule doesn’t just apply to income and loss, it applies to all tax items. That would include, for example, depreciation items. An S corporation can’t do special allocations. This often can be a distinct disadvantage.
Death-time basis planning. A partnership (or LLC taxed as a partnership) is allowed to make an I.R.C. §754 election to increase the basis of its assets when a partner’s interest is sold or when a partner dies. That means that the entity can increase its adjusted tax basis in the entity’s assets so that it matches the basis that a buyer or heir takes. That would normally be, for example, the step-up (date of death) basis for inherited property. An S corporation cannot make an I.R.C. §754 election. Consequently, this can be another tax disadvantage of an S corporation.
Business loans. Care must be taken here. A loan to an S corporation can jeopardize the S election. Also, state laws must be followed, and the IRS likes to characterize loan repayments as distributions that are taxable. Also, distributions must also generally be pro rata. There is more flexibility regarding loans to and from the entity for a partnership/LLC. A corresponding concern with S corporation loans involves accounting issues involving the matching of interest and other income. The bottom line is that, in general, it’s more cumbersome to make loans to and from an S corporation compared to an LLC/partnership.
Farm programs. Whenever there is a limitation of liability, the entity involved is limited to a single payment limit. That would be the case with a farming S corporation. So, generally, a general partnership is the entity that best maximizes farm program payment limits – there is a limit for each partner. Each member can hold their interest as an LLC to achieve the liability limitation that an S corporation would otherwise provide, but there wouldn’t be an entity-level limitation.
Asset distribution. An S corporation has the potential to recognize gain when corporate assets are distributed. Generally, LLCs don’t have that issue.
Formalities. The state law rules surrounding formation are more elaborate with respect to S corporations as compared to LLCs.
Dissolution. There generally is less tax cost associated with dissolving an LLC as compared to an S corporation.
S corporations can be a useful estate/succession planning tool. With the general plan now being one of inclusion of assets in the decedent’s estate, creating a separate entity for the successor generation can provide valuation benefits for the decedent. However, care must be taken in utilizing the S corporation. In addition, other entity types (particularly the LLC) can provide greater tax benefits on numerous issues. There are drawbacks to using an S corporation. Also, it’s important to remember that with any type of entity planning as part of an estate/succession plan, there is no such thing as “one size fits all.” As with any type of planning, consultation with experienced professionals is a must.
Monday, November 4, 2019
Estate, business and succession planning changed dramatically with the enactment of the American Taxpayer Relief Act (ATRA) enacted in early 2013. The federal estate tax exemption was indexed for inflation and stood at $5.25 million for deaths in 2013. It adjusted upward for the next few years until the Tax Cuts and Jobs Act (TCJA) was enacted in late 2017 and increased it to $11.18 million for deaths in 2018. With an adjustment for inflation it presently stands at $11.4 million for deaths (and taxable gifts made) in 2019. Consequently, very few estates have any concern about the federal estate tax. The TCJA also made significant changes to the federal income tax. One significant new provision is the 20 percent pass-through deduction for individuals and entities other than C corporations.
For those farming and ranching operations that plan to continue in the family from generation to generation, entity planning is often part of the overall business plan. What are the major points to consider? There are numerous tax and non-tax considerations.
Some thoughts on estate and business planning – it’s the topic of today’s post.
Basics. The goal of most individuals and families is to minimize the impact of the federal estate tax at death. But, as noted above, with the exemption at $11.4 million for 2019 and “portability” of the amount of any unused exclusion at the death of the first spouse for use by the surviving spouse, the estate tax is not an issue except for very few estates. That means that, for most families, it is an acceptable strategy to cause assets to be included in the decedent’s estate at death to get a basis “step-up.” Thus, succession plans that have been in existence for a while should be re-examined to ensure consistency with current law.
Buy-out agreement. For family businesses involving an S corporation, some sort of shareholder buy-out agreement is a practical necessity. Over time, however, if that agreement is not revisited and modified, the value stated may no longer reflect reality. In fact, it may have been established when the estate tax was projected to be more of a potential burden than it is now. The changes to the federal estate tax in recent years may be one reason, by themselves, to reexamine existing buy-sell agreements.
Consider Not Making Gifts of Business Interests. Historically, transition planning has, at least in part, involved the parents’ generation gifting business interests to the next generation of the family interested in operating the business. However, there might be a better option to consider. It may be a more beneficial strategy to have the next generation of operators start their own businesses and ultimately blend the parents’ business into that of the next generation. Not only does this approach eliminate potential legal liabilities that might be associated with the parents’ business, it also avoids gift tax complications.
A couple of recent cases provide guidance on this approach and illustrate how goodwill is treated when a business transitions from one generation to the next. Goodwill is the value of the business beyond the value of the identifiable business assets. It’s an intangible asset that is often tied to an individual. Goodwill can be an important aspect of farm and ranch businesses.
In Bross Trucking, Inc. v. Comr., T.C. Memo. 2014-107, a father owned and operated a trucking company as a C corporation. He was the sole shareholder. The company got embroiled in some safety issues and ceased operations. Consequently, the father’s three sons started their own trucking business. The sons used some of the equipment that had been leased to their father’s business. The sons had used the same business model and the business had the same suppliers and customers. Importantly, the father was not involved in the son’s business. However, the IRS claimed that the father’s corporation should be taxed on a distribution of intangible assets (i.e., goodwill) under I.R.C. §311. That goodwill, the IRS also maintained, had been gifted to the sons. The Tax Court disagreed, holding that the goodwill was personal to the father and did not belong to the corporation. Key to this holding was that the father did not have an employment agreement with the corporation and there was no non-compete agreement. Thus, there was nothing that tied the father’s conduct to the corporation. The lack of an employment contract or a non-compete agreement avoided the transfer of goodwill that might have been attributable to customer relationships or other corporate rights. That had the effect of reducing the corporate value, and also reduced its value on liquidation (an important point for C corporations).
In Estate of Adell v. Comr., T.C. Memo 2014-155, a similar strategy was involved with a favorable result. In this case, the Tax Court allowed a reduction in value for estate tax purposes by the amount of the executive’s personal goodwill. The point is that the value of a business is dependent on the contacts and reputation of a key executive. Thus, a business owner can sell their goodwill separate from the other business assets. In the case, the decedent owned all of the stock of a satellite uplink company at the time of his death. Its only customer was a non-profit company operated by the decedent’s son. The estate and the IRS battled over valuation with the primary contention being operating expenses that included a charge for the son’s personal goodwill – the success of the decedent’s business depended on his son’s personal relationships with the non-profit’s board and the son did not have a non-compete agreement with the father’s business. Thus, the argument was, that a potential buyer only if the son was retained. The Tax Court determined that the son’s goodwill was personally owned independent of the father’s company, and the father’s company’s success was tied to the relationship with the son’s business. In addition, the Tax Court found it important that the son’s goodwill had not been transferred to his father’s business either via a non-compete agreement or any other type of contract. The ultimate outcome was that the decedent’s estate was valued at about one-tenth of what the IRS initially argued for.
These cases indicate that customer (and vendor) relationships can be an asset that belongs to the persons that run the businesses rather than belonging to the businesses. Thus, those relationships (personal goodwill) can be sold (and valued) separately from corporate assets. That’s a key point in a present estate landscape. With the general plan to include assets in the estate to get a basis increase rather than gifting those assets away pre-death to the next generation, an entirely separate entity for the next generation of operators can also provide valuation benefits. Planning via wills and trusts at the death of the parent can then merge the parent’s business with the next generation’s business.
Another case on the issue, involving an S corporation, resulted in an IRS win. However, the case is instructive in showing the missteps to avoid. In Cavallaro v. Comr., T.C. Memo. 2014-189, involved the merger of two corporations, one owned by the parents and one owned by a son. The parents' S corporation developed and manufactured a machine that the son had invented. The son did not patent the invention, and the parents' corporation claimed the research and development credits associated with the machine. The sons' corporation sold the machine (liquid dispenser) to various users, but the intellectual property rights associated with the machine were never formally received. The two corporations were merged for estate planning purposes, with the parents' receiving less stock value than their asset ownership value. The lawyers involved in structuring the transaction "postulated" a technology transfer for significant value from the son to the parents that had occurred in 1987. The transfer was postulated because there were no documents concerning the alleged transaction executed in 1987. Instead, the lawyers executed the transfer documents in 1995. The IRS asserted that no technology transfer had occurred, and that the merger resulted in a gift from the parents to the son of $29.6 million for which no gift tax return had been filed and no taxes paid. The Tax Court agreed with the IRS and the resulting gift tax (at 1995 rates) was $14.8 million. On appeal, the appellate court held that the valuation methodology of the expert witness for the IRS contained an error and remanded the case to the Tax Court. Cavallaro v. Comr., 842 F.3d 16 (1st Cir. 2016). On remand, after correcting for the methodological flaw, the Tax Court decreased the gift value by $6.9 million. Cavallaro v. Comr., T.C. Memo. 2019-144.
The Cavallaro case represents a succession plan gone wrong. The taxpayers in the case were attempting to transfer the value in their company (which had been very successful) to their children via another family business in a way that minimized tax liability. As noted above, what was structured was a merger that was based on a fictitious earlier value transfer between the entities. The IRS claimed that the taxpayers had accepted an unduly low interest in the merged company and their sons had received an unduly high interest. The Tax Court agreed.
Estate and business planning is a complex process. There are many considerations that are part of a successful plan. Today’s post addressed only a few.
Tuesday, October 29, 2019
One of the new taxes created under Obamacare is a 3.8 percent tax on passive sources of income of certain individuals. It’s called the “net investment income tax” and it took effect in January of 2013. Its purpose was to raise about half of the revenue needed for Obamacare. It’s a complex tax that can surprise an unsuspecting taxpayer – particularly one that has a one-time increase in investment income (such as stock). But it can also apply to other sources of “passive” income, such as income that is triggered upon the sale of farmland.
But are farmland sales always subject to the additional 3.8 percent NIIT? Are there situations were the sale won’t be subject to the NIIT? These questions are the topic of today’s post.
The NIIT is 3.8% of the lesser of (1) net investment income (NII); or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). I.R.C. §1411. The threshold amount is not indexed for inflation. For this purpose, MAGI is defined in Treas. Reg. §1.1411-2(c)(2). For an estate or trust, the NIIT is 3.8% of the lesser of (1) undistributed NII; or (2) the excess of AGI (as defined in I.R.C. §67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins ($12,750 for 2019). I.R.C. §1411(a)(2).
What is NII? For purposes of the NIIT, net investment income (NII) is gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the NII tax doesn't apply. I.R.C. §1411(c)(1)(A)(i). If the taxpayer either owns or is engaged in a trade or business directly or indirectly through a disregarded entity, the determination of character of income for NIIT purposes is made at the individual level. Treas. Reg. §1.1411-4(b)(1). If the income, gain or loss traces to an investment of working capital, it is subject to the NIIT. I.R.C. §1411(c)(3). Also, the NIIT applies to business income if the trade or business at issue is a passive activity. I.R.C. §1411(c)(2)(A). But, if income is subject to self-employment tax, it’s not NII subject to the NIIT. I.R.C. §1411(c)(6).
Sale of Farmland and the NIIT
Capital gain income can trigger the application of the NIIT. However, if the capital gain is attributable to the sale of a capital asset that is used in a trade or business in which the taxpayer materially participates, the NIIT does not apply. For purposes of the NIIT, material participation is determined in accordance with the passive loss rules of I.R.C. §469.
If an active farmer sells a tract of land from their farming operation, the capital gain recognized on the sale is not subject to the NIIT. However, whether the NIIT applies to the sale of farmland by a retired farmer or a surviving spouse is not so easy to determine. There are two approaches to determining whether the NIIT applies to such sales – the I.R.C. §469(f)(3) approach and the I.R.C. §469 approach
I.R.C. §469(h)(3) approach. I.R.C. §469(h)(3) provides that “a taxpayer shall be treated as materially participating in any farming activity for a taxable year if paragraph (4) or (5) of I.R.C. §2032A(b) would cause the requirements of I.R.C. §2032A(b)(1)(C)(ii) to be met with respect to real property used in such activity if such taxpayer had died during the taxable year.” The requirements of I.R.C. §2032A(b)(1)(C)(ii) are met if the decedent or a member of the decedent’s family materially participated in the farming activity five or more years during the eight years preceding the decedent’s death. In applying the five-out-of-eight-year rule, the taxpayer may disregard periods in which the decedent was retired or disabled. I.R.C. §2032A(b)(4). If the five-out-of-eight year rule is met with regard to a deceased taxpayer, it is deemed to be met with regard to the taxpayer’s surviving spouse, provided that the surviving spouse actively manages the farming activity when the spouse is not retired or disabled. I.R.C. §2032A(b)(5).
To summarize, a retired farmer is considered to be materially participating in a farming activity if the retired farmer is continually receiving social security benefits or is disabled; and materially participated in the farming activity for at least five of the last eight years immediately preceding the earlier of death, disability, or retirement (defined as receipt of social security benefits).
The five-out-of-eight-year test, once satisfied by a farmer, is deemed to be satisfied by the farmer’s surviving spouse if the surviving spouse is receiving social security. Until the time at which the surviving spouse begins to receive social security benefits, the surviving spouse must only actively participate in the farming operation to meet the material participation test.
“Normal” I.R.C. §469 approach. A counter argument is that I.R.C. §469(h)(3) concerns the recharacterization of a “farming activity,” but not the recharacterization of a rental activity. Thus, if a retired farmer is no longer farming but is engaged in a rental activity, §469(h)(3) does not apply and the normal material participation tests under §469 apply.
What are the material participation tests of I.R.C. §469? As set forth in Treas. Reg. §1.469-5T, they are as follows:
(1) The individual participates in the activity for more than 500 hours during such year;
(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
The above tests don’t apply to a limited partner in a limited partnership, and only one of the tests is likely to have any potential application in the context of a retired farmer to determine whether the taxpayer materially participated in the farming activity – the test of material participation for any five years during the ten years preceding the sale of the farmland.
Clearly, the “normal” approach would cause more transactions to be subject to NIIT. It’s also the approach that the IRS uses, and it is likely the correct approach.
Sale of land held in trust. When farmland that has been held in trust is sold, the IRS position is that only the trustee of the trust can satisfy the material participation tests of §469. This is an important point because of the significant amount of farmland that is held in trust, particularly after the death of the first spouse, and for other estate and business planning reasons. However, the IRS position has been rejected by the one federal district court that has ruled on the issue. Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003). The IRS did not appeal the court’s opinion, but continued to assert in in litigation in other areas of the country. In a case from Michigan in 2014, the U.S. Tax Court in a full tax court opinion, rejected the IRS’s position. Frank Aragona Trust v. Comm’r, 142 T.C. 165 (2014). The Tax Court held that the conduct of the trustees acting in the capacity of trustees counts toward the material participation test as well as the conduct of the trustees as employees. The Tax Court also implied that the conduct of non-trustee employees would count toward the material participation test. The court’s opinion makes it less likely that the NIIT will apply upon trust sales of farmland where an actual farming business is being conducted.
Obamacare brought with it numerous additional taxes. One of those, the NIIT, applies to passive income of taxpayer’s with income above a certain threshold. The NIIT can easily be triggered upon sale of particular assets that have been held for investment or other purposes, including farmland. Some planning may be required to avoid its impact.
Friday, September 27, 2019
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.
- 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.
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.
Wednesday, September 25, 2019
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.
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.
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.
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.
Monday, September 23, 2019
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.
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.
Wednesday, September 11, 2019
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.
There’s never a dull moment in ag law and tax.
Tuesday, September 3, 2019
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.
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).
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—
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
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.
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.
Tuesday, August 20, 2019
Through 2016, the U.S. Treasury Department was pushing for the elimination of valuation discounts for federal estate and gift tax purposes. However, as part of the elimination of “non-essential” regulations under the Trump Administration, the Treasury announced in 2017 that it would no longer push for the removal of valuation discounts to value minority interests in entities or for interests that aren’t marketable. That means that the concept of valuation discounting is back in vogue – for those that need it. Of course, with the increase in the federal estate and gift tax applicable exclusion amount to $11.4 million (for deaths occurring and gifts made in 2019), the practice of valuation discounting is only used in select instances.
But, one area in which valuation discounting remains rather prominent is in the context of entity valuation when built-in gain (BIG) tax is involved. Can a discount be claimed for BIG tax? If so, what’s the extent of the discount? These are the topics of today’s post.
Illustration of the problem
Assume that Sam is interested in buying a tract of real estate. Sam finds two identical tracts – tract “A” and tract “B.” Sid owns tract A outright, and tract B is owned by a C corporation. Both tracts are worth $2 million and each have a cost basis of $200,000. If Sam buys tract A from Sid for $2 million and sells it five years later for $4 million, the capital gain triggered upon sale will be $2 million and the resulting tax (assuming a 20 percent effective capital gain tax rate) will be $400,000. So, the result is that Sam invested $2 million and five years later received $3.6 million when he “cashed-in” his investment.
However, if Sid owns tract B inside of a C corporation and Sam were to pay $2 million to buy 100 percent of the C corporate stock, he would receive the corporation’s stock with the land at the low $200,000 basis. Thus, upon sale of the land five years later for $4,000,000, the capital gain inside the corporation is $3.8 million). Based on a hypothetical capital gain tax rate of 20 percent, the capital gains tax liability inside the corporation is $760,000. This leaves $3,240,000 left to distribute from the corporation to Sam. Assuming Sam’s basis in the corporate stock is $2,000,000 (the amount he originally paid for the stock), Sam has additional capital gain at the shareholder level of $1,240,000. Assuming a capital gain tax rate of 20 percent, Sam must pay an additional $248,000 in capital gain tax at the shareholder level. So, the total tax bill to Sam is $1,008,000. The result is that Sam received $2,992,000 when he cashed his investment in five year later.
So, in theory, would Sam pay the same amount Sam for tract “A” as he would for tract “B”? The answer is “no.” Sam would pay an amount less than fair market value to reflect the BIG tax he would have to pay to own tract “B” outright and not in the C corporate structure. That’s the basis for the discount for the BIG tax – to reflect the fact that the taxpayer in Sam’s position would not pay full fair market value for the asset. Rather, a discount from fair market value would be required to reflect the BIG tax that would have to be paid to acquire the asset outright and not in the C corporate structure.
BIG Tax Discount - The IRS and the Courts
IRS position and early cases. The IRS maintained successfully (until 1998) that no discount for BIG tax should apply, but the courts have disagreed with that view. That all changed in 1998 when the Tax Court decided Estate of Davis v. Comr., 110 T.C. 530 (1998) and the U.S. Court of Appeals for the Second Circuit decided Eisenberg v. Comr., 155 F.3d 50 (1998). In those cases, the court held that, in determining the value of stock in a closely held corporation, the impact of the BIG tax could be considered. In Eisenberg, the appellate court directed the Tax Court (on remand) that some reduction in value to account for the BIG tax was appropriate. Ultimately, the Tax Court did not get to decide the amount of the discount, because the case settled. The IRS acquiesced in the Second Circuit’s opinion and treats the applicability of the discount for BIG tax as a factual matter to be determined by experts using generally applicable valuation principles. A.O.D. 1999-001 (Jan. 29, 1999).
The level of the discount. Initially, the courts focused on the level of the discount. But, in 2007, the United States Court of Appeals for the Eleventh Circuit in Estate of Jelke III v. Comr., 507 F.3d 1317(11th Cir. 2007), held that in determining the estate tax value of holding company stock, the company's value is to be reduced by the entire built-in capital gain as of the date of death. In 2009, the U.S. Tax Court followed suit and essentially allowed a full dollar-for-dollar discount in a case involving a C corporation with marketable securities. Estate of Litchfield v. Comr., T.C. Memo. 2009-21. In 2010, the Tax Court again allowed a full dollar-for-dollar discount for BIG tax in Estate of Jensen v. Comr., T.C. Memo. 2010-182.
The Tax Court, in 2014, held that a BIG tax discount was allowable. Estate of Richmond v. Comr., T.C. Memo. 2014-26. Ultimately, the Tax Court determined that the BIG tax discount was 43 percent of the tax liability (agreeing with the IRS) rather than a full dollar-for-dollar discount, but only because the potential buyer could defer the BIG tax by selling the securities at issue over time. That meant, therefore, that the BIG tax discount was to be calculated in accordance with the present value of paying the BIG tax over several years.
Implications for Divorce Cases
While the rulings in Jelke III, Litchfield and Jensen are important ones for estate tax valuation cases, they may not have a great amount of practical application given that very few estates are subject to federal estate tax, and of those that are taxable, only a few involve a determination of the impact of BIG tax on valuation. However, the impact of BIG tax in equitable distribution settings involving divorce may have much greater practical application. Many states utilize the principles of equitable distribution in divorce cases. Under such principles, the court may distribute any assets of either the husband or wife in a just and reasonable manner. Any factor necessary to do equity and justice between the parties is to be considered. Technically, the tax consequences to each spouse are to be considered. However, the amount (or even the allowance) of a discount for built-in capital gains tax is not well settled.
In divorce settings, courts tend to be reluctant to deduct potential tax liability from the distribution of the underlying assets. For example, a Pennsylvania court, in a 1995 opinion, refused to deduct the potential tax liability associated with the distribution of defined benefit pension plans. Smith v. Smith, 439 Pa. Super. 283, 653 A.2d 1259 (1995). The court held that potential tax liability could be considered in valuing marital assets only where a taxable event has occurred or is certain to occur within a time frame such that the tax liability can be reasonably predicted. The North Carolina Court of Appeals has ruled likewise in Weaver v. Weaver, 72 N.C. App. 409 (1985), as have courts in New Jersey (see, e.g., Stern v. Stern, 331 A.2d 257 (N.J. 1975); Orgler v. Orgler, 237 N.J. Super. 342, 568 A.2d 67 (1989); Goldman v. Goldman, 275 N.J. Super. 452, 646 A.2d 504 (1994), cert. den., 139 N.J. 185, 652 A.2d 173 (1994)), Delaware (Book v. Book, No. CK88-4647, 1990 Del. Fam Ct. LEXIS 96 (1990)), West Virginia Hudson v. Hudson, 399 S.E.2d 913 (W. Va. 1990); Bettinger v. Bettinger, 396 S.E.2d 709 (W. Va. 1990)) and South Dakota (See, e.g., Kelley v. Kirk, 391 N.W.2d 652 (1986)). But, the Oregon Court of Appeals, has indicated that a reduction for taxes should be allowed in divorce cases subject to equitable distribution rules. In re Marriage of Drews, 153 Ore. App. 126, 956 P.2d 246 (1998).
The courts have largely dismissed the IRS view that generally opposed a BIG tax discount. It’s simply not the way that buyers operate in actual transactions. In any event, when a discount for BIG tax is sought, hiring a tax expert and a valuation expert can go along way to establishing a full dollar-for-dollar discount for the BIG tax.
Tuesday, July 23, 2019
In last Friday’s post, I examined what an Employee Stock Ownership Plan (ESOP) is, the basic structure of an ESOP, and the benefits of using an ESOP. In Part Two today, I look at an ESOP’s potential pitfalls, how the U.S. Department of Labor might get involved (in not a good way), and the impact of the Tax Cuts and Jobs Act (TCJA) on ESOPs.
ESOPs and ag businesses – part two. It’s the topic of today’s post.
What the DOL Looks For
The U.S. Department of Labor (DOL) has a national enforcement project focused on ESOPS. The Employee Benefits Security Administration (EBSA) is an agency within the DOL that enforces the Employee Retirement Income Security Act of 1974 (ERISA) and is charged with protecting the interests of the plan participants. One of the primary concerns of the DOL is the belief that ESOPs suffer chronically from bad appraisals. As a result, the EBSA has increased its level of scrutiny of ESOP appraisals, and litigates cases it believes are egregious and could not be settled or otherwise resolved. In these situations, the basic allegation is that the fiduciaries of the ESOP didn’t exercise adequate diligence in obtaining and reviewing the appraisals as part of the transaction process.
Appraisals that are based on projections that are too optimistic can result in an overpayment by the ESOP in the transaction. This can be a particular problem when the appraisal is prepared by a party to the transaction – the same people that are selling the stock to the ESOP or who are subordinates of the sellers. I.R.C. §401(a)(28)(C) requires that all employer securities which are not readily tradeable on an established securities market must be valued by an “independent appraiser.” An “independent appraiser” is a “qualified appraiser” as defined by Treas. Reg. §1.170A-13(c)(5)(i). For example, in Churchill, LTD. Employee Stock Ownership Plan & Trust v. Comr., T.C. Memo. 2012-300, pet. for rev. den., No. 13-1295, 2013 U.S. App. LEXIS 11046 (8th Cir. May 29, 2013), the appraiser did not satisfy the requirements to be a qualified appraiser. The court also upheld the IRS determination to revoke the ESOP as a disqualified plan from 1995 forward (total of 15 years) for failure to meet certain statutory requirements (i.e., failure to timely amend plan documents necessitated by tax law changes and failure in addition to not having a qualified appraiser) to which ESOPs are subject.
If the ESOP fiduciaries simply accept the projections without determining whether the projections are realistic that will likely constitute a breach of their fiduciary duties. So, simply plugging management projections into the ESOP appraisal without a critical review by the fiduciaries is problematic. Clearly, an ESOP’s fiduciaries should be communicating with the appraisers about the projections and asking questions. Similarly, if the appraisal incorporates a control premium when the ESOP is not really buying control, that will bring scrutiny from the EBSA. The reason for the scrutiny is that the result will be an enhanced stock value over what it should be in reality. Relatedly, an issue can arise where the ESOP pays full value for the stock but does not get all of the upside potential because of dilution caused by warrants, options, or earn-outs that are not considered in determining adequate consideration. That results in overpayment for the stock. The EBSA is also concerned about the use of out-of-date financials on which the appraisals are based which don’t reflect current corporate reality.
Also, EBSA looks for situations where the plan effectively owns the company, but is not exercising any of its ownership rights in the company. In other words, in this situation the claim is that company management is effectively “looting” the company of its value and the ESOP fiduciaries are doing little or nothing to protect the value of the corporate stock.
The Cactus Feeders Case
Basic facts. The concerns of the DOL and the EBSA were illustrated recently in a matter involving Cactus Feeders, Inc. (CFI), a large cattle feeding business. In early March of 2016, the DOL filed a lawsuit in federal district court in Amarillo, TX, against CFI and various fiduciaries to the CFI ESOP for allegedly causing the ESOP to pay tens of millions of dollars more than the DOL claims it should have paid for company stock. The court filing points out ESOPs require care in their implementation and usage to avoid government scrutiny and the possible fines and penalties, and revocation that can accompany failing to meet all of the technical requirements.
The DOL alleged that Lubbock National Bank (the ESOP trustee) violated its fiduciary obligations under the (ERISA) when it caused the ESOP to overpay for company stock. The DOL also claimed that CFI, as the ESOP administrator and acting through its board of directors and designated ESOP committee members, knew of the trustee’s breaches of duty and didn’t stop them. The ESOP, which already owned 30 percent of corporate stock, bought the remaining 70 percent for $100 million which DOL claims was too high of a price to pay because it failed to account for warrants and stock options that would dilute the ESOP’s equity from 100 percent to 55 percent when exercised; a lack of marketability discount; and a price adjustment for an investors’ rights agreement that allowed the selling shareholders to retain control over CFI for a 15-year period.
Settlement. On May 4, 2018, the DOL and CFI settled. The settlement also involved CFI’s insurers, certain parties involved with the ESOP committee, and the ESOP trustee. The settlement involved the payment of an additional $5.4 million into the CFI ESOP. Acosta v. Cactus Feeders, Inc., et al., No. 2:16-cv-00049-J-BR (N.D. Tex. May 4, 2018). In addition, the settlement placed additional requirements on the ESOP trustee that are comparable to an agreement the DOL reached in 2014 with GreatBanc Trust Co. Basically, the agreement requires the CFI ESOP trustee to follow specified procedures when serving as a trustee or other fiduciary of an ESOP that is subject to ERISA when non-publicly traded employer securities are involved. But, it did not require the CFI ESOP trustee to do a number of things that the DOLwas seeking – such as reviewing financing options for ESOPs; obtaining “fairness” opinions; obtain sufficient insurance to provide liability coverage as a fiduciary; perform oversight of a valuation advisor; and maintain documentation of when control is given up via an ESOP transaction.
Impact of the TCJA
The TCJA retained the existing tax benefit when an ESOP owns an S corporation. In that situation, the portion of ESOP earnings that are attributable to the S corporation are exempt from federal (and most state) income tax. In other words, the flow-through tax status of the S corporation is recognized. However, when an ESOP owns a C corporation or less than 100 percent of an S corporation, the TCJA will have an impact. Under the TCJA, the C corporate tax rate was changed to a flat 21 percent, effective January 1, 2018. Depending on the prior applicable tax rate for the corporation, this could be a benefit. As for interest expense deductibility (which could be an issue for an ESOP where the company borrowed funds to finance the acquisition), the TCJA limits the deduction for business interest to the sum of business interest income; 30% of the taxpayer’s adjusted taxable income for the tax year; and the taxpayer’s floor plan financing interest for the tax year. Any disallowed business interest deduction can be carried forward indefinitely (with certain restrictions for partnerships). But, the limitation doesn’t apply to a taxpayer with gross receipts of $25 million or less. A “farming business” can elect out of the limitation (with some “pain” incurred on the depreciation side of things).
On the ESOP valuation issue, the reduction in the top C corporate tax rate (federal) from 35 percent to 21 percent may result in enhanced after-tax corporate earnings. If so, it will trigger higher valuations when the ESOP is valued using the discounted cash-flow method (which is a common ESOP valuation approach). This rate reduction could also result in higher ESOP repurchase obligations.
If an ESOP transaction is treated seriously, is minimally complex (e.g., the plan buys shares of common stock at fair market value), and the trustee considers how the structure of the transaction can either help or hurt plan participants, it is likely that the ESOP will avoid scrutiny. Clearly, the trustee should be communicating with the appraisers, analyzing company projections by comparing them with industry competitors and historical numbers, and determining whether the plan should be paying for control (it shouldn’t when the plan can’t control who manages the company or how it is managed). In addition, the use of an independent appraiser is required.
Certainly, ESOPS are useful primarily as a management succession vehicle for a closely held business. Also, they tend to work better for lower income, relatively younger employees compared to the typical company retirement plan. But, they are very complex and potentially dangerous. They do require meticulous compliance to avoid catastrophic results, and should never be used as a tax shelter for a closely-held business when the owner wants to maintain control. They require compliance with complex qualification rules on an annual basis, which requires significant legal and consulting bills. So, in the right situation, an ESOP can be useful and may even outperform a more traditional retirement plan. But, that’s to be expected given the greater inherent compliance costs and risks.
Is an ESOP a good tool for your farming or ranching operation? It depends.
Friday, July 19, 2019
What Is An ESOP?
In existence since the 1970s, an employee stock ownership plan (ESOP) is a type of qualified retirement plan that is designed to provide employees with ownership in the company by investing (primarily) in shares of stock of the employer-company. According to data from the National Center for Employee Ownership, there are about 7,000 ESOPs in the United States covering approximately 14 million employees.
Does an ESOP work for employees of a farming/ranching operation or an agribusiness? In part one of a two-part series, today’s post lays out the basics of an ESOP – how it’s established and the potential benefits. In part two next week I will examine potential problem areas as well as how the new tax law (as of the beginning of 2018) impacts the use of an ESOP.
ESOPs in agriculture – it’s the topic of today’s blog post.
An ESOP involves employee ownership of the business. There are several ways that an employee can obtain ownership in the business. One is to buy stock in the company. Other ways involve an employee being gifted stock, receiving stock as a bonus or obtaining it via a profit-sharing plan. But, the most common way for an employee to obtain ownership in the business is by use of an ESOP.
In the typical ESOP transaction, the company establishes the plan by means of a trust fund – an “employee benefit trust” (hopefully with competent tax and legal counsel) and appoints an ESOP trustee. The trustee then negotiates with a selling shareholder to establish the terms of the sale of the shareholder’s stock to the ESOP. The company borrows the necessary funds from a third-party lender on the ESOP’s behalf and loans the funds to the ESOP which uses the funds to buy the stock from the selling shareholder with the seller receiving cash and taking a note for the balance. The company will make annual (tax-deductible) contributions of cash to the ESOP which the ESOP uses to repay the inside loan. The company uses the payment received from the ESOP to make payments on the third-party loan.
An alternative approach is for the company to have the trust borrow money to buy stock with the company making contributions to the plan so that the loan can be paid back. Unlike other retirement plans, an ESOP can borrow money to buy stock. Consequently, an ESOP can buy large percentages of the company in a single transaction and repay the loan over time using company contributions. The trustee is appointed by the company’s board of directors to manage the trust and can be an officer or other corporate insider. Alternatively, the trustee can be an independent person that is not connected to the corporation as an officer or otherwise. It is advisable that an external trustee be used to negotiate the terms and execute the transaction involving the purchase of shares of stock from a selling shareholder. The trustee has the right to vote the shares acting in a fiduciary capacity. However, the ESOP may require that certain major corporate transactions (i.e., mergers, reorganizations, and significant asset sales) involve the participation of ESOP participants in terms of instructing the trustee with respect to voting the stock shares that are allocated to their accounts. I.R.C. §409(e)(3). ESOP participants do not actually own the shares, the trust does. Thus, an ESOP participant has only the right to see the share price and number of shares allocated to their account on an annual basis. They have no right to see any internal financial statements of the company.
The ESOP shares are part of the employees’ remuneration. The shares are held in the ESOP trust until an employee either retires or otherwise parts from the company. The trust is funded by employer contributions of cash (to buy company stock) or the contributions of company shares directly.
Retirement Plan Characteristics
An ESOP is a qualified retirement plan that is regulated by I.R.C. §4975(e)(7) as a defined contribution plan. As such, ESOPs are regulated by ERISA which sets minimum standards for investment plans in private industry. Only corporations can sponsor an ESOP, but it is possible to have non-corporate entities participate in an ESOP. An ESOP must include all full-time employees over age 21 in the plan and must base stock allocations on relative pay up to $265,000 (2016 level) or use some type of level formula. ESOPs are provided enhanced contribution limits, which may include the amount applied to the repayment of the principal of a loan incurred for the purposes of acquiring employer securities. Employers are allowed to deduct up to an additional 25 percent of the compensation paid or accrued during the year to the employees in the plan as long as the contributions are used to repay principal payments on an ESOP loan. I.R.C. §404(a)(9)(A).
In addition, an employer with an ESOP may deduct up to another 25 percent of compensation paid or accrued to another defined benefit contribution plan under the general rule of I.R.C. §404(a)(3).
In addition, contributions made to the ESOP applied to the repayment of interest on a loan incurred for the purpose of acquiring qualifying employer securities are also deductible, even though in excess of the 25 percent limit. I.R.C. §404(a)(9)(B). But, these two provisions, do not apply to an S corporation. I.R.C. §404(a)(9)(C). As a qualified retirement plan, an ESOP must satisfy I.R.C. §401(a) to maintain its tax-exempt status. While an ESOP is not subject to the normal ERISA rules on investment diversification, the fiduciary has a duty to ensure that the plan’s investments are prudent. In addition to basic fiduciary duties designed to address the concern of an ESOP concentrating retirement assets in company stock, it is not uncommon for a company with an ESOP to also have a secondary retirement plan for employees.
What Happens Upon Retirement or Cessation of Employment?
When one the employee retires or otherwise parts from the company, the company either buys the shares back and redistributes them or voids the shares. An ESOP participant is entitled to a distribution of their account upon retirement or other termination of employment, but there can be some contingencies that might apply to delay the distribution beyond the normal distribution time of no later than the end of the plan year. For plan participants that terminate employment before normal retirement age, distributions must start within six years after the plan year when employment ended, and the company can pay out the distributions in installments over five years, with interest. If employment ceased due to death, disability or retirement, the distribution must start during the plan year after the plan year in which the termination event occurred, unless elected otherwise. If the ESOP borrowed money to purchase employer securities, and is still repaying the loan, distributions to terminating employees are delayed until the plan year after the plan year in which the loan is repaid. In addition, no guarantee is made that the ESOP will contain funds at the time distributions are required to begin to make the expected distributions.
What Are The Benefits of an ESOP?
For C corporations with ESOPS, the selling shareholder avoids the “double tax” inherent in asset sales because the sale is a stock sale. As such, gain can be potentially deferred on the sale of the stock to the ESOP. To achieve successful deferral, the technical requirements of I.R.C. §1042 must be satisfied and the ESOP, after the sale, must own 30 percent or more of the outstanding stock of the company and the seller must reinvest the sale proceeds into qualified replacement property (essentially, other securities) during the period beginning three months before the sale and ending 12 months after the sale. If the replacement property is held until the shareholder’s death, the gain on the sale of the stock to the ESOP may permanently avoid tax.
Corporate contributions to the ESOP are deductible if the contributions are used to buy the shares of a selling shareholder. As a result, an ESOP can be a less costly means of acquiring a selling shareholder’s stock than would be a redemption of that stock. Also, the ESOP does not pay tax on its share of the corporate earnings if the corporation is an S corporation. Thus, an S corporation ESOP is not subject to federal income tax, but the S corporation employees will pay tax on any distributions they receive that carry out the resulting gains in their stock value.
From a business succession/transition standpoint, an ESOP does provide a market for closely-held corporate stock that would otherwise have to be sold at a discount to reflect lack-of marketability of the stock, although the lack of marketability must be considered in valuing the stock. Indeed, one of the requirements that an ESOP must satisfy is that it must allow the participants to buy back their shares when they leave the company (a “repurchase obligation”).
Compared to a traditional 401(k) retirement plan, ESOP company contribution rates tend to be higher, and ESOPS tend to be less volatile and have better rates of return.
In part two next week, I will look at the potential drawbacks of an ESOP and why the U.S. Department of Labor (DOL) gets concerned about them. That discussion will include a recent DOL ESOP investigation involving a major ag operation. It will also involve a look at how the Tax Cuts and Jobs Act impacts ESOPs.
Wednesday, July 3, 2019
On August 13-14 Washburn University School of Law along with co-sponsors Kansas State University Department of Agricultural Economics and WealthCounsel, LLC will be conducting the 2019 National Summer Farm Income Tax/Estate and Business Planning Conference in Steamboat Springs, CO. This is a great opportunity for practitioners with agricultural clients as well as agricultural producers to get two days of in-depth education/training on issues that impact the agricultural sector.
The Steamboat Springs seminar, it’s the topic of today’s post.
Speakers and Agenda
This is the 15th summer that I have been conducting a national event, with that first one held in beautiful Ely, Minnesota. Sometimes there is more than one during the summer, with the event usually held at a very nice location so that attendees can enjoy the area with their families if they choose to do so. This summer is no exception. Steamboat Springs is a lovely place on the western side of the Rocky Mountain National Park.
The speakers this year in addition to myself are Paul Neiffer, Stan Miller and Timothy O’Sullivan. Paul has taught with me for several years at this event (and others) and many of you are familiar with him. Stan is a partner in a law firm in Little Rock, Arkansas and the founder of WealthCounsel, LLC. Stan will be speaking on the second day and will be addressing the necessary planning steps to assist farm and ranch families keep the business going into the future. Also, on the Day 2, Tim O’Sullivan will provide the key details on long-term care planning, and dealing with family disharmony and its impact on the tax and estate planning/business succession planning process. Tim has an extensive estate planning practice with Foulston Siefkin, LLP in Wichita, Kansas. He is particularly focused and has expertise in the areas of Elder Law and Trusts and Estates.
On the first day, Paul and myself will go through the current, key farm income tax issues. Of course, the I.R.C. §199A deduction will be a big topic. Just a couple of weeks ago, the Treasury released the draft proposed regulations on how the deduction applies in the context of agricultural/horticultural cooperatives and patrons. We will take a deep dive into that topic, for sure. Many questions remain. We will also numerous other topics and provide insight into discussions in D.C. on specific issues and the legislative front. It will be a full day.
You can see the full agenda here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
The event will be held at the beautiful Steamboat Grand Hotel. A roomblock is established for the conference. Information on the hotel can be found here: https://steamboatgrand.com/ For those brining families, there are many sights to see and places to visit in the town and the surrounding area.
You can register for both days or just a single day. Also, the conference is live streamed in the event you are not able to attend in person. Just click on the conference link provided above to learn more. You can register here: http://washburnlaw.edu/employers/cle/farmandranchtaxregister.html
On Monday, August 12 I will be participating in another conference at the Steamboat Grand Hotel focusing on conservation easements. That event is sponsored by several land trusts. Contact me personally about that conference if you are interested in learning more.
I hope to see you in Steamboat Springs next month! If you can’t attend in person, we trust you will benefit from watching the live presentation online.
Tuesday, June 11, 2019
The organization of the farming business is important to those farm and ranch families that are wanting to transition the business to the next generation. Other families don’t have heirs that are interested in continuing the family business. For them organizational issues are important from a present tax and farm program payment limitation standpoint (perhaps), but not necessarily that critical for future business succession.
In today’ post, I take a look at some recent developments relevant to entity structuring. These developments point out just a couple of the various issues that can arise in different settings.
S Corporation Basis Required to Deduct Losses
An S corporation shareholder reports corporate income or loss on their personal income tax return for the year in which the corporate year ends. I.R.C. §1366(a). Losses or deductions passed through to the shareholder first reduce stock basis. After stock basis has been reduced to zero, remaining loss amounts are applied against debt basis. I.R.C. §1367(b)(2)(A). In a year where losses decrease stock and debt basis to zero, the losses can be deducted only if the shareholder increases basis before the end of the corporation’s tax year.
One way to increase basis is to lend money to the S corporation. But, the loan transaction must be structured properly for a basis increase to result. For example, in In Litwin v. United States, 983 F.2d 997 (10th Cir. 1993), the court allowed the principal shareholder and principal investor in a Kansas corporation involved in the provision and installation of certain fuel systems for motor vehicles a bad debt deduction for amounts loaned to the corporation. Why? Because the shareholder’s loan was tied to his desire to remain a shareholder/employee and he personally guaranteed the large loans that exceeded his investment. In other words, he was at-risk and his business motives outweighed his investment motives.
But, a couple of recent developments reveal the wrong way to structure loan transactions if a basis increase is desired. In Messina v. Comr., T.C. Memo. 2017-213, the petitioners, a married couple, formed an investment advisory firm. They also each owned 40 percent of the outstanding stock of an S corporation. The S corporation subsequently became the 100 percent owner of another business that elected to be a qualified subchapter S subsidiary (QSUB). The QSUB borrowed money from an unrelated third party to finance the acquisition of another business. The petitioners then formed another S corporation that they were the sole owners of. They then used that second S corporation to buy the debt of the QSUB. The petitioners claimed that they could use the QSUB debt that the second S corporation held to increase their tax basis in the first S corporation so that they could deduct losses that passed through to them from the first S corporation. The petitioners claimed that the second S corporation was to be ignored because it was merely acting as an agent or conduit of the petitioners (an incorporated pocketbook of the petitioners). Thus, the petitioners claimed that they had made an actual economic outlay with respect to the acquisition of the QSUB debt to their financial detriment. As such, the petitioners claimed that the second S corporation should be ignored, and its debt actually ran directly between the first S corporation and its shareholders, of which they owned (combined) 80 percent.
The IRS disallowed the loss deduction due to insufficient basis and the Tax Court agreed. The Tax Court determined that there was no evidence to support the claim that the second S corporation was operating as the petitioners’ incorporated pocketbook. The Tax Court noted that the second S corporation had no purpose other than to acquire the debt of the QSUB, and the petitioners did not use the second S corporation to pay their expenses of the expenses of the first S corporation. There also was no evidence that the second S corporation was the petitioners’ agent because the corporation operated in its own name and for its own account. The Tax Court also held that the petitioners had not made any economic outlay except to the second S corporation. As such, the second S corporation could not be ignored, and the petitioners could not use its debt to increase their tax basis. The Tax Court noted that 2014 IRS final regulations and I.R.C. §1366(d)(1)(B) require that shareholder loans must run directly between the S corporation and the shareholder.
More recently, another court determined that an S corporation shareholder failed to achieve a basis increase on loan transaction. In Meruelo v. Comr., No. 18-11909, 2019 U.S. App. LEXIS 13305 (11th Cir. May 6, 2019), 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 he 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 also 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.
The Peril of the Boilerplate
The use of standard, boilerplate, drafting language is common. However, there rarely are situations where “one-size-fits-all” language in documents such as wills, trusts, and formative documents for business entities will work in all situations. That point was clear in another recent development.
In a recent IRS Private Letter Ruling (directed to a specific taxpayer upon the taxpayer’s request), a multi-member LLC elected to be treated for tax purposes as an S corporation. Later, the shareholders entered into an operating agreement that governed the rights of shareholders. Section 10 of the agreement provided that, “Upon dissolution…the proceeds from the liquidation of the Company’s assets shall be distributed…to the Members in accordance with their respective positive Capital Account Balances; and, the balance, if any, to the Members in accordance with their respective Percentage interests.” The language is “boilerplate” and was intended to meet the substantial economic effect provisions of Treas. Reg. §1.704-1(b)(1) and protect special allocations of the partnership.
Unfortunately, the language did not require that the distributions be equal to a “per share” basis in all situations. Instead, they could be disproportionate upon liquidation to the extent of differences in their capital accounts at the time of liquidation. That proved to be a problem. The LLC engaged in a reorganization and sought a ruling on whether the language created a second class of stock that would terminate the S election. The IRS determined that the fact that the rights were not strictly proportionate created more than a single class of stock in violation of I.R.C. §1362(b)(1)(D) and terminated the S election as of the date of the adoption of the operating agreement. However, the IRS determined that the termination was inadvertent, and the S status of the LLC was restored retroactively. Priv. Ltr. Rul. 201918004 (Nov. 15, 2018).
Trusts – Is the End in Sight?
When does a trust end? Either by its terms or when there is no longer any purpose for it. Those are two common ways for a trust to end. This was an issue in a recent case from Wyoming. In re Redland Family Trust, 2019 WY 17 (2019), involved a family trust. The case had been before the Wyoming Supreme Court on multiple occasions. The trust was created in 1989 and amended in 1995. The amendment provided for the appointment of a successor trustee; always required the service of two trustees; created a marital trust for the survivor of the settlors; and revised the buyout provision. The grantors and their five children made contributions to the trust. Upon the death of one of the grantors in 2007 one of the children was appointed as co-trustee. Ligation arose when the surviving grantor’s property was not conveyed to the trust and then again involving removal of the trustees, and an appointed trustee moved to have the trust terminated due to the administrative difficulties to administer, family dysfunction, and because the trust no longer served its purpose. The defendants, (including the co-trustee that resigned) asserted that termination was moot and moved to have the new co-trustee removed. The trial court did not remove the co-trustee and found that the trust was still valid. The trial court found that the co-trustee did not violate any fiduciary duties and that the defendants failed to show gross and willful misconduct to justify her removal. Further the trial court found that the co-trustee’s claims that the trust was invalid should have been raised in the original trust challenge. The trial court determined that the primary reason for the trust (to keep the lands and leases together for the Redland family) had not been frustrated and that the trust remained administratively functional and was not "unlawful, contrary to public policy, or impossible.
On appeal, the Wyoming Supreme Court affirmed. The Court determined that the trust still had a purpose - to keep the ranch holdings together to conduct business. Even though the other purpose of minimizing tax consequences had failed, consolidation of ranch holdings remained a legitimate purpose. The Court also determined that the co-trustee did not violate her fiduciary duties, her duties of impartiality or loyalty, and that her actions did not amount to gross and willful misconduct. In addition, the Court found that the duty of impartiality did not require the trustee to treat all beneficiaries fairly, but simply to act in the best interest of the beneficiaries and equally defend the intentions of the settlors. While the Court could find no precedent with respect to the duty of loyalty the Court held that merely seeking termination of the trust was not a breach of loyalty. In addition, the Court determined that hostility between parties did not warrant removal.
There are various ways to structure business arrangements. Not every structure is right for each family situation, but there’s a unique business plan that will do well for you – once you figure out what your goals and objectives are and have a solid understanding of your factual setting. But, peril lurks. Today’s post examined just a couple of the issues that can arise. Make sure to have good planners assisting.
Friday, May 24, 2019
During life, many farmers and ranchers are focused on building their asset base, making sure that the business transitions successfully to the next generation, and preserving enough assets for the next generation’s success. Historically, farm and ranch families haven’t widely used life insurance, but it can play an important role in estate, business and succession planning. It can also help protect a spouse (and dependents, if any) against a substantial drop in income upon the death of the farm operator. It can also provide post-death liquidity and fund the buy-out of non-farm heirs.
Planning with life insurance for farmers and ranchers – that’s the topic of today’s post.
A primary purpose of life insurance during the life of the insured farm operator is to provide for the family in the event of death. In that sense, life insurance can provide the necessary capital to build an estate. But, it can also protect income and capital of the farming or ranching business which could be threatened by the operator’s death. Selling off farm assets, including land, to pay debts after the operator’s death will threaten continuity of the business. Life insurance is a means of providing the necessary liquidity to protect against the liquidation of operating assets.
Unfortunately, my experience has been that many legal and tax professionals often overlook the usefulness of insurance as part of the overall plan. This can leave a gaping hole in the estate and business plan that otherwise need not be there. The result is that many farm and ranch families may feel that “the land is my life insurance.” But, what if funds are needed to be unexpected expenses at death? What about debt levels that have increased in recent years? Is it really good to have to liquidate a tract or tracts of land to pay off expenses associated with death and retire burdensome debt?
So how can life insurance be utilized effectively during life? That depends on the economic position of the operator, the asset value of the operation and the legal and tax rules surrounding the ownership of life insurance. Of course, the cost of life insurance must be weighed against options for accumulating funds for use post-death. Also, consideration must be given to the amount of insurance needed, the type of life insurance that will fit the particular situation, and who the insured(s) will be.
From an economic standpoint, life insurance tends to provide a lower return on investment than other alternative capital investments for a farmer or rancher. It’s also susceptible to inflation (not much of an issue in recent years) because of the potentially long time before there is a payout under the policy. But, also from an economic standpoint, life insurance proceeds are generally not included in the beneficiary’s gross income. I.R.C. §101(a)(1).
For younger farmers and ranchers, premium payments can be reduced by putting a term policy in place to cover the beneficiary’s premature death. The term policy can later be converted to a permanent policy. That’s a key point. The use of and plan for life insurance is not static. Life insurance wanes in importance as a mechanism to help build wealth as the farm operation matures and becomes more financially successful and stable. The usage and type of life insurance will change over the life cycle of the farm or ranch business.
From a tax standpoint, life insurance proceeds are included in the insured’s gross estate if the proceeds are received by or for the benefit of the estate. As such, they are potentially subject to federal estate tax. However, the current $11.4 million exemption equivalent of the unified credit (per person) takes federal estate tax off the table for the vast majority of farming and ranching estates. In addition, if the proceeds are payable to the estate, they also become subject to creditors’ claims as well as probate and estate administration costs. If the beneficiary is legally obligated to use the proceeds for the benefit of the estate, the proceeds are included in the estate regardless of whether the estate is the named beneficiary. It makes no difference who took the policy out or who paid the premiums. But, the proceeds are included in the decedent’s gross estate only to the extent they are actually used to discharge claims. See, e.g., Hooper v. Comr., 41 B.T.A. 114 (1940); Estate of Rohnert v. Comr., 40 B.T.A. 1319 (1939); Prichard v. United States, 255 F. Supp. 552 (5th Cir. 1966).
But, there is a possible way to have the funds available to cover the obligations of the decedent’s estate without having the insurance proceeds being included in the estate. That can be accomplished by authorizing the beneficiary to pay charges against the estate or by authorizing the trustee of a life insurance trust to use the proceeds to pay the estate’s obligations, buy the assets of the estate at their fair market value, or make loans to the estate. Treas. Reg. §20.2042-1(b)(1). In that situation, the proceeds aren’t included in the decedent’s estate because there is no legal obligation (i.e., duty) of the beneficiary (or trustee if the policy is held in trust) to use the proceeds to pay the claims of the decedent’s estate. See, e.g., Estate of Wade v. Comr., 47 B.T.A. 21 (1942). However, achieving this result requires careful drafting of policy ownership language along with the description of how the policy proceeds can be used to avoid an IRS claim that the decedent retained “incidents of ownership” over the policy at the time of death. I.R.C. §2042. In addition, the policy holder’s death within three years of transferring the policy can cause inclusion of the policy proceeds in the decedent’s estate. I.R.C. §2035.
Other Uses of Life Insurance
Loan security. Life insurance can be pledged as security for a loan. This means that a farmer or rancher can use it as collateral for buying additional assets to be used in the business. In this event, the full amount of the policy proceeds will be included in the decedent’s gross estate, but the estate can deduct any outstanding amount that is owed to the creditor, including accrued interest. It makes no difference whether the creditor actually uses the insurance proceeds to pay the outstanding debt.
Funding a buy-sell agreement. For those farming and ranching operations where the desire is that the business continue into subsequent generations as a viable economic unit, ensuring that sufficient liquid funds are available to pay costs associated with death is vitally important to help ease the transition from one generation to the next. Having liquid funds can also be key to buying out non-farm heirs so that they do not acquire ownership interests in the daily operational aspects of the business. Few things can destroy a successful generational transition of a farming or ranching business more effectively than a sharing of managerial control of the business between the on-farm and off-farm heirs. Life insurance proceeds can be used fund a buy-out of the off-farm heirs. How is this accomplished? For example, an on-farm heir of the farm operator could buy a life insurance policy on the life of the operator. The policy could name the on-farm heir as the beneficiary such that when the operator dies the proceeds would be payable to the on-farm heir. The on-farm can then use the proceeds to buy-out the interests of the off-farm heirs. In addition, the policy proceeds would be excluded from the operator’s estate.
There are other approaches to the addressing the transition of the farming/ranching business. Of course, one way to approach the on-farm/off-farm heir situation is for the parents’ estate plans to favor the on-farm heirs as the successor-operators. But, this can lead to family conflict if the younger generation perceives the parents’ estate plans as unfair. Whether this point matters to the parents is up to them to decide. Another approach is to leave property equally to the on-farm and the off-farm heirs. But, this approach splits farm ownership between multiple children and their families and can result in none of the families being able to derive sufficient income from their particular ownership interest. This causes the ownership interest to be viewed as a “dead” asset. Remember, off-farm heirs often prefer cash as their inheritance. Sentimental ownership of part of the family farming or ranching operation may last for a while, but it tends to not to be a long-term feeling for various reasons. Sooner or later a sale of the interest will be desired, real estate will be partitioned and the future of the family farming operation will be destroyed. A life insurance funded buy-out can be a means to avoiding these problems.
Today’s post merely introduced the concept of integrating life insurance in the estate/business plan of a farmer or rancher. Other considerations involving life insurance include a determination of the appropriate type of life insurance to be purchased, the provisions to be included in a life insurance contract, and the estate tax treatment of life insurance. Ownership planning is also necessary. As you can see, it gets complex rather quickly. However, the use of life insurance as part of an estate plan can be quite beneficial.
Wednesday, May 22, 2019
The question often arises with farm and ranch clients that engage in estate, business or succession planning as to what the optimal entity structure is for the business? There’s no easy, one-size-fits-all answer to that question. It simply depends on numerous factors. In fact, the question is best answered by asking a question in return – what do you want the farming or ranching business to look like after you and your spouse are gone? What are your goals and objectives. If planning starts from that standpoint, then it is often much easier to get set on a path for creating an “optimal” entity structure.
Some thoughts on structuring the farming or ranching business – that’s the topic of today’s post
Food For Thought
In many planning scenarios it is useful to create a checklist of points to consider that are relevant in the entity selection decisionmaking process. The next step would then be to apply those points to the goals and objectives of the parties. For starters, consider the following:
C corporations. The following are relevant to C corporations:
- A C corporation can be formed tax free if property is exchanged for stock; the transferors (as a group) hold 80 percent or more of the stock immediately after the exchange of property for stock; and the formation is for a business purpose.
- C corporate income is subject to tax at a flat rate of 21 percent.
- A C corporation is not eligible for the 20 percent qualified business income deduction of I.R.C. §199A that is available to a sole proprietor or the member of a pass-through entity (such as a partnership or S corporation).
- While gain that is realized on the sale of stock of a farming corporation can’t be excluded under the special rules that apply to qualified small business stock (I.R.C. §1202), if the stock is that of a corporation engaged in processing activities, the gain can be excluded. There are other rules that can limit (or eliminate) this capital gain exclusion.
- When a C corporation converts to S corporation status, the built-in gains (BIG) tax applies to the built-in gains on income items. I.R.C. §1374(a). The Tax Cuts and Jobs Act (TCJA) didn’t eliminate the BIG tax, but it did lower it to 21 percent.
- A C corporation has good flexibility in establishing its capitalization structure as well as how it allocates income, losses, deductions and credits.
- A C corporation is potentially subject to additional penalty taxes if too much earnings are accumulated without legitimate, well documented business reasons, or If too much income is passive.
- The alternative minimum tax presently doesn’t apply to C corporate income.
- A corporation for the farming operating entity will limit farm program payment limitations to a single $125,000 limit at the entity level. That amount will then be divided by the number of shareholders. If a pass-through entity is the operating entity, the number of payment limits will be determined by the number of members of the entity.
- A C corporation can deduct state income tax. This should be contrasted with the TCJA limitation on the deduction of such taxes for individuals that is pegged at $10,000 (including real property taxes on property that is not used in the conduct of the taxpayer’s trade or business). I.R.C. §164(b)(6).
- A C corporation can provide employees with the tax-free fringe benefits of meals (limited to 50 percent by I.R.C. §274(n)) and lodging that are supported by legitimate business reasons (and satisfy other conditions). This benefit is not available to sole proprietors and partners in a partnership. See, e.g., Rev. Rul. 69-184, 1969-1 C.B. 256. That is also the result for S corporation employees who own, directly or indirectly, more than 2% of the outstanding stock of the S corporation may not receive certain otherwise tax-free fringe benefits (including meals and lodging). See I.R.C. §1372. Attribution rules apply for determining who is considered to be an S corporation shareholder. I.R.C. §318.
- A farming or ranching C corporation can generally use the cash method of accounting.
- In some states, a C corporation cannot own or operate agricultural land unless members of the same family own a majority of the corporate stock. State laws differ on the specific rules barring C corporations from being involved in agriculture, and some states don’t have such rules.
- A C corporation faces the potential of a double layer of tax upon liquidation.
- The C corporation generally does provide good estate planning opportunities. In other words, it tends to be a good organizational vehicle for transitioning ownership from one generation to the next.
What About Income Tax Basis?
Given the currently high level of the federal estate tax exemption equivalent of the unified credit (11.4 million per decedent for deaths in 2019), income tax basis planning is high on the priority list. Thus, when federal estate tax is not a potential concern, planning generally focuses on making sure that property is included in a decedent’s estate. This raises some basic planning rules that must be considered:
- For property that is included in a decedent’s estate for purposes of federal estate tax, the basis of that property in the hands of the person inherits the property is generally the fair market value (FMV) as of the date of the decedent’s death. I.R.C. §Sec. 1014(a)(1)).
- But, the “stepped-up” basis rule (to the date-of-death value) doesn’t apply to property that is income in respect of a decedent (IRD) under §691. R.C. §1014(c). An item is IRD something that decedent was entitled to as gross income but wasn’t’ included in income due to death in accordance with the decedent’s method of accounting. See Treas. Reg. §1.691(a)-1(b). Farmers and ranchers have some common occurrences of IRD such as…
- Deferred gain to be reported from installment sales and deferred sales of crops and livestock;
- The portion (on a pro rata) basis or crop-share rentals due at the time of death;
- Receivables for a cash basis farmer;
- Unpaid wages;
- The value of commodities stored at an elevator (cooperative). Reg. §1.691(a)-2(b), Example 5 (canning factory and processing cooperative).
- Accrued interest income on Series E/EE bonds;
- When a decedent’s estate makes an election under I.R.C. §2032A to value ag land in the estate at its value as ag property (known as the “special use” value) rather than at its fair market value, the basis of the land in the hands of the heir is the special use value. There is no basis “step-up” to fair market value at the time of death. Treas. Reg. §§1014(a)(3); 1.1014-3(a).
- While the income of a pass-through entity is taxed only at the owner level, and the pass-through income increases the owner’s tax basis in the owner’s interest in the pass-through entity, a C corporation pays tax at the corporate level and then tax is also paid at the shareholder level on dividends or proceeds of liquidation. In addition, C corporate income does not increase the shareholder’s stock basis.
Just Starting Out – Creating a New Entity
If an organizational structure is initially being put into place, again there are numerous factors to consider in determining whether the farming or ranching business should operate as a C corporation or a pass-through entity. In addition, to those factors pointed out above, the following factors should also be considered:
- Is it anticipated that the primary or sole shareholder will hold the corporate stock until death?
- Where will the business be incorporated and do business? If the business will be a C corporation, does the state of incorporation or other states in which the corporation will do business have a state income tax?
- What tax bracket(s) will apply to the shareholders?
- If the underlying business of the corporation would qualify for the 20 percent qualified business income deduction of I.R.C. §199A, what’s the differential between the corporate tax rate of 21 percent and the individual rate less the 20 percent deduction? Will that full 20 percent deduction be available if the entity weren’t a C corporation? This can involve a rather complex analysis.
- What type of assets are involved? Will they appreciate in value? If so, the corporate tax rate of 21 percent plus the second layer of tax on gain of the appreciated asset value at the shareholder level upon liquidation (or on a qualified dividend) will exceed the maximum 23.8 percent capital gain rate that applies to an individual (20 percent rate plus an additional 3.8 percent on passive gain under Obamacare. I.R.C. §1411.
- Is it anticipated that the business will retain earnings or pay it out in the form of compensation, rents or other expenses? Growing businesses tend to retain earnings. Paid-out earnings of a C corporation are taxed again at the shareholder level.
- Is income expected to fluctuate widely? If so, remember that the C corporate tax rate is a flat 21 percent.
- Will there be sufficient funds to pay consistent income to the owners of the business? If so, that can mean that (if a C corporation structure is utilized) shareholder-employees can receive tax benefits at the individual level. If a corporate-level loss is incurred in doing so, that loss can be used to offset future taxable income.
- Under the TCJA, losses can offset up to 80 percent of pre-NOL taxable income.
- The loss (for a farming corporation) can be carried back two years. I.R.C. §172(b)(1)(B).
- From an accounting and tax planning standpoint, is a fiscal year desired? A C corporation can have a fiscal year-end and the individual shareholders can have a calendar year-end.
So, what is the best entity structure for your farming or ranching operation? The discussion above merely scratches the surface of a very complex matter. However, if you clearly articulate your goals and objectives for the future of your business to your planners, and provide complete information on assets, liabilities, land ownership, current arrangements, family data and dynamics, cropping and livestock history and tax history, then a good plan can be put in place that can, at least in the short-term satisfy your objectives. Then, there must be a commitment to routinely review and update the plan as necessary. There is no “one-size-fits-all” business plan, and plans aren’t static. There is cost involved, of course, but the successful operations realize that the cost is a small compared to the benefits.
Tuesday, May 14, 2019
This summer Washburn Law School is sponsoring its summer national ag tax and estate and business planning conference in Steamboat Springs, Colorado on August 13-14. The event will be held at the beautiful Steamboat Grand Hotel, and is co-sponsored by the Department of Agricultural Economics at Kansas State University and WealthCounsel. Registration is now open for the two-day event, and onsite seating is limited to the first 100 registrants. However, the event will be live streamed over the web for those who can’t make it to Steamboat.
Key Ag Tax and Planning Topics
The QBID. As we historically have done at this summer event, we devote an entire day to ag income tax topics and an entire second day to planning concepts critical to farm and ranch families. Indeed, on Aug. 13, myself and Paul Neiffer will begin the day with a dive back into the qualified business income deduction (QBID) of I.R.C. §199A and take a look at the experience of the past filing season (that largely continues uninterrupted this year). For many clients, returns were put on extension in hopes that issues surrounding the QBID, or the DPAD/QBID for patrons of cooperatives would get resolved. Plus, software issues abounded, and the IRS issued conflicting (and some incorrect) information concerning the QBID. In addition, the season began with errors in Pub. 225, the Farmers’ Tax Guide. Some states even piggy-backed the IRS errors for state income tax purposes and coupling. That made matters very frustrating.
On the QBID discussion, we will take a close look at the rental issue. That seems to be a rather confusing matter for many practitioners. Is there an easy way to separate rental situations so that they can be easily analyzed? We will break it down as simply as possible and explain when to use the safe-harbor – it’s probably not nearly as often as you think. What is an I.R.C. §162 trade or business activity? How do the passive loss rules interact with the QBID?
For farmers that are patrons of ag cooperatives, how is the DPAD/QBID to be calculated? What information is needed to properly complete the return? Where does what get reported? My experience so far this tax season in seminars is that it is taking me about three hours just to recap and review the QBID and go through practitioner questions that came in during tax season and share how they were answered. The discussion has been great, and at the end of the discussion, you will have a better handle on how the QBID works for your clients. Is it really as complicated as it seems?
Selected ag topics. After a brief break following the QBID discussion, we will get into various ag-related tax topics and how the changes brought about by the TCJA impact ag returns. What were the problem areas of applying the new rules during the filing season? What are the key tax issues that farm and ranch clients are presently facing. Currently, disaster issues loom large in parts of the Midwest and Plains. Also, Farm Bill-related issues associated with CCC loans and the impact on the PLC/ARC decision are important. What about how losses are to be treated and reported? Those rules have changed. Depreciation rules have also been modified. But, is it always in a client’s best interests to maximize the depreciation deduction? What about trades? The reporting of personal property trades has changed dramatically. How do those get reported now? What are the implications for clients?
Cases and Rulings
Of course, the day wouldn’t be complete without going through the key rulings and cases from the prior year. There are always many important developments in the courts and with the IRS. Some are even amusing! It’s always insightful to learn from the mistakes of others, and from others that are blazing the trail for others to follow. We will work through all of the key ag-related cases and rulings from the past 12-18 months.
We will have specific session focusing on depreciation, the passive loss rules (and how to report on the return); ag disasters; and the 2018 Farm Bill. Day 1 will be a full day.
Ag Estate and Business Planning
On August 14, we turn our attention to planning concepts for the farm and ranch family. Joining me on Day 2 will be Stan Miller, the founder of WealthCounsel, LLC. In addition to providing estate and business planning education, WealthCounsel, LLC also provides drafting software. In addition, Timothy O’Sullivan joins the Day 2 teaching team. Tim has a longstanding practice in Wichita, Kansas, where he focuses on estate planning and the administration of trusts and estates.
Recent developments. Day 2 begins with a rapid summary of the development that impact estate and business planning. For most clients, the issue is not tax avoidance given the presently high levels of the applicable exclusion. Rather, the issue is including property in the estate to achieve a stepped-up basis. I will go through recent developments impacting the basis planning issue and other developments impacting charitable giving as well as retirement planning.
Other issues. Tim O’Sullivan will devote a session to dealing with family disharmony and how to keep it from cratering a good estate plan. Tim will also have a separate session on incorporating good long-term care planning into the overall family estate and business plan. This is a very important topic for many farm and ranch families – particularly those that want to keep the family business in tact for future generations. I will have separate sessions on charitable giving; planning for second (and subsequent) marriages; and common estate planning mistakes. To round out Day 2, Stan Miller will devote a session to techniques that can professionals can implement to preserve family held farms and ranches for future generations. This will be a timely topic given the many variables that farmers and ranchers must handle to help their operations continue to be successful.
For more information about the event and to register, click here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
A room block for the conference is available at the Steamboat Grand Hotel and is accessible from the page at the link provide above or here: https://group.steamboatgrand.com/v2/lodging-offers/promo-code?package=49164&code=WASH19_BLK
If you can’t attend, the conference is live streamed. Information about signing up for the live streaming is also available on the first link provided above.
Conservation Easement Seminar
I will also be presenting at another CLE/CPE event in Steamboat on Monday, August 12 immediately preceding our two-day conference. That event is sponsored by the Colorado Cattlemen’s Agricultural Land Trust, the Eagle Valley Land Trust, and the Yampa Valley Land Trust, and focuses on the legal, real estate and tax issues associated with conservation easement donations. I will provide more information about that event as it becomes available.
This two-day seminar is a high-quality event this summer in a beautiful location. If you are in need of training on ag tax and planning related issues, this is the event for you. In addition, the full day on conservation easements preceding the two-day conference is an excellent opportunity to dig into a topic that IRS is looking at closely. It’s important to complete these transactions properly and this conference will lay out the details as to how to do it properly.
I hope to see you either in-person in Steamboat Springs later this summer or via the web. It will be a great event for your practice!
Friday, April 26, 2019
This summer, Washburn University School of Law will be sponsoring a two-day Farm and Ranch Tax and Estate/Business Planning Seminar in Steamboat Springs, CO. The event will be on August 13-14 at the Steamboat Grand Hotel. This seminar presents an extensive, in-depth coverage and analysis of tax and estate/business problems and issues involving farm and ranch clients over two-days. Attendance can either be in-person or via online over the web.
In today’s post, I outline the coverage of the topics at the seminar and the presenters as well as related information about registering. Steamboat Springs – Summer of 2019!
Topics and Speakers
On Day 1 (August 13), Paul Neiffer (CPA with CliftonLarsonAllen and author of the FarmCPA blog) will be presenting with me. We will start the day with a discussion of the I.R.C. §199A (QBI) deduction. Many issues surfaced during the 2018 tax filing season concerning the QBI deduction. The IRS produced contradictory statements concerning the deduction and the tax software companies also struggled to keep the software up with the developments. During this opening session, Paul and I will walk through QBI deduction issues as applied to farm and ranch clients and address many questions with detailed answers – a very real “hands-on” approach that is practitioner-friendly.
During the next session on Day 1, I Paul and I will take two hours to cover a potpourri of selected farm income tax topics. Those issues that are the present “biggies” will be addressed as well as current issues that practitioners are having with the IRS involving ag clients.
After lunch on Day 1, I will highlight some of the most important recent cases and rulings for farm and ranch taxpayers, and what those developments mean as applied on the farm and in the farm economy. Any new legislation will also be addressed, whether it’s income tax or other areas of the law (such as bankruptcy) that impact ag clients.
We will then devote an hour to common depreciation issues and how the rules have changed and are to be applied post-TCJA. What are the best depreciation planning techniques? We will work through the answers.
Following the afternoon break, I will dive into the passive loss rules. What do they mean? How do they apply to a farm client? How do they interact with the QBI deduction? What is a real estate professional? How to the grouping rules work? These questions (and more) will be answered and numerous examples will show how the rules work in various contexts.
Day 1 finishes out with Paul covering tax and planning issues associated with the 2018 Farm Bill and the choices farm clients have and how the new rules work. I will then cover the tax rules associated with ag disasters and casualties. There are many of those issues for clients that will show up during the 2019 tax filing season, especially for farm/ranch clients in the Midwest and Plains states.
On Day 2, our focus turns to farm and ranch estate and business planning. I will begin the day with an update of the key recent developments that impact the estate and succession planning process. What were the key cases of the past year? What about IRS rulings and pronouncements? I will cover those and show you how they apply to your clients.
Day 2 then continues with a key session on how to use estate planning concepts to minimize family disharmony. This session is presented by Tim O’Sullivan with Foulston Siefken LLP in Wichita, KS. Tim has a broad level of experience in estate planning and the handling of decedent’s estates. This is a “must attend” session for estate planners and deals with a topic that is often overlooked as an element in putting together a successful estate and business transition plan.
After the morning break on Day 2, I will cover the tax and legal issues associated with the use of trusts. Trusts are an often-used tool for farm and ranch clients, but what is the correct type for your client? The answer to that question is tied to the facts. Also, can a state tax a trust beneficiary or the trust itself if there isn’t any physical connection with the state? It’s an issue presently before the U.S. Supreme Court. By the time of the seminar, we will likely have an answer to that question.
How does the TCJA impact charitable giving? What are the new charitable planning techniques? What factors are important? I will address these questions and more in the session leading up to lunch.
After the lunch break on Day 2, I will deal with an unfortunate, but important topic- what is appropriate estate and business planning in second marriage situations? If the plan doesn’t account for this issue, significant disruptions can occur, and expectations may not be met. This is an important session dealing with a topic that tends to be overlooked.
I will then provide a breather from some heavy topics with a lighter (and fun) one – what are common estate and business planning mistakes? What classic situations have you dealt with in your practice over the years? Mistakes are frequent, but some seem to occur over and over. Can they be identified and prevented? That’s the goal of this session.
Tim O’Sullivan then returns for another session. This time, Tim does a deep dig into long-term health care planning. How can farm and ranch assets and resources be preserved? What are the applicable rules? What if only one spouse needs long-term care? Should assets be transferred? If so, to whom? This is a very important session designed to give you the tools you need for your long-term care planning toolbox.
Day 2 finishes with a key session by Stan Miller on how estate and business planning concepts can be used to help make sure the family farm survives for families that want it to survive as a viable economic unit. Stan is a founder of WealthCounsel, LLC and a principal in the company. Stan has a long background in estate and business planning. He is also a partner with ILP + McChain Miller Nissman in Little Rock, Arkansas. This session is a great capstone session for the day that will bring the day’s discussion together and get down to how the concepts discuss throughout the day can be used to help the farming and ranching business of a client survive the ups and downs of the economy, as well as family situations.
The seminar will be held on Tuesday and Wednesday, August 13-14 at the Steamboat Grand Hotel, in Steamboat, Colorado. It is co-sponsored by the Kansas State University Department of Agricultural Economics and WealthCounsel, LLC. You can find more registration information here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
On another note, on Monday, August 12, also in Steamboat, I will be participating in another seminar (also in Steamboat Springs) sponsored by the Colorado Cattlemen’s Agricultural Land Trust, the Eagle Valley Land Trust, and the Yampa Valley Land Trust. Half of the day will concern legal issues associated with conservation land trusts. The other half of the day will address real estate issues associated with conservation land trusts. These issues are very important in many parts of the country in addition to Colorado. As further details are provided, I will pass those along. This all means that there will be three full days of tax and legal information available this coming August in Steamboat Springs.
As I noted above, the seminar can be attended either in-person on online via the web. Registration will open up soon, so get your seat reserved. Steamboat Springs, CO is a beautiful area on the western slope of the Colorado Rockies.
Hope to see you there!!
Thursday, April 18, 2019
In recent weeks, I have written a couple of posts on various aspects of the passive loss rules contained in I.R.C. §469. Indeed, over the past two years, I have written six posts on the various aspects of the passive loss rules and their application to farm and ranch taxpayers. With today’s post, I add to those numbers by examining another aspect of the passive loss rules and how it applies to a common tax and business planning technique of farmers and ranchers – renting the farm/ranch land to the farm/ranch operating entity.
The “self-rental” limitation of the passive loss rules – it’s the topic of today’s post.
Passive Loss Rules - Basics
As noted in prior posts, to deduct passive losses (the amount by which the taxpayer’s aggregate losses from all passive activities for the tax year exceed aggregate income from those activities), an investor must have passive income. Stated another way, a passive activity loss can only offset passive income (with a few exceptions). The rule makes it quite difficult for a taxpayer to deduct passive losses unless they have another activity that is generating passive income.
Avoiding Passive Losses
Materially participate. There are two ways to approach the limitation of passive loss rules. One is to not be engaged in passive activities. A passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not materially participate. I.R.C. §469(c). Under the general rule, rental activities are passive. I.R.C. §469(c)(2). But, as noted in prior posts, there are exceptions. In addition, the activity is not a passive activity if the taxpayer is involved in it on a basis that is regular continuous and substantial. Basically, the taxpayer has to be involved in the daily management of the activity for a sufficient amount of time. The regulations provide seven tests for material participation. Treas. Reg. §1.469-5T(a)(1)-(7).
Create passive income and the risk of recharacterization. The other approach is be involved in activity that generates passive income that could then be offset by passive losses from another activity. Indeed, when the passive loss rules became law, there was immediate interest in creating what came to be known as passive income generators (PIGs). These are investment activities that throw off passive income, allowing the investor to match the passive income from the activity against passive losses. The IRS anticipated this and published regulations in the mid-1980's that recharacterized, or gave the IRS the power to recharacterize, passive income as non-passive income which was ineligible to offset passive losses. This became known as the “slaughter of pigs.” There are ten categories of recharacterization.
Bare land leases. One recharacterization rule applies to bare land leases. Treas. Reg. §1.469-2T(f)(3). Under this recharacterization rule, net income from a rental activity is considered not from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Id. The rule converts both net rental income and any gain on disposition from passive income to portfolio income (i.e., income from investments, dividends, interest, capital gains). But, the recharacterization rule only applies if there is net income from the rental activity. If there is a loss, the loss remains passive.
Example: Dr. Sawbones owns interests in multiple limited partnerships that have suspended losses. In an attempt to use those losses, Sawbones bought farmland for $400,000. $100,000 of the purchase price was allocated to fences, tile lines, grain bins and other depreciable property. Sawbones cash leased the land to his cousin via a cash rent lease in an attempt to generate passive income that he could offset with the suspended passive losses. However, because only 25 percent of the unadjusted basis is attributable to depreciable property, the cash rent income is recharacterized (for passive loss rule purposes) as portfolio income and will not offset the suspended passive losses from the limited partnerships. However, if the cash rent produces a net loss after taxes, interest and depreciation, the loss is a passive loss. This is not the result that Sawbones was hoping to achieve. The regulation has been upheld as valid. See, e.g., Wiseman v. Comr., T.C. Memo. 1995-303.
Self-rentals. Farmers and ranchers sometimes structure their businesses in multiple entities for estate and business planning (and tax) purposes. Such a structure may involve the individual ownership of the land that is then rented to the operating entity that the landlord also has an ownership interest in. Alternatively, the land may be held in some type of non-C corporation entity and rented to the operating entity. If the land lease does not involve the landlord’s material participation and the rental amount is set at fair market value (or slightly less), self-employment tax is avoided on the rental income even though the landlord materially participates in the operating entity as an owner. See Martin v. Comr., 149 T.C. 293 (2017). However, it’s also a classic self-rental situation that trips another recharacterization rule for passive loss purposes. Under this rule, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates. Treas. Reg. §1.469-2(f)(6). But, just like the recharacterization rule mentioned above for bare land leases, recharacterization only applies if there is net income from the self-rental activity. If a loss occurs, the loss remains passive. While an exception exists for rentals in accordance with a written binding contract entered into before February 19, 1988, that lease must have been a rather long-term lease at the time it was entered into for the grandfathering provision to still apply. Treas. Reg. §1.469-11(c)(1)(ii). It’s not possible to renew or draft an addendum to the original lease and come within the exception. See, e.g., Krukowski v. Comr., 114 T.C. 366 (2000), aff’d., 239 F.3d 547 (7th Cir. 2002). It also applies to S corporations. Williams v. Comr., No. 15-60341, 2016 U.S. App. LEXIS 1756 (5th Cir. Feb. 5, 2016), aff’g., T.C. Memo. 2015-76.
Example: For estate and business planning purposes, Mary put most of her farmland in an entity that she is the sole owner and employee of. Mary continued to own her livestock buildings, a machine shed and additional farmland, and rented them to the entity under a cash lease. Mary reported the rental income on Schedule E (Form 1040). However, because the rental income is derived from a business in which Mary materially participates, she cannot carry the rental income to Form 8582 (the passive activity loss Schedule) within her Form 1040. Instead, the net rental income is treated as coming from a non-passive activity. Mary will have to carry the net rental income from Schedule E directly to page one of her Form 1040. If Mary has passive losses from other sources, she will not be able to use those losses to offset the rental income.
It’s not possible to make a grouping election to overcome the self-rental regulation. See, e.g., Carlos v. Comr., 123 T.C. 275 (2000). As I noted in a prior post on the passive loss rules, a taxpayer can make an election to group multiple rentals as a single activity for passive loss rule purposes if the rental activities represent an appropriate economic unit. Treas. Reg. §1.469-4(c). But, even with such a grouping election the self-rental rule will still apply.
Example: Bill and Belinda are married and file a joint return. They own two tracts of farmland and cash lease each tract to the farming entity (an S corporation) that they own and operate. One of the tracts generates cash rental income of $200,000. The other tract produces an $80,000 loss. On their Schedule E for the tax year, they group the two tracts together as a single activity with the result that the net rental income reported is $120,000. Under the self-rental regulation, the IRS could separate the two rental tracts with the result that the $200,000 of income from one tract is recharacterized as non-passive and the $80,000 loss remains passive and cannot offset the $200,000 income. The $80,000 loss will be a suspended passive activity loss on Form 1040.
One option might be for Bill and Belinda to group the land rental activity that produces a loss with their operating entity. They can do that if the rental activity is “insubstantial” in relation to the business activity. Treas. Reg. §1.469-4(d)(1). In addition, they could group the rental activity that produced a loss with the operating entity (business activity) if they each have the same percentage ownership in the operating entity that they do in the rental activity. Such a grouping will result in the rental activity loss not being passive if they materially participate in the operating entity.
One more point on grouping – can a self-rental be grouped (“aggregated”) with the farming entity to maximize an I.R.C. §199A deduction? I.R.C. §199A is the new 20 percent deduction available for sole-proprietors and pass-through businesses on qualified business income. The answer is that as long as the farming entity and the land rental are part of a common group and have the same tax year, the rent will be aggregated with the farm income. That can optimize the use of the 20 percent deduction.
The passive loss rules are tricky. The cases are legion. Rentals are tricky, and the IRS can recharacterize rental activities to eliminate hoped-for passive income generators. Make sure you understand how the rules apply.
Friday, March 29, 2019
The developments in agricultural law and taxation keep rolling in. Many of you have requested more frequent posts on recent developments, so today’s post is devoted to just a handful that are important to farmers, ranchers and the professionals that represent them. In today’s post I take a look at a couple of recent farm bankruptcy cases, the use of a trust to hold farm and ranch property, and the rights of grazing permit holders on federal land.
Selected recent developments in agricultural law and tax – it’s the topic of today’s post.
Times continue to be difficult in agriculture with bankruptcy matters unfortunately taking on increased significance. In one recent case, In re Wulff, No. 17-31982-bhl, 2019 Bankr. LEXIS 388 (Bankr. E.D. Wis. Feb. 11, 2019), the debtor filed Chapter 12 bankruptcy and submitted a complete list of creditors. One of the creditors did not receive notice of the bankruptcy because of a bad address but became aware of the debtor’s bankruptcy upon attempting to collect on their account after the proof of claim deadline had passed. There were multiple plans submitted to the court that were rejected for various reasons, but every plan submitted accounted for the creditor that did not have notice. Ultimately, the debtor’s plan was confirmed. After confirmation, the creditor attempted to file a proof of claim and the trustee objected. The creditor maintained that it filed as soon as receiving notice of the proceedings. The court allowed the claim, but that the creditor had not established grounds for an extended timeframe to file the proof of claim. Even so, the court noted that the debtor’s initial plan and amended plans all accounted for the creditor’s claim. All the plans were consistent with the creditor’s late-filed proof of claim. Thus, the court confirmed the debtor’s reorganization plan with the late-filed proof of claim upon a finding that it was consistent with the plan.
In another bankruptcy case, In re Smith, Nos. 17-11591-WRS, 18-1068-WRS, 2019 Bankr. LEXIS 234 (Bankr. M.D. Ala. Jan. 29, 2019), the debtor filed bankruptcy in 2017. At the time of filing, the debtor had a 2006 loan secured by his farmland that had matured. Instead of foreclosing, the creditor bank and the debtor negotiated a renewal in 2012. Another creditor, an agricultural cooperative, held a 2009 lien. In determining priority, the court held that the bank’s liens were prior to the cooperative’s liens. The court determined that the 2012 renewal of the bank note, even if the bank new of the cooperative’s lien, did not cause the bank to lose priority. While the court noted that sometimes an advancement on an existing mortgage causes the underlying mortgage to lose priority over subsequent liens, the court determined that the 2012 renewal was not an advancement. There was no evidence that additional funds were loaned to the debtor by the bank. In addition, the court determined that the bank’s lowering of the interest rate on the obligation did not cause the creditor to lose priority.
Trusts and Estate Planning
Trusts are a popular tool in estate planning for various reasons. One reason is that a trust can help consolidate farming and ranching interests and aid in the succession planning process. The benefit of consolidating farm and ranch property in trust was the issue of a recent Wyoming case. In re Redland Family Trust, 2019 WY 17 (2019), involved a family that has been involved in contentious litigation over a family trust. The case had been before the Wyoming Supreme Court on multiple occasions. The trust was created in 1989 and amended in 1995. The amendment provided for the appointment of a successor trustee; always required the service of two trustees; created a marital trust for the survivor of the settlors; and revised the buyout provision. The grantors and their five children made contributions to the trust. Upon the death of one of the grantors in 2007 one of the children was appointed as co-trustee. Ligation arose when the surviving grantor’s property was not conveyed to the trust and then again involving removal of the trustees, and an appointed trustee moved to have the trust terminated due to the administrative difficulties to administer, family dysfunction, and because the trust no longer served its purpose. The defendants, (including the co-trustee that resigned) asserted that termination was moot and moved to have the new co-trustee removed.
The trial court did not remove the co-trustee and found that the trust was still valid. The trial court found that the co-trustee did not violate any fiduciary duties and that the defendants failed to show gross and willful misconduct to justify her removal. Further the trial court found that the co-trustee’s claims that the trust was invalid should have been raised in the original trust challenge. The trial court determined that the primary reason for the trust (to keep the lands and leases together for the Redland family) had not been frustrated and that the trust remained administratively functional and was not "unlawful, contrary to public policy, or impossible.
On appeal, the Wyoming Supreme Court affirmed. The Court determined that the trust still had a purpose - to keep the ranch holdings together to conduct business. Even though the other purpose of minimizing tax consequences had failed, consolidation of ranch holdings remained a legitimate purpose. The Court also determined that the co-trustee did not violate her fiduciary duties, her duties of impartiality or loyalty, and that her actions did not amount to gross and willful misconduct. In addition, the Court found that the duty of impartiality did not require the trustee to treat all beneficiaries fairly, but simply to act in the best interest of the beneficiaries and equally defend the intentions of the settlors. While the Court could find no precedent with respect to the duty of loyalty the Court held that merely seeking termination of the trust was not a breach of loyalty. In addition, the Court determined that hostility between parties did not warrant removal.
Rights of Grazing Permittees
In the U.S. West, the ability to graze on federally owned land is essential to economic success. An understanding of those rights is essential, and many legal battles in the West involve associated rights and responsibilities on federal land. One of those issues involves the erection of improvements. In Johnson v. Almida Land & Cattle Co., LLC, 2019 Ariz. App. Unpub. LEXIS 140 (Ariz. App. Ct. Jan. 31, 2019), the defendant owned a grazing allotment and was permitted to graze cattle on the allotted Forest Service land in Arizona. Consistent with the grazing permit, the defendant erected an electric fence on the allotment. In June 2011, the plaintiff collided with the fence while riding an off-road motorcycle, when he turned off a Forest Service road onto an unmarked, unimproved “two-track route” which the fence crossed. The plaintiff brought sued for negligence and the defendant moved for summary judgment on the basis that it owed no duty of care to the plaintiff. The trial court granted the motion, agreeing that there was no duty of care under the Restatement (Second) of Torts.
On appeal, the appellate court determined that the issue was whether a federal permittee owes a duty of care to the public with respect to construction of improvements on the land. Determination of that issue, the appellate court reasoned, was dependent on state law. On that point, the appellate court found that a criminal statute will establish a tort duty if the statute is designed to protect the class of persons in which the plaintiff is included, against the risk of the type of harm which has in fact occurred as a result of its violation, regardless of whether the statute mentions civil liability. The relevant AZ criminal statute held that a person commits a misdemeanor of public nuisance if that person knowingly and unlawfully obstructs a “public highway,” “public thoroughfare,” “roadway” or “highway.” The appellate court held that this public nuisance statute prohibiting the obstruction of certain types of pathways, also created a tort duty in those who erect improvements that impact those paths. Based on this interpretation, the court held that AZ law establishes a public policy giving rise to a tort duty with respect to the obstruction of certain types of public pathways. Consequently, a permittee on federal land owes a duty of care to the public when it erects an improvement across a publicly accessible route. However, the appellate court held that the facts were insufficient to determine, as a matter of law, whether the route at issue qualified as a “public highway,” “public thoroughfare,” “roadway” or “highway.” Consequently, the appellate court reversed on the duty of care issue and remanded to determine if the route fell within the scope of the relevant statutes.
Agricultural law is a “goldmine” of issues that landowners, producers and their legal and tax counsel must stay on top of. It’s a dynamic field. In a few more weeks, I will dig back into the caselaw for additional key recent developments.
Wednesday, March 13, 2019
Last April I devoted a post to the general grouping rules under I.R.C. §469. https://lawprofessors.typepad.com/agriculturallaw/2018/04/passive-activities-and-grouping.html Those rules allow the grouping of passive investment activities with other activities in which the taxpayer materially participates. Thus, for example, an investor in an ethanol plant might be able to group the losses from that investment with the taxpayer’s farming activity. Grouping may make it more likely that the taxpayer can avoid the passive loss rules and fully deduct any resulting losses.
But, there’s another grouping rule – one that applies to a taxpayer that has satisfied the tests to be a real estate professional and it’s only for purposes of determining material participation in rental activities. This election is an all-or-nothing election – either all of the taxpayer’s rental activities are aggregated or none of them are.
The aggregation election for real estate professionals – that’s the focus of today’s post.
Real Estate Professional
In last Thursday’s post, https://lawprofessors.typepad.com/agriculturallaw/2019/03/passive-losses-and-real-estate-professionals.html I detailed the rules under I.R.C. §469 pertaining to a real estate professional. To qualify as a “real estate professional” two test must be satisfied: (1) more than 50 percent of the personal services that the taxpayer performs in trades or business for the tax year must be performed in real property trades or businesses in which the taxpayer materially participates; and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. I.R.C. §469(c)(7). If the two tests are satisfied, as noted above, the rental activity is no longer presumed to be passive and, if material participation is present, the rental activity is non-passive. I.R.C. §469(c)(7)(A)(i).Another way of putting is that once the tests of I.R.C. §469(c)(7) are satisfied it doesn’t necessarily mean that rental losses are non-passive and deductible, it just means that the rental losses aren’t per se as passive under I.R.C. §469(c)(2). See, e.g., Gragg v. United States, 831 F.3d 1189 (9th Cir. 2016); Perez v. Comr., T.C. Memo. 2010-232. An additional step remains – the taxpayer must materially participate in each separate rental activity (if there are multiple activities).
Note: The issue of whether a taxpayer is a real estate professional is determined on an annual basis. See, e.g., Bailey v. Comr., T.C. Memo. 2001-296. In addition, when a joint return is filed, the requirements to qualify as a real estate professional are satisfied if either spouse separately satisfies the requirements. I.R.C. §469(c)(7)(B).
Is Separate Really the Rule?
As noted above, if a taxpayer has multiple rental activities, the taxpayer must materially participate in each activity. That can be a rather harsh rule. But, there is an exception. Actually, there are two. If material participation test cannot be satisfied, the taxpayer can use a relaxed rule of active participation. I.R.C. §469(i). That rule allows the deduction of up to $25,000 of losses (subject to an income phase-out). In addition, the taxpayer can make an election to aggregate all of the rental activities that the taxpayer is involved in for purposes of meeting the material participation test. Treas. Reg. §1.469-9(g)(1). This aggregation election is available to a taxpayer that has satisfied the requirements to be a qualified real estate professional under I.R.C. §469(c)(7). See, e.g., C.C.A. 201427016 (Jul 3, 2014).
Points on aggregation. Aggregation only applies to the taxpayer’s rental activities. Activities that aren’t rental activities can’t be grouped with rental activities. In addition, it’s only for purposes of determining whether the material participation test has been met. Because the election only applies to rental activities, time spent on non-rental activities won’t help the taxpayer meet the material participation test for the rental activities. This makes the definition of a “rental activity” important. I highlighted the designated rental activities in last Thursday’s post. One of them is that the real estate must be used in a rental activity rather be realty that is held in the taxpayer’s trade or business where the average period of customer use for the property is seven days or less. Temp. Treas. Reg. §1.469-1T(e)(3)(ii); see also Bailey v. Comr., T.C. Memo. 2001-296.
By election only. Aggregation is accomplished only by election. Treas. Reg. §1.469-9(g)(3). It’s not enough to simply list all of the rental activities of the taxpayer in a single column on Schedule E. In Kosonen v. Comr., T.C. Memo. 2000-107, the petitioner owned seven residential rental properties. As of the beginning of 1994, he had non-deductible suspended losses of $215,860 from his properties. He put in almost 1,000 hours in rental activities in each of 1994 and 1995. On this 1994 return, he listed each rental property and loss separately on Schedule E and reported a combined loss of $56,954 on line 42 of Schedule E – the line where a taxpayer that is materially participating in rental activities reports net income or loss from all rental activities. He also reported the loss on line 17 of Form 1040 and subtracted it from other income to compute his adjusted gross income. He also filed Form 8582 to report the $56,954 loss. However, he didn’t attach an aggregation statement to the return noting that he was electing to treat his rental real estate activities as a single activity. He also didn’t combine his 1994 Schedule E rental real estate losses with his previously suspended losses. The IRS noted that had a proper election been made that the petitioner would have satisfied the material participation requirement. But, the IRS took the position that an election had not been made and as a result the material participation requirement had to be satisfied with respect to each separate activity. Because he could meet the material participation test in any single activity by itself, the IRS asserted, the resulting losses were suspended and couldn’t offset active income. The Tax Court agreed with the IRS. While the form of his entries on the return were consistent with an aggregation election, the Tax Court held that his method of reporting net losses as active income was not clear notice of an aggregation election. The fact that the IRS had not yet issued guidance on how to make an aggregation election didn’t eliminate the statutory requirement to aggregate, the Tax Court concluded.
Attached statement. To satisfy the statutory election requirement, the election statement attached to the return should clearly state that an election to aggregate rental activities is being made via I.R.C. §469(c)(7)(A) and that the taxpayer is a qualifying taxpayer in accordance with I.R.C. §469(c)(7)(B).
Late election relief. It is possible to make a late election via an amended return. In Rev. Proc. 2011-34, 2011-24 I.R.B. 875, the IRS said a late election can be made in situations where the taxpayer has filed returns that are consistent with having made the election. In that event, the late election applies to all tax years for which the taxpayer is seeking relief. The late election is made by making the election in the proper manner as indicated above as an attachment to the amended return for the current tax year. The attachment must identify the tax year(s) for which the late election is to apply, and explain why a timely election wasn’t initially made. The opportunity to make a late election is important. See, e.g., Estate of Ramirez, et al. v. Comr., T.C. Memo. 2018-196.
Binding election. The aggregation election cannot be revoked once it is made – it is binding for the tax year in which it is made and for all future years in which the taxpayer is a qualifying real estate professional. If intervening years exist in which the taxpayer was not a qualified real estate professional, the election has no effect in those years and the taxpayer’s activities will be evaluated under the general grouping rule of Treas. Reg. §1.469-4. Treas. Reg. §1.469-9(g)(1).
Years applicable. If the election hasn’t been made in a year during which the taxpayer was a qualified real estate professional, it can still be made in a later year. But, the election is of no effect if it is made in a year that the taxpayer doesn’t satisfy the requirements to be a real estate professional. Treas. Reg. §1.469-9(g)(1). In other words, the election may be made in any year in which the taxpayer is a qualifying taxpayer for any tax year in which the taxpayer is a qualifying taxpayer. In addition, the failure to make the election in one year doesn't bar the taxpayer from making the election in a later year. Treas. Regs. §§1.469-9(g)(1) and (3).
Revocation. While the aggregation election is normally binding, the aggregation election can be revoked for a year during which the taxpayer’s facts and circumstances change in a material way. If that happens, the election can be revoked by filing a statement with the original tax return for that year. According to the regulations, the statement must provide that the I.R.C. §469(c)(7)(A) election is being revoked and describe the material change in the taxpayer’s factual situation that justifies the revocation. Treas. Reg. §1.469-9(g)(3).
Rental real estate activities held in limited partnerships. What happens if the taxpayer makes the election to aggregate all real estate rental activities but not all of the taxpayer’s interests in real estate activities are held individually by the taxpayer? The regulations address this possibility and use an example of an interest in a rental real estate activity held by the taxpayer as a limited partnership interest. Treas. Reg. §1.469-9(f)(1). The result is that the effect of the aggregation election doesn’t necessarily apply in this situation. Instead, the taxpayer’s combined rental activities are deemed to be a limited partnership interest when determining material participation and the taxpayer must establish material participation under one of the tests that apply to determine the material participation of a limited partner contained in Treas. Reg. 1.469-5T(e)(2). Treas. Reg. §1.469-9(f)(1). But, there is a de minimis exception that applies if the taxpayer’s share of gross rental income from all limited partnership interests in rental real estate is less than 10 percent of the taxpayer’s share of gross rental income from all of the taxpayer’s interests in rental real estate for the tax year. In this situation, the taxpayer can determine material participation by using any of the tests for material participation in Treas. Reg. §1.469-5T(a) that apply to rental real estate activities. Treas. Reg. §1.469-9(f)(2). This is also the rule if the taxpayer has an interest in a rental real estate activity via an LLC. An LLC interest is not treated as a limited partnership interest for this purpose. Thus, the taxpayer can use any of the seven tests for material participation contained in Treas. Reg. §1.469-5T(a). See, e.g., Garnett v. Comr., 132 T.C. 368 (2009); Hegarty v. Comr., T.C. Sum. Op. 2009-153; Newell v. Comr., T.C. Memo. 2010-23; Thompson v. Comr., 87 Fed. Cl. 728 (2009), acq. in result only, A.O.D. 2010-002 (Apr. 5, 2010); Chambers v. Comr., T.C. Sum. Op. 2012-91.
It should be noted that in its 2017-2018 Priority Guidance Plan, the IRS stated that it planned to finalize regulations under I.R.C. §469(h)(2). That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. Those regulations were initially issued in temporary form and became proposed regulations in 2011. Until the IRS takes action to effectively overturn the Tax Court decisions via regulation, the issue will boil down (as it has in the Tax Court cases referenced above) to an analysis of a particular state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership.
Effect on losses. The aggregation election also impacts the handling of losses. Once the aggregation election is made, prior year disallowed passive losses from any of the aggregated real estate rental activities can be used to offset current net income from the aggregated activities regardless of which activity produces the income or prior year loss. At least this is the position take in the preamble to the regulations. See Preamble to T.D. 8645 (Dec. 21, 1995). This is the result even if the disallowed prior year losses occurred in tax years before the aggregation election was made. Treas. Reg. §1.469-9(e)(4).
Any suspended losses remain suspended until substantially all of the combined activities (by virtue of the election) are disposed of in a fully taxable transaction. This would be an issue if a rental real estate activity with a suspended loss is aggregated with other rental real estate activities. Those suspended losses would not be deductible until the entire aggregated activity (now treated as a single activity) is disposed of. Thus, depending on the amount of the suspended losses at issue, it may not be a good idea to make the aggregation election in this situation. Likewise, it also may not be a good idea to make the aggregation election if the taxpayer has positive net income from rental real estate activities and passive losses from activities other than rental real estate activities. If the election is made in this situation, the rental activities won’t be passive, and the taxpayer won’t be able to use the losses from the other passive activities to offset the income from the rental real estate activities. The losses could then end up being suspended and non-deductible until the entire (combined) activity is disposed of.
The aggregation election is an election that is available only for real estate professionals and can make satisfying the material participation test easier. That can allow for full deductibility of losses from rental real estate activities. But, the terrain is rocky. Good tax advice and planning is essential.