Monday, October 12, 2020

Principles of Agricultural Law

PrinciplesForBlog2020Fall-cropped

Overview

The fields of agricultural law and agricultural taxation are dynamic.  Law and tax impacts the daily life of a farmer, rancher, agribusiness and rural landowner practically on a daily basis.  Whether that is good or bad is not really the question.  The point is that it’s the reality.  Lack of familiarity with the basic fundamental and applicable rules and principles can turn out to be very costly.  As a result of these numerous intersections, and the fact that the rules applicable to those engaged in farming are often different from non-farmers, I started out just over 25 years ago to develop a textbook that addressed the major issues that a farmer or rancher and their legal and tax counsel should be aware of.  After three years, the book was complete – Principles of Agricultural Law - and it’s been updated twice annually since that time. 

The 47th edition is now complete, and it’s the topic of today’s post – Principles of Agricultural Law.

Subject Areas

The text is designed to be useful to farmers and ranchers; agribusiness professionals; ag lenders; educational professionals; lawyers, CPAs and other tax preparers; undergraduate and law students; and those that simply want to learn more about legal and tax issues.  The text covers a wide range of topics.  Here’s just a sample of what is covered:

Ag contracts.  Farmers and ranchers engage in many contractual situations, including ag leases, to purchase contracts.  The potential perils of verbal contracts are numerous and can lead to unnecessary litigation. What if a commodity is sold under forward contract and a weather event destroys the crop before it is harvested?  When does the law require a contract to be in writing?  For purchases of goods, do any warranties apply?  What remedies are available upon breach? If a lawsuit needs to be brought to enforce a contract, how soon must it be filed? Is a liability release form necessary?  Is it valid?  What happens when a contract breach occurs?  What is the remedy? 

Ag financing.  Farmers and ranchers are often quite dependent on borrowing money for keeping their operations running.  What are the rules surrounding ag finance?  This is a big issue for lenders also?  What about dealing with an ag cooperative and the issue of liens?  What are the priority rules with respect to the various types of liens that a farmer might have to deal with? 

Ag bankruptcy.  A unique set of rules can apply to farmers that file bankruptcy.  Chapter 12 bankruptcy allows farmers to de-prioritize taxes.  That can be a huge benefit.  Knowing how best to utilize those rules is very beneficial.  That’s especially true with the unsettled issue of whether Payment Protection Program (PPP) funds can be utilized by a farmer in bankruptcy.  The courts are split on that issue.

Income tax.  Tax and tax planning permeate daily life.  Deferral contracts; depreciation; installment sales; like-kind exchanges; credits; losses; income averaging; reporting government payments; etc.  The list could go on and on.  Having a basic understanding of the rules and the opportunities available can add a lot to the bottom line of the farming or ranching operation as well as help minimize the bleeding when times are tough.

Real property.  Of course, land is typically the biggest asset in terms of value for a farming and ranching operation.  But, land ownership brings with it many potential legal issues.  Where is the property line?  How is a dispute over a boundary resolved?  Who is responsible for building and maintaining a fence?  What if there is an easement over part of the farm?  Does an abandoned rail line create an issue?  What if land is bought or sold under an installment contract?  How do the like-kind exchange rules work when farmland is traded? 

Estate planning.  While the federal estate tax is not a concern for most people and the vast majority of farming and ranching operations, when it does apply it’s a major issue that requires planning.  What are the rules governing property passage at death?  Should property be gifted during life?  What happens to property passage at death if there is no will?  How can family conflicts be minimized post-death?  Does the manner in which property is owned matter?  What are the applicable tax rules?  These are all important questions.

Business planning.  One of the biggest issues for many farm and ranch families is how to properly structure the business so that it can be passed on to subsequent generations and remain viable economically.  What’s the best entity choice?  What are the options?  Of course, tax planning is a critical part of the business transition process.

Cooperatives.  Many ag producers are patrons of cooperatives.  That relationship creates unique legal and tax issues.  Of course, the tax law enacted near the end of 2017 modified an existing deduction for patrons of ag cooperatives.  Those rules are very complex.  What are the responsibilities of cooperative board members? 

Civil liabilities.  The legal issues are enormous in this category.  Nuisance law; liability to trespassers and others on the property; rules governing conduct in a multitude of situations; liability for the spread of noxious weeds; liability for an employee’s on-the-job injuries; livestock trespass; and on and on the issues go.  Agritourism is a very big thing for some farmers, but does it increase liability potential?  Nuisance issues are also important in agriculture.  It’s useful to know how the courts handle these various situations.

Criminal liabilities.  This topic is not one that is often thought of, but the implications can be monstrous.  Often, for a farmer or rancher or rural landowner, the possibility of criminal allegations can arise upon (sometimes) inadvertent violation of environmental laws.  Even protecting livestock from predators can give rise to unexpected criminal liability.  Mail fraud can also arise with respect to the participation in federal farm programs.  The areas of life potentially impacted with criminal penalties are worth knowing, as well as knowing how to avoid tripping into them.

Water law.  Of course, water is essential to agricultural production.  Water issues vary across the country, but they tend to focus around being able to have rights to water in the time of shortage and moving the diversion point of water.  Also, water quality issues are important.  In essence, knowing whether a tract of land has a water right associated with it, how to acquire a water right, and the relative strength of that water rights are critical to understand.

Environmental law.  It seems that agricultural and the environment are constantly in the news.  The Clean Water Act, Endangered Species Act and other federal (and state) laws and regulations can have a big impact on a farming or ranching operation.  Just think of the issues with the USDA’s Swampbuster rules that have arisen over the past 30-plus years.  What constitutes a regulatory taking of property that requires the payment of compensation under the Constitution?  It’s good to know where the lines are drawn and how to stay out of (expensive) trouble.

Regulatory law.  Agriculture is a very heavily regulated industry.  Animals and plants, commodities and food products are all subject to a great deal of regulation at both the federal and state level.  Antitrust laws are also important to agriculture because of the highly concentrated markets that farmers buy inputs from and sell commodities into.  Where are the lines drawn?  How can an ag operation best position itself to negotiate the myriad of rules?   

Conclusion

It is always encouraging to me to see students, farmers and ranchers, agribusiness and tax professionals get interested in the subject matter and see the relevance of material to their personal and business lives. Agricultural law and taxation is reality.  It’s not merely academic.  The Principles text is one that can be very helpful to not only those engaged in agriculture, but also for those advising agricultural producers.  It’s also a great reference tool for Extension educators. It’s also a great investment for any farmer – and it’s updated twice annually to keep the reader on top of current developments that impact agriculture.

If you are interested in obtaining a copy, perhaps even as a Christmas gift, you can visit the link here:  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html.  Instructors that adopt the text for a course are entitled to a free copy.  The book is available in print and CD versions.  Also, for instructors, a complete set of Powerpoint slides is available via separate purchase.  Sample exams and work problems are also available.  You may also contact me directly to obtain a copy.

If you are interested in obtaining a copy, you can visit the link here:  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html.  You may also contact me directly. 

October 12, 2020 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)

Wednesday, August 5, 2020

The Use of the LLC For the Farm or Ranch Business – Practical Application

Overview

Last week I wrote a two-part series on how the single-member LLC can be utilized as part of a farming or ranching business.  A large part of my focus was on the single-member LLC and what it means to be a disregarded entity.  In part two, I noted that the Tax Court has held that while a single-member LLC is a disregarded entity for federal income tax purposes, it is respected for federal estate and gift tax purposes.  As a result, valuation discounts can be available to decrease the taxable value of the owner’s interest in the single-member LLC.

In today’s post, guest author Marc Vianello, of Vianello Forensic Consulting, provides a practical application of the concepts that I discussed last week.  Many thanks to Marc for today’s article.

Single-Member LLCs – Valuation Implications

Assume that Broad Horizon Family Farms is a Kansas farming/ranching family comprised of a father, mother, son, and daughter.  The farm/ranch is operated as a unified business under the ownership of a four-partner general partnership.  As an unincorporated entity, this structure allows for four payment limitations for federal farm program payment purposes.  The partners of the partnership are four Kansas LLCs that each own an equal 25 percent interest in the partnership—no partner has control, and no family member is a partner. 

Also assume that father, mother, son, and daughter each own 100 percent of one of the four LLCs.  Each family member, therefore, owns a 100 percent interest in an LLC that owns a 25 percent interest in the partnership.  Assuming that the partnership agreement does not limit the partners’ LLC transfer rights, how does this play out for valuation purposes?

To answer that question, we need to know what the partnership owns; its expected future cash flows; and a valuation date.  For purposes of the example, assume that the valuation date is June 30, 2020, and that Broad Horizon Family Farms has the following assets and liabilities:

  • 2,000 acres of farm and ranch land with a real estate valuation of $8,000,000;
  • 200 cow/calf pairs with an auction value of $300,000;
  • $1,000,000 fair market value of equipment;
  • $700,000 of harvested grains and in on-farm storage priced at current commodity prices;
  • Cash on hand of $150,000.
  • Land debt of $3,050,000, with interest accruing at the annual rate of 6.75 percent We will assume that the partner LLCs and their individual owners have guaranteed the debt.

These assumptions result in the following partnership balance sheet stated at fair market value (not cost), and a capital structure that is approximately 30 percent debt and 70 percent equity without regard to built-in gains taxes, and  38.1 percent debt, 61.9 percent equity after deducting the taxes:

 

 Appraised Value

 Tax Basis

 Tax Rate

 After-Tax Value

 Cash

$   150,000

 n/a

 n/a

$   150,000

 Commodities

             700,000

                      -

40%

       420,000

 Cattle

              300,000

                      -

20%

      240,000

 Equipment

          1,000,000

                      -

40%

       600,000

 Land

    8,000,000

     1,000,000

20%

   6,600,000

 Total assets

$10,150,000

   

$8,010,000

         

 Debt (6.75% rate)

 3,050,000

   

       3,050,000

 Partnership equity

  7,100,000

 

  _4,960,000

 Total debt and equity

$10,150,000

   

 $8,010,000

On an asset basis, the Partnership equity might have an asset based “as if marketable” value of $4,960,000 as an operational whole, or $1,240,000 per LLC partner.  But that is not the fair market value of the LLC partner’s interest in the Partnership, because a hypothetical buyer would be buying into a partnership of which 75% ownership is held be family-related parties.  Accordingly, a minority discount is appropriate.  Let’s assume a 15 percent discount in this case, resulting in a minority discounted value of $1,054,000 per 25 percent Partnership interest.      

Now let’s make some assumptions regarding the annual operations of the Partnership.  For this discussion, we will make the simplifying assumption of constant results subject to inflationary growth of 1.25 percent annually:

  • Because the partnership is comprised of four equal partners, assume that there are no perquisites of control in the manner of operation and the handling of distributions. The projected operations are assumed to continue in all respects as in the past.
  • Father, mother, son, and daughter provide all of the labor, and work 50 hours weekly. The LLCs receive periodic distributions equal to 75 percent of book net income.  These payments total $554,344 annually ($138,586 to each partner LLC).  Let’s also assume that the LLC partners flow the payments directly through to their owners, that is, to father, mother, son, and daughter. 
  • Valuation requires that the fair market value of the work being performed by related parties be determined. Accordingly, we will assume that the labor provided by father, mother, son, and daughter could be replaced with a three-employee independent work force at an average hourly rate of $20, with each employee working a 50-hour week.  Note that the allocation of wages in the valuation scenario would not be equal; some higher paid person would be the manager, and the lowest paid worker may receive just minimum wage.  The independent work force payroll on a 50-hour week would be $156,000.
  • The farm/ranch generates $1,500,000 of annual gross revenues, which is $750 per acre.
  • Annual crop inputs are $300,000.
  • Annual animal care costs are $95,000
  • Annual other operating expenses are $160,000.
  • Annual interest of $205,875 (6.75 percent) is paid on the $3,050,000 of debt.
  • Net capital expenditures equal to 25% of book net income are incurred. This represents net capital costs of $184,781 annually, for which Section 179 deductions are assumed to be taken.
  • A 40 percent effective income tax rate is assumed to impute taxes to the Partnership. This is necessary to equate the Partnership’s income to that of a C corporation, because the cost of equity capital valuation metrics derive from publicly traded C corporations.
  • A 20 percent tax rate is assumed to calculate the effect of dividend tax avoidance by the flow through tax nature of the Partnership compared to the non-flow through nature of C corporations from which the cost of equity capital valuation metrics are derived.

These assumptions result in the below operating results.  The “adjusted” column is used for further valuation analysis.

 

 Operating Results

 

 Unadjusted

 Adjusted

     

 Gross revenues

$1,500,000

$1,500,000

     

 Wages

-

156,000

 Crop inputs

 300,000

300,000

 Animal care costs

95,000

95,000

 Other operating expenses

    160,000

    160,000

 Total operating expenses

    555,000

    711,000

     

 Operating profit

945,000

789,000

 Interest expense

   (205,875)

          0

 Book net income

739,125

 

 Net capital expenditures

(184,781)

(184,781)

 Distributions to the LLCs

   (554,344)

                  -

 Net cash flow from operations

$                -  

 604,219

 Imputed income taxes at 40%

 

   (241,688)

 Imputed after-tax cash flow to capital

 

$   362,531

If an 18 percent cost of equity is assumed as well as a forty percent tax deduction benefit for interest expense, the assumed 38.1 percent/61.9 percent debt/equity capital structure results in a weighted average cost of capital (“WACC”) of 12.688 percent.  The assumed growth rate of 1.25 percent therefore results in a capitalization rate of 11.438 percent.  Thus, we calculate a capitalized value of $3,169,478.  But because the partnership is a flow through entity, it is necessary to make another adjustment to equate it to the financial effects of a C corporation.  Assuming a 20 percent qualified dividend tax rate, the value of the avoided shareholder dividend taxes is $792,369.  Accordingly, the partnership equity might have cash flow based “as if marketable” value of $3,961,847 as an operational whole - $990,462 per 25 percent Partnership interest.  No discount for minority interest applies to this calculation. 

Imputed after-tax cash flow to capital

 

 $   362,531

 Assumed capitalization rate

 

11.438%

 Capitalized value

 

     3,169,478

 Adjustment for avoided shareholder dividend taxes

     792,369

 "As if marketable" value based on cash flow

 

$3,961,847

Valuation professionals must reconcile the “as if marketable” values of their different approaches.  It is often concluded that the value is not less than the amount that could be realized based on liquidation, but a 25 percent partner would not be able to compel liquidation.  Thus, the common conclusion is that the “as if marketable” value of a 25 percent partnership interest is $990,462 based on the partnership’s cash flow.  But this is not fair market value.  The valuation metrics derive from C corporations whose shares are traded in the public markets—they are liquid, while the 25% partnership interests held by the LLCs are not—they are illiquid.  Accordingly, a discount for lack of marketability (“DLOM”) must be subtracted from the “as if marketable” value to arrive at fair market value. 

Practitioners use a variety of tools to estimate DLOMs.  The most simplistic approaches use the average of various small published studies of the discounts reflected in the prices of (1) restricted stocks compared to their publicly traded versions; and (2) stocks sold before completion of an initial public offering (“IPO”) to their IPO prices.  Through 1988, these restricted studies a range of 30-35 percent.  The implied discounts trended downward thereafter with changes in SEC Rule 144.  The pre-IPO studies suggested larger discounts in the 40-45 percent range.  Larger databases of restricted stock and pre-IPO transactions now exist, and are used by many practitioners to estimate DLOM.  Nevertheless, relying on restricted stock and/or pre-IPO transactions for DLOM estimate is problematic and may be unreliable.  To support this see Vianello, Empirical Research Regarding Discounts for Lack of Marketability, Chapters 3-5 (July 2019).  Available at https://dlomcalculator.com/wp-content/uploads/2019/07/Empirical-Research-Regarding-DLOM-with-Guide.pdf.

An alternative method of estimating an appropriate DLOM uses the VFC DLOM Calculator, which couples the time and price risks associated with marketing privately held securities to various option pricing formulae.  Unlike other methodologies, the VFC DLOM Calculator is a date specific, facts and circumstances tool supported by empirical research.  The formula most appropriate for DLOM estimation is the VFC Longstaff formula.  You can find the VFC DLOM Calculator and its supporting empirical research at https://dlomcalculator.com/

Using the partnership’s characteristics (an SIC Code range of 0100 to 0299; Asking Price of $2,000,000 to $4,000,000; 4 Employees; Annual Revenues of $1,000,000 to $2,000,000), a reasonable conclusion is that the average marketing time required by an LLC partner to sell its interest in the Partnership is 232 days, with a standard deviation of 197 days.  This compares to an average of 123 days to obtain SEC approval for a public offering by a large business in the 0000 to 0999 SIC Codes.  See Vianello, Empirical Research Regarding Discounts for Lack of Marketability, Table 1.1 (July 2019).  Available at https://dlomcalculator.com/wp-content/uploads/2019/07/Empirical-Research-Regarding-DLOM-with-Guide.pdf.  The VFC DLOM Calculator informs us that we can be 95 percent confident that the average marketing period is between 226 and 239 days based on these statistics.

Using a selection of four publicly traded classified as “Agriculture Production – Crops” (SIC Code 0100) and “Agriculture Production – Livestock & Animal Specialties” (SIC Code 0200), the VFC DLOM Calculator tells us that the long-term average price volatility of the companies’ stocks is 38.1 percent, with a standard deviation of 59.0 percent.  The VFC DLOM Calculator informs us that we can be 95 percent confident that the average price volatility is between 37.3 percent and 39.0 percent using the complete set of price data.  Using this data and the above marketing period parameters, results in a risk-adjusted DLOM estimate of 22.3 percent.

But there has recently been increased price volatility in the stock market because of coronavirus uncertainty.  Looking only at the 90 trading days before June 30, 2020, the VFC DLOM Calculator tells us that the average price volatility was 70.2 percent, with a standard deviation of 76.9 percent.  The VFC DLOM Calculator informs us that we can be 95 percent confident that the average price volatility is between 62.2 percent and 78.1 percent using the more current set of price data.  Using this data and the above marketing period parameters, results in a risk-adjusted DLOM estimate of 40.3 percent.  The VFC DLOM Calculator informs us that we can be 95 percent certain that the appropriate DLOM based on the more current price data is between 35.0 percent and 45.7 percent. The economic circumstances prevailing as of June 30, 2020, counsel to this higher DLOM estimate.

Using a 40.3 percent DLOM, we might conclude that the fair market value of a 25 percent interest in the partnership held by the partner LLC is $591,306 ($990,462 x (1-.403))

 However, the family members don’t own interests in the partnership.  They instead own 100 percent interests in their respective LLCs.  What is the fair market value of these LLCs?  It’s something less than $591,306, because the LLC, too, is subject to a lack of marketability.  Additional professional consideration must be given to developing the appropriate DLOM.  For example, it may be a discount more associated with financial portfolio risks than with agriculture risks.

Conclusion

This use of the single-member LLC can be a valuable aspect of an intergenerational transfer of the farming or ranching business.  Coupled with a general partnership farming entity, the single-member LLC can also optimize receipt of federal farm program payment limitations.  Further structuring of the management form of the LLC can also bring additional income and self-employment tax savings. 

August 5, 2020 in Business Planning | Permalink | Comments (0)

Friday, July 31, 2020

Estate and Business Planning for the Farm and Ranch Family – Use of the LLC (Part Two)

Overview

In Part One earlier this week, I focused on the use of a single-member limited liability company (LLC) as part of the estate/business/succession plan for the farming and ranching operation.  As noted in Part One, a single-member LLC is often used to hold general partner interests in the farming general partnership so that federal farm program payments can be maximized and achieve liability protection.  Also, noted in Part One was that a single-member LLC can be a “disregarded entity.”  That means that the entity is disregarded as an entity separate from its owner if the owner does not have limited liability.

For a single-member LLC that is a disregarded entity, what does the single-member of the LLC own?  Is it the interest in the LLC or the underlying asset(s) of the LLC?  If the entity is respected as an entity separate from its owner, can valuation discounts for the owner’s interest in the entity be achieved for federal estate and gift tax purposes?  If so, that’s a big planning (and tax saving) opportunity.

How a single-member LLC as a disregarded entity is treated for federal estate and tax purposes – it’s the topic of today’s post.

Valuation Concepts – In General

The answer to the question of what an owner of a single-member LLC owns makes a difference as far as the valuation of the interest owned is concerned because of the possible effect of valuation discounts.  Those discounts are for lack of control and minority interest.  With a single-member LLC, there is no discount for lack of control – the single-owner has full control.  But, as a privately held business, a discount for lack of marketability might be available if the LLC is respected as an entity. 

The value of an asset for federal gift and estate tax purposes is “fair market value.”  That’s defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.” Treas. Reg. §§20.2031-1(b); 25.2512-1; Rev. Rul. 59-60, 1959-1 C.B. 237.  State law controls the determination of what has been transferred in the valuation process. 

Under the “check-the-box” regulations, a business entity that is not classified as a corporation is a “domestic eligible entity” and, without an election, is “[d]isregarded as an entity separate from its owner if it has a single owner.”  Treas. Reg. §301.7701-3(b)(1)(ii).  Under Treas. Reg. §301.7701-1(a) and 301.7701-2(c)(2), an entity with a single member is disregarded as an entity separate from its owner “for federal tax purposes.”  That definition raises two questions: 1) What does “for federal tax purposes” mean?  Does it mean federal income as well as federal transfer (estate and gift) taxes?; and 2) does it bar the use of the “willing buyer/willing seller” valuation rule?   In 2004, the IRS shed some light on the first  question when it ruled that although a disregarded entity is not recognized for federal income tax purposes, the entity exists under state law and state law controls the owner’s rights and economic interests.  Rev. Rul. 2004-88, 2004-2 C.B. 165.  In 2009, the full Tax Court answered both questions and defined the interest owned by a single-member LLC owner.

The Pierre Case

In Pierre v. Comr., 133 T.C. 24 (2009), the petitioner received a $10 million gift in 2000.  Later that year, she created a single-member LLC in accordance with New York law and transferred cash and marketable securities to it worth about $4.25 million.  She held 100% ownership of the LLC and did not file an election with Form 8823 to be treated as an association taxable as a corporation.  Thus, the LLC was a disregarded entity.  Twelve days after funding the LLC, the petitioner transferred her entire interest in the LLC to trusts established for the benefit of her son and granddaughter.  She accomplished that by gifting a 9.5 percent interest in the LLC to each trust and then by selling a 40.5 percent interest in the LLC to each trust in exchange for promissory notes with a face amount of slightly over $1 million each.  In valuing the transfers for gift tax purposes, her valuation expert applied a 30 percent discount to the value of the LLC’s underlying assets (which turned out to be 36.5% for gift tax purposes due to an error in valuing the underlying assets).  The petitioner filed a federal gift tax return (Form 709) reporting the taxable value of the gift to each trust in accordance with the valuation expert’s report.  The IRS issued a notice of deficiency on the basis that the gifts should have been treated as gifts of proportionate shares of the LLC’s assets rather than transfers of interests in the LLC.  As such, as 100% owner of the LLC’s assets, no discount was appropriate.  The IRS took the position that the entity was the check-the-box regulations meant that the LLC was to be disregarded as an entity separate from the petitioner – they were one in the same. 

The petitioner claimed that NY state property law governed for transfer tax purposes rather than federal tax law.  Under NY law, the LLC was not to be disregarded.  Rather, upon the LLC’s formation, NY law created an interest in the LLC that was distinguishable from the petitioner.  The LLC became the petitioner’s personal property that held legal title to the assets that the entity contained.  Indeed, the NY LLC statute stated that, “A member has no interest in the specific property of the limited liability company.”  N.Y. Limited Liability Company Law Section 601

The full Tax Court, in a 10-6 decision, agreed with the petitioner and determined that “for federal tax purposes” was limited to federal income tax and that the petitioner owned an interest in the LLC rather than the underlying assets of the LLC.  As such, the willing buyer/willing seller valuation test applied to valuing the transferred interests which could then carry out any applicable valuation discounts.  The Tax Court pointed out that “state law defines and federal tax law determines the tax treatment of property rights and interests.”  See also Morgan v. Comr., 309 U.S. 78 (1940); United States v. National Bank of Commerce, 472 U.S. 713 (1985); Knight v. Comr., 115 T.C. 506 (2000).  The Tax Court also concluded that the check-the-box regulations don’t define property interests.  Instead, they merely allow the election of specific tax treatment for federal tax purposes, and that the Congress did not specifically disallow valuation discounts in the context of single-member LLCs – they aren’t listed in I.R.C. §§2701-2704 along with other transactions that can’t claim valuation discounts.  Thus, the petitioner’s gift tax liability was to be determined by the value of the transferred LLC interests rather than by a hypothetical transfer of the underlying assets of the LLC. 

In a second Tax Court opinion in the case, the Tax Court noted that the petitioner made the gifts and sales on the same day.  Pierre v. Comr., T.C. Memo. 2010-106.  Thus, the court treated them as a single part-gift/part-sale transaction.  That had the effect of reducing the lack of control discount slightly (from a claimed 35 percent to 30 percent) because the combined 50% gift/sale to each transferee could block the appointment of a new manager under the LLC operating agreement.  The petitioner also couldn’t come up with any non-tax reasons for separating the transfers into gifts and sales. 

Conclusion

The Pierre case is important because, as full Tax Court opinion, it provides strong support for the proposition that the asset to be valued for transfer tax purposes is the LLC interest and not the property that the LLC holds.  Planning and valuation opportunities are possible based on that notion.  A single-member LLC holding a farmer’s general partnership interest in a farming operation can be structured to obtain valuation discounts when the interest is gifted to a member of the subsequent generation as well as at death.  That makes the cost of intergenerational transfers of farming interests less which will be even more important if the federal estate and gift tax exemption level declines from its present level.

In a post next week, the concepts discussed in this two-part series will be applied to a family farm operation engaged in an intergenerational transfer.

July 31, 2020 in Business Planning | Permalink | Comments (1)

Monday, July 27, 2020

Estate and Business Planning for the Farm and Ranch Family – Use of the LLC (Part 1)

Overview

In the family business planning context for a farm and ranch, the key to success is for the senior generation to clearly express goals.  Doing so assists the planning team in using entities and associated tax planning techniques to satisfy those goals.  For business transition/succession purposes, the use of the limited liability company (LLC) is one entity structure that can work in the right situation and with the right set of facts. 

Often, in agriculture, the entity that conducts the farming operations is established as a general partnership with each partner having his own single-member LLC.  This is done in order to optimize (under most farm programs) the receipt of payment limitations.  The general partnership doesn’t limit liability, but it also doesn’t limit at the entity level the number of “person” determinations for payment limitation purposes.  Limited liability for each partner is achieved via the use of the single-member LLC to hold the partnership interest.

A single-member LLC can also be a “disregarded” entity?  What does that mean?  Is the entity simply disregarded for tax purposes, or is the entity respected in ways that make a big difference from a tax and estate planning perspective?  How does it all fit together for a farming operation? 

Utilizing an LLC as part of farm/ranch business succession – it’s the topic of today’s post – Part One of a two-part series.

Business/Succession Planning Goals

I have worked with farm families on estate and business succession plans for almost 30 years.  Each situation is unique.  There is no “one size fits all.”  However, I can make an observation concerning what are typical goals of the farm or ranch family, at least from the senior generation’s perspective.  The senior generation typically wants to retain control of the operation for as long as possible.  But, along with that goal of retaining control is often the desire to transfer equity ownership in the operational entity to other family members.  Any transfer is often required to be with restrictions that bar transfer outside the family.  Limited liability is commonly desired, as is flexibility in any entity form to deal with changes in the family structure and the tax landscape.  Also, it is a common desire to minimize taxation both upon entity formation and throughout the future; maximize government payments; and create the potential for valuation discounts – both for gifted interests and for the interests retained by the parents at death.

An LLC – What is it?

An LLC is an S corporation with fewer eligibility requirements and more flexibility with regards to the capital structure.  When an LLC is taxed as a partnership, it can be more advantageous than an S corporation – debt can be included in member basis; there is more flexibility given to multiple classes of interest; and distributions are more tax advantageous.  As compared to a limited partnership, LLC members can participate in management without losing the feature of limited liability.  Thus, an LLC basically blends the advantages of both the corporate and partnership form of business.  It has the advantage of a flow-through entity with the structure of a corporation.  An LLC’s management can either be conducted by all of the members acting together or by managers that the members select.  The members can choose the management structure desired, and multiple classes of ownership are allowed.  If the LLC is classified as a partnership or sole proprietorship for tax purposes, the entity is not taxed on business income.  All items of income, loss, deduction and credit are passed through to the member(s) and taxed at the member’s individual ratesI.R.C. 704(a). 

What Does It Mean To Be a “Disregarded” Entity?

While it takes at least one member for an LLC to be formed there is no limitation on the number of members – unlike an S corporation which is limited to 100 shareholders.  I.R.C. §1361(b)(1)(A). Under what are known as the “check-the-box” regulations,” an LLC with only one member can elect to be treated for tax purposes an association taxable as a corporation or as an entity disregarded as an entity separate from its owner.  Regs. Secs. 301.7701-1, et seq.  If no election is made on Form 8832, the default rule is that the entity is disregarded as an entity separate from its owner if the owner does not have limited liability. 

A single-member LLC is a separate entity from its owner, except when it comes to taxes.  That is a distinguishing feature from a sole proprietorship, and it protects the owner from debts and liabilities of the business.  But, both a single-member LLC and a sole proprietorship file a Schedule F (or C for non-farm businesses) to report business income and deductions.  The amounts on the Schedule are then included with the owner’s individual income tax return. 

That raises a question – for tax purposes, what does the single-member of the LLC own?  Is it an interest in the LLC or the underlying asset(s) of the LLC?  Why might that matter?

Guaranteeing debt.  Insight into precisely what a single-member LLC owner owns can be gleaned from IRS guidance on the handling of debt in a single-member LLC.  Under the “at-risk” rules of I.R.C. §465, a loss from an activity to which the rules apply are disallowed unless the taxpayer is “at risk” with respect to the activity.  A taxpayer is “at risk” with respect to an activity to the extent that the taxpayer contributes money or basis or borrows funds that are contributed to the activity, but only to the extent that the taxpayer is personally liable for repayment or to the extent of the value of collateral pledged to secure the borrowed funds.  I.R.C. §§465(b)(1)-(2).  But, what if the member of a single-member LLC that is a disregarded entity guarantees the debt?  Does that count as being “at risk” in the entity’s activity?  The Code doesn’t address the issue. The answer to that question turns on what the single member actually owns. 

In CCA 201308028 (Nov. 14, 2012), the taxpayer was the sole owner of an LLC that was treated as a disregarded entity.  The LLC owned a second LLC that was also treated as a disregarded entity.  The second LLC borrowed funds for use in its business activity.  The taxpayer, the first LLC and two S corporations that the taxpayer wholly owned guaranteed the debt.  The taxpayer also provided the lender with a commercial guarantee for the full loan amount.  The taxpayer unconditionally guaranteed the full prepayment of the loan but did not waive subrogation or reimbursement rights against the second LLC or the right of contribution from the first LLC and the two S corporations.  The IRS, following the approach of the Second, Eighth and Eleventh Circuits, determined that the taxpayer would be ultimately liable as the payor of last resort and not protected against loss and, therefore, would be “at risk” if the taxpayer did not have a right of contribution from the other co-guarantors. See  Waters v. Commissioner, 978 F.2d 1310 (2d Cir. 1992), cert. denied, 507 U.S. 1018 (1993); Young v. Commissioner, 926 F.2d 1083 (11th Cir. 1991); Moser v. Commissioner, 914 F.2d 1040 (8th Cir. 1990).  It’s an “economic realities” test.  That rationale applies when a taxpayer guarantees debt of an LLC that is taxed either as a partnership or as a disregarded entity. 

The IRS followed up the CCA with A.M. 2014-3 (Aug. 27, 2013) where the IRS concluded that an LLC member that guarantees the LLC’s debt is at risk for purposes of I.R.C. §465 in the situation where the LLC is treated as a partnership or a disregarded entity.  The IRS said that a member’s guarantee of qualified non-recourse (debt whose satisfaction may be obtained on default only out of the particular collateral given and not out of the debtor's other assets) financing of an LLC increased the member’s amount at risk to the extent of the guarantee. 

With this IRS guidance in mind, transactions involving debt guarantees have more certainty.  That means that planners can structure deals in accordance with the economics of the particular situation and lender requirements. The guidance also supports the notion that a member of an LLC that is treated as a disregarded entity owns an interest in the entity rather than the underlying assets in the entity.  The entity is respected for tax purposes. 

Employment tax.  A disregarded entity is treated as a corporation for employment tax purposes.  Treas. Reg. §301.7701-2(c)(2).  Thus, the entity is responsible for paying employment taxes and any excise taxes that apply.  Consequently, a single-member LLC must have an EIN and a bank account in its name.  Self-employment tax also applies.  If a partnership owns a disregarded entity, the partners are treated as self-employed.  They are not employees of the disregarded entity.  REG-114307-15, 81 F.R. 26763 (May 4, 2016), 2016 I.R.B. 1006. 

Identification of the entity.  The IRS can require the owner of a disregarded entity to report the entity’s employer identification number (EIN) on the taxpayer’s individual return.  I.R.C. §§6011(b); 6109(b); PMTA 2016-08.  The basic requirement is that there must be sufficient information on the return so that the taxpayer is properly identified.  Because an individual taxpayer that is a member of a single-member LLC has both a social security number and an EIN, listing both numbers on the taxpayer’s return could help the IRS to cross-reference the numbers and associate correct information and returns with the taxpayer.  Including both numbers does not invalidate the return and could avoid confusion on the IRS part. 

Conclusion

In Part Two, I will explore how a single-member LLC as a disregarded entity is treated for federal estate and gift tax purposes.  If a single-member LLC is a respected entity separate from its owner, perhaps valuation discounts for entity interests can apply.  Again, the outcome of the issue turns on what the owner of the single-member LLC actually owns. 

July 27, 2020 in Business Planning | Permalink | Comments (0)

Saturday, July 25, 2020

Recent Court Developments of Interest

Overview

The court decisions of relevance to agricultural producers, rural landowners and agribusinesses keep on coming.  There never seems to be a slack time.  Today’s article focuses on some key issues involving bankruptcy, business valuation, and insurance coverage for loss of a dairy herd due to stray voltage.  More ag law court developments – that’s the topic of today’s post.

 

Court Determines Interest Rate in Chapter 12 Case

In re Key Farms, Inc., No. 19-02949-WLH12, 2020 Bankr. LEXIS 1642 (Bankr. D. Wash. Jun. 23, 2020)

 The bankrupt debtor in this case is a family farming operation engaged in apple, cherry, alfalfa, seed corn and other crop production. The parents of the family own 100 percent of the debtor. In 2014, the debtor changed its primary lender which extended a line of credit to the debtor that the father personally guaranteed and a term loan to the debtor that the father also personally guaranteed. The lender held a first-priority security interest in various real and personal property to secure loan repayment. The debtor became unable to repay the line of credit and the default caused defaults on the term loan and the guarantees. The lender sued to foreclose on its collateral and have a receiver appointed.

The debtor filed Chapter 12 bankruptcy and proposed a reorganization plan where it would continue farming during 2020-2024 in accordance with proposed budgets. The plan provided for repayment of all creditors in full, and repayment of the lender over 20 years at a 4.5 percent interest rate (prime rate of 3.25 percent plus 1.25 percent). The lender opposed plan confirmation.

In determining whether the reorganization plan was fair and equitable to the lender based on the facts, the bankruptcy court noted the father’s lengthy experience in farming and familiarity with the business and that the farm manager was experienced and professional. The court also noted that parents had extensive experience with crop insurance and that they were committing unencumbered personal assets to the plan.  In addition, the court took note of the debtor’s recent shift to more profitable crops and a demonstrated ability to manage around cash flow difficulties, and that the lender would be “meaningfully oversecured.” The court also determined that the debtor’s farming budgets appeared to be based on reasonable assumptions and forecasted consistent annual profitability. However, the court did note that the debtor had a multi-year history of operating losses in recent years; was heavily reliant on crop insurance; was engaged in an inherently risky business subject to forces beyond the debtor’s control; had no permanent long-term leases in place for the considerable amount of acreage that it leased; could not anticipate how the Chinese Virus would impact the business into the future; and proposed a lengthy post-confirmation obligation to the lender.

Accordingly, the court made an upward adjustment to the debtor’s prosed additional 1.25 percent to the prime rate by increasing it by at least 1.75 percent. The court scheduled a conference with the parties to discuss how to proceed.

 

Valuation Discount Applies to Non-Voting Interests

Grieve v. Comr., T.C. Memo. 2020-28

The petitioner was the Chairman and CEO of a company. After his wife’s death, he established two limited liability companies, with a management company controlled by his daughter as the general partner in each entity holding a 0.2 percent controlling voting manger interest and a 99.8 percent nonvoting interest in each entity held by a family trust – a grantor retained annuity trust (GRAT). The petitioner gifted the 99.8 percent interest in the two entities and filed Form 709 to report the gifts. The IRS revised the reported value of the gifts and asserted a gift tax deficiency of about $4.4 million based on a theoretical game theory construct.

According to the IRS, a hypothetical seller of the 99.8 percent nonvoting interests in the two LLCs would not sell the interests at a large discount to the net asset value (NAV), but would seek to enter into a transaction to acquire the 0.2 percent controlling voting interest from the current owner of that interest in order to obtain 100 percent ownership and eliminate the loss in value as a result of lack of control and lack of marketability. In support of this, the IRS assumed that the owner of the 99.8 percent nonvoting interest would have to pay the controlling 0.2 percent voting member a premium above their undiscounted NAV. Under traditional methodology, the IRS expert estimated that a 28 percent discount to the NAV was appropriate for the 99.8 percent nonvoting units. But, instead of accepting that level of discount, the IRS proposed that the owner of the nonvoting units would pay a portion of the dollar amount of the discount from NAV to buy the remaining 0.2 percent voting interest.

The petitioner’s expert used a standard valuation methodology to prepare valuation appraisal reports. This expert applied a lack of control discount of 13.4 percent for the gift to the GRAT and a 12.7 percent lack of control discount for the gift to the irrevocable trust. The valuation firm also applied a 25 percent discount for both gifts.

The Tax Court determined that the IRS failed to provide enough evidence for its valuation estimates. The Tax Court also rejected the IRS assumption of the impact of future events on valuation, noting that the IRS valuation expert reports lacked details on how the discounts were calculated. Thus, the Tax Court rejected the proposed valuation estimates of the IRS and accepted those of the petitioner. The result was a 35 percent discount (total) for entity-level lack of control and lack of marketability compared to a 1.4 percent discount had the IRS approach been accepted.

 

S Corporation Value Accounts for Tax on Shareholders

Kress v. United States., 327 F. Supp. 2d 731 (E.D. Wisc. 2019)

The taxpayers, a married couple, gifted minority interests of stock in their family-owned S corporation to their children and grandchildren in 2007-2009. The taxpayers paid gift tax on the transfers of about $2.4 million. The taxpayers’ appraiser valued the S corporation earnings as of the end of 2006, 2007 and 2008 as a fully tax-affected C corporation. On audit, the IRS also followed a tax-effected approach to valuation of the S corporation earnings but applied an S corporation premium (pass-through benefit) and asserted that the gifts were undervalued as a result. The IRS assessed an additional $2.2 million of federal gift tax. The taxpayers paid the additional tax and sued for a refund in 2016.

The issue was the proper valuation of the S corporation. Historically, the IRS has not allowed for tax-affected S corporation valuation based on Gross v. Comr., T.C. Memo. 1999-254; Wall v. Comr., T.C. Memo. 2001-75; Estate of Heck v. Comr., T.C. Memo. 2002-34; Estate of Adams v. Comr., T.C. Memo. 2002-80; Dallas v. Comr., T.C. Memo. 2006-212; and Estate of Gallagher v. Comr, T.C. Memo. 2011-148. The IRS also has an internal valuation guide that provides that “…no entity level tax should be applied in determining the cash flows of an electing S corporation. …the personal income taxes paid by the holder of an interest in an electing S corporation are not relevant in determining the fair market value of that interest.”

But other courts have allowed the tax impact on shareholders. See, e.g., Delaware Open MRI Radiology Associates, 898 A.2d 290 (Del. Ct. Chanc. 2006); Bernier v. Bernier, 82 Mass. App. Ct. 81 (2012).

The court accepted the tax-affect valuation but disallowed the S corporation premium that IRS asserted. The court also allowed a discount for lack of marketability between 25 percent and 27 percent depending on the year of the transfer at issue.

 

Stray Voltage Could Lead to Partial Insurance Coverage

Hastings Mutual Insurance Co. v. Mengel Dairy Farms, Inc., No. 5:19CV1728, 2020 U.S. Dist. LEXIS 87612 (N.D. Ohio May 19, 2020)

 The defendant unexpectedly had several cows and calves die and also suffered a loss of milk production and profits. The defendant filed a claimed against the plaintiff for insurance coverage for death of livestock, cost of investigation and repairs, and loss of business profits. The plaintiff investigated the claim, utilizing an electrical company to do so. The electrical company found a stray electrical current present on the property. The plaintiff then hired a fire and explosion company to investigate the property. This investigation resulted in a finding of no stray voltage on the property, but the company did express its belief that stray voltage did cause the defendant’s harm. As a result, the plaintiff paid the insurance claim for death of livestock and repairs, but not for loss of business profits.

The plaintiff then filed an action for a determination under the policy of whether loss of business profits was a covered loss. The plaintiff sought a declaratory judgment specifying that coverage for loss and damage resulting from the stray voltage was not triggered because the defendant was not subject to a “necessary suspension” of farming operations, and that the defendant’s loss or damage had to be directly caused by a “peril insured against” rather than being caused by dehydration which resulted from the cattle’s reaction to the stray voltage. The defendant filed a counterclaim for breach of contract; breach of good faith and fair dealing; and unjust enrichment. The plaintiff moved for summary judgment on the basis that the policy wasn’t triggered for lack of electrocution and that there was no suspension in the defendant’s business operations. The court determined that the policy did not define the term electrocution in the context of dairy animals. As such, the court concluded that the term could be reasonably interpreted to mean death by electrical shock or the cause of irreparable harm. As an ambiguous term, it was defined against the plaintiff and in the defendant’s favor. The court also refused to grant summary judgment on the cause of death issue. In addition, because the defendant did not cease operations, the court concluded that the policy provided no coverage for lost profits. The court also rejected the defendant’s breach of contract claim due to lack of suspending the business and rejected the good faith/fair dealing claim because mere negligence was not enough to support such a claim. The unjust enrichment claim was likewise denied.

Conclusion

The cases discussed above are all quite relevant to agricultural producers.  For those struggling financially that find themselves in a Chapter 12, the interest rate utilized in the case is of primary importance.  Many factors go into determining the rate, and farming operations can achieve a lower rate by meeting certain factors listed by the court in the decision mentioned above.  Likewise, the valuation issue is critical, particularly if the federal estate tax exemption amount were to drop.  When federal (and, possibly, state) estate tax is involved, valuation is the “game.”  Finally, in all insurance cases, the language of the policy is critical to determine coverage application.  Any ambiguous terms will be construed against the company.  In all situations, having good legal counsel is a must.

July 25, 2020 in Bankruptcy, Business Planning, Insurance | Permalink | Comments (0)

Wednesday, July 15, 2020

Transitioning the Farm or Ranch – Stock Redemption

Overview

A major issue for farm and ranch families that have at least one child or other heir that is interested in taking over the business after the senior generation either retires or dies, is how to transition the business to that next generation of managers/operators. 

For farming and ranching operations that operate in a corporate structure, one way to transition the business is by means of a corporate stock redemption.  What are the pros and cons of a corporate redemption?  How does it actually work mechanically?

Corporate stock redemptions – it’s the topic of today’s post.

“Retiring” the Senior Generation

Compared to a sole proprietor farming operation, the tax “hit” to a retiring owner can often be much less in the corporate structure.  When a sole proprietor retires and assets are sold, the tax consequences can be harsh.  Grain and livestock in inventory and depreciable property (other than 20-year general purpose farm buildings) are subject to ordinary income tax treatment upon sale.  In addition, any I.R.C. §1245 depreciation recapture is not eligible for the installment method of reporting.  However, the sale of corporate stock by a retiring owner is taxed at capital gain rates that are lower than the ordinary income tax rates.  That’s the case whether the stock is sold directly to the buyer or by means of a stock redemption.  In addition, the installment method of reporting the income is available allowing for income tax deferral. 

On the other end of the transaction, the next generation that is acquiring an ownership interest in the farming entity also has tax implications.  When assets are purchased directly from a sole proprietor farmer or when a partnership interest is acquired with a basis-step up election in place, enhanced tax deductions are available.  In addition, any basis that can be allocated to depreciable property results in deferred deductions.  On the other hand, the seller recognizes depreciation recapture that must be recognized at the time of sale.  See I.R.C. §1245.

One advantage of a stock redemption over a direct sale (at least to the buyer) is that a stock redemption can be used to fund the acquisition of stock with corporate earnings that are taxed at a 21 percent rate under current law. 

Advantages

The primary advantage of a corporate stock redemption is that it can remove post-tax wealth that has built up inside the corporation at a 21 percent rate.  The same is true for future wealth built up if the payout occurs by virtue of installment reporting.  In addition, interest expense is deductible inside the corporation if, for example, a member of the next generation individually buys the stock  Likewise, there is no additional payroll tax burden that would otherwise occur if a person in the subsequent generation withdrew funds from corporate earnings to acquire stock from the senior generation. 

Disadvantage

With a corporate stock redemption, there is no increase in stock basis in the hands of the acquiring next generation.  That’s the case even though the seller (senior generation) could have a large gain to report on the transaction. 

Complete Redemption

The redemption of the senior shareholder’s stock must be a complete redemption to achieve capital gain tax treatment. The redeemed shareholder’s interest in the corporation must be completely extinguished. If it is, the proceeds received by the retiring shareholder, as indicated above, are treated as capital gain.  That’s the case even if the corporation has earnings and profits what would otherwise be taxed as ordinary income if they were distributed to the retiring shareholder.  I.R.C. §302(a).  A complete redemption also eliminates characterization of the redemption as a dividend that would be taxed at ordinary income tax rates up to the amount of the earnings and profits of the corporation. 

A complete redemption is also required for the transaction to be eligible for installment reporting.  I.R.C. §302(b)(3).  To accomplish a complete redemption, the senior shareholder must agree to have no involvement in the corporation for 10 years following the transaction.  That means the former senior shareholder can’t be a consultant or an employee or a director during that time-span.  No salaries or director fees for 10 years!  However, it is permissible for the corporation to continue to employ the redeemed shareholder’s spouse and provide fringes via a lease of real estate to the corporation (and collateralization agreements) if the arrangement is structured to ensure payment on the installment note involving the redeemed stock, the employment contract for the spouse and the lease.  That is especially true if the collateralization agreements are entered into in an arms’-length transaction and is comparable to arrangements involving unrelated parties.  See, e.g., Hurst v. Comr., 124 T.C. 16 (2005).  But, it is important that the redeemed shareholder not be determined to be involved in the business via the spouse. 

As for being a consultant to the corporation, the U.S. Tax Court held in 1984 that consulting services could be provided by the redeemed shareholder occasionally and medical insurance benefits could continue without the redemption being taxed as a dividend.  Lynch v. Comr., 83 T.C. 597 (1984).  But, the IRS doesn’t like consulting arrangements involving a redeemed shareholder.  See Rev. Rul. 70-104, 1970-1 C.B. 66.  In addition, an ongoing consulting arrangement is not permissible.  Lynch v. Comr., 801 F.2d 1176 (9th Cir.1986).      

If a prohibited interest is acquired within the 10-year post transaction timeframe, the redeemed shareholder  must notify the IRS.    Indeed, the redeemed shareholder must attach an agreement to the tax return saying that such notification will be made.  I.R.C. §302(c)(2)

If the rules for a complete redemption are violated, stock basis won’t offset gain and installment sale treatment is not available.    

How is a complete stock redemption accomplished?  The rules governing a complete stock redemption are set forth in I.R.C. §302(b)(3).  As noted above, the senior generation shareholder must surrender all of his stock either all at once or in exchange for an installment note that is payable over time.  After the redemption, if the remaining shareholders are related (in accordance with family attribution rules) to the shareholder that is being bought out, the redeemed shareholder can’t have any interest in the corporation for 10 years except for an interest acquired by bequest or inheritance.  An exception from this rule, however, allows the redeemed shareholder to be a landlord or a creditor. See, e.g, Priv. Ltr. Rul. 8551014 (Sept. 19, 1985). 

A redemption can also occur in the context of an I.R.C. §1041 transaction (such as incident to a divorce or otherwise between spouses).  Prop. Treas. Reg. §1.1041-2. 

Prior Family  Transfers

Another potential “snag” in the planning process is that an “anti-abuse” rule says that  capital gain treatment is not available if there have been family transfers of stock within 10 years before  the redemption.  I.R.C. §302(c)(2)(B).  Family attribution rules of I.R.C. §318 apply to define family members in this context. The rule seems to disallow gifts to family members.  However, if tax avoidance wasn’t one of the principal purposes of the transfer, then the transfer is permissible.  Basically, it comes down to whether the taxpayer can prove a non-tax purpose for the transfer and that avoiding tax was not a principal purpose.  Thus, if the prior transfer involved, for example, a parent that owned all of the corporate stock of a family farming or ranching corporation and gifted stock to a child that was being groomed as the successor as part of the parent’s estate and succession plan, a complete stock redemption would still be available and treated favorably from a tax standpoint.  See Rev. Rul. 77-293, 1977-2 C.B. 91.

Conclusion

A stock redemption can be part of a business succession transition plan for farming and ranching corporations.  But, planning for it is a necessity to ensure that the redemption achieves the anticipated benefits.

July 15, 2020 in Business Planning | Permalink | Comments (0)

Thursday, June 4, 2020

Summer 2020 – National Farm Income Tax/Estate and Business Planning Conference

Overview

On July 20-21, Washburn Law School will be conducting a national conference on farm income tax and farm estate and business planning in Deadwood South Dakota.  Also occurring nearly simultaneously will be the law school’s first “CLE Excursion.”  In today’s post I provide a preview of the conference and the excursion.

Farm Income Tax/Estate and Business Planning Conference

If you represent ag clients in handling tax issues and or work with them on estate and business plans, this conference is a focused event on issues tailored to the farm clientele that will be useful to your business.  Numerous tax rules as well as the rules surrounding estate and business planning for the ag client are unique.  The unique rules and the planning challenges and opportunities they present will be discussed.

The conference will be held at the Lodge at Deadwood, a premier conference facility in just outside Deadwood, South Dakota in the beautiful Black Hills with proximity to Mount Rushmore, Devils Tower, Spearfish Canyon and other beautiful locations. 

Day 1 (July 20) – Farm Income Tax

On Monday, July 20, the discussion will focus on various farm income tax topics.  Speakers for the day include myself, Paul Neiffer, and U.S. Tax Court Judge Elizabeth Crewson Paris   The topics for the day include:

  • Caselaw and IRS update (including tax provisions in the CARES Act)
  • CARES Act Update (PPP and EIDL)
  • GAAP Accounting Update
  • Restructuring Credit Lines
  • Deducting Bad Debts
  • Forgiving Installment Sale Obligations
  • Passive Losses
  • R.C. §199A Advanced Planning
  • Practicing Before the U.S. Tax Court
  • NOLs and EBLs
  • FSA Advanced Planning
  • CFAP Update (including payment limitation planning)
  • Like-Kind Exchanges and I.R.C. §1245 property

Day 2 (July 21) – Farm Estate and Business Planning

On Tuesday, July 21, the focus will shift to farm estate and business planning.  Speakers for the day along with myself will be Prof. Jeff Jackson, Brandon Ruopp, Marc Vianello and Prof. Shawn Leisinger

  • Caselaw and IRS update
  • Incorporating a Gun Trust Into an Estate Plan
  • Retirement Planning
  • Common Estate Planning Mistakes of Farmers and Ranchers
  • Post-Death Management of the Family Farm and Ranch Business
  • Estate and Gift Tax Discounts for Lack of Marketability
  • Valuation of Farm Chattels and Marketing Rights
  • Ethical Issues Related to Risk

You can learn more about the conference and find registration information here:  http://washburnlaw.edu/employers/cle/farmandranchtax.html

CLE Excursion

Corresponding with the farm income tax and estate/business planning conference will be Washburn Law School’s “CLE Excursion.  While this event is primarily for Washburn Law Alumni, others are welcome to register.  An informal gathering will be on Friday evening, July 17.  On Saturday, July 18, with two hours of CLE that day.  A day of sightseeing is planned for Sunday, July 19 with a CLE conference also at the Lodge at Deadwood.  CLE topics for July 20 will be: 

  • Ethics
  • Gun Trusts
  • Law and Technology

On July 20 an excursion will also take place to Mount Rushmore and Crazy Horse mountain.  You can learn more about this event and register here: http://washburnlaw.edu/employers/cle/deadwoodcle.html

Virus Concerns?

If you are unable to attend due to the virus or concerns over the virus, the two-day conference will be live-streamed.  We use a superior streaming technology that allows you to participate in the conference from the comfort and safety of your own office.  

Room Block

A room block has been established for the tax/planning conference.  When you call the Lodge at Deadwood, just mention that you will be attending Washburn Law School’s summer conference.  A special rate has been negotiated for the room block.

Conclusion

This conference will take place shortly after the end of the filing season (assuming it isn’t postponed again) at a time when many will also be ready for a nice place to vacation at and also take in a continuing education conference.  It is also possible to register for both events and pick and choose the topics you would like to attend.  In addition, as noted the farm income tax/farm estate and business planning conference can also be attended online as it will be broadcast live online. 

I hope to see you in Deadwood this summer.  If you can’t be there, I hope you can attend online.

June 4, 2020 in Business Planning, Estate Planning | Permalink | Comments (0)

Friday, April 24, 2020

Summer 2020 – National Farm Income Tax/Estate and Business Planning Conference

Overview

This coming July, Washburn Law School will be conducting a national conference on farm income tax and farm estate and business planning in Deadwood South Dakota.  Also occurring nearly simultaneously will be the law school’s first “CLE Excursion.”  In today’s post I provide a preview of the conference and the excursion.

Farm Income Tax/Estate and Business Planning Conference

If you represent ag clients in handling tax issues and or work with them on estate and business plans, this conference is a focused event on issues tailored to the farm clientele that will be useful to your business.  Numerous tax rules as well as the rules surrounding estate and business planning for the ag client are unique.  The unique rules and the planning challenges and opportunities they present will be discussed.

The conference will be held at the Lodge at Deadwood, a premier conference facility just outside Deadwood, South Dakota in the beautiful Black Hills with proximity to Mount Rushmore, Devils Tower, Spearfish Canyon and other beautiful locations. 

Day 1 (July 20) – Farm Income Tax

On Monday, July 20, the discussion will focus on various farm income tax topics.  Speakers for the day include myself, Paul Neiffer, and U.S. Tax Court Judge Elizabeth Crewson Paris   The topics for the day include:

  • Caselaw and IRS update
  • GAAP Accounting Update
  • Restructuring Credit Lines
  • Deducting Bad Debts
  • Forgiving Installment Sale Obligations
  • Passive Losses
  • R.C. §199A Advanced Planning
  • Practicing Before the U.S. Tax Court
  • NOLs and EBLs
  • FSA Advanced Planning
  • Like-Kind Exchanged and I.R.C. §1245 property

Day 2 (July 21) – Farm Estate and Business Planning

On Tuesday, July 21, the focus will shift to farm estate and business planning.  Speakers for the day along with myself will be Prof. Jeff Jackson, Brandon Ruopp, Marc Vianello and Prof. Shawn Leisinger

  • Caselaw and IRS update
  • Incorporating a Gun Trust Into an Estate Plan
  • Retirement Planning
  • Common Estate Planning Mistakes of Farmers and Ranchers
  • Post-Death Management of the Family Farm and Ranch Business
  • Estate and Gift Tax Discounts for Lack of Marketability
  • Valuation of Farm Chattels and Marketing Rights
  • Ethical Issues Related to Risk

You can learn more about the conference and find registration information here:  http://washburnlaw.edu/employers/cle/farmandranchtax.html

CLE Excursion

Corresponding with the farm income tax and estate/business planning conference will be Washburn Law School’s “CLE Excursion.  While this event is primarily for Washburn Law Alumni, others are welcome to register.  An informal gathering will be on Friday evening, July 17.  On Saturday, July 18, with two hours of CLE that day.  A day of sightseeing is planned for Sunday, July 19 and a couple of hours of CLE are also available that day as well as a reception that evening preceding the two-day tax and estate/business planning conference that begins the next day.  All of the CLE events and the reception will be held at the Lodge at Deadwood.  Additional CLE topics for this July 20 event will be: 

  • Ethics
  • Gun Trusts
  • Law and Technology

Also on July 20 an excursion will also take place to Mount Rushmore and Crazy Horse mountain.  You can learn more about this event and register here: http://washburnlaw.edu/employers/cle/deadwoodcle.html

Conclusion

This conference will take place shortly after the end of the filing season at a time when many will also be ready for a nice place to vacation at and also take in a continuing education conference.  It is also possible to register for both events and pick and choose the topics you would like to attend.  In addition, the farm income tax/farm estate and business planning conference can also be attended online as it will be broadcast live online.  A room block has been established for the tax/planning conference.  When you call the Lodge at Deadwood, just mention that you will be attending Washburn Law School’s summer conference.  A special rate has been negotiated for the room block.

I hope to see you in Deadwood this summer.  If you can’t be there, I hope you can attend online.

April 24, 2020 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, April 15, 2020

Court Developments of Interest

Overview

In recent articles on this blog, I have taken a look at the various parts of recently enacted legislation as a consequence of the economic trauma the federal and state governments have imposed on businesses and individuals as a recent of the virus.  Today, I step away from virus related developments and focus on recent court opinions of relevance to agricultural law and taxation. 

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

Valuation Discounting – Assignee Interests

Streightoff v. Comr., T.C. Memo. 2018-178, aff’d., No. 19-60244, 2020 U.S. App. LEXIS 10070 (5th Cir. Mar. 31, 2020).

Limited partnerships (and their variant – the family limited partnership), emerged as an important estate and business planning tool in the early 1990s.  They can be useful for farming and ranching operations of relatively higher net worth as a vehicle to transfer interests in the farming or ranching business to a succeeding generation at a discounted value.  That discounted value is often achieved by working the transferor into a minority position before death and the creation of multiple types of partnership interests, and also holding those partnership interests in different types of entities.  Discounted value can also be achieved (under the laws of some states) by transferring an assignee interest rather than the actual interest in the partnership.  Assignee interests are, in essence, limited partnership interests with economic participation equal to that of limited partnership interests but typically without the same rights.  They typically do not carry the right to vote, inspect partnership books or transfer their interests.  Thus, the claim is, they should be valued less than a general partnership interest and even less than a limited partnership interest for both federal gift tax as well as estate tax purposes - if they are established and transferred properly.  That was the issue in a recent case.

In Streightoff, the decedent had created a limited partnership under Texas law before death. The decedent held a one percent general partner interest and an 88.99 percent limited partner interest. Eight of the decedent’s family members owned the balance of the limited partner interests. The partnership didn’t conduct any meetings and held cash, equities, bonds and mutual funds. The decedent had the power to approve the sale of partnership interests and had a right of first refusal on all sales. The partnership agreement described persons who acquired partnership interests as “assignees.”

A few years before death, the decedent purported to create an “assignee” interest in his revocable trust with respect to his 88.99 percent limited partnership interest. The decedent’s estate tax return reported the decedent’s limited partnership interest as an “assignee” of the revocable trust and claimed a 37.2 percent discount for lack of marketability discount and lack of control. The estate based the level of the discount on the notion that the trust only held an assignee interest consistent with the partnership agreement which stated that, “A transferee who was not admitted as a substituted limited partner would hold the right to allocations and distributions with respect to the transferred interest, but would have no right to information or accounting or to inspect the books or records of the partnership and would not have any of the rights of a general or limited partner (including the right to vote on partnership matters)."

The IRS reduced the extent of the discount and asserted a deficiency of about $500,000. While the estate claimed that the lack of marketability discount should be 27.5 percent based on a possible holding period until 2075, the Tax Court determined that the decedent’s assignee interest was essentially the same thing as a limited partnership interest. Accordingly, the Tax Court settled on an 18 percent discount for lack of marketability. No discount for lack of control was allowed because the Tax Court found that the partnership interest was significant and carried with it the power to remove the general partner. The appellate court affirmed on appeal, concluding that the Tax Court properly determined that the assignment was essentially a transfer of the decedent’s partnership interest. The “assignment” clearly conveyed more than an assignee interest. 

 

Petition to Quiet Title Over Disputed Boundary Denied

Liddiard v. Mikesh, No. 19-0143, 2020 Iowa App. LEXIS 267 (Iowa Ct. App. March 18, 2020)

If an individual possesses someone else's land in an open and notorious fashion with an intent to take it away from them, such person (known as an adverse possessor) can become the true property owner after the statutory time period has expired via a quiet title action.  Adverse possession statutes vary by jurisdiction in terms of the requirements a person claiming title by adverse possession must satisfy and the length of time property must be adversely possessed.  A boundary between two properties can also be established by acquiescence.  This theory applies when neither of the adjacent owners knows the location of the true boundary.  Instead, the parties treat a particular marker or line as the boundary for a prescribed period of time.  Both parties simply agree (acquiesce) to treat that particular line or marker as the boundary.  Both of these concepts were involved in a recent Iowa case.

The parties had been adjoining rural landowners since 1988. When the defendant bought his tract, a survey was conducted.  That survey was relied on in litigation between the parties concerning a dispute over logged timber on a five-acre parcel where ownership between the parties was not clear via the respective deeds. A few years later the plaintiff sued to quiet title to the disputed area claiming that the true boundary was the existing fence line based on either the theory of adverse possession or boundary by acquiescence.

The trial court determined that the plaintiff had failed to establish the requirements for either theory, and refused to quiet title in the plaintiff. On appeal, the appellate court agreed. Based on the evidence, the appellate court determined that the plaintiff failed to establish exclusive use of the disputed area for the statutory period and did not substantially maintain or improve the area.  Thus not all of the elements of adverse possession were satisfied.  In addition, the plaintiff did not bring the quiet title action for six years after the initial dispute over timber. The appellate court also determined that the defendant did not treat the fence line as the boundary. Thus, no boundary by acquiescence was established because both parties did not assume the fence line was the boundary. 

Court Addresses Direct and Indirect Discharges Under CWA – Awaiting Supreme Court Guidance

Conservation Law Foundation v. New Hampshire Fish & Game Department, No. 18-CV-996-PB, 2020 U.S. Dist. LEXIS 59608 (D. N.H. Apr. 6, 2020).

The plaintiff claimed that the defendant had violated the Clean Water Act (CWA) by allowing a hatchery that the defendant owned and operated to discharge pollutants into a river in violation of the hatchery’s National Pollutant Discharge Elimination System (NPDES) permit. The plaintiff claimed that the defendant was making both direct and indirect discharges in violation of its NPDES permit. The direct discharge claims were based on current and anticipated future discharges directly from the hatchery into the river. The indirect discharge claims stemmed from past releases of phosphorus by the hatchery that became sediment at the bottom of the river.  Those discharges continued to leach phosphorus into the water.

The trial court dismissed the direct discharge claims and directed the parties to submit additional arguments with respect to the indirect discharge claims. The direct discharge claims were dismissed because in late 2019, the EPA released a new NPDES permit for the hatchery which ultimately may allow the discharges that the plaintiffs claim violate the CWA. Because the anticipated 2020 permit may moot some or all of the plaintiffs’ direct discharge claims, the court dismissed those claims. As for the indirect discharge claims, the court noted that the plaintiffs’ arguments that the defendants have violated the CWA by allowing pollutants to enter a water of the United States through a conduit is similar to an issue that is presently before the United States Supreme Court.  See Hawaii Wildlife Fund v. County of Maui, 881 F.3d 754 (9th Cir. 2018), pet. for cert. granted, County of Maui v. Hawaii Wildlife Fund, 139 S. Ct. 1164 (2019)Because how the Supreme Court rules on the indirect discharge claim could impact the court’s decision in this case, the court requested that the parties file additional briefing on whether the Maui case should influence the court’s decision. 

Alimony Payments Not Deductible

Biddle v. Comr., T.C. Memo. 2020-39

In divorce situations, it’s fairly common for one ex-spouse to become legally obligated to make payments to the other ex-spouse.  Before 2018, the ex-spouse making alimony payments could deduct them for federal income tax purposes.  To be deductible alimony, a payment could not be classified as fixed or deemed to be child support under a set of complex rules, as evidenced in a recent Tax Court case.

Under the facts of the case, the petitioner and his wife were married for 14 years and had four children together before divorcing in 2010. The divorce decree included provisions for “child support” and “alimony.” The decree ordered the petitioner to pay monthly child support of $1,795.63 per month until each child reached age 18, died, married, entered military school or became self-sufficient. The decree also ordered the petitioner to pay “permanent periodic alimony” of $1,592.50 for at least five years until either the youngest child reached age 18, the ex-wife or petitioner died, the ex-wife remarried at the five-year point or later, or the wife became self-supporting. The decree also specified that if the husband received a pay raise that half of the net increase would increase the alimony payment. The decree was later modified to reduce the monthly child support amount because the petitioner took custody of an additional child. No change was made to the alimony payment.

On petitioner’s 2015 return, he claimed a $28,000 alimony deduction. The IRS disallowed the deduction as nondeductible child support because of one of the contingencies terminating payment was petitioner’s youngest child turning 18. The Tax Court upheld the IRS position. The Tax Court noted that under I.R.C. §71(c)(2)(A), the payments would count as child support until the child turned 18. Here, the decree clearly stated that the designated alimony payments would terminate on the contingency that the petitioner’s youngest child turn 18. That was a contingency relating to a child that qualifies a payment as nondeductible child support. This is the result, the court noted, even though the decree designated separate amounts for child support and alimony. The parties’ intent also was immaterial. 

Conclusion

Even though the focus of much present thought and discussion is on the virus and the economic wreckage that (primarily) state governmental policies are causing, the courts continue to crank out important cases.  Make sure you are still paying attention to what is going on.

April 15, 2020 in Business Planning, Civil Liabilities, Environmental Law, Estate Planning | Permalink | Comments (0)

Wednesday, April 1, 2020

Disaster/Emergency Legislation – Summary of Provisions Related to Loan Relief; Small Business and Bankruptcy

Overview

The disaster/emergency legislation enacted in late March is wide-ranging and far-sweeping in its attempt to provide economic relief to the damage caused by various federal and state “shut-downs” brought on by a widespread viral infection that originated in China in late 2019 and has spread to the United States.  The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) provides relief to small businesses and their employees, including farmers and ranchers, as well as to certain students.  Some states have also acted to temporarily stop mortgage foreclosures. 

I am grateful to Joe Peiffer of Ag and Business Legal Strategies located in Hiawatha, Iowa, for his input on some of the topics discussed below.

Recent disaster/emergency legislation related to loan relief, small business and bankruptcy – it’s the topic of today’s post.   

Deferral of Student Loan Payments

The CARES Act provides temporary relief for federal student loan borrowers by requiring the Secretary of Education to defer student loan payments, principal, and interest for six months, pthrough September 30, 2020, without penalty to the borrower for all federally owned loans. This provides relief for over 95 percent of student loan borrowers. 

Bankruptcy Changes

The CARES Act makes the following changes to the bankruptcy Code:

  • A one-year increase in the debt limit to $7.5 million (from $2.73 million) for small businesses that file Chapter 11 bankruptcy. For one year after date of enactment, following the bill’s enactment, the measure temporarily excludes federal payments related to COVID-19 from income calculations under Chapter 11 bankruptcy proceedings. It would also allow debtors experiencing hardship because of COVID-19 to modify existing bankruptcy reorganization plans.  CARES Act, §1113.
  • Individuals and families currently undergoing Chapter 13 bankruptcy may seek payment plan modifications if they are experiencing a material financial hardship due to the virus, including extending payments for up to seven years after the due date of the initial plan payment. This provision expires one year after date of enactment.  
  • “Income” for Chapter 7 and Chapter 13 debtors does not include virus-related payments from the federal government. This provision expires one year after date of enactment.
  • For Chapter 13 debtors, “disposable income” for purposes of plan confirmation does not include virus-related payments. This is also a one-year provision

“Small Employer” Relief

The CARES Act provides qualified small businesses various options. 

  • Immediate SBA Emergency Economic Injury Disaster Grants. These $10,000 grants (advances) are to be used for authorized costs such as providing paid sick leave; maintaining payroll to retain employees; meeting increased material costs; making rent or mortgage payments; and repaying obligations which cannot be met on account of revenue losses.  The grants are processed directly through the Small Business Association (SBA), but the SBA may utilize lenders (that are an SBA authorized lender) for the processing and making of the grants.  A grant applicant may request an expedited disbursement.  If such a request is made, the funds are to be disbursed within three days of the request. The CARES Act also removes standard program requirements including that the borrower not be able to secure credit elsewhere or that the borrower has been in business for at least a year, as long as the business was in operation as of January 31, 2020.  CARES Act, §1110.
  • Traditional SBA Economic Injury Disaster Loans (EIDL). The CARES Act expands this existing program such that the SBA can provide up to $2 million in loans to meet financial obligations and operating expenses that couldn’t be met due to the virus such as fixed debts, payroll, accounts payable and other bills attributable to actual economic injury. The loans are available to businesses and organizations with less than 500 employees.  The interest rate is presently 3.75 percent and cannot exceed 4 percent for small businesses that can receive credit elsewhere.  Businesses with credit available elsewhere are ineligible.  The interest rate for non-profits is 2.75%.  The length of the loan can be for up to 30 years with loan terms determined on a case-by-case basis, based on the borrower’s repayment ability.  Applications will be accepted through December of this year.
  • Forgivable SBA 7(a) Loan Program Paycheck Protection Loans. The Paycheck Protection Loan Program (PPP) is an extension of the existing SBA 7(a) loan program with many of the existing restrictions on 7(a) loans waived for a set timeframe including guarantee and collateral requirements and the requirements that the borrower cannot find credit elsewhere.   In addition, a small business loan borrower is eligible for loan forgiveness on existing SBA 7(a) loans.  The 7(a) loan program is the SBA's primary program for providing financial assistance to small businesses. For borrowers with an existing 7(a) loan, the SBA will pay principal, interest, and any associated loan fees for a six-month period starting on the loan’s next payment due date.  Payment on deferred loans start with the first payment after the deferment period.  However, this relief does not apply to loans made under the PPP. 
  • For purposes of the PPP, a “qualified small business” is defined as a business in existence as of February 15, 2020 paying employees or independent contractors that does not have more than 500 employees or the maximum number of employees specified in the current SBA size standards, whichever is greater; or if the business has more than one location and has more than 500 employees, does not have more than 500 employees (those employed full-time, part-time or on another basis) at any one location and the business' primary NAICS code starts with "72" (Accommodation and Food Service – e.g., hotels, motels, restaurants, etc.); or is a franchisee holding a franchise listed on the SBA's registry of approved franchise agreements; or has received financing from a Small Business Investment Corporation. 

    Farmers and ranchers are eligible for PPP loans if the business has 500 or fewer employees; or the business has average annual gross receipts of $1 million or less.  If neither of those tests can be satisfied, the ag business can still qualify if the net worth of the business does not exceed $15 million and the average net income after federal income taxes (excluding carry over losses) for the two full fiscal years before the date of the PPP application does not exceed $5 million.  Affiliation rules are used, when applicable, in determining qualification under the tests.   

    Sole proprietorships and self-employed individuals (i.e., independent contractors) may qualify under this program if the sole proprietor/self-employed person has a principal residence in the United States, and the individual filed or will file a Schedule C for 2019.

    Note:  While the SBA guidance on the issue only refers to Schedule C businesses, it seemed that “Schedule F” should be able to be substituted.  Further guidance, discussed below, has added some clarity to the issue. 

    Additionally, certain I.R.C. §501(c)(3) organizations; qualified veterans’ organizations; employee stock ownership plans; and certain Tribal businesses are also eligible.  Ineligible businesses are those that have engaged in any illegal activity at the federal or state level; household employers; any business with a 20 percent or more owner that has a criminal history; any business with a presently delinquent SBA loan; banks; real estate landlords and developers; life insurance companies; and businesses located in foreign countries.

    The terms and conditions, like the guaranty percentage and loan amount, may vary by the type of loan.  The lender must be SBA-approved.  The loan proceeds can be used for payroll costs (up to a per-employee cap of $100,000 of cash wages (as prorated for the covered period)); a mortgage or rent obligation; payment of utilities; and any other debt obligation incurred before the “covered period” (February 15, 2020 – June 30, 2020) – however, amounts incurred on this expense is not eligible for forgiveness) plus compensation paid to an independent contractor of up to $100,000 per year.  Included in the definition of “payroll costs” are salary, wages, commissions, or similar compensation; guaranteed payments of a partner in a partnership and a partner’s share of income that is subject to self-employment tax (subject to a per-partner cap of $100,000); cash tips; payment for vacation, parental, family, medical or sick leave; an allowance for dismissal or separation; payments for providing group health care benefits, including insurance premiums; payment of retirement benefits; payment of state or local tax assessed on the compensation of employees; and agricultural commodity wages.  Not included in the computation of payroll costs are Federal FICA and Medicare taxes and Federal income tax withholding (but, SBA has subsequently taken the position that this is to be ignored  such that the computation should be based on gross payroll); any compensation paid to an employee whose principal place of residence is outside the United States (e.g., H-2A workers); qualified sick leave and family leave wages that receive a credit under the Families First Coronavirus Response Act. 

    Note:  Wages for an H-2A worker employed under an H-2A contract for over 180 days can establish their U.S. address as their principal residence and include their wages in average payroll.  Once, associated utility costs should also count as eligible expenses. 

    Under the PPP, the bank can lend up to 250 percent of the lesser of the borrower’s average monthly payroll costs (before the virus outbreak) or $10,000,000 (with some exclusions including compensation over $100,000).  For example, if the prior year’s payroll was $300,000, the maximum loan would be $62,500 (total payroll of $300,000 divided by 12 months = 25,000 x 2.5 = $62,500).  The SBA guarantee is 100 percent. 

    Note:  For farm borrowers, some lenders have been reported as claiming that the receipt of a PPP loan makes the farmer ineligible for the ag part of the CARES Act Food Assistance Program.  That is incorrect.  It is also incorrect that the receipt of a PPP loan by a farmer impacts the farmer’s USDA subsidies.  The is no statutory support for either of those propositions. 

    Self-employed taxpayers became eligible for loans on April 10, 2020.  For a self-employed taxpayer, the loan amount is based on the taxpayer’s net self-employment earnings, limited to $100,000 of net self-employment income.  The maximum loan to a self-employed taxpayer is set at 20.8333 percent of self-employment earnings (plus other payroll costs).  For a Schedule C taxpayer, that amount can be determined from line 31 (net profit).  If that amount is over $100,000, the loan is limited to $100,000.  If line 31 is a loss, the loan amount would normally be zero, but one-half of employee payroll costs can be added in.  For a 2019 Schedule F, the applicable line is line 34.  A copy of the taxpayer’s 2019 Schedule C (or Schedule F) must be provided to SBA.

    Note:  The SBA has taken the position that a loss is shown on line 34 of Schedule F that the taxpayer does not qualify for any loan based on earnings and could only qualify for a loan based on employee payroll costs.Thus, the income of a farmer reported on Form 4797 (as the result of an equipment trade, for example, will not qualify.  Thus, while a farmer’s Schedule F income might be a loss, but significant income may be present on Form 4797 (which is not subject to self-employment tax), such a farmer will not be able to reconcile the Schedule F to include all equipment gains.  Likewise, gains attributable to farmland and buildings are also excluded.  Presently, it is unknown whether rental income that is not reported Schedule F qualifies (such as that reported on either Schedule E or on Form 4835). 

    The amount of loan forgiveness for a self-employed taxpayer equals 2/13 of the 2019 line 31 income.  Thus, for a loan that is limited to $20,833, the amount forgiven would be $15,384 ($100,000/52 x 2.5). 

    For partnerships, filing is at the partnership level.  This precludes each partner from receiving a loan.  The law is unclear, however, whether income is based on guaranteed payments to partners or partnership gross receipts.   According to the SBA’s interpretation, a partnership is allowed to count all employee payroll costs.  In addition, the partnership can count all self-employment income of partners computed as the total self-employment income reported on line 14a of Schedule K/K-1.  That amount is then reduced by any I.R.C. §179 expense deduction claimed; unreimbursed partnership expenses claimed, and depletion claimed on oil and gas properties.  That result is then multiplied by 92.35% to arrive at net self-employment earnings. If the final amount exceeds $100,000, it is to be reduced to $100,000. 

    Note.  Multiplying by 92.35% for Schedule F farmers appears not to be required but may be required in a future announcement since the same calculations usually apply to Schedule C and Schedule F filers on Schedule SE.

    Note:  Many farm partnerships have a manager managed LLC structure that allows for a reduction in self-employment tax.  Even though this income is considered to be ordinary income, it appears that none of that income will qualify for a PPP loan.

    Note:  S or C corporations are only allowed to use taxable Medicare wages & tips from line 5c of Form 941.  These wages are subject to FICA and Medicare taxes.

    Based on the SBA position, if it is determined to apply to Form 943 filers, commodity wages will not be allowed for calculating total employee payroll costs.  Thus, it is possible that if a farmer received an original PPP loan using commodity wages, the loan may need to be revised. 

    Likewise, if a taxpayer has an interest in more than one partnership that are treated as self-employed entities, a question remains as to whether each entity can qualify for a loan.  For instance, if a farmer is a partner in three partnerships and earns at least $100,000 of net self-employment earnings in each partnership, can each partnership use the farmer’s full $100,000 compensation limit or must it be allocated among each partnership?  

    For an LLC that is taxed as a partnership, only the amount a partner receives as a guaranteed payment is taxed as self-employment income.  For taxpayer’s with interests in multiple single-member LLCs, a holding company can file for the entities under its ownership or each entity can file for a loan.  What is not known is whether if only one entity is profitable whether a loan can be filed only for the profitable entity.  Similarly, it is not known whether a taxpayer’s compensation from each entity is allowed in full (if it is doesn’t exceed $100,000/entity) even though total earnings exceeds $100,000, or whether the taxpayer’s compensation is limited to $100,000. 

    The interest rate is set at one percent and cannot exceed 4 percent. Payments, including principal, interest and fees can be deferred anywhere from six to 12 months, and the SBA will reimburse lenders for loan original origination fees. A borrower can then apply for loan forgiveness to the extent the loan proceeds were used to cover payroll costs (at least 75 percent), mortgage interest, rent and utility payments during the eight-week period following loan disbursement. 

    Note:  According to the SBA, the forgivable portion of the non-payroll costs is limited to 25 percent. 

    The borrower must have been in business as of February 15, 2020 and employed employees and paid salaries and taxes or had independent contractors and filed Form 1099-MISC for them. Guarantee fees are waived, and the loans are non-recourse to the borrower, shareholders, members and partners of the borrower.  There is no collateral that is required, and the borrower need not show an inability to secure financing elsewhere before qualifying for financing from the SBA. 

    The SBA will pay lenders for processing loans under the Payroll Protection Program in an amount of 5 percent of the loan up to $350,000; 3 percent of the loan from $350,000 to $2 million; and 1 percent of loans of $2 million or more.  Lender fees are payable within five days of disbursement of the loan. 

    A borrower under the PPP can apply for loan forgiveness on amounts the borrower incurs after February 14, 2020, in the eight-week period immediately following the loan origination date (e.g., the receipt of the funds) on the following items (not to exceed the original principal amount of the loan): gross payroll costs (not to exceed $100,000 of annualized compensation per employee); payments of accrued interest on any mortgage loan incurred prior to February 15, 2020; payment of rent on any lease in force prior to February 15, 2020 (no differentiation is made between payments made to unrelated third parties and related entities (self-rents)); fuel for business vehicles and, payment on any utilities, including payment for the distribution of electricity, gas, water, transportation, telephone or internet access for which service began before February 15, 2020.  The amount forgiven is not considered taxable income to the borrower.  Documentation of all payment received under the PPP is necessary to receive forgiveness.  Any amount that remains outstanding after the amount forgiven is to be repaid over two years, after a six-moth deferral, at a one percent interest rate. 

    Note:  For a sole proprietorship or self-employed individual, it is unclear whether the loan forgiveness amount is based on eight weeks of self-employment income in 2019 plus amounts spent on qualified amounts, or whether the amount forgiven is limited to eight weeks of self-employment income.   

    The amount forgiven will be reduced proportionally by any reduction in the number of full-time equivalent employees retained as compared to the prior year. The proportional reduction in loan forgiveness also applies to reductions in the pay of any employee.  The reduction if loan forgiveness applies when the reduction of employees or an employee’s prior year’s compensation exceeds 25 percent.  It is increased for wages paid to employees that are paid tips. A borrower will not be penalized by a reduction in the amount forgiven for termination of an employee made between February 15, 2020 and April 26, 2020, as long as the employee is rehired by June 30, 2020.

    Note:  For both the loan calculation and the amount of forgiveness a taxpayer cannot include any owner’s health insurance or retirement payments.  Reference is to simply be made to Schedule C or Schedule F net income. 

    Note:  As for loan forgiveness for the self-employed owner compensation, apparently Schedule C (of Schedule F) compensation shown on the 2019 return is used.  This amount is then divided by 52 (weeks in the year) and multiplied by eight.  The resulting amount is (apparently) forgiven. 

    The SBA “audits” the requirements that taxpayers certify both that there was economic uncertainty and that the funds were actually needed in order to keep employees on the payroll and paid during the period February 15, 2020 through June 30, 2020.  For farmers, with sufficient liquidity that not poised to shut-down, being able to establish that that the funds were needed for payroll purposes could be difficult to establish.  This could be particularly true for grain farmers and others that are currently planting crops, have sufficient liquidity or lines-of-credit available, and have an adequate percent of their crop insured and have the ability to pay their employees.  For dairy, livestock and produce operations, it will likely be much easier to satisfy the payroll requirement.  Clearly, documentation as to the need for the loan is critical to maintain, as is documentation after the end of the eight-week loan forgiveness period. 

    Note:  A taxpayer that receives a PPP loan is ineligible for the Employee Retention Tax Credit. (discussed next), and is barred from applying for unemployment.

    Certain qualified small businesses are eligible for loan forgiveness of certain SBA loans.  A “covered loan” is a loan added under new §7(a)(36) of the Small Business Act (15 U.S.C. §636(a)).  The amount forgiven is equal to the sum of costs incurred and payment made during the eight-week period beginning on the covered loan’s origination date.  Forgiven amounts are excluded from gross income up to the principal amount of the loan.  To be forgiven, loan proceeds must be used to cover rent paid under a lease agreement in force before February 15, 2020; a mortgage that was entered into in the ordinary course of business that is the borrower’s liability, and is a mortgage on real or personal property incurred before February 15, 2020; or utilities (electricity, gas, water transportation, telephone or internet access) for which service began before February 15, 2020.  The borrower must verify that the amount for which forgiveness is requested was used for the permissible purposes.  The amount of loan forgiveness is subject to a reduction formula tied to employee layoffs.  The numerator of the formula it the average number of full-time employees per month.  The denominator is, at the borrower’s election, the average number of full-time employees per month employed from Feb. 15, 2019 to Jun. 30, 2019 or the average number of full-time employees per month employed from Jan. 1, 2020 to Feb. 29, 2020. 

    Note:  Expenses attributable to loan forgiveness (rent, mortgage, utilities, etc.) are not deductible.  See I.R.C. §265. 

    Employers with seasonal employees use a different formula to calculate payroll costs.  A seasonal employer uses the average total monthly payments for payroll for the twelve-week period beginning Feb. 15, 2019; or, by election, Mar. 1, 2019 through Jun. 1, 2019.  As an alternative, the employer may choose to use any consecutive 12-week period between May 1, 2019 and September 15, 2019.  Thus, if payroll costs are much higher in the summer time to harvest crops, the employer will qualify for a larger PPP loan.     

    To receive any loan forgiveness, the employer must spend at least 75 percent of the loan proceeds on labor costs.  There is also a reduction formula for employee salaries and wages, with the amount forgiven reduced by the amount of any reduction in salary or wages of any employee during the covered period.  That is the excess of 25 percent of total salary and wages for the most recent quarter for that employee.  For purposes of this formula, employees earning over $100,000 are excluded.  If an employer rehires the employees or raises salaries and wages back to their prior level by Jun. 30, 2020, the rehire is not considered for purposes of the formula.  CARES Act, §1106.

  • Employee Retention Credit. If a government order requires an employer to partially or fully suspend operations due to the virus (there is no statutory definition of “partially” or “fully”), or if business gross receipts have declined by more than 50 percent as compared to the same quarter in the immediately prior year,  the employer can receive a payroll tax credit equal to 50 percent of employee compensation (“qualified wages”) up to $10,000 (per employee) paid or incurred from March 13, 2020 and January 1, 2021. For employers with greater than 100 full-time employees, qualified wages are wages paid to employees when they are not providing services (“services” is undefined) due to the coronavirus-related circumstances described above. For eligible employers with 100 or fewer full-time employees, all employee wages qualify for the credit, whether the employer is open for business or subject to a shut-down order. Qualified wages must not “exceed the amount such employee would have been paid for working an equivalent duration during the 30 days immediately preceding such period.”  As noted, the credit applies to the first $10,000 of compensation, including health benefits, paid to an eligible employee. The credit is provided for wages paid or incurred from March 13, 2020 through December 31, 2020.
  • The credit is allowed in each calendar quarter against Medicare tax or the I.R.C. §3221(a) tax imposed on employers at the rate of 50 percent of wages paid to employees during the timeframe of the virus limited to the applicable employment taxes as reduced by any credits allowed under I.R.C. §§3111(e) and (f) as well as the tax credit against amounts for qualified sick leave wages and qualified family leave wages an employer pays for a calendar quarter to eligible employees under the FFCRA.  Thus, “applicable employment taxes” are reduced by the I.R.C. §§3111(e)-(f) credits and those available under the FFCRA.  Then, the resulting amount is reduced by the Employee Retention Credit.  If a negative amount results, the negative amount is treated as an overpayment that will be refunded pursuant to I.R.C. §6402(a) and I.R.C. §6413(b).  CARES Act, §2301.
  • Express Loan Program. The SBA’s Express Loan Program loan limit is increased to $1 million (from $350,000) until December 31, 2020.  This program features an accelerated turnaround time for SBA review, with a response to applications within 36 hours.  CARES Act, §1102(c).
  • Tax Credit to Fund Paid Sick Leave. An employer with an employee that is paid sick-leave on account of the virus receives a FICA tax credit (employer share only) equal to the lesser of wages plus health care costs or $511 per day for up to 10 days.  An employer providing sick leave to an employee with a sick family member, the credit is $200 per day, up to a maximum of $10,000.

Planning strategies.  For businesses with immediate cashflow needs, a $10,000 EIDL grant can be applied for.  Simultaneously, application can be made for PPL program loan.  But, as noted, the basis for the separate loans and the costs being paid with each loan are different.  An application can then be made seeking loan forgiveness.  If this approach is inadequate, a traditional EIDL loan can be applied for.  Also, if the business has sufficient cashflow, one of the FICA/Medicare tax credit options can be considered.  Also, for employers with employees impacted by the virus or are caring for affected family members, the sick leave credit or the employee retention credit can be utilized if business operations were suspended or if gross receipts declined substantially. 

Conclusion

The CARES Act contains many provisions that small employers can utilize to bridge the economic divide created by the government reaction to the virus.  As the new programs are implemented rules will be developed that should address presently unanswered questions.  The SBA has up to 30 days following the enactment of the CARES Act to issue regulations implementing and providing guidance on certain CARES Act provisions.  In addition, the Treasury Department is required to issue regulations implementing and providing guidance under many CARES Act provisions. Issuance of regulations and guidance could delay loan approval and disbursement or modify/waive certain loan requirements.

The disaster/emergency legislation also made numerous tax changes. Those will be addressed in a future post.

April 1, 2020 in Bankruptcy, Business Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Wednesday, March 25, 2020

Farm and Ranch Estate And Business Planning In 2020 (Through 2025)

Overview

The Tax Cuts and Jobs Act (TCJA) has made estate and business planning much easier for most farm and ranch families.  Much easier, that is, with respect to avoiding the federal estate tax.  Indeed, under the TCJA, the exemption equivalent of the unified credit is set at $11.58 million per decedent for deaths in 2020, and with an unlimited marital deduction and the ability to “port” over the unused exclusion (if any) at the death of the first spouse to the surviving spouse, very few estates will incur federal estate tax.   The TCJA also retains the basis “step-up” rule.  That means that property that is included in the decedent’s estate at death for tax purposes gets an income tax basis in the hands of the recipient equal to the property’s fair market value as of the date of death.

But, with the slim chance that federal estate tax will apply, should estate and business planning be ignored?  The answer is “no” if the desire is to keep the farming or ranching business in the family. 

The basic estate planning strategies for 2020 and for the life of the TCJA (presently, through 2025) – that’s the topic of today’s post.

Basic Considerations

Existing plans should focus on avoiding common errors and look to modify outdated language in existing wills and trusts.  For example, many estate plans utilize "formula clause" language.  That language divides assets upon the death of the first spouse (regardless of whether it is the husband or the wife) between a "credit shelter trust," which utilizes the remaining federal estate tax exemption amount, and a "marital trust," which qualifies for the (unlimited) federal estate tax marital deduction.  The intended result of the language is to cause the “credit shelter” trust’s value to be taxed in the first spouse’s estate where it will be covered by the exemption, and create a life estate in the trust property for the surviving spouse that will “bypass” the surviving spouse’s estate upon the surviving spouse’s subsequent death.  As for the martial trust assets, tax on those assets is postponed (if it is taxed at all) until the surviving spouse dies.

It’s also important to have any existing formula clauses in current estate plans reviewed to ensure the language is still appropriate given the increase in the federal exemption amount.  It may be necessary to have an existing will or trust redrafted to account for the change in the law and utilize language that allows for flexibility in planning.   

In addition, for some people, divorce planning/protection is necessary.  Also, a determination will need to be made as to whether asset control is necessary as well as creditor protection.  Likewise, consideration may need to be made of the income tax benefits of family entities to shift income (subject to family partnership rules of I.R.C. §704(e)) and create qualifying deductions for the entity.  The entity may have been created for estate and gift tax discount purposes, but now could provide income tax benefits.  In any event, family entities (such as family limited partnerships (FLPs) and limited liability companies (LLCs)) will continue to be valuable estate planning tools for farmers and ranchers with wealth that is potentially subject to federal estate (and gift) tax.

For the vast majority of family farming and ranching operations, it is not beneficial from a tax standpoint to make gifts during life.  Gifted property provides the donee with a “carryover” income tax basis.  I.R.C. §1015(a).  A partial basis increase can result if the donor pays gift tax on the gift.  I.R.C. §1015(d).   If the property is not gifted, but is retained until death the heirs will receive a income tax basis equal to the date of death value.  I.R.C. §1014.  That means income tax basis planning is far more important than avoiding federal estate tax for most people.  But, some states tax transfers at death with exemptions that are often much lower than the federal exemption.  In those situations, planning to avoid or minimize the impact of state estate/inheritance tax should not be ignored.  Also, consideration should be made to determine whether insurance is still necessary to fund any potential estate tax liability  

Other estate planning points to consider include:

  • For life insurance, it’s probably not a good idea to cancel the policy before having that move professionally evaluated. That’s particularly the case for trust-owned life insurance.  For pension-owned life insurance, for those persons that are safely below the exemption, adverse tax consequences can likely be avoided.
  • Evaluate irrevocable trusts and consider the possibility of “decanting.” Decanting is the process of pouring the assets of one irrevocable trust into another irrevocable trust that contains more desirable terms.  The rules surrounding trust decanting are complex concerning the process of decanting, but it can be a valuable option when unforeseen circumstances arise during trust administration.
  • For durable powers of attorney, examine the document to see whether there are caps on gifted amounts (the annual exclusion is now $15,000) and make sure to not have inflation adjusting references to the annual exclusion.
  • For qualified personal residence trusts (QPRTs) that were created when the estate tax exemption was $2 million, the conventional advice was to deed the house from the QPRT to the children or a remainder trust (which might have been a grantor trust), with a written lease agreement in favor of the parent/donor who would continue to live in the house. Now, it may be desired to have the home included in the estate for basis step-up purposes and the elimination of gain on sale.
  • While FLPs and LLCs may have been created to deal with an estate tax value-inclusion issue, it may not be wise to simply dismantle them because estate tax is no longer a problem for the client. Indeed, it may be a good idea to actually cause inclusion of the FLP interest in the estate.  This can be accomplished by revising the partnership or operating agreement and having a parent document control over the FLP.  Then, an I.R.C. §754 election can be made which can allow the heirs to get a basis step-up.
  • At least through 2025, the choice of entity for the operational side of the farm/ranch business should be reevaluated in light of the 20 percent qualified business income deduction for non-C corporate businesses and the 21 percent income tax rate for C corporations.

Other Planning Issues

While income tax basis planning (using techniques to cause inclusion of asset value in the estate at death) is now of primary importance for most people, asset protection may also be a major concern.  Pre-nuptial agreements have become more common in recent decades, and marital trusts are also used to ultimately pass assets to the heirs of the first spouse to die (who may not be the surviving spouse’s heirs) at the death of the surviving spouse. 

Powers of attorney for both financial and health care remain a crucial part of any estate plan.  For a farm family, the financial power should be in addition to the FSA Form 211, and give the designated agent the authority to deal with any financial-related matter that the principal otherwise could. 

For farms and ranches concerning about the business remaining viable into subsequent generations, the building of a management team is essential.  This involves the development of management skills in the next generation, communication and recognizing various strengths and weaknesses of the persons involved.  It’s also critical to ensure fair compensation for the inputs of labor and/or capital involved and adjust compensation arrangements over time as the changes in the inputs occur.  Also, valuing ownership interests in a closely-held farming/ranching business is important.  This can be largely achieved by a well thought-out and drafted buy-sell agreement as well as a first-option agreement.

Conclusion

While estate planning has been made easier by the TCJA, that doesn’t mean that it is no longer necessary.  Reviewing existing plans with an estate planning professional is important.  Also, the TCJA is only temporary.  The estate and gift tax provisions expire at the end of 2025. When that happens, the exemption reverts to what it was under prior law and then is adjusted for inflation.  If current law is not extended, it is estimated that the federal estate and gift tax exemption will somewhere between $6.5 and $7.5 million.  While those numbers are still high enough to cover the vast majority of people, they are a far cry from the present $11.58 million amount. 

One thing is for sure – a great deal of wealth is going to transfer in the coming decades.  One estimate I have seen is that approximately $30 trillion in asset value will transfer over the next 30-40 years.  That’s about a trillion per year over that timeframe.  A chunk of that will involve farm and ranch real estate, livestock, equipment and other personal property.

These topics will be addressed in detail at the Summer Ag Tax and Ag Estate/Business Conference in Deadwood, South Dakota on July 20-21.  You can learn more about the conference and register here:  http://washburnlaw.edu/employers/cle/farmandranchtax.html

March 25, 2020 in Business Planning, Estate Planning | Permalink | Comments (0)

Friday, March 13, 2020

More Selected Caselaw Developments of Relevance to Ag Producers

Overview

Periodically on this blog I write about recent caselaw and IRS developments that farmers, ranchers and others should be aware about.  The courts are constantly churning out cases that are important to agriculture and tax developments are always non-stop.  It’s amazing how broad the reach is of the issues the courts and IRS address that touches agriculture in one way or another.  Many of these issues may not be given much thought on a daily basis, but perhaps they should.

In today’s post, I look at a few more recent developments of relevance to agriculture – it’s the focus of today’s post.

IRS Loses Valuation Case

Grieve v. Comr., T.C. Memo. 2020-28

When interests in closely-held businesses are transferred, either by death or gift, and either federal estate or gift tax is involved, the valuation issue becomes highly relevant.  For farms and ranches, blocks of non-controlling stock may be involved and the IRS may seek to apply a premium to the value of the stock to increase estate or gift taxes owed.  Recently, the U.S. Tax Court shot down an IRS attempt to attach a premium to a gift of non-controlling stock among family members. 

In the case, after the petitioner’s wife died, he formed two LLCs (Rabbit and Angus) for financial management and estate planning purposes. He then transferred some of the Class B shares of Rabbit to a grantor-retained annuity trust (GRAT) and the Class B shares of Angus to an irrevocable trust. The petitioner filed a 2013 gift tax return (Form 709) and attached appraisal reports that reported a taxable gift of nearly $10 million. The IRS rejected that valuation, claiming that the proper valuation was $17.8 million, and issued a notice of deficiency.

The Tax Court examined both appraisal reports, noting that the petitioner’s appraisal reports included independent analysis of the LLC shares using a combination of market and income approaches to determine the total value. Conversely, the Tax Court noted that the IRS included an assumption that selling the Class B share would encourage the petitioner’s daughter (who solely owned the Class A shares) to sell her 0.2 percent interest in the entities, which would increase the petitioner’s interests. However, the daughter testified that she would not be inclined to sell her interest, and if she were to sell, would seek a much higher premium that the IRS estimated. The Tax Court also determined that the IRS appraisal also relied on additional hypothetical scenarios that were inconsistent and insufficient to consider a change to the petitioner’s appraisal and the discounts concluded in the report. In addition, the Tax Court noted that the IRS appraiser failed to provide support for the valuations, and also did not provide evidence that his appraisal methodology was subject to peer review.

The Tax Court concluded that the IRS failed to provide sufficient evident to support its expert appraiser’s conclusion that the interests of the LLCs were undervalued and that the petitioner’s gifts of the assets to the two trusts were likewise undervalued. The Tax Court rejected the IRS position that the petitioner had underreported gift tax by $4.4 million and also rejected the IRS penalties of $600,000. 

IRAs and the Constitution

Conard v. Comr., 154 T.C. No. 6 (2020)

So that people are disincentivized from using their retirement savings for things other than retirement, the IRS hits withdrawals before age 59-1/2 with a 10 percent penalty.  Exceptions to the penalty apply, but even if a taxpayer fits within an exception the amount withdrawn still must be reported into income.  Exemptions include distributions made post-death; because the account owner is total and permanently disabled, to cover qualified post-secondary education expenses; distributions made after being called to active military duty for 180 days; or within a year of a child’s birth or adoption. 

The U.S. Tax Court recently dealt with a constitutional challenge to such penalty exemptions.  In the case, the petitioner had not yet reached age 59-1/2 at the time the she received a distribution from a qualified retirement plan. Consequently, the IRS assessed the 10 percent early withdrawal penalty of I.R.C. §72(t). She sought review of the asserted tax deficiency and challenged the additional tax on the basis that the application of the tax to her early distribution violated the Constitution’s Fifth Amendment Due Process Clause because exceptions exist to the penalty that are applicable to taxpayers that haven’t reached age 59-1/2, such as for disability, etc.

The Tax Court disagreed, applying the rational basis test (low-level scrutiny) to evaluate the constitutionality of the Code provision. The Tax Court determined that test applied because the provision did not invade a substantive constitutional right or freedom or involve a suspect classification. As a result, the constitutionality of the provision could only be overcome by an explicit demonstration that the statute established hostile and oppressive discrimination against particular persons and classes. The Tax Court noted that the petitioner did not claim that the penalty provision concerned a substantive constitutional right or freedom or involved a suspect classification. Age is not a suspect classification for purposes of equal protection. Thus, the provision was presumed constitutional if it had a legitimate governmental purpose. The Tax Court noted that Committee Reports concerning the provision provided that the statute aimed “to provide means for financing retirement” and that penalties for early withdrawals were “designed to insure that retirement plans will not be used for other purposes.” An exemption from the penalty for disability, for example, satisfied a legitimate objective of encouraging taxpayers to provide for times of inability to work. 

Huge FBAR Penalty Imposed

United States v. Ott, No. 18-cv-12174, 2020 U.S. Dist. LEXIS 32514 (E.D. Mich. Feb. 26, 2020)

In recent years, some farmers and ranchers have started operations in locations other than the United States.  Others may have bank accounts in foreign jurisdictions.  Still others may serve as an agent under a power of attorney for someone that has a bank account in a foreign jurisdiction.  In that event, every year, under the Bank Secrecy Act, anyone that owns or has an interest in or signature authority over certain foreign accounts such as bank accounts, brokerage accounts and mutual funds, must report the account(s) by filing a Report of Foreign Bank and Financial Accounts (FBAR) on FinCEN Form 114.  The proper box must also be checked on Schedule B of Form 1040.  Failure to do so can trigger a penalty.  Willful failure to do so can result in a monstrous penalty.  A recent case points out how bad the penalty can be for misreporting.

In the case, the taxpayer had a foreign bank account with aggregate highest balance of $1.9 million, $770,000 and $1.76 million for the three tax years at issue. Form 1040, Schedule B contains a question with a box to be checked asking whether the taxpayer had a financial interest in or signature authority over a financial account located in a foreign country. The box on Schedule B was checked “No” which was the default in the software that the return preparer used. The taxpayer also did not file an FBAR Form for any of the three years. The FBAR Form is required to be filed when the aggregate account balance exceeds $10,000.

The IRS claimed that the taxpayer had constructive knowledge of his reporting requirements by signing his tax returns which included a reference to the FBAR on Schedule B, and that the naming his sister's Canadian address on the accounts was an act of concealment. The taxpayer argued that he was simply negligent and there was no will failure to file the FBARs. The Court examined the definition of willfulness for purposes of FBAR filing and concluded that the taxpayer could have easily determined the need to file the FBAR. Accordingly, the court held that the taxpayer willfully failed to file the FBAR Form and assessed penalties for the years at issue in the amount of $988,245. 

Lakes Have Constitutional Rights?

Drewes Farms Partnership v. City of Toledo, No. 3:19 CV 434, 2020 WL 966628 (N.D. Ohio Feb. 27, 2020) No. 3:19 CV 434 2020 U.S. Dist. LEXIS 36427 (N.D. Ohio Feb. 27, 2020)

The genesis of this case actually began in a bar in Toledo (no word on whether the bar was across from the depot).  Apparently, the inebriated were commiserating over the pollution of Lake Erie.  Ultimately, the ideas of that night got formulated into a ballot question at a special election for the citizens of Toledo concerning whether Lake Erie should be granted legal rights that people have.  It was the first rights-based legislation in the U.S. aimed at protecting an ecosystem – Lake Erie, its tributaries and the species that live there. 

When election time came, sufficient Toledo citizens voted to add the “Lake Erie Bill of Rights” (LEBOR) to the city’s charter in early 2019. The LEBOR prohibited any infringement of the “rights” of Lake Erie to “exist, flourish, and naturally evolve” without explaining the kind of conduct that would infringe those “rights.” The plaintiff, a farming operation that grows crops in four counties near Toledo and Lake Erie, sued to invalidate the LEBOR on constitutional grounds for lack of due process as being void for vagueness. The court agreed and vacated the LEBOR in its entirety. 

Conclusion

There are always developments involving agriculture.  It’s good to stay informed. 

March 13, 2020 in Business Planning, Estate Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Thursday, March 5, 2020

Registration Open For Summer Ag Income Tax/Estate and Business Planning Seminar

Overview

Registration is now open for this summer’s national ag tax and estate/business planning conference in Deadwood, South Dakota.  The conference is set for July 20-21 at The Lodge at Deadwood.  In today’s post I briefly summarize the conference, the featured speakers and registration.

Deadwood, South Dakota - July 20-21, 2020

The conference will be in Deadwood, South Dakota on July 20 and 21.  The event is sponsored by the Washburn University School of Law.  The Kansas State University Department of Agricultural Economics is a co-sponsor. Some of the morning and afternoon breaks are sponsored by SkySon Financial and Safe Harbour Exchange, LLC.  The location is The Lodge at Deadwood.  The Lodge is relatively new, opening in 2009.  It is located just west of Deadwood on a bluff that overlooks the town.  You can learn more about The Lodge here: https://www.deadwoodlodge.com/hotel.  The Lodge has great conference facilities and also contains the Deadwood Grille featuring Western dining.  For families with children, The Lodge contains an indoor water playland.  There is also transportation from The Lodge to Main street in Deadwood where the shops and local attractions are located.  Deadwood is in the Black Hills area of western South Dakota.  Nearby is Mt. Rushmore, Crazy Horse, Custer State Park, Devil’s Tower and Rapid City.  The closest flight connection is via Rapid City.  The Deadwood area is a beautiful area, and the weather in late July should be fabulous. 

Featured Speakers

On Day 1, July 20, joining me on the program will be Paul Neiffer.  Paul has been doing the summer seminars with me for several years now and is affiliated with CliftonLarsonAllen, LLP.  We enjoy working together to provide the best in ag tax education that you can find.  We will discuss new cases and IRS developments; GAAP Accounting; restructuring credit lines; deducting bad debts; forgiving installment sale debt and some passive loss issues.  We will also get into advanced tax planning issues associated with the qualified business income deduction of I.R.C. Sec. 199A as well as net operating loss issues under the new rules; FSA advanced planning and like-kind exchanges when I.R.C. §1245 property is involved. 

Also with us as a Day 1 speaker is the honorable Judge Elizabeth Paris of the U.S. Tax Court.  She will provide an informative session on litigating a case before the U.S. Tax Court and the special rules and procedures of the court – what you need to know before filing a case with the Tax Court.  Judge Paris has issued opinions in several important ag cases during her tenure on the court, including Martin v. Comr., 149 T.C. 293 (2017), and is a great speaker.  You won’t want to miss her session.

I will lead off Day 2, July 21, with coverage of the most recent ag-related cases and rulings impacted farm and ranch estate and business planning.  Also joining me on Day 2 will be Prof. Jeffrey Jackson, a colleague of mine at Washburn University School of Law.  He will present a session on gun trusts for holding firearms and the unique issues that passing firearms at death can present.  Prof. Jackson will discuss what a gun trust is and how it works, what it cannot do, and client counseling with respect to passage of firearms by gift or at death.  Prof. Jackson's presentation will be followed by a session involving a comprehensive review of the new rules surrounding retirement planning after the SECURE act by Brandon Ruopp, an attorney from Marshalltown, Iowa.  

Also making a presentation on Day 2 will be Marc Vianello.  Marc is a CPA and the managing member of Vianello Forensic Consulting, LLC.  He is an experienced financial professional with and intensive 30-year history as a forensic accountant and expert witness regarding damages in highly complex litigation, including breach of contract, intellectual property (patent, Lanham, trade secret, copyright), business valuation, franchise, agriculture, Qui Tam and class action, personal injury, employment, casualties, financial crimes, and all other types of income and valuation damages. Marc also has an extensive background regarding the computation of estate and gift tax discounts for lack of marketability.  Marc’s presentation will focus on how practitioners can utilize forensic accounting techniques and expert testimony to bolster a client’s position against the IRS on audit as well as in court.

Other topics that I will address on Day 2 include the common estate planning mistakes of farmers and ranchers; post-death management of the farm or ranch business; and the valuation of farm chattels and marketing rights.

Day 2 will conclude with an hour session on ethics.  Prof. Shawn Leisinger of Washburn School of Law will present a session on the ethical issues related to risk I the legal context and how to ethically advise clients concerning risk decisions. 

Webcast

If you are unable to join us in-person for the two-day event in Deadwood, the conference will be broadcast live over the web.  The webcast will be handled by Glen McBeth.  Glen handles Instructional Technology at the law library at the law school.  Glen has broadcast the last few summer seminars and does a tremendous job producing a high-quality webcast. 

Room Block

A room block has been established at The Lodge for conference attendees under Washburn University School of Law.  The rate is $169 per night and is valid from July 17 through July 22.  The room block will release on June 19.  The Lodge does not have an online link for reservations, but you may call the front desk at (877) 393-5634 and tell them they need to make reservations under the Washburn University Law School room block.  As noted, the room block begins the weekend before the seminar begins so that you can arrive early and enjoy the weekend in Deadwood and the Black Hills area before conference if you’d like. 

Alumni Event

Washburn’s law school will also be holding an alumni event at The Lodge that corresponds with the summer seminar.  There will be a social event for law school alumni and registrants of the summer seminar on Sunday evening, July 19.  That event will be followed the next day with a CLE seminar focusing on law and technology.  This CLE event will also be at The Lodge and will run simultaneously with Day 1 of the two-day summer seminar on July 20.  The summer seminar will continue on July 21.

Sponsorship

If your business is interested in sponsoring a breakfast, break or lunch, and having vending space at the conference, please let me know.  It’s a great event to interact with practitioners that represent the legal and tax needs of farmers and ranchers from across the country that are involved in many aspects of agriculture.

Conclusion

If you have farm or ranch clients that you work with on tax, estate or business planning, this conference is an outstanding opportunity to receive specialized training in ag tax in these areas and interact with others.  The conference is also appropriate for agribusiness professionals, rural landowners and agricultural producers. 

More detailed information about the conference and registration information is available here:  http://washburnlaw.edu/employers/cle/farmandranchtax.html.  I look forward to seeing you in Deadwood or having you participate via the web.   

March 5, 2020 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, February 24, 2020

Partnership Tax Ponderings – Flow-Through and Basis

Overview

For medium-sized and larger farming operations that grow crops covered by federal farm programs, a general partnership is often the entity of choice for the operational part of the business because it can aid in maximizing federal farm program benefits for the farming operation.  I have discussed this issue in prior posts – how to maximize farm program benefits in light of the overall planning goals and objectives of the family farming operation.

Partnerships, however, can present rather unique and complex tax issues.  The “flow-through” feature of partnership taxation and tax basis of a partnership interest – these are the topics of today’s post.   

Partner's income

Partnerships are not subject to federal income tax.  I.R.C. §701. The partnership’s income and expense is determined at the entity (partnership) level.  Then, each partner takes into account separately on the partner’s individual return the partner’s distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit.  I.R.C. §702.  This sounds simple enough, but the facts of a particular situation can make the application of the rule something other than straightforward. 

For example, in Lipnick v. Comr., 153 T.C. No. 1 (2019), the petitioner’s father owned interests in partnerships that owned and operated rental real estate.  In 2009, the partnerships borrowed money (in the millions of dollars) and distributed the proceeds to the partners.  The loans had a 5.88 percent interest rate and a note secured by the partnership’s assets, but no partner was personally liable on the notes.  The father deposited the proceeds of the distributions in his personal account, and he later invested the funds in money market and other investment assets which he also held in his personal accounts until his death in late 2013.  The partnerships incurred interest expense on the loans from 2009-2011, and the father treated his distributive share of the interest on the loans that the partnerships paid that passed through to him as “investment interest” on Schedule A of his individual return.  By doing so, he deducted the investment interest to the extent of his net investment income.  See I.R.C. §163(d)(1).

In mid-2011, the father transferred his partnership interests to the petitioner with the petitioner agreeing to be bound by the operating agreement of each partnership.  However, the petitioner did not become personally liable on any of the partnership loans.  The gifts relieved the father of his shares of the partnership liabilities and he reported substantial taxable capital gain as a result. 

The father also owned minority interests in another partnership that owned and operated rental real estate.  In early 2012, this partnership borrowed $20 million at a 4.19 percent interest rate and distributed the proceeds to the partners.  Partnership assets secured the associated note, but no partner was personally liable on the note.  Again, the father deposited the funds in his personal account and then invested the money in money market funds and other investment assets that he held in his personal accounts until death.  Under the terms of his will, he bequeathed his partnership interest to the petitioner. 

The loans remained outstanding during 2013 and 2014, and the partnerships continued to pay interest on them with a proportionate part passed through to the petitioner.  The petitioner treated the debts as allocable to the partnerships’ real estate assets and reported the interest expense on his 2013 and 2014 individual returns (Schedule E) as regular business interest that offset the passed-through real estate income from the partnerships.  On Schedule E, the interest expense was netted against the income from each partnership with the resulting net income reported on Forms 1040, line 17.  The IRS disagreed, construing the interest as investment interest (“once investment interest, always investment interest”) reportable on Schedule A with the effect of denying any deduction because the petitioner didn’t have any investment income.

The Tax Court disagreed with the IRS position.  The Tax Court noted that the partnership debt was a bona fide obligation of the partnership and the petitioner’s partnership interest was encumbered at the time it was gifted to him.  The Tax Court also pointed out that the petitioner did not receive any distributions of loan proceeds to him and he didn’t use any partnership distributions to make investment-related expenditures.  The Tax Court determined that the proper treatment of the petitioner was that he made a debt-financed acquisition of the partnership interests that he acquired from his father.  Under I.R.C. §163(d) the debt proceeds were to be allocated among all of the partnerships’ real estate assets using a reasonable method, and the interest was to be allocated in the same fashion.  Treas. Reg. §1.163-8T(c)(1). 

Under the tracing rule of the regulation, debt is allocated by tracing disbursements of the debt proceeds to specific expenditures.  While the tracing rule is silent concerning its application to partnerships and their partners, the IRS has provided guidance.  Notice 89-35, 1989-1 C.B. 675.  In that guidance, the IRS provided that if a partner uses the proceeds of a debt-financed distribution to acquire property held for investment, the corresponding interest expense that the partnership incurs and is passed on to the partner will be treated as investment interest.  But, the Tax Court held that the petitioner was not bound to treat the interest expense passed through to him in the same manner as his father.  The Tax Court noted that the petitioner, instead of receiving debt-financed distributions, was properly treated as having made a debt-financed acquisition of his partnership interests for purposes of I.R.C. §163(d).  He also made no investment expenditures from distributions that he received.  See Treas. Reg. §1.163-8T(a)(4)(i)(C).  Furthermore, because the partnerships’ real estate assets were actively managed in the operation of the partnerships, they didn’t constitute investment property.  The Tax Court also held as irrelevant the fact that the petitioner was not personally liable on the debts.  That fact did not mean that his partnership interest was not “subject to a debt” for purposes of Subchapter K.  It was enough that he had acquired his partnership interests subject to the partnership debts. 

Basis

A taxpayer’s income tax basis in an asset is important to know.  Basis is necessary to compute gain on sale, transfer or other disposition of the asset.  The starting point for computing basis is tied to how the taxpayer acquired the asset.  In general, for purchased assets, the purchase price establishes the taxpayer’s basis.  If the property is received by gift, the donor’s basis becomes the donee’s basis.  For property that is acquired by inheritance, the value of the inherited property as of the date of the decedent’s death pegs the basis of the asset in the recipient’s hands.  The same general rules apply with respect to a partnership interest when establishing the starting point for computing basis.  But, as with other assets, the basis in a partnership interest adjusts over the time of the taxpayer’s ownership of the interest.  For example, the basis in a partnership interest is increased by contributions to the partnership as well as taxable and tax-exempt income.  It is decreased by distributions, nondeductible expenses and deductible losses.  I.R.C. §705.  But, the deductibility of a partner’s distributive share of losses is limited to the extent that the partner has insufficient basis in the partner’s partnership interest.  I.R.C. §704(d)

Sec. 754 election

When a partnership distributes property or transfers the partner’s partnership interest (such as when a partner dies), the partnership can elect under I.R.C. §754 to adjust the basis of partnership property.  See, e.g., Priv. Ltr. Ruls. 201909004 (Dec. 3, 2018); 201919009 (Aug. 9, 2018); and 201934002 (May 16, 2019). This election allows a step-up or step-down in basis under either I.R.C. §734(b) or I.R.C. §743(b) to reflect the FMV at the time of the exchange. This election has the advantage of not taxing the new partner on gains or losses already reflected in the purchase price of his or her partnership interest. The partnership must file the election by the due date of the return for the year the election is effective, normally with the return.  In late 2017, the IRS proposed to amend Treas. Reg. §1.754-1(b)(1) to eliminate the requirement that an I.R.C. §754 election be signed by a partner of the electing partnership.  REG-116256-17, 82 Fed. Reg. 47408 (Oct. 12, 2017).    

I.R.C. §743 requires a partnership with an I.R.C. §754 election in place or with a substantial built-in loss to adjust the basis of its property when a partnership interest is transferred.  I.R.C. §743(d).  A partnership has a substantial built-in loss if the partnership's basis in its property exceeds the fair market value by more than $250,000.  Id.  But, do contingent liabilities count as “property” for purposes of I.R.C. §743?  The answer is not clear.  Treas. Reg. §1.752-7 treats contingent liabilities as I.R.C. §704(c) property, but the I.R.C. §743 regulations do not come right out and say that contingent liabilities are “property” for purposes of I.R.C. §743

The IRS addressed the lack of clarity in 2019.  In Tech. Adv. Memo. 201929019 (Apr. 4, 2019), two partnerships with the same majority owner merged.  The merging partnership was deemed to have contributed all of its assets and liabilities in exchange for an interest in the resulting partnership.  Then the interest in the resulting partnership was distributed to the partners in complete liquidation.  The resulting partnership had a substantial built-in loss – the result when either the adjusted basis in the partnership property exceeds its fair market value by more than $250,000 or the transferee partner is allocated a loss of more than $250,000 if the partnership sells its assets for fair market value immediately after the merger. 

I.R.C. §743(b) requires a mandatory downward inside-basis adjustment in this situation, but the question presented was whether it applies to a deemed distribution of an interest.  The IRS determined that it did, taking the position that a deemed distribution of an interest of the resulting partnership was to be treated as a sale or exchange of the interest of the resulting partnership.  See I.R.C. §§761(e) and 743.   

As for the adjusted basis computation in the transferred partnership interest for the transferee partner, the IRS said that the resulting partnership’s liabilities (including contingent ones) must be included in the transferee partner’s basis in the partnership interest.  They are also to be included in the transferee partner’s basis in the transferred partnership interest.  Likewise, they are to be included in the transferee partner’s share of the resulting partnership’s liabilities to the extent of the amount of the I.R.C. §731(a) gain that the transferee partner would recognize absent the netting rule of Treas. Reg. §1.752-1(f).  But, deferred cancellation-of-debt income (under I.R.C. §108(i)) is not to be included in calculating the transferee partner's share of previously taxed capital because this type of income is not taxable gain for purposes of I.R.C. §743.

Conclusion

General partnerships can be a very useful entity for the operational entity of a farm.  Liability protection can be achieved by holding the partnership interests in some form of entity that limits liability – such as a limited liability company.  But, with partnerships comes tax complexity.  When a partnership interest is transferred (by sale, gift or upon death) the tax consequences can become complicated quickly.  The same is true when partnerships are merged.  Understanding how the flow-through nature of a partnership works, and how basis is computed and adjusted in a partnership is important when such events occur.

February 24, 2020 in Business Planning, Income Tax | Permalink | Comments (0)

Friday, February 14, 2020

Summer 2020 Farm Income Tax/Estate and Business Planning Conference

Overview

Washburn University School of  Law in conjunction with the Department of Agricultural Economics at Kansas State University is sponsoring a farm income tax and farm estate/business planning seminar in Deadwood, South Dakota on July 20 and 21.  This is a premier event for practitioners with an agricultural clientele base, agribusiness professionals, farmers and ranchers, rural landowners and others with an interest in tax and planning issues affecting farm and ranch families.

For today’s post I detail the agenda for the event. 

Monday July 20

The first day of the conference begins with my annual update of developments in farm income tax from the courts and the IRS.  I will address the big ag tax issues over the past year.  That session will be followed up with a session on GAAP accounting and the changes that will affect farmer’s financial statements.  Topics that Paul Neiffer of CliftonLarsonAllen discuss will include revenue recognition and lease accounting changes.

After the morning break, I will examine several farm tax topics that are of current high importance – tax issues associated with restructuring credit lines; deducting bad debts; forgiving installment sale debt; and selected passive loss issues.  Paul will follow up my session with an hour of I.R.C. §199A advanced planning that can maximize the qualified business income deduction for clients. 

After the luncheon, U.S. Tax Court Judge Elizabeth Paris will speak for 90 minutes on practicing before the U.S. Tax Court.  She will present information all attorneys and CPAs need to consider if they are interested in representing clients in the U.S. Tax Court.  She will cover topics including the successful satisfaction of Tax Court notice pleading requirements; multiple exclusive jurisdictions of the Tax Court; troubleshooting potential conflicts and innocent spouse issues; utilizing S-Case procedures to a client’s advantage;  and available Tax Court website resources.

I will follow the afternoon break with a discussion of issues associated with net operating losses and excess business losses.  I will take a look at how the late 2017 tax legislation changed the rules for net operating losses and excess business losses – how the modified rules work; carrybacks and carryforwards; limitations; relevant guidance; business and non-business income; and entity sales. After my session, Paul will be back to discuss Farm Service Agency Advanced Planning and how to maximize a farm client’s receipt of ag program payments without sacrificing them at the altar of self-employment tax savings. 

For the final session of the day I will discuss  I will discuss real estate trades when I.R.C. §1245 property (such as grain bins and hog confinement buildings and other structures) is involved in the exchange. address the rules to know, how to identify and avoid the traps and the necessary forms to be filed   

Tuesday July 21

I will begin the second day of the conference by providing an update of key developments in the courts and the IRS over the past year that impact estate, business and succession planning for farmers and ranchers.  It will be a fast-paced survey of cases and rulings that practitioners must be aware of when planning farm and ranch estates and succession plans.  My opening session will be followed by a an hour session on how to incorporate a gun trust into an estate plan.  Prof. Jeff Jackson of Washburn Law School will lead the discussion and explore the basic operation of a gun trust to hold firearms and the mechanics of such a trust’s operation.  Jeff will discuss the reasons to create a gun trust; their effectiveness as an estate planning tool to hold firearms; common myths and understandings about what a gun trust can do; special rules associated with gun trusts; and client counseling issues associated with gun trusts.

After the morning break, Brandon Ruopp, a private practitioner from Marshalltown, Iowa, will provide a comprehensive review of the rules concerning contributions, rollovers, and required minimum distributions for IRA's and qualified retirement plans following the passage of the SECURE Act in late 2019.  I will follow Brandon’s session with a brief session on the common estate planning mistakes that farm and ranch families make that can be easily avoided if they are spotted soon enough.  With the many technical rules that govern estate and business planning, sometimes the “little things” loom large.  This session addresses these common issues that must be addressed with clients.

After the luncheon, I will provide a brief session on the post-death management of the family farm or ranch business.  I will discuss the issues that must be dealt with after the death of family member of the family business.  This session will also examine probate administration issues that commonly arise with respect to a farm or ranch estate, including the application of Farm Service Agency rules and requirements.  Also addressed will be distributional and tax issues; issues associated with partitioning property; handling marital property and disclaimers; potential CERCLA liability; and issues associated with estate tax audits.

Next up will be Marc Vianello, a CPA in the Kansas City area who is well-renown in the area of valuation discounting.  Marc’s session will provide a summary of Marc’s research into the market evidence of discounts for lack of marketability.  The presentation will challenge broadly used methodologies for determining discounts for lack of marketability, and illustrate why such discounts should be supported by probability-based option modeling. 

Following the afternoon break, I will discuss the valuation of farm chattels and marketing rights and the basic guidelines for determining the estate tax value of this type of farm property. 

The final session of the day will be devoted to ethics.  Prof. Shawn Leisinger at Washburn Law School will present an interesting session on ethical issues related to risk in a legal context and how to understand and advise clients.  Shawn’s presentation will look at how different people, and different attorneys, approach risk taking through a live exercise and application of academic risk approaches to the outcomes.  Then, the discussion looks at how an attorney can get competent and ethically advise clients concerning risk decisions in practice.  Participants will be challenged to contemplate how their personal approach to risk may impact, or fail to impact, client decisions and choices.

Law School Alumni Reception and CLE

On Sunday evening, July 19, Washburn Law School, in conjunction with the conference will be holding a law school alumni function.  Conference attendees are welcome to attend the reception.  On Monday, July 20, a separate CLE event will be held for law school alumni at the same venue of the conference.  Details on the alumni reception and the CLE topics will be forthcoming.

Registration

Registration for the conference will be available soon.  Be watching my website – www.washburnlaw.edu/waltr for details as well as this blog.  The conference will be held at the Lodge at Deadwood. https://www.deadwoodlodge.com/  A room block has been established for the weekend before the conference and for at least a day after the conference ends.

Conclusion

I hope to see you at Deadwood in July.  If you’re looking for high quality CPE/CLE for farm and ranch clients, this conference will be worth your time.

February 14, 2020 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Friday, January 17, 2020

Principles of Agricultural Law

Overview

Principles2020springedition400x533The fields of agricultural law and agricultural taxation are dynamic.  Law and tax impacts the daily life of a farmer, rancher, agribusiness and rural landowner practically on a daily basis.  Whether that is good or bad is not really the question.  The point is that it’s the reality.  Lack of familiarity with the basic fundamental and applicable rules and principles can turn out to be very costly.  As a result of these numerous intersections, and the fact that the rules applicable to those engaged in farming are often different from non-farmers, I started out just over 25 years ago to develop a textbook that addressed the major issues that a farmer or rancher and their legal and tax counsel should be aware of.  After three years, the book was complete – Principles of Agricultural Law - and it’s been updated twice annually since that time. 

The 46th edition is now complete, and it’s the topic of today’s post – Principles of Agricultural Law.

Subject Areas

The text is designed to be useful to farmers and ranchers; agribusiness professionals; ag lenders; educational professionals; laywers, CPAs and other tax preparers; undergraduate and law students; and those that simply want to learn more about legal and tax issues.  The text covers a wide range of topics.  Here’s just a sample of what is covered:

Ag contracts.  Farmers and ranchers engage in many contractual situations, including ag leases, to purchase contracts.  The potential perils of verbal contracts are numerous as one recent bankruptcy case points out.  See, e.g., In re Kurtz, 604 B.R. 549 (Bankr. D. Neb. 2019).  What if a commodity is sold under forward contract and a weather event destroys the crop before it is harvested?  When does the law require a contract to be in writing?  For purchases of goods, do any warranties apply?  What remedies are available upon breach? If a lawsuit needs to be brought to enforce a contract, how soon must it be filed?

Ag financing.  Farmers and ranchers are often quite dependent on borrowing money for keeping their operations running.  What are the rules surrounding ag finance?  This is a big issue for lenders also?  For instance, in one recent Kansas case, the lender failed to get the debtor’s name exactly correct on the filed financing statement.  The result was that the lender’s interest in the collateral (a combine and header) securing the loan was discharged in bankruptcy.   In re Preston, No. 18-41253, 2019 Bankr. LEXIS 3864 (Bankr. D. Kan. Dec. 20, 2019). 

Ag bankruptcy.  A unique set of rules can apply to farmers that file bankruptcy.  Chapter 12 bankruptcy allows farmers to de-prioritize taxes.  That can be a huge benefit.  Knowing how best to utilize those rules is very beneficial.

Income tax.  Tax and tax planning permeate daily life.  Deferral contracts; depreciation; installment sales; like-kind exchanges; credits; losses; income averaging; reporting government payments; etc.  The list could go on and on.  Having a basic understanding of the rules and the opportunities available can add a lot to the bottom line of the farming or ranching operation. 

Real property.  Of course, land is typically the biggest asset in terms of value for a farming and ranching operation.  But, land ownership brings with it many potential legal issues.  Where is the property line?  How is a dispute over a boundary resolved?  Who is responsible for building and maintaining a fence?  What if there is an easement over part of the farm?  Does an abandoned rail line create an issue?  What if land is bought or sold under an installment contract? 

Estate planning.  While the federal estate tax is not a concern for most people and the vast majority of farming and ranching operations, when it does apply it’s a major issue that requires planning.  What are the rules governing property passage at death?  Should property be gifted during life?  What happens to property passage at death if there is no will?  How can family conflicts be minimized post-death?  Does the manner in which property is owned matter?  What are the applicable tax rules?  These are all important questions.

Business planning.  One of the biggest issues for many farm and ranch families is how to properly structure the business so that it can be passed on to subsequent generations and remain viable economically.  What’s the best entity choice?  What are the options?  Of course, tax planning is part and parcel of the business organization question. 

Cooperatives.  Many ag producers are patrons of cooperatives.  That relationship creates unique legal and tax issues.  Of course, the tax law enacted near the end of 2017 modified an existing deduction for patrons of ag cooperatives.  Those rules are very complex.  What are the responsibilities of cooperative board members? 

Civil liabilities.  The legal issues are enormous in this category.  Nuisance law; liability to trespassers and others on the property; rules governing conduct in a multitude of situations; liability for the spread of noxious weeds; liability for an employee’s on-the-job injuries; livestock trespass; and on and on the issues go.  It’s useful to know how the courts handle these various situations.

Criminal liabilities.  This topic is not one that is often thought of, but the implications can be monstrous.  Often, for a farmer or rancher or rural landowner, the possibility of criminal allegations can arise upon (sometimes) inadvertent violation of environmental laws.  Even protecting livestock from predators can give rise to unexpected criminal liability.  Mail fraud can also arise with respect to the participation in federal farm programs.  The areas of life potentially impacted with criminal penalties are worth knowing, as well as knowing how to avoid tripping into them.

Water law.  Of course, water is essential to agricultural production.  Water issues vary across the country, but they tend to focus around being able to have rights to water in the time of shortage and moving the diversion point of water.  Also, water quality issues are important.  In essence, knowing whether a tract of land has a water right associated with it, how to acquire a water right, and the relative strength of that water rights are critical to understand.

Environmental law.  It seems that agricultural and the environment are constantly in the news.  The Clean Water Act, Endangered Species Act and other federal (and state) laws and regulations can have a big impact on a farming or ranching operation.  Just think of the issues with the USDA’s Swampbuster rules that have arisen over the past 30-plus years.  It’s good to know where the lines are drawn and how to stay out of (expensive) trouble.

Regulatory law.  Agriculture is a very heavily regulated industry.  Animals and plants, commodities and food products are all subject to a great deal of regulation at both the federal and state level.  Antitrust laws are also important to agriculture because of the highly concentrated markets that farmers buy inputs from and sell commodities into.  Where are the lines drawn?  How can an ag operation best position itself to negotiate the myriad of rules?   

Conclusion

The academic semesters at K-State and Washburn Law are about to begin for me.  It is always encouraging to me to see students getting interested in the subject matter and starting to understand the relevance of the class discussions to reality.  The Principles text is one that can be very helpful to not only those engaged in agriculture, but also for those advising agricultural producers.  It’s also a great reference tool for Extension educators. 

If you are interested in obtaining a copy, you can visit the link here:  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html

January 17, 2020 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)

Friday, December 20, 2019

2020 National Summer Ag Income Tax/Estate and Business Planning Seminar

Overview

Each summer for almost 15 years, I have conducted a national summer seminar at a choice location somewhere in the United States.  During some summers, there has been more than a single event.  But, with each event, the goal is to take agricultural tax, estate planning and business planning education and information out to practitioners in-person.  Over the years, I have met many practitioners that do a great job of representing agricultural producers and agribusinesses with difficult tax and estate/business/succession planning situations.  Because, ag tax and ag law is unique, the detailed work in preparing for those unique issues is always present.

The 2020 summer national ag tax and estate/business planning seminar – it’s the topic of today’s post.

Deadwood, South Dakota - July 20-21, 2020

Hold the date for the 2020 summer CLE/CPE seminar.  This coming summer’s event will be in Deadwood, South Dakota on July 20 and 21.  The event is sponsored by the Washburn University School of Law.  The Kansas State University Department of Agricultural Economics will be a co-sponsor.  The location is The Lodge at Deadwood.  The Lodge is relatively new, opening in 2009.  It is located just west of Deadwood on a bluff that overlooks the town.  You can learn more about The Lodge here: https://www.deadwoodlodge.com/hotel.  The Lodge has great conference facilities and also contains the Deadwood Grille featuring Western dining.  For families with children, The Lodge contains an indoor water playland.  There is also transportation from The Lodge to Main street in Deadwood where the shops and local attractions are located.  Deadwood is in the Black Hills area of western South Dakota.  Nearby is Mt. Rushmore, Crazy Horse, Custer State Park and Rapid City.  The closest flight connection is via Rapid City.  To the west is Devil’s Tower in Wyoming.  The Deadwood area is a beautiful area, and the weather in late July should be fabulous. 

Featured Speakers

On Day 1, July 20, joining me on the program will be Paul Neiffer.  Paul has been doing the summer seminars with me for several years now and is affiliated with CliftonLarsonAllen, LLP.  We enjoy working together to provide the best in ag tax education that you can find.  Also, confirmed as a Day 1 speaker is the honorable Judge Elizabeth Paris of the U.S. Tax Court.  She will provide an informative session on litigating a case before the U.S. Tax Court and the special rules and procedures of the court.  Judge Paris has decided several important ag cases during her tenure on the court, and is a great speaker.  You won’t want to miss her session.

I will lead off Day 2 with coverage of the most recent ag-related cases and rulings impacted farm and ranch estate and business planning.  Also joining me on Day 2 will be Prof. Jeffrey Jackson, a colleague of mine at Washburn University School of Law.  He will present a session on gun trusts for holding firearms and the unique issues that passing firearms at death can present.  Prof. Jackson will discuss what a gun trust is and how it works, what it cannot do, and client counseling with respect to passage of firearms by gift or at death.

Also making a presentation on Day 2 will be Marc Vianello.  Marc is a CPA and the managing member of Vianello Forensic Consulting, LLC.  He is an experienced financial professional with and intensive 30-year history as a forensic accountant and expert witness regarding damages in highly complex litigation, including breach of contract, intellectual property (patent, Lanham, trade secret, copyright), business valuation, franchise, agriculture, Qui Tam and class action, personal injury, employment, casualties, financial crimes, and all other types of income and valuation damages. Marc also has an extensive background regarding the computation of estate and gift tax discounts for lack of marketability.  Marc’s presentation will focus on how practitioners can utilize forensic accounting techniques and expert testimony to bolster a client’s position against the IRS on audit as well as in court.

The Day 1 and Day 2 speakers and agenda aren’t fully completed yet, but the ones mentioned above are confirmed.  An ethics session may also be added.    

Webcast

The two-day event will be broadcast live over the web.  The webcast will be handled by Glen McBeth, Instructional Technology at the Washburn Law School Law Library.  Glen has broadcast the last few summer seminars and does a tremendous job producing a high-quality webcast. 

Room Block

A room block at The Lodge will be established and you will be able to reserve your room as soon as the seminar brochure is finalized and registration is opened.  The room block will begin the weekend before the seminar begins so that you can arrive early and enjoy the weekend in Deadwood and the Black Hills area prior to the event if you’d like. 

Alumni Event

Washburn’s law school will also be holding an alumni event at The Lodge that corresponds with the summer seminar.  Presently, the plan is to have a social event for law school alumni and registrants of the summer seminar on Sunday evening, July 19.  That event will be followed the next day with a CLE seminar focusing on law and technology.  That CLE event will also be at The Lodge and will run simultaneously with Day 1 of the two-day summer seminar on July 20.  The summer seminar will continue on July 21.

Sponsorship

If your business is interested in sponsoring a breakfast, break or lunch, and having vending space at the conference, please let me know.  It’s a great event to interact with practitioners that represent the legal and tax needs of farmers and ranchers from across the country that are involved in many aspects of agriculture.

Conclusion

Please hold the date for the July 20-21 conference and, for law school alumni (as well as registrants for the two-day event), the additional alumni reception and associated CLE event.  It looks to be an outstanding opportunity for specialized training in ag tax and estate/business planning. 

December 20, 2019 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, November 6, 2019

S Corporation Considerations

Overview

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 deathI.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. 

Conclusion

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.

November 6, 2019 in Business Planning | Permalink | Comments (0)

Monday, November 4, 2019

Some Thoughts on Ag Estate/Business/Succession Planning

Overview

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. 

Fundamental Considerations

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. 

Instructive Cases 

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.

Conclusion

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.

November 4, 2019 in Business Planning | Permalink | Comments (0)

Tuesday, October 29, 2019

Does the Sale of Farmland Trigger Net Investment Income Tax?

Overview

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.

Background

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.

Conclusion

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. 

 

October 29, 2019 in Business Planning, Income Tax | Permalink | Comments (0)