Agricultural Law and Taxation Blog

Accumulated Earnings; Starting in Farming; Ag Data and Selling the Farm and Residence

Overview

The legal and tax issues that farmers and ranchers can potentially face are practically innumerable.  Today I have pulled four more out of the hat to briefly discuss.  The first one is one that can occur if you have a C corporation and retain too much of the corporate earnings in the corporation.  The next one discusses the possibility of using the funds in a 401(k) as start-up capital for a farming business.  Will it work?  What might be a trigger for the IRS to examine?  Then I turn my attention to Ag Data.  With any technology there are pros and cons.  What might some of those be for Ag Data?  Finally, I briefly discuss how to best utilize the home-sale gain exclusion rule when selling a farm.

More food for thought on the topic of ag law and taxes – it’s the topic of today’s post.

Accumulated Earnings Tax

The accumulated earnings tax is a tax you may not have heard about.  But, if your farming business is in a C corporation or an S corporation that used to be a C corporation, it’s a tax you should be aware of. 

The accumulated earnings tax is a 20 percent penalty that is imposed when a corporation retains earnings over $250,000 that are beyond the reasonable needs of the business instead of paying dividends.  Not paying dividends avoids the shareholder-level tax on dividends. 

Whether a purpose exists to avoid the shareholder-level tax is a subjective determination based on the facts and circumstances.  Don’t unreasonably accumulate corporate earnings while not paying dividends.  Also, don’t use corporate earnings for investments unrelated to the farming business.  Corporate loans to a shareholder for personal purposes are a “no-no” as is the use of corporate funds for a shareholder’s personal benefit.

Make sure you document why you are retaining earnings.  Such reasons as needing cash to buy more farmland or insuring against business risks or buying out a senior member of the family business are fine.

But, again, make sure you record your reasons for the accumulations in your corporate annual meeting minutes and other corporate documents.  And remember, if the accumulated earnings tax applies, it’s in addition to what the corporate tax liability is.  It’s a pure penalty.

Using a 401(k) for Start-Up Capital

One of the drawbacks to starting in farming on a full-time basis is the lack of capital.  But you just might have a substantial asset that you could tap to create the necessary working capital. 

If you have a 401(k), you might be able to use the funds to start a farming business.  To do this, you will need to create a C corporation to establish a 401(k) plan and then roll over your current 401(k) at the old employer into the new 401 (k) plan.  The new plan will then buy shares in the corporation and become an owner.  The money put into the corporation will then become the working capital that the corporation can use to buy equipment and plant crops and so forth. 

There is no limit on how much stock the 401(k) can buy.  This means that unlike borrowing money from a 401(k) which is limited to $50,000 or cashing in the plan and paying taxes and a 10 percent penalty on the funds received, you can maximize the amount of capital you put into the farm business.

The IRS has noted some abuses with these transactions.  Some people have set up a corporation simply to buy a motor home for example.  If you do that and get audited, you can expect the IRS to disallow the purchase for tax purposes.  But if you use the cash to create a farming entity and will be actively farming, there should be no issue with using your 401(k) to fund it. Actively farming – that’s the key.

Ag Data and Proof of Damages

Farmers have several reasons to collect ag data about their farming practices.  One of those might be to prove damage to crops in court.  In one recent case, the management of a lake dam increased the lake level and made farm field tile in the area ineffective to drain significant rainfalls.  The result was that water ponded in the fields and significantly reduced crop yields.  But could the farmer prove his damages in terms of lost yield and revenue?

With harvesting data, the court was able to see exactly where the flooded areas of the fields were and how flooding specifically affected yields.  The data showed that flooding, and not soil type, was the reason for the lower yields in the flooded parts of the fields.  Drone photos were also used to confirm the yield data.  The court could see how the pictures of the fields matched the harvest data.  Comparison data from nearby fields that did not drain into the lake watershed was also used to show what the yield would have been without the elevated lake level. 

The court awarded the farmer almost $500,000 in damages for crop loss and field tile.  Ag data helped make the case and will be an important part of many ag tort cases in the future.  

The case is Houin v. Indiana Department of Natural Resources, 205 N.E.3d 196 (Marshall Co. Cir. Ct. 2021), aff'd. in part and rev'd in part, Indiana Department of Natural Resources v. Houin, 191 N.E.3d 241 (Ind. Ct. App. 2022).

Utilizing the Home Sale Exclusion When Selling the Farm

When selling the farm, how much land can be carved out and sold with the farm home to qualify for a special tax break? 

For married taxpayers that file jointly up to $500,000 of gain that is attributable to the sale of the taxpayer’s principal residence can be excluded from income. It’s one-half of that amount for a taxpayer that files as a single person.  But what if the farm sale also involves the residence?  How much (if any) of the farmland and outbuildings can be included with the residence to fill up that $500,000 amount?

Under current tax regulations, farmland can be treated as part of the principal residence if it is adjacent to land containing the home and is used as part of or along with the home. What is the practical application of those requirements?  The IRS rulings and court decisions indicate that the barnyard and areas used in connection with the home can be included as the “residence” portion of the sale.  Also, local zoning rules can come into play.  For many farm sales, an acre or two can likely be included with the home. 

Of course, each situation is dependent on the facts and the outcome depends on the particular situation.  But, if the facts support it, including at least some adjacent land with the principal residence can be a significant tax-saving technique.  It’s best to fill up that $500,000 amount if your facts allow you to do it.

Conclusion

It’s harvest season, so for those of you in harvest be careful and use common sense.  I have been on the road quite a bit recently – from North Dakota to Iowa to western Nebraska.  This week my travels take me to Idaho for an all-day tax seminar followed by a day of Steelhead fishing on the Salmon River.  Hopefully, I’ll get some good pictures to share with you.  Then it’s on to west Texas for two-days of tax lecturing.  Then a couple of events in Kansas before the fall KSU Tax Institutes begin.  I have also mixed in a couple of events for high school students – trying to plant seeds in the minds of young people of the need for well-trained rural attorneys.  I enjoy their questions and their enthusiasm and energy.  A tip of my hat to their teachers – I couldn’t do it.

More Legal and Tax Issues Involving Farmers and Ranchers

Overview

With today’s article I look at more legal and tax issues that farmers and ranchers need to know about.  Being aware of legal and tax issues is a means of overall risk management for the operation. 

More discussion of legal and tax issues – it’s the topic of today’s post.

Getting Sued in Another State – The Personal Jurisdiction Issue

Walters v. Lima Elevator Co., 84 N.E.3d 1218 (Ind. Ct. App. 2017)

If you engage in a business transaction involving your farm or ranch in another state and a lawsuit is filed based on that transaction, does that state’s legal system have jurisdiction over you?  In 1945, the U.S. Supreme Court said that a party (particularly a corporation or a business) could be sued in a state if the party had “minimum contacts” with that state.  International Shoe Company v. State of Washington, 326 U.S. 310 (1945).  Over time, many courts have wrestled with the meaning of “minimum contacts,” but it basically comes down to whether the party is deriving the benefit of doing business with that particular state or is sufficiently using the resources of that state.  That’s oversimplifying the application of the Court’s reasoning, but I think you get the point.

In terms of applying the “minimum contacts” theory to farm businesses, a recent case provides a good illustration.  In the case, a Michigan farmer ordered seed from an Indiana elevator about 20 miles away.  It was the third time he had done this.  He bought the seed on credit, and when it was ready he went to the elevator to pick it up.  When he didn’t pay for the seed, the elevator sued him in the local court in Indiana.  He sought to dismiss the case on the basis that the Indiana court didn’t have jurisdiction over him. He claimed that he lacked sufficient minimum contacts with Indiana to be sued there.  The court disagreed.  The Michigan farmer had “purposely availed” himself of the privilege of conducting business in Indiana.  Because of that, the court reasoned, he could have reasonably anticipated being subject to the Indiana judicial system if he didn’t pay his bill.  His due process rights were also not violated – his farm was less than 20 miles away from the Indiana elevator.

If you intentionally conduct business in a state and are sued as a result of your contacts and actions with that state, that state’s courts will likely have personal jurisdiction over you.

Social Security Planning for Farmers

Introduction

Part of retirement planning for a farmer includes Social Security benefits.  Relatedly, if you are nearing retirement age you might be asking yourself when you should start drawing Social Security benefits. The answer is, “it depends.”  But there are a few principles to keep in mind.

The first point to keep in mind is that maximum Social Security benefits can be received if you don’t withdraw benefits until you reach full retirement age – that’s presently between ages 66 and 67.  Additional benefits can be achieved for each year of postponement until you reach age 70.  Another point is that some Social Security benefits are reduced once certain income thresholds are reached.  For 2024, if you haven’t reached full retirement age and earn more than $22,320, benefits get reduced $1 for every $2 above the limit.  During the year in which you reach full retirement age, the earnings limit is $59,520 with a $1 dollar reduction for every $3 dollars over the limit. Once you hit full retirement age, the limit on earning drops off. 

In-kind wages count toward the earnings limitation test, but employer-provided health insurance benefits don’t.  Also, federal farm program payments are not earnings for years other than the first year you apply for Social Security benefits. 

So, when should you start drawing benefits?  It depends on your particular situation and your retirement plan.  The Social Security Administration has some useful online calculators that can help.  Check out ssa.gov.

Common Estate Planning Mistakes of Farmers

What are some common mistakes that farmers and ranchers make when it comes to estate planning? 

Consider the following:

• Not ensuring title ownership of property complies with your overall estate planning goals and objectives. This includes the proper use of jointly held property, as well as IRAs and other documents that have beneficiary designations. 
• Not knowing what the language in a deed means for purposes of passage of the property at death.
• Leaving everything outright to a surviving spouse when the family wealth is potentially subject to federal estate tax.
• Thinking that “fair” means “equal.” If you have both “on-farm” and “off-farm” heirs, the control of the family business should pass to the “on-farm” heirs, and the “off-farms” heirs should get an income interest that is roughly balanced in value to that of the “on-farm” heirs’ control interest.  Leaving the farm to all the kids equally is rarely a good idea in that situation.
• Letting tax issues drive the process.
• Not preserving records and key documents in a secure place where the people that will need to find them know where they are. 
• And not routinely reviewing your plan. Life events may have changed your goals or objectives.

I could list more, but these are some big ones.  Try to avoid these mistakes with your estate plan.

When is a Partnership Formed?

Farmers and ranchers often do business informally.  That informality can raise a question of whether the business arrangement has created a partnership.  If that is determined to be the case, numerous legal issues might be created. 

A big potential issue is that of unlimited liability.  Partners are jointly and severally liable for the debts of the partnership that arise out of partnership business.  Also, a partnership files its taxes differently than do individuals, and assets that are deemed to be partnership assets could pass differently upon the death of someone deemed to be a partner.

So how do you know if your informal arrangement is a partnership?  From a tax standpoint, if you’re splitting net income from the activity rather than gross, IRS could claim the activity is a partnership.  While simply jointly owning assets is not enough, by itself, to constitute a partnership, if you refer to you and your co-worker as “partners” or create a partnership bank account or fill out FSA documents as a “partnership,” a court could conclude the activity is a partnership.  Most crop-share or livestock share leases are not partnerships, but you must be careful.  It’s best to execute a written lease and clearly state that no partnership is intended if you don’t want questions to come up.

The IRS missed asserting that an informal partnership arrangement had been created by a mother and her daughter in a Tax Court case last year involving an Oklahoma ranch, and also lost on a hobby loss argument.  Carson v. Comr., 2024 U.S. Tax Ct. LEXIS 1624 (U.S. Tax Ct. May 18, 2023).  Don't count on IRS missing the same arguments in your situation.

Conclusion

There will be more issues to discuss next time.

More Legal Scenarios Involving Farmers and Ranchers

Overview

As I have noted many times before.  There are many ways in which the law intersects with the daily lives of farmers and ranchers.  Today’s article addresses several of those areas.  Just a little thinking out loud on a random basis.

Self-defense; Good Samaritan laws; preparing for the exit; and cleaning out fencerows – some random topics addressed in today’s post.

Self-Defense

A common question in agricultural settings is how far you can go in defending your personal property from those that would cause damage or steal.  

Agricultural property is often exposed to those who might want to steal, damage or destroy. Where’s the line drawn in far you can go to protect it?  In general, to protect property from vandalism and theft, you have a right to use force that is reasonably necessary under the circumstances.  But you can’t use force beyond what could reasonably be believed necessary under the circumstances, and you can’t use such force as is likely to lead to great bodily injury or death. 

A famous Iowa case from the early 1970s points out that you can’t use force that could physically harm or kill another person in defending your personal property if your life isn’t likewise threatened.  For instance, be careful using guard dogs to ward off trespassers.  The general rule with respect to guard dogs is that you can’t use any more force through an animal than you could personally.  So, if a guard dog injures or kills an intruder, it is the same as if you had done it. Likewise, liability for a dog's dangerous propensities cannot be avoided by posting a sign notifying trespassers of a dog's presence. 

You can take steps to protect your property. Just don’t use any force that is more than what is necessary for the situation.

Relatedly, what can you do within the bounds of the law to defend yourself from an animal such as a dog or a bull or other farm animal that isn’t yours?  In recent years, some states have enacted “stand your ground” provisions that allow you to use whatever force you think is necessary to protect yourself from an equivalent threat, up to and including lethal force.  You don’t have a duty to get away before using force. But you can’t just fire away at will.  Your use of deadly force must be justified – and that you’ll have to prove.  You don’t get a presumption that you could use deadly force. 

In rural settings, the issue often comes up with dogs and livestock that don’t belong to you.  If the animal threatens you with great bodily harm or death, then you can take the animal’s life.  But you’ll have to establish through video or eyewitness testimony that your action was justified.  You’ll likely be charged with animal cruelty or damage to property and then you must establish that you acted properly based on the circumstances.  Remember whether you acted properly is based on whether you had a reasonable fear for your life.  A jury will determine that question if the matter ends up in court. 

So, only take an animal’s life when it’s the last resort, and make sure you have evidence to back up your action. 

Good Samaritan Laws

You’re not legally required to render aid to another person who is in peril.  But does the law provide any protection if you try to help? 

The law used to discourage people from helping others in peril.  One extreme example was the Genovese case in Queens, New York in 1964.  Many people watched from their homes as Kitty Genovese was attacked in the early morning hours on her return to her apartment from work.  No one did anything until it was too late.  They later said that they feared liability for getting involved.  This event helped spur the enactment in all states of “Good Samaritan” laws.

A Good Samaritan law specifies that if you help a person in peril without expectation of compensation, you can only be held liable for injuries resulting from recklessness or willful intent to injure.  These state laws also provide slightly different treatment for emergency medical technicians and hospital staff.

Even though the law doesn’t require you to help someone else in peril, if you do you won’t be liable for any injuries resulting from your attempt to help unless your assistance is reckless, or you intentionally injure the person.  Kitty’s situation was horrible, but it did result in a good change in the governing legal rules. And, in agricultural settings, the rule can also apply in situations where aid is rendered to livestock in peril. 

Preparing for the Exit

When it comes to estate planning, we tend to think of wills and trusts and powers of attorney.  But there are other things you can do before those documents are drafted that will make creating those documents easier and smooth the transition upon death. 

When you work on your estate plan, don’t forget to organize and document other information for those that will need it.  A good idea is to put in a binder a list of your retirement plan information, and copies of health and life insurance policies. Burial plot location and funeral instructions.  Also, provide your email, computer and phone passwords as well as bank account information and data about your debts and bills.  Also, put in that binder copies of your driver’s license, birth certificate, social security card, and marriage license.  Also include documents related to real estate, a list of your assets, land that you own, stored crops, livestock and marketing contracts.  Also include copies of crop insurance policies and USDA program contracts and all your key business relationships. 

Make sure the right person knows where to find the binder and make sure they have access to it. 

Having this information collected will be helpful for any additional steps in the estate planning process. It will also likely allow more efficient use of an attorney’s time in drafting the necessary documents for your estate plan.

Issues when Cleaning Out a Fencerow

Cleaning up fencerows seems to be an ongoing project.  But the cleanup process can generate legal issues that you might not have thought about. 

When you’re cleaning out a fence row legal issues can arise that you might not have thought about.  For example, what should you do if there’s a tree in the fence line?  In that situation, each adjacent owner has an ownership interest in the tree. It’s considered to be jointly owned and you could be liable for damages if you cut it down and your neighbor objects.  But, if only the branches or roots of a tree extend past the property line and onto an adjoining neighbor’s property, the branches and roots don’t give the neighbor an ownership interest in the tree.  In that situation, you can trim the branches that hang over onto your property.  That’s an important point, for example, if you are dealing with a thorn tree that can puncture tires.

Always make sure to trim branches, bushes and vines on a property line with care.  Keep the neighbor’s rights in mind when doing the cleanup work.  Maintaining good communication is aways beneficial when property line work is involved.  Also, if a neighbor’s tree falls onto your property, it’s your responsibility to clean up the mess – but you can keep the resulting firewood.  The converse is also true.  And it’s not a trespass to be on your neighbor’s side of the fence when doing fence maintenance, such as cleaning out a fence row.

Conclusion

There will be more issues to discuss next time.

From Transition Documents to Inflation to Recent SCOTUS Opinions on Agency Deference and Water Compacts

Buy-Sell Agreements

Buy-sell agreements can be very important to help assure smooth transitioning of the business from one generation to the next.  But it’s important that a buy-sell agreement be carefully drafted and followed. 

In my view, next to a properly drafted will or trust, a buy-sell agreement is often an essential part of transitioning the family farming or ranching operation to the next generation.  A well-drafted buy-sell agreement is designed to prevent the transfer of business interests outside the family unit. 

But the key is that they must be drafted carefully and strictly followed.  In a recent case, two brothers owned the family business.  The corporation owned life insurance on each brother so that if one died, the corporation could use the proceeds to redeem his shares – it was a standard redemption-style buy-sell agreement.  One brother died, and the IRS included the value of his stock interest in his estate on the basis that the corporation’s fair market value included the life insurance proceeds intended for the stock redemption. 

The courts have reached different conclusions as to whether that’s correct, and the U.S. Supreme Court took the case to clear up the difference.  Recently, the Supreme Court said the policy proceeds were included in the corporate value.  That had the effect of increasing the deceased brother’s estate such that it triggered about an additional $1 million in estates tax compared to what would have been the result had the policy proceeds not been included in the corporation upon his death.   

The problem was that the brothers didn’t annually certify the value of the corporation or have it appraised.  Going forward, proper drafting of buy-sell agreements will be critical and naming the corporation as the beneficiary of the insurance proceeds may not be best.  That indicates that a cross-purchase agreement is the correct approach, perhaps pairing it with an insurance LLC. 

I will have more details on the implications of the Court’s decision on business transition planning in Vol. 1, Ed. 2 of the Rural Practice Digest at mceowenaglawandtax.substack.com  

The case is Connelly v. United States, 144 S. Ct. 1406 (2024).

Effects of Inflation

It’s a “Tax”

Inflation and deflation – what’s its impact on your farming or ranching operation or your plan to transition farm assets to the next generation?  The impact is likely substantial. 

Much recent news has focused on the Fed leaving interest rates unchanged to fight inflation. But prices are still high and rising faster than expected.  Two years ago, inflation peaked at about 9 percent and today it’s hovering around 3 or 4 percent.  So why haven’t prices dropped?  It’s because inflation isn’t the price level, it’s the rate of increase in prices.  A reduction from 9 percent to 3 percent doesn’t mean that prices should drop 6 percent, it means that they will go up 3 percent. 

Three years ago, you could transfer $300,000 worth of equipment over two years and the buyer would only have to pay an interest cost of about $1,500.  Now that’s almost $25,000.  If you want to sell $1 million of farmland on an installment basis to the next generation, the interest cost three years ago was about $160,000.  Now it’s $400,000. 

Deflation is a different story.  When prices drop the dollars in your pocket are worth more, but your loans and debts become more costly in real terms.

So, you’re being taxed by the amount of inflation. The Fed hints at dropping interest rates to manage inflation, but the reality is that it should be raising rates to curb inflation.

Administrative Agencies – Jury Trials and “Chevron” Deference

Right to a Jury Trial.  Late in its recently concluded term, the U.S. Supreme Court issued two opinions involving federal administrative agencies.  Both opinions could have a significant positive impact or farmers and ranchers involved in the federal administrative process.  In the first case, the Court determined that when the Securities and Exchange Commission (SEC) seeks to impose civil penalties against a defendant for alleged securities fraud, the Constitution’s Seventh Amendment requires that the defendant receive a jury trial.  The Court based its reasoning that SEC fraud is essentially the same as a common law fraud claim which squarely fits within the Seventh Amendment’s requirement of a jury trial. 

The Court’s opinion is of significance to agriculture because of the frequency with which ag producers encounter administrative agencies and sub-agencies such as the USDA, the NRCS, the FSA, the EPA and the COE, for example.  Justice Gorsuch noted in his concurrence that during the period under study in the case, the SEC was about 90 percent of the matters that it heard compared to 69 percent of the matters that were litigated in court.  Historically, the same is true of USDA disputes involving ag producers. Requiring jury trials when the USDA seeks to impose a fine on an issue that essentially involves a matter of the common law – such as a drainage issue or a Swampbuster issue or crop insurance fraud, could have the effect of fewer enforcement actions against farmers being brought in the first place.

The case is Securities and Exchange Commission v. Jarkesy, No. 22-859, 2024 U.S. LEXIS 2847 (U.S. Sup. Ct. Jun. 27, 2024).

“Chevron Doctrine” Repealed.  The day after Jarkesy was decided, the U.S. Supreme Court repealed an administrative review rule known as the Chevron Doctrine. It stems from a prior decision of the Court in 1984.  The implications on agriculture of the Court’s most recent decision reversing its 1984 decision could be enormous. 

Under the Chevron Doctrine, Courts are to defer to administrative agency interpretations of a statute where the intent of the Congress was ambiguous and where the interpretation is reasonable or permissible.  That set a low hurdle for an agency to clear.  If the agency’s interpretation of a statute was not arbitrary, capricious or manifestly contrary to the statute, the agency’s interpretation would be upheld.

Now the Supreme Court said it got it wrong back in 1984.  The Court said that the Chevron Doctrine’s presumption was misguided because agencies have no special competence in resolving statutory ambiguities. Courts do. The decision is a big one for agriculture because of the many administrative issues farmers and ranchers can find themselves entangled in.  At least in theory, the Court’s opinion establishes a higher threshold for agency rulemaking – close may be good enough in horseshoes and hand grenades, but it won’t be any more when it comes to agency rulemaking.  That will likely also have an impact on the administrative agency review process.

Time will tell of the true impact of the Court’s decision on agriculture.  But since the Chevron decision, the number of pages in the Federal Register - where agencies are required to publish their proposed and final rules – has nearly doubled.  And so has the litigation.    

Again, I will have more detailed coverage of the implications of the Court’s decision in Vol. 1, Ed. 2 of the Rural Practice Digest found at mceowenaglawandtax.substack.com

The case is Loper Bright Enterprises, et al. v. Raimondo, No. 22-451, 2024 U.S. LEXIS 2882 (U.S. Sup. Ct. Jun. 28, 2024).

Water Law and State Compacts

Water in the West is a big issue for agriculture because of its relative scarcity.  Sometimes, the states enter into agreements to determine water usage of water that flows between them.  One of those agreements, or Compacts, was recently before the U.S. Supreme Court.  

The Rio Grande Compact was signed in 1938 by Colorado, New Mexico, and Texas, and approved by the Congress the next year, to equitably apportion the waters of the Rio Grande Basin.  Under the Compact, Colorado committed to deliver a certain amount of water to the New Mexico state line.  A minimum quality standard was also established. 

In 2014, Texas sued New Mexico for allowing the Rio Grande’s water reserves to be channeled away for its use which deprived Texas of its equal share in the river's resources.  In 2018, the Supreme Court said the federal government should be a party to the case. 

To resolve the dispute, Texas and New Mexico entered into a proposed consent decree.  But recently the Supreme Court blocked it because the federal government’s interests were essential to the Compact.  That had been clear since 2018. 

So, when states try to determine water allocation, if the federal government has an interest, the Congress must approve the deal – that’s clearly stated in the Constitution at Article I, Section 10, Clause 3: “No State shall, without the Consent of Congress,… enter into any Agreement or Compact with another State”… The federal government is likely to have an interest in water deals among the states, particularly in the West. 

More discussion coming in the Rural Practice Digest, Vol. 1, Ed. 2 at mceowenaglawandtax.substack.com

The case is Texas v. New Mexico, No. 141 Orig., 2024 U.S. LEXIS 2713 (U.S. Sup. Ct. June 21, 2024).

Rural Practice Digest - Substack

Overview

I have started a new Substack that contains the “Rural Practice Digest.”  You can access it at mceowenaglawandtax.substack.com.  While I will post other content from time-to-time that is available without a paid subscription, the Digest is for paid subscribers.  The inaugural edition is 22 pages in length and covers a wide array of legal and tax topics of importance to agricultural producers, agribusinesses, rural landowners and those that represent them.

Contents

Volume 1, Edition 1 sets the style for future editions - a lead article and then a series of annotations of court opinions, IRS developments and administrative agency regulatory decisions.  The lead article for Volume 1 concerns losses related to cooperatives.  The USDA is projecting that farm income will be down significantly this year.  That means losses will be incurred by some and some of those will involve losses associated with interests in cooperatives.  The treatment of losses on interests in cooperatives is unique and that’s what I focus on in the article.

The remaining 19-pages of the Digest focus on various other aspect of the law that impacts farmers and ranchers. Here’s an overview of the annotation topics that you will find in Issue 1:

• Chapter 12 Bankruptcy
• Partnership Election – BBA
• Valuation Rules and Options
• S Corporation Losses
• Nuisance
• Fair Credit Reporting Act
• Irrigation Return Flow Exemption and the CWA
• What is a WOTUS?
• EPA Regulation Threatens AI
• Trustee Liability for Taxes
• Farm Bill
• Tax Reimbursement Clauses in IDGTs
• QTIP Marital Trusts and Gift Tax
• FBAR Penalties
• Conservation Easements
• Hobby Losses
• Sustainable Aviation Fuel
• IRS Procedures and Announcements
• Timeliness of Tax Court Petition
• BBA Election
• SCOTUS Opinion on Fees to Develop Property
• Quiet Title Act
• Animal I.D.
• “Ag Gag” Update
• What is a “Misleading” Financing Statement
• Recent State Court Opinions
• Upcoming Seminars

Substack Contents

In addition to the Rural Practice Digest, I plan on adding video content, practitioner forms and other content designed to aid those representing agricultural clients in legal and tax matters, and others simply interested in keeping up on what’s happening in the world of agricultural law and taxation.

Conclusion

Thank you in advance for your subscription.  I trust that you will find the Digest to be an aid to your practice.  Your comments are welcome.  mceowenaglawandtax.substack.com

From the Desk…and Email…and Phone… (Ag Law Style)

Overview

Today’s post is a summary of just a snippet of the items that have come across my desk in recent days.  It’s been a particularly busy time.  The semester has ended at the two universities I teach at, exams are graded and now the seminar season heats up in earnest for the rest of the year.  This week it’s Branson for a two-day farm tax and farm estate/business planning seminar.  Then it’s back to the law school to do the anchor leg of the law school’s annual June CLE.  Next week it’s a national probate seminar and a fence law CLE.  The following week involves battling the IRS on a Tax Court case and the line between currently deductible expenses and those that must be capitalized.  Oh, and I’ll soon start a new subscription publication.  The first edition of the first volume is about ready.  So stay tuned.

For now, today’s post is on miscellaneous ag law topics.

Aerial Crop Dusting

Most cases involving injury to property or to individuals are based in negligence.  That means that someone breached a duty that was owed to someone else that caused damage to them or injured their property.  But there are some situations where a strict liability rule applies.  One of those involves the aerial application of chemicals to crops.  It is perhaps the most frequent application of the doctrine to agriculture. It’s based on the notion that crop dusting is an inherently dangerous activity. In addition, some states may have regulations applicable to aerial crop dusting.  For example, in Arkansas, violation of aerial crop spraying regulations constitutes evidence of negligence, and the negligence of crop sprayers can be imputed to landowners. 

If you utilize crop dusting as part of your farming operation, it’s best from a liability standpoint to hire the work done.  In that event, if chemical drift occurs and damages a neighbor’s crops, trees or foliage, you won’t be liable if you didn’t control or were otherwise involved in how the spraying was to be done.  Especially if all applicable regulations are followed.

Right of First Refusal

A right of first refusal allows the holder the right to buy property on the same terms offered to another bona fide purchaser.  Once notified, the holder can either choose to buy the property on the same terms offered to a third party or decline and allow the owner to sell to the third party.  A right of first refusal can be useful in ag land transactions when there is a desire to ensure that a party has a chance to acquire the property. 

A right of first refusal can be useful in certain settings involving the sale of agricultural land.  Perhaps a longstanding tenant would like to be given a chance to acquire the leased land.  Or maybe a certain family member should be given the chance to buy into the family farming operation.  But it is critical that the property actually be offered to the holder of the right before it is sold to someone else.  If that doesn’t happen the owner can be sued for monetary damages and the third party that had either actual or constructive notice of the right of first refusal can be sued for specific performance.

When a right of first refusal is involved, it’s a good idea to record it on the land records to put the public and any potential buyer on notice.  Also, investigate changes concerning the property – such as to whom lease payments are being made.  The holder must stay vigilant to protect their right.

Ag Leases and Taxes

Leasing farmland is critical to many farmers and farming operations.  What’s the best way to structure an ag lease from a tax standpoint?  Tenants and landlords are often good at understanding the economics of a farm lease and utilize the best type of lease to fit their situation.  A farm lease can be structured to appropriately balance the risk and return between the landlord and tenant. 

There are also many income tax issues associated with leasing farmland.  For the tenant farmer, the lease income is income from a farming business.  That means it’s subject to self-employment tax.  It also means that the tenant can take advantage of the tax provisions that are available for persons that are engaged in the trade or business of farming. 

Whether the landlord gets those same tax advantages depends on whether the landlord is materially participating.  If so, the landlord has self-employment income, but is eligible to exclude at least a portion of USDA cost-share payments from income. The landlord can also deduct soil and water conservation expenses, as well as fertilizer and lime costs.  A landlord engaged in farming can also elect farm income averaging, can receive federal farm program benefits, and can have a special use valuation election made in the estate at death to help save federal estate tax. 

The right type of lease can be very beneficial. 

Corporate Loans

Lending corporate cash to shareholders of a closely-held corporation can be an effective way to give the shareholders use of the funds without the double-tax consequences of dividends.  But an advance or loan to a shareholder must be a bona fide loan to avoid being a constructive dividend.  In addition, the loan must have adequate interest. If it doesn’t meet these criteria, it will be taxed as a dividend distribution.  In addition, it’s not enough for you to simply declare that you intended the withdrawal to be a loan.  There must be additional reliable evidence that the transaction is a debt.  So, what does the IRS look for to determine if a loan is really a loan?

If you have unlimited control of the corporation, there’s a greater potential for a disguised dividend, and if the corporation hasn’t been paying dividends despite having the money to do so, that’s another strike.  Did you record the advances on the corporate books and records as loans and execute notes with interest charged, a fixed maturity date and security given?  Were there attempts to repay the advances in a bona fide manner?  The control issue is a big one for farming and ranching corporations, and few farm corporations pay dividends.  This makes it critical to carefully build up evidence supporting loan characterization. 

NewH-2A Rule

The H-2A temporary ag worker program helps employers who anticipate a lack of available domestic workers.  Under the program foreign workers are brought to the U.S. to perform temporary or seasonal ag work including, but not limited to, labor for planting, cultivating, or harvesting.  Recently, the Department of Labor published a Final Rule designed to enhance protections for workers under the H-2A program. 

Effective June 28, a new Department of Labor final rule will take effect.  The rule is termed, “Improving Protections for Workers in Temporary Agricultural Employment in the United States.”   The rule will impact the temporary farmworker program.  The rule’s purpose is to increase wage transparency, clarify when an employee can be terminated for cause, and prevent employer retaliation among temporary seasonal ag workers. There are also expanded transportation safety requirements, new employer disclosure requirements and new rules for worker self-advocacy.   

The rule is lengthy and complex, but here’s a few points of particular importance:

• New restrictions on an employers’ ability to terminate workers;
• Workers employed under the H-2A program have the right to payment for three-fourths of the hours offered in the work contract, even if the work ends early; housing and transportation until the worker leaves; payment for outbound transportation; and, if the worker is a U.S. worker, to be contacted for employment in the next year, unless they are terminated for cause.
• An employer may only terminate a worker “for cause” when the employer demonstrates the worker has failed to comply with employer policies or rules or to satisfactorily perform job duties after issuing progressive discipline, unless the worker has engaged in egregious misconduct. The rule establishes five conditions that must be satisfied to ensure disciplinary and/or termination processes are justified and reasonable.
• For vehicles that are required by Department of Transportation regulations to be manufactured with seat belts, the employer must retain and maintain those seat belts in good working order and prohibit the operation of a vehicle unless each worker is wearing a seat belt.

Only applications for H-2A employer certifications submitted to the Department of Labor on or after August 29 will be subject to the new rule. 

You can expect legal challenges to the rule.  But, in the meantime, if you use temporary foreign workers on your farm, you should start creating and implementing policies and procedures to comply with the new rule as well as updating your existing H-2A applications.

The rule is published at 89 Fed. Reg. 33898.

Conclusion

The topics in ag law and tax are diverse.  There’s never a dull moment. 

Summer Seminars – Branson and Jackson Hole

Registration for both of the national summer seminars that Paul Neiffer and I will be doing is now open.  The Branson (College of the Ozarks) seminar is in-person only, but the Jackson Hole event is offered both in-person and online.  For those attending the Jackson Hole seminar in-person, a room block is established at the Virginian Resort at a reduced rate.

The topics that we will cover are the same at both locations (although the material for Jackson Hole will be updated and current through mid-July).

Here’s a list of the topics we will be covering:

• Federal Tax Update
• Farm Bill Update
• Beneficial Ownership Information (BOI) Reporting
• Depreciation Planning
• Tax Planning Considering the Possible Sunset of TCJA
• How Famers Might Benefit from the Clean Fuel Production Tax Credit
• Conservation Easements
• Federal Estate and Gift Tax Update
• SECURE Act 2.0
• Split Interest Land Transactions
• Manager-Managed LLCs
• Types of Trusts
• Monetized Installment Sales
• Charitable Remainder Trusts or Cash Balance Plans
• Special Use Valuation
• Buy-Sell Agreements (planning in light of the Connelly decision)

Registration

For more information about the Branson event, and registration, click here:   https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html

For more information about the Jackson Hole event, and registration, click here:   https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html

Branson Summer Seminar on Farm Income Tax and Estate/Business Planning

Overview

On June 12-13, I will be conducting a farm income tax and farm estate and business planning seminar at the Keeter Center on the campus of College of the Ozarks near Branson, MO.  This is a live, in-person presentation only.  No online option is available.  My partner in presentation is Paul Neiffer.  Paul and I have done these summer events for a number of years and are teaming up again this summer to provide you with high quality training on the tax issues you deal with for your farm and ranch clients.

Topics

Here’s a list of the topics that Paul and I will be digging into:

• Federal Tax Update
• Farm Bill Update
• Beneficial Ownership Information (BOI) Reporting
• Depreciation Planning
• Tax Planning Considering the Possible Sunset of TCJA
• How Famers Might Benefit from the Clean Fuel Production Tax Credit
• Conservation Easements
• Federal Estate and Gift Tax Update
• SECURE Act 2.0
• Split Interest Land Transactions
• Manager-Managed LLCs
• Types of Trusts
• Monetized Installment Sales
• Charitable Remainder Trusts or Cash Balance Plans
• Special Use Valuation
• Buy-Sell Agreements (planning in light of the Connelly decision)

Registration

The link for registration is below and can be found on my website – www.washburnlaw.edu/waltr and the seminar is sponsored by McEowen, P.L.C.  You may mail a check with your registration or register and pay at the door.  Early registration is eligible for a lower rate.  Certification is pending with the National Association of State Boards of Accountancy (NASBA) to qualify for 16 hours of CPE credit and corresponding CLE credit (for attorneys). 

Here is the specific link for the event:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html

Jackson Hole

Paul and I will present the same (but updated) seminar in Jackson Hole, Wyoming, on August 5 and 6.  That event will also be broadcasted live online.

We hope to see you there!

Court Reigns in Unconstitutional Federal Power – Impacts BOI Reporting

Overview

The Corporate Transparency Act (CTA), P.L. 116-283, enacted in 2021 as part of the National Defense Authorization Act, contains new “beneficial ownership information” (BOI) reporting rules for many businesses.  The CTA was passed with the purported purpose of enhancing transparency in entity structures and ownership to combat money laundering, tax fraud and other illicit activities. In short, it’s an anti-money laundering initiative designed to catch those that are using shell corporations to avoid tax.  The BOI reporting requirement is designed to capture more information about the ownership of specific entities operating in or accessing the U.S. market.  The effective date of the CTA is January 1, 2024.    

However, in early March, a federal trial court in Alabama, in a case involving a constitutional challenge to the CTA granted the challengers’ motion for summary judgment.  National Small Business United v. Yellen, No. 5:22-cv-1448-LCB, 2024 U.S. Dist. LEXIS 36205 (N.D. Ala. Mar. 1, 2024).  The court’s ruling puts BOI reporting on hold for the plaintiffs’ 65,000 members.

Background

Who needs to report?  The CTA breaks down the reporting requirement of “beneficial ownership information” between “domestic reporting companies” and “foreign reporting companies.”  A domestic reporting company is a corporation, limited liability company (LLC), limited liability partnership (LLP) or any other entity that is created by filing of a document with a Secretary of State or any similar office under the law of a state or Indian Tribe.  A foreign reporting company is a corporation, LLC or other foreign entity that is formed under the law of a foreign country that is registered to do business in any state or tribal jurisdiction by the filing of a document with a Secretary of State or any similar office. 

Note:  Sole proprietorships that don’t use a single-member LLC are not considered to be a reporting company. 

Reporting companies typically include LLPs, LLLPs, business trusts, and most limited partnerships and other entities are generally created by a filing with a Secretary of State or similar office. 

For entities created after 2023, businesses that are required to report ownership information (corporation, LLC, or similar entity as noted above) must also report the identity of “applicants.” 

Exemptions.  Exemptions from the reporting requirement apply for securities issuers, domestic governmental authorities, insurance companies, credit unions, accounting firms, tax-exempt entities, public utility companies, banks, and other entities that don’t fall into specified categories.  In total there are 23 exemptions including an exemption for businesses with 20 or more full-time U.S. employees, report at least $5 million on the latest filed tax return and have a physical presence in the U.S.   But, for example, otherwise exempt businesses (including farms and ranches) that have other businesses such as an equipment or land LLC or any other related entity will have to file a report detailing the required beneficial ownership information.  Having one large entity won’t exempt the other entities. 

What is a “Beneficial Owner”?  A beneficial owner can fall into one of two categories defined as any individual who, directly or indirectly, either:

• Exercises substantial control over a reporting company, or
• Owns or controls at least 25 percent of the ownership interests of a reporting company.

Note:  Beneficial ownership is categorized as those with ownership interests reflected through capital and profit interests in the company.

What must a beneficial owner do?  Beneficial owners must report to the Financial Crimes Enforcement Network (FinCEN).  FinCEN is a bureau of the U.S. Department of the Treasury that collects and analyzes information about financial transactions to combat domestic and international money laundering, terrorist financing and other international crimes.  Beneficial owners must report their name, date of birth, current residential or business street address, and unique identifier number from a recognized issuing jurisdiction and a photo of that document.  Company applicants can only be the individual who directly files the document that creates the entity, or the document that first registers the entity to do business in the U.S.  A company applicant may also be the individual who is primarily responsible for directing or controlling the filing of the relevant document by someone else. This last point makes it critical for professional advisors to carefully define the scope ot engagement for advisory services with clients.

Note:  If an individual files their information directly with FinCEN, they may be issued a “FinCEN Identifier” directly, which can be provided on a BOI report instead of the required information.

Filing deadlines.  Reporting companies created or registered in 2024 have 90 days from being registered with the state to file initial reports disclosing the persons that own or control the business. NPRM (RIN 1506-AB62) (Sept 28, 2023). If a business was created or registered to do business before 2024, the business has until January 1 of 2025 to file the initial report.  Businesses formed after 2024 must file within 30 days of formation.  Reports must be updated within 30 days of a change to the beneficial ownership of the business, or 30 days from when the beneficial owner becomes aware of or has reason to know of inaccurate information that was previously filed. 

Note:  FinCEN estimates about 32.6 million BOI reports will be filed in 2024, and about 14.5 million such reports will be filed annually in 2025 and beyond. The total five-year average of expected BOI update reports is almost 12.9 million.

Penalties.  The penalty for not filing is steep and can carry the possibility of imprisonment.  Specifically, noncompliance can result in escalating fines ranging from $591 per day up to $10,000 total and prison time of up to two years.  Penalties may also apply for unauthorized disclosures.

State issues.  A state is required to notify filers upon initial formation/registration of the requirement to provide beneficial ownership information to the FinCEN.  In addition, states must provide filers with the appropriate reporting company Form.

Constitutional Challenge

The National Small Business United, an organization with over 65,000 members, filed a constitutional challenge against the CTA claiming that the CTA exceeded the Constitution’s limits on the power of the Congress to legislate and was not sufficiently connected to any specifically enumerated power that would make it either a necessary or proper means of achieving a policy goal of the Congress.  The court rejected the government’s defense of the CTA that it was constitutional under the plenary power of the Congress to conduct foreign affairs as well as under the Commerce Clause and the Congress’ taxing power. 

The court disagreed on all claims noting that the Supreme Court had ruled in 2011 that the foreign affairs power did not extend to the CTA because the CTA regulated only internal transactions.  Indeed, the court noted that informational reporting such as the BOI reporting, has historically been a matter reserved for the States. 

More importantly, the court rejected the government’s Commerce Clause defense.  With few exceptions, since the mid-1930s, the Commerce Clause has been interpreted to give almost absolute power to the Congress to regulate commerce among the states.  However, here the court noted that, “[t]he plain text of the CTA does not regulate the channels and instrumentalities of commerce, let alone commercial or economic activity.”  It was not sufficient to trigger federal regulatory authority via the Commerce Clause that a business that is registered with a State then uses the channels of commerce for its business activity, even if the business activity substantially affects interstate and foreign commerce.  The Congress has the power to regulate the business activity but cannot require additional reporting information of a business that is already registered to do business with a State.  The court noted that the Congress could have created a reporting rule that was constitutional by simply triggering the reporting requirement once a business engages in  commercial business activity, and pointed out that FinCEN’s customer due diligence rule from 2016 provides “nearly identical information” in a constitutional manner. 

The government’s taxing power argument also failed, the court determined, because the civil penalties for noncompliance with the rules were not a tax – they were fixed amounts with no income thresholds and did not vary.

What Now?

FinCEN is currently not enforcing the reporting rule against the plaintiff's members.  It is anticipated that the government will appeal.  Once the appellate opinion is issued, the losing side will almost certainly seek review by the U.S. Supreme Court.  It is also anticipated that a request will be made for a court to stay the enforcement of the BOI reporting rules entirely while the judicial process plays out.  Of course, the Congress could amend the BOI reporting rules in accordance with the directions of the trial court. 

This all means that covered businesses should prepare the necessary information to be filed, but not file it at the present time.  There is no need to provide the government with ownership data that it may, ultimately, not be entitled to. 

Conclusion

The U.S. Supreme Court will have the final say (judicially) on the matter.  Congress will likely not act until it has too.  So, the process could take some time which means the reporting rules will remain in “limbo” for the balance of 2024.   The trial court’s judgment may not ultimately be sustained, but it is refreshing to see a federal court reign in an exercise of federal power.

Top Ten Developments in Agricultural Law and Taxation in 2023 – (Part One)

Overview

With my two prior blog articles I started looking at some of the most significant developments in agricultural law and taxation during 2023.  With today’s article I begin the look at what I view as the ten most significant developments in 2023.  These make my Top Ten list because of their significance on a national level to farmers, ranchers, rural landowners and agribusiness in general.

Developments ten through eight of 2023 – that’s the topic of today’s post.

10. Entire Commercial Wind Development Ordered Removed

United States v. Osage Wind, LLC, No. 4:14-cv-00704-CG-JFJ,

2023 U.S. Dist. LEXIS 226386 (N.D. Okla. Dec. 20, 2023)

In late 2023, a federal court ordered the removal of an entire commercial wind energy development (150-megawatt) in Oklahoma and set a trial for damages.  The litigation had been ongoing since 2011 and was the longest-running legal battle concerning wind energy in U.S. history.  The ruling follows a 2017 lower court decision concluding that construction of the development constituted “mining” and required a mining lease from a tribal mineral council which the developers failed to acquire.  United States v. Osage Wind, LLC, 871 F.3d 1078 (10th Cir. 2017).  The court’s ruling granted the United States, the Osage Nation and the Osage Minerals Council permanent injunctive relief via “ejectment of the wind turbine farm for continuing trespass.”

The wind energy development includes 84 towers spread across 8,400 acres of the Tallgrass Prairie involving leased surface rights, underground lines, overhead transmission lines, meteorological towers and access roads.  Removal costs are estimated at $300 million.  In 2017, the U.S. Circuit Court of Appeals for the Tenth Circuit held that the wind energy company’s extraction, sorting, crushing and use of minerals as part of its excavation work constituted mineral development that required a federally approved lease.  The company never received one.  The Osage Nation owns the rights to the subsurface minerals that it purchased from the Cherokee Nation in the late 1800s pursuant to the Osage Allotment Act of 1906.  The mineral rights include oil, natural gas and the rocks that were mined and crushed in the process of developing the project. 

In its decision to order removal of the towers, the court weighed several factors but ultimately concluded that the public interest in private entities abiding by the law and respecting government sovereignty and the decision of courts was paramount.  The court pointed out that the defendant’s continued refusal to obtain a lease constituted interference with the sovereignty of the Osage Nation and “is sufficient to constitute irreparable injury.” 

Note:  The lengthy litigation resulting in the court’s decision is representative of the increasing opposition in rural areas to wind energy production grounded in damage to the viewshed, landscape and wildlife.  During 2023, including the court’s opinion in this case, there were 51 restrictions or rejections of wind energy projects and 68 rejections of solar energy projects.  See, Renewable Rejection Database, https://robertbryce.com/renewable-rejection-database/

9.         Reporting Foreign Income

Bittner v. United States, 598 U.S. 85 (2023)

The Bank Secrecy Act of 1970 requires U.S. financial institutions to assist U.S. government agencies in detecting and preventing money laundering by, among other things, maintaining records of cash purchases of negotiable instruments, filing currency transaction reports for cash transactions exceeding $10,000 in a single business day, and reporting suspicious activities that might denote money laundering, tax evasion and other crimes.  The law also requires a U.S. citizen or resident with foreign accounts exceeding $10,000 to report those account to the IRS by filing FinCEN Form 114 (FBAR) by the due date for the federal tax return.  The failure to disclose foreign accounts properly or in a timely manner can result in substantial penalties. 

In this case, the plaintiff was a dual citizen of Romania and the United States.  He emigrated to the United States in 1982, became a U.S. citizen, and lived in the United States until 1990 when he moved back to Romania.  He had various Romania investments amounting to over $70 million.  He had 272 foreign accounts with high balances exceeding $10,000.  He was not aware of the FBAR filing requirement for his non-U.S. accounts until May of 2012.  The initial FBARs that he filed did not accurately report all of his accounts.  In 2013, amended FBARs were filed properly reporting all of his foreign accounts.  The IRS audited and, in 2017, computed the plaintiff’s civil penalties at $2,720,000 for a non-willful violation of failing to timely disclose his 272 foreign account for five years 2007-2011.

The plaintiff denied liability based on a reasonable cause exception.  He also claimed that the penalty under Section 5321 of the Bank Secrecy Act applied based on the failure to file an annual FBAR reporting the foreign accounts, and that the penalty was not to be computed on a per account basis. 

The trial court denied the plaintiff’s reasonable cause defense and held him liable for violations of the Bank Secrecy Act.  The trial court determined that the penalty should be computed on a per form basis and not on a per account basis.  Thus, the trial court computed the penalty at $50,000 ($10,000 per year for five years).  On appeal, the appellate court affirmed on the plaintiff’s liability (i.e., rejected the reasonable cause defense), but determined that the penalty was much higher because it was to be computed on a per account basis. 

On further review, the U.S. Supreme Court (in a 5-4 decision) determined that the penalty was to be computed on a per form basis and not a per account basis.  The Court’s holding effectively reduced the plaintiff’s potential penalty from $2.72 million to $50,000.  The majority relied on the text, IRS guidance, as well as the drafting history of this penalty provision in the Bank Secrecy Act.  The Court did not address the question of where the line is to be drawn between willful and non-willful conduct for FBAR purposes. 

Note:  The Supreme Court’s decision was a major taxpayer victory.  However, the point remains that foreign bank accounts with a balance of at least $10,000 at any point during the year must be reported.  This is an important point for U.S. citizen farmers and ranchers with farming interests in other countries. 

8. New Corporate Reporting Requirements

            Corporate Transparency Act (CTA), P.L. 116-283

Overview.  The Corporate Transparency Act (CTA), P.L. 116-283, enacted on January 1, 2021 (as the result of a veto override), as part of the National Defense Authorization Act, was passed to enhance transparency in entity structures and ownership to combat money laundering, tax fraud and other illicit activities. In short, it’s an anti-money laundering initiative designed to catch those that are using shell corporations to avoid tax.  It is designed to capture more information about the ownership of specific entities operating in or accessing the U.S. market.  The effective date of the CTA is January 1, 2024.   

Who needs to report?  The CTA breaks down the reporting requirement of “beneficial ownership information” between “domestic reporting companies” and “foreign reporting companies.”  A domestic reporting company is a corporation, limited liability company (LLC), limited liability partnership (LLP) or any other entity that is created by filing of a document with a Secretary of State or any similar office under the law of a state or Indian Tribe.  A foreign reporting company is a corporation, LLC or other foreign entity that is formed under the law of a foreign country that is registered to do business in any state or tribal jurisdiction by the filing of a document with a Secretary of State or any similar office. 

Note:  Sole proprietorships that don’t use a single-member LLC are not considered to be a reporting company. 

Reporting companies typically include LLPs, LLLPs, business trusts, and most limited partnerships and other entities are generally created by a filing with a Secretary of State or similar office. 

Exemptions.  Exemptions from the reporting requirement apply for securities issuers, domestic governmental authorities, insurance companies, credit unions, accounting firms, tax-exempt entities, public utility companies, banks, and other entities that don’t fall into specified categories.  In total there are 23 exemptions including an exemption for businesses with 20 or more full-time U.S. employees, report at least $5 million on the latest filed tax return and have a physical presence in the U.S.   But, for example, otherwise exempt businesses (including farms and ranches) that have other businesses such as an equipment or land LLC or any other related entity will have to file a report detailing the required beneficial ownership information.  Having one large entity won’t exempt the other entities. 

What is a “Beneficial Owner”?  A beneficial owner can fall into one of two categories defined as any individual who, directly or indirectly, either:

• Exercises substantial control over a reporting company, or
• Owns or controls at least 25 percent of the ownership interests of a reporting company

Note:  Beneficial ownership is categorized as those with ownership interests reflected through capital and profit interests in the company.

What must a beneficial owner do?  Beneficial owners must report to the Financial Crimes Enforcement Network (FinCEN).  FinCEN is a bureau of the U.S. Department of the Treasury that collects and analyzes information about financial transactions to combat domestic and international money laundering, terrorist financing and other international crimes.  Beneficial owners must report their name, date of birth, current residential or business street address, and unique identifier number from a recognized issuing jurisdiction and a photo of that document.  Company applicants can only be the individual who directly files the document that creates the entity, or the document that first registers the entity to do business in the U.S.  A company applicant may also be the individual who is primarily responsible for directing or controlling the filing of the relevant document by someone else. This last point makes it critical for professional advisors to carefully define the scope ot engagement for advisory services with clients.

Note:  If an individual files their information directly with FinCEN, they may be issued a “FinCEN Identifier” directly, which can be provided on a BOI report instead of the required information.

Filing deadlines.  Reporting companies created or registered in 2024 have 90 days from being registered with the state to file initial reports disclosing the persons that own or control the business. NPRM (RIN 1506-AB62) (Sept 28, 2023). If a business was created or registered to do business before 2024, the business has until January 1 of 2025 to file the initial report.  Businesses formed after 2024 must file within 30 days of formation.  Reports must be updated within 30 days of a change to the beneficial ownership of the business, or 30 days from when the beneficial owner becomes aware of or has reason to know of inaccurate information that was previously filed. 

Note:  FinCEN estimates about 32.6 million BOI reports will be filed in 2024, and about 14.5 million such reports will be filed annually in 2025 and beyond. The total five-year average of expected BOI update reports is almost 12.9 million.

Penalties.  The penalty for not filing is steep and can carry the possibility of imprisonment.  Specifically, noncompliance can result in escalating fines ranging from $500 per day up to $10,000 total and prison time of up to two years.    

State issues.  A state is required to notify filers upon initial formation/registration of the requirement to provide beneficial ownership information to the FinCEN.  In addition, states must provide filers with the appropriate reporting company Form.

How to report.  Businesses required to file a report are to do so electronically using FinCEN’s filing system obtaining on its BOI e-filing website which is accessible at https://boiefiling.fincen.gov. 

Note:  On December 22, 2023, FinCEN published a rule that governing access to and protection of beneficial ownership information. Beneficial ownership information reported to FinCEN is to be stored in a secure, non-public database using rigorous information security methods and controls typically used in the Federal government to protect non-classified yet sensitive information systems at the highest security level. FinCEN states that it will work closely with those authorized to access beneficial ownership information to ensure that they understand their roles and responsibilities in using the reported information only for authorized purposes and handling in a way that protects its security and confidentiality.

Conclusion

I will continue the trek through the “Top Ten” of 2023 in the next post.

Funding a Buy-Sell Agreement with Corporate Owned Life Insurance – Will Corporate Value Be Enhanced?

Overview

In part one of this series (published back on July 3), I discussed buy-sell agreements in general and noted how beneficial they can be in the intergenerational transfer of a farm or ranch where keeping the business in the family is the key goal.  There I covered buy-sell agreements in general, the various types of agreements and common triggering events. 

With today’s article I dive deeper into other issues associated with buy-sell agreements -valuation rules and funding approaches.  A recent court opinion points out the importance of following the valuation procedures set forth in the buy-sell agreement.

Part two of a two-part series on buy-sell agreements – it’s the topic of today’s post.

Valuation 

While very few farming and ranching operations (and small businesses in general) are subject to the federal estate tax because of the current level of the exemption, some are.  For those that are, in addition to providing a market for closely held shares at a determinable price, the buy-sell agreement can serve as a mechanism for establishing the value of the interest for estate tax purposes – or otherwise establish value of the decedent’s interest at death.

General rule.  In general, the value of a closely held business (or other property) is determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the FMV of the property, or any restriction on the right to sell or use the property.  I.R.C. §2703(a).

Exception – statutory requirements.  A buy-sell agreement can establish the value of a deceased owner’s interest if six basic requirements are satisfied.  Three of the requirements are statutory and three have been judicially created.  The statutory requirements are found at I.R.C. §2703(b). 

The statutory requirements specify that the buy-sell agreement must:

• Be a bona fide business arrangement; I.R.C. §2703(b)(1)
• Not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; I.R.C. §2703(b)(2) and
• Contain terms that are comparable to other arrangements entered into by persons in arms’ length transactions.  I.R.C. §2703(b)(3)

A buy-sell agreement must satisfy each of the three statutory requirements if family members own 50 percent or more of the property subject to the restriction.  An agreement is deemed to satisfy all three of the statutory requirements if more than 50 percent of the value of the property subject to the restriction is owned directly or indirectly by individuals who are not members of the transferor’s family.  The interests owned by the nonfamily members must be subject to the same restrictions as the property owned by the transferor.  Treas. Reg. §25.2703-1(b)(3). 

Exception – caselaw requirements.  Judicial opinions have created three additional requirements that a buy-sell agreement must satisfy to be effective to establish the value of a decedent’s interest.  See, e.g., Estate of True v. Comr., 390 F.3d 1210 (10th Cir. 2004); St. Louis County Bank v. United States, 674 F.2d 1207 (8th Cir. 1982).  Based on these cases, the agreement must also: contain a purchase price that is fixed and determinable under the agreement; be legally binding during life and after death; and have been entered into for a bona fide business reason and not be a substitute for a testamentary disposition for full and adequate consideration. To establish the purchase price with certainty an appropriate valuation method must be established. An independent party valuation will not only satisfy the requirements of I.R.C. §2703 but also provide an estimate of the potential funding obligation and the liquidity expectations of the seller/estate. See Rev Rul. 59-60 as amplified by Rev. Rul. 83-120,1983-2 CB 170.

The courts have indicated that preserving a business with family control for purposes of continuity and management can serve as a bona fide business arrangement.  See St. Louis County Bank v. United States, 674 F.2d 1207 (8th Cir. 1982); Estate of Lauder v. Comr., T.C. Memo. 1992-736; Estate of Gloeckner v. Comr., 152 F.3d 208 (2nd Cir. 1998).  This includes planning for the future liquidity needs of the decedent’s estate.  Estate of Amlie v. Comr., T.C. Memo. 2006-76.  But an entity that consists only of marketable securities is not a bona fide business arrangement.  Holman v. Comr., 601 F.3d 763 (8th Cir. 2010).  The long-established position of the IRS is that, “It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts to determine whether the agreement represents a bona fide business arrangement or a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth.”  Rev.Rul 59-60, 1959-1 CB 137. See also Estate of True v. Comr., T.C. Memo 2001-167, aff’d., 390 F.3d 1210 (2004); Estate of Blount v. Comr., T.C. Memo. 2004-116.  

Note:  The business reasons for executing the buy-sell agreement should be documented.   

The buy-sell agreement must not simply be a device to reduce estate tax value.  This requires more than expressing a desire to maintain family control of the business.  See, e.g., Estate of True v. Comr., 390 F.3d 1210 (10th Cir. 2004); Estate of Lauder v. Comr., T.C. Memo. 1992-736.  In addition, a buy-sell agreement must have terms that are comparable to other buy-sell agreements that are entered into at arms-length. This requirement is satisfied if the agreement is one that unrelated parties in the same line of business could have reached in an arms’ length transaction.  Treas. Reg. §25.2703-1(b)(4).  This fair bargain standard is typically based on expert opinion testimony. 

Funding Approaches

To be operational, the parties to the agreement must have funds available to buy the stock at the time the agreement is triggered.  It is possible to use accumulated earnings of the business to fund a redemption. But such a strategy may not be treated as a “reasonable need of the business” with the result that the business (if it is a C corporation) could be subject to the accumulated earnings tax. I.R.C. §531. However, corporate accumulations used to pay off a note given a stockholder for a redemption is a reasonable need of the business, as a debt retirement cost. But see Smoot Sand & Gravel Corp. v. Comr., 274 F.2d 495 (4th Cir. 1960), cert. denied, 362 U.S. 976 (1960).

The use of life insurance.  Typically, life insurance is purchased for each business owner to cover the total purchase price (or at least the down payment). However, the premiums on such policies are not deductible (see I.R.C. §264) and can create a substantial ongoing expense.

Corporate-owned.  One approach is for the corporation to buy a life insurance policy on the life of each stockholder, with the corporation as the policy owner, premium payor, and beneficiary of these policies. The corporation would then use the life insurance to finance the purchase if, at the end of the first option period, the corporation buys the deceased stockholder’s interest. Or the corporation could lend the insurance proceeds to the stockholders if, at the end of the corporate option period, it is decided that the surviving stockholders should be the buyers (or to the extent stock remained to be purchased after the corporation’s option expires). Investment payments would be deductible to the stockholders and income to the corporation.

Shareholder-owned.  An alternative approach is for each shareholder to buy, pay for, own, and be the beneficiary of a life insurance policy for each of the other shareholders. The surviving shareholders would then receive the proceeds when one shareholder dies, and, if a cross-purchase is indicated and appropriate, use the proceeds as the necessary funds to carry out the buy-sell agreement. The surviving shareholders could also lend the proceeds to the corporation if a redemption agreement is utilized, to enable the corporation to buy additional shares, or the surviving shareholders could make capital contributions which would have the effect of increasing each shareholder’s stock basis.

Note:  The cash value of a permanent life insurance policy may be withdrawn by loan or surrender of the policy, but the value may be a very small percentage of the death benefit, inadequate to finance the buy-out. Disability insurance may be used to finance a purchase occasioned by an owner’s disability, but it can be quite expensive, and cannot be applied toward the purchase of an interest of an owner who is retiring or used to prevent the sale of an interest in the business to a buyer outside the family unit.

Other Approaches

A combination of the above approaches could also be used for funding the wait-and-see buy-sell agreement. For example, the corporation could own cash value life insurance and the owners could own term insurance. Also, the parties could have a split-dollar arrangement whereby the corporation pays for the cash value portion of the premiums and the shareholders own the policy and pay for the term portion of the premiums, with the proceeds split between them.

Potential Problem of Life-Insurance Funding

One potential problem of a corporation being the beneficiary of a life insurance policy designed to fund the buy-out of a deceased shareholder is that the IRS could argue that the policy proceeds are included in the corporate value.  In Estate of Blount v. Comr., T.C. Memo. 2004-116, the issue was whether the insurance proceeds contractually deduction to the redemption of corporate shares being valued be treated as corporate property for valuation purposes.  The decedent owned 83 percent of the stock in a corporation at death.  There was a life insurance policy owned by the company that provided some $3.1 million to pay off the mandated buyout of the shares under a buy-sell agreement providing for a fixed value of the decedent shares. The buy-sell agreement value was held not to be controlling for estate tax purposes, mainly because the deceased owned 83 percent of the stock and could have changed the agreement at any time. Furthermore, the court determined that the buy-sell agreement was not similar to those involved in arm’s length transactions.

The 11^th circuit reversed on the basis that the redemption obligation of the buy-sell agreement was a liability that offset the value of the death benefits used to fund the redemption. Estate of Blount v. Comr., 428 F.3d 1338 (11th Cir. 2005).  Thus, even if the death benefits were included in the corporate value, there was a corresponding offsetting liability that would be accounted for by a “reasonably competent business person interested in acquiring the company.”  Id. 

Note:  In a decision preceding the Tax Court’s decision in Blount, the Ninth Circuit court deducted the insurance proceeds from the value of the organization when they were offset by an obligation to pay those proceeds to the estate in a stock buyout.  Cartwright v. Comr., 183 F.3d 1034 (9th Cir. 1999).   

The issue in Blount and Cartwright resurfaced in Connelly v. United States, No. 4:19-cv-01410-SRC, 2021 U.S. Dist. LEXIS 179745 (E.D. Mo. Sept. 21, 2021). In Connelly, two brothers were the only shareholders of a closely-held family roofing and siding materials business.  They entered into a stock purchase agreement that required the company to buy back shares of the first brother to die.  The company then purchased about $3.5 million in life insurance coverage to ensure it had enough cash to redeem the stock.  The brother holding the majority of the company’s shares (77.18 percent) died on October 1, 2013.  The company received $3.5 million in insurance proceeds.  The surviving brother chose not to buy his shares, so the company used a portion of the proceeds to buy the deceased brother’s shares from his estate for $3 million pursuant to a Sale and Purchase Agreement.  Under the agreement the estate received $3 million, and the decedent’s son received a three-year option to buy company stock from the surviving brother.  If the surviving brother sold the company within 10 years, the brother and decedent’s son would split evenly any gains from the sale. 

The estate valued the decedent’s stock at $3 million and included that amount in the taxable estate.  Upon audit the IRS asserted that the fair market value of the decedent’s corporate stock should have factored-in the $3 million in life-insurance proceeds used to redeem the shares which, in turn, resulted in a higher value of the decedent’s stock than was reported.  The IRS assessed over $1 million in additional estate tax.  The estate paid the deficiency and filed a refund claim in federal district court. 

The district court noted that a stock-purchase agreement is respected when determining the fair market value of stock for estate tax purposes upon satisfying the requirements of I.R.C. §2703(b) (as noted above), and the additional judicially created requirements (also noted above).    The IRS expert claimed that the insurance proceeds should be included in the company’s value as a non-operating asset, and that allowing the redemption obligation to offset the insurance proceeds undervalued the company’s equity and the decedent’s equity interest in the company, and would create a windfall for a potential buyer that a willing seller would not accept.  The IRS expert concluded that the fair market value of the company was $6.86 million rather than $3.86 million.  The IRS also claimed that the stock purchase agreement failed to control the value of the company.  The estate claimed that the company sold the decedent’s shares at fair market value and that the shares had been properly valued.  Thus, according to the estate, the $3 million in life insurance proceeds were properly excluded from the decedent’s estate based on the appellate opinion in Blount.  The estate claimed that the stock purchase agreement provided a sufficient basis for the court to accept the estate’s valuation as the proper estate-tax value of the decedent’s shares.  On that point, the IRS claimed that the stock purchase agreement was not a bona fide business arrangement and, as such, didn’t control the value of the decedent’s stock.  The IRS position was that the stated estate planning objectives of the stock purchase of continued family ownership of the company were insufficient to make it a bona fide business arrangement, particularly because the brothers did not follow it by disregarding the agreement’s pricing mechanisms. 

The district court did not rule on the bona fide business arrangement issue because it determined that the estate had failed to show that the stock purchase agreement was not a device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration.  The process that the surviving brother and the estate used in selecting the redemption price bolstered the court’s conclusion that the stock purchase agreement was a testamentary device.  They also did not obtain an outside appraisal or professional advice on setting the redemption price, thereby disregarding the appraisal requirement set forth in the agreement.  The district court also noted that the agreement didn’t provide for a minority interest discount for the surviving brother’s shares or a lack of control premium for the decedent’s shares with the result that the decedent’s shares were undervalued.  This also, according to the district court, demonstrated that the stock purchase agreement was a testamentary device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration and was not comparable to similar agreements negotiated at arms’ length. 

On the issue of whether the life insurance proceeds should be included in corporate value, the court rejected the appellate court’s approach in Blount, finding it to be analytically flawed.  The court concluded that the appellate court in Blount had misread Treas. Reg. §20.2031-2(f)(2), and that the regulation specifically requires consideration to be given to non-operating assets including life insurance proceeds, “to the extent such nonoperating assets have not been taken into account in the determination of net worth.”  The district court concluded that the text of the regulation does not indicate that the presence of an offsetting liability means that the life insurance proceeds have already been “taken into account in the determination of a company’s net worth.”  The district court concluded that, “by its plain terms, the regulation means that the proceeds should be considered in the same manner as any other nonoperating asset in the calculation of the fair market value of a company’s stock…. And…a redemption obligation is not the same as an ordinary corporate liability.”  There is a difference, the court noted, between a redemption obligation that simply buys shares of stock, and one that also compensates for a shareholder’s past work.  One that only buys stock is not an ordinary corporate liability – it doesn’t change the value of the corporation as a whole before the shares are redeemed.  It involves a change in the ownership structure with a shareholder essentially “cashing out.”  The court noted that the parties had stipulated that the decedent’s shares were worth $3.1 million, aside from the life insurance proceeds.  The insurance proceeds were not offset by the company’s redemption obligation and, accordingly, the company’s fair market value and the decedent’s shares included all of the insurance proceeds, and the IRS position was upheld. 

On appeal the U.S Court of Appeals for the Eighth Circuit affirmed.  Connelly v. United States, 70 F.4th 412 (8th Cir. 2023).  The appellate court held that the stock purchase agreement requiring the redemption of a deceased shareholder’s shares did not affect the value of the shares for estate tax purposes under I.R.C. §2703 because it did not provide for a fixed price or a formula for arriving at one. Instead, the agreement merely laid out two mechanisms by which the brothers might agree on a price - mutual agreement or appraisal. As for the appraisal approach, there was nothing in the agreement that fixed or prescribed a formula or measure for determining the price that the appraisers would reach. Thus, neither mechanism constituted a fixed or determinable price for valuation purposes. The appellate court determined that the $3 million that the corporation actually paid for the deceased brothers shares constituted an amount determined after death that was derived by an agreement between the brothers and not by any formula in the buy-sell agreement.

As for the value of the corporation (and, hence, the deceased brother’s interest in the corporation), the appellate court determined that the life insurance proceeds were an asset that increased the shareholders’ equity and that an obligation to redeem shares is not a liability in the ordinary business sense.  Thus, the proper valuation of the corporation in accordance with I.R.C.  §§2042 and 2031 must include the life insurance proceeds without treating the obligation to redeem shares as an offsetting liability.  The court reasoned that in order for a willing buyer at the time of the brother’s death to own the stock outright, a willing buyer would account for control the life insurance proceeds and therefore would pay up to $6.86 million for the corporation, quote taking into account end quote the life insurance proceeds and then either extinguishing the agreement or redeeming the shares. Conversely, the appellate court determined that a hypothetical willing seller of the corporation would not find acceptable a price of $3.86 million with the knowledge that the company would be receiving $3 million in life insurance proceeds.

To illustrate its rationale, the appellate court explained explain that if it valued the corporation without accounting for the life insurance proceeds intended for redemption, then upon the brother’s death each share was worth $7,720 before redemption.  After redemption, the deceased brother’s interest is extinguished, with the surviving brother having full control of the corporation’s $3.86 million value.  The appellate court noted that this would essentially quadruple the value of the surviving brother’s shares, but that treating the life insurance as an offsetting liability would leave the stock value undisturbed (which was the estate’s position). The economic reality of the situation, the appellate court concluded, was that the life insurance proceeds was an asset that increased shareholders’ equity.  The buy-sell agreement thus had nothing to do with being a corporate liability. 

Note:  A separate insurance LLC could be used to fund a buy-sell agreement in light of Connelly.  The insurance LLC would collect the life insurance proceeds on the deceased owner.  The LLC’s value would not be increased by the death benefit because it is allocated to the other owners in accordance with the buy-sell agreement due to special allocations in a LLC taxed as a partnership.  See I.R.C. §704.  A formal appraisal would likely only be required if there is real estate or some other difficult to value asset that the LLC owns.  This does add a layer of complexity, but if there are more than two owners the additional complexity may be worth it.

Arguably, there is now a split on this issue between the 8th Circuit on one hand, and the 9th and 11th Circuits on the other (keep in mind the brothers in Connelly didn’t follow the buy-sell agreement).  Indeed, a petition for certiorari was filed with the U.S. Supreme Court on August 15, 2023.  Will the Supreme Court agree to hear Connelly?  Not very likely at all. 

Conclusion

A buy-sell agreement can be a very important part of a succession plan for a family farming/ranching business (or any small, family-owned business for that matter).  However, it’s critical that the agreement be drafted properly and followed by the business owners.

LLCs/LPs and S.E. Tax – Will Steve Cohen Now Settle?

Overview

As I have previously written on this blog, a big question in self-employment tax planning is whether an LLC member is a limited partner.  In those prior articles, it was noted that the IRS/Treasury hadn’t yet finalized a regulation that was initially proposed in 1997 to address the issue.  For businesses other than those providing professional services, characterization of an LLC member’s interest is determinative of whether the member has self-employment tax liability on amounts distributed to the member (other than guaranteed payments).  That means that proper structuring of the entity matters as does the drafting of the LLC operating agreement and the conduct of the members. 

Now, the U.S. Tax Court has issued a fully reported opinion confirming that state law classifications of a partner’s interest is not conclusive on the self-employment tax issue.  That is a key point because Steve Cohen, owner of the New York Mets, has filed a case with the Tax Court challenging the assessment of self-employment tax on about $350 million in distributions (other than guaranteed payments to limited partners in his investment (hedge fund) firm.  Is the Tax Court’s recent opinion a warning to Mr. Cohen that he should look to settle his case?  Perhaps.

Self-employment tax implications of LLCs – when is a member really a limited partner?   That’s the topic of today’s post.

Background - LLCs and Self-Employment Tax

Net earnings from self-employment includes the distributive share of income or loss from a trade or business carried on by a partnership.  I.R.C. §1402(a).  Thus, the default rule is that all partnership income is included, unless it is specifically excluded.  Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization.  Are they general partners or limited partners?  Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC.  So, what is a limited partner?  The test of whether an interest in an entity treated as a partnership for tax purposes is treated as a limited interest or a general interest, for the purpose of applying the self-employment tax is stated at Prop. Reg. §1.1402(a)-2(h), issued in 1997. 

Note:  Immediately after the Proposed Regulation was issued, the Congress passed a statute prohibiting the IRS from finalizing the Regulation within one year.  Nothing further has been forthcoming.  Although still in Proposed Regulation form, this regulation remains the best available authority. 

The Proposed Regulation establishes a three-part general rule, with two exceptions, that may permit limited partner treatment under certain conditions.  A third exception to limited partner treatment applies in the context of professional service businesses (e.g., law, accounting, health, engineering, etc.).  Under the general rule, a member is not treated as a limited partner if:  (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year.  Prop. Treas. Reg. §1.1402(a)-2(h)(2). 

An exception applies only if the interest-holder owns a single class of interest (regardless of whether there are multiple classes outstanding) and failure of the 500-hour test is the sole reason for treatment of the interest as a general interest.  In addition, the interest held must meet certain threshold requirements:

• There must be at least one member holding the same class of interest who meets all three of the requirements under the general rule, without application of any exceptions;
• The share of that class of interest held by those members must be “substantial” (with respect to the class of interest at issue and not with respect to the entity as a whole), based on the facts and circumstances (a safe harbor of 20 percent, in aggregate, is provided at Treas. Reg. §1.1402(a)-2(h)(6)(v)); and
• The interests held by those members must be “continuing” (an undefined term).

Another exception to the general rule applies only if the member owns at least two classes of interests and the same threshold requirements are satisfied.  This exception may permit a member to treat the distributive share attributable to at least one class as a limited interest if the three requirements of the general rule are met with respect to any class that the member holds.  In that case the distributive share attributable to that interest is not subject to self-employment tax.  But, the distributive share attributable to any interest held by a member that does not meet the three requirements of the general rule is subject to self-employment tax.  This all means that a portion of a member’s total distributive share may be subject to self-employment tax, and some may not be.

Note:  Under the general rule, it is likely that the entire distributive share of all members of a member-managed LLC will be subject to self-employment tax because state law likely gives all members the authority to contract.  Likewise, LLP statutes likely give management rights which means that the second requirement of the general rule cannot be satisfied.  As a result, neither exception to the general rule can be met because both exceptions require at least one member to satisfy all three requirements of the general rule. 

The Castigliola case.  In Castigliola, et al. v. Comr, T.C. Memo. 2017-62, a group of lawyers structured their law practice as member-managed Professional LLC (PLLC).  On the advice of a CPA, they tied each of their guaranteed payments to what reasonable compensation would be for a comparable attorney in the locale with similar experience.  They paid self-employment tax on those amounts.  However, the Schedule K-1 showed allocable income exceeding the member’s guaranteed payment.  Self-employment tax was not paid on the excess amounts.  The IRS disagreed with that characterization, asserting self-employment tax on all amounts allocated. 

The Tax Court (Judge Paris) agreed with the IRS.  Based on the Uniform Limited Partnership Act of 1916, the Revised Limited Partnership Act of 1976 and Mississippi law (the state in which the PLLC operated), the court determined that a limited partner is defined by limited liability and the inability to control the business.  The members couldn’t satisfy the second test.  Because of the member-managed structure, each member had management power of the PLLC business.  In addition, because there was no written operating agreement, the court had no other evidence of a limitation on a member’s management authority.  In addition, the evidence showed that the members actually did participate in management by determining their respective distributive shares, borrowing money, making employment-related decisions, supervising non-partner attorneys of the firm and signing checks.  The court also noted that to be a limited partnership, there must be at least one general partner and a limited partner, but the facts revealed that all members conducted themselves as general partners with identical rights and responsibilities.  In addition, before becoming a PLLC, the law firm was a general partnership.  After the change to the PLLC status, their management structure didn’t change. 

The court did not mention the proposed regulations, but even if they had been taken into account the outcome of the case would have been the same.  Member-managed LLCs are subject to self-employment tax because all members have management authority.  It’s that simple.  In addition, as noted below, there is an exception in the proposed regulations that would have come into play. 

Note:  As a side-note, the IRS had claimed that the attorney trust funds were taxable to the PLLC.  The court, however, disagreed because the lawyers were not entitled to the funds.

Structuring to Minimize Self-Employment Tax – The Manager-Managed LLC

There is an entity structure that can minimize self-employment tax.  An LLC can be structured as a manager-managed LLC with two membership classes.  With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4).  They do, however, have self-employment tax on any guaranteed payments.

Service businesses.  The manager-managed structure does not achieve self-employment tax savings for personal service businesses, such as the one involved in Castigliola.  Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership.  Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter).  Thus, for a professional services partnership (such as the law firm at issue in the case), structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.     

Note:  If a member of a services partnership (e.g. LLC) is merely an investor that is not involved in the operations of the LLC as a business and is separately paid for services rendered, any distributive share is not subject to self-employment tax.  See, e.g., Hardy v. Comr., T.C. Memo. 2017-16.  But, if the distributive share is received from fees from the LLC’s business, the distributive share is subject to self-employment tax.  See, e.g., Renkemeyer, Campbell & Weaver, LLP, 136 T.C 137 (2011). 

Farming and ranching operations.  For LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated.  The result is that a member holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.

Example.  Here's what it might look like for a farming operation:

A married couple operates a farming business as an LLC.  The wife works full-time off the farm and does not participate in the farming operation.  But she holds a 49 percent non-manager ownership interest in the LLC.  The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest.  But, the husband, as the farmer, also holds a 2 percent manager interest.  The husband receives a guaranteed payment for his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC.  The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax.  The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives.  This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC. 

Additional benefit.  There is another potential benefit of utilizing the manager-managed LLC structure.  Until the net investment income tax of I.R.C. §1411 is repealed, it applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return).  While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager.  I.R.C. §469(h)(5).  Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of the other spouse from passive to active income that will not be subject to the 3.8 percent surtax.

Note:  Returning to the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.

Soroban Capital Partners LP

The Tax Court has now issued a fully reported opinion (meaning it is of national significance in all jurisdictions) taking Castigliola one step further and holding that creating a limited partner interest under state law is not necessarily enough to have a limited partner interest for self-employment tax purposes.  Soroban Capital Partners LP v. Comr., 161 T.C. No. 12 (2023).  The petitioner was a limited partnership that made guaranteed payments and distributed ordinary income to its limited partners. However, the petitioner excluded distributions of ordinary income to its limited partners from its computation of net earnings from self-employment.  Its basis for doing so was that the limited partners’ interest conformed to state law.  The IRS disagreed asserting that wasn’t enough and that the functions and roles of the limited partners also had to be analyzed for self-employment tax purposes. The Tax Court agreed with the IRS.

The Tax Court was faced with the definition of a “limited partner” for purpose of the exception from s.e. tax under I.R.C. §1402(a)(13).  The Tax Court noted that the proposed regulations provided a definition, that the Congress froze the finalization of the regulation for six months and has said very little about the issue since the freeze was lifted, and has not provided a definition.  The Tax Court noted that it had applied a “functional analysis” test in Renkemeyer, but that this was the first time the Tax Court was asked to determine the self-employment tax status of limited partner in a state law limited partnership (having passed on the issue in a 2020 case).  The Tax Court determined that the functional analysis test applied based largely on statutory construction of I.R.C. §1402(a)(13) which excludes from self-employment tax “the distributive share of any item of income or loss of a limited partner, as such.”  The Court concluded that the “as such” language meant that there wasn’t a blanket exclusion for a limited partner.  Instead, the statute only applies to a limited partner that is acting as a limited partner.  If a limited partner is anything more than merely an investor, self-employment tax applies to the partner’s distributive share. 

Note:  The court noted that the petitioner cited legislative history in an attempt to support its position, but that the legislative history actually supported the position of the IRS.  The Tax Court also noted that the petitioner put forth “myriad other arguments” none of which were persuasive.  The petitioner even cited language in the instructions for Form 1065 which it claimed defined a limited partner, but the Tax Court noted that the definition did not purport to define a limited partner. 

The Tax Court held that a functional inquiry into the roles and activities of the petitioner’s individual partners under I.R.C. §1402(a)(13) “involves factual determinations that are necessary to determine Soroban’s aggregate amount of net earnings from self-employment.”  Accordingly, the Tax Court denied the petitioner’s motion for summary judgment and set forth the rule going forward in evaluating the application of self-employment tax for limited partners in professional service businesses.

Conclusion

The manager-managed LLC provides a better result than the result produced by the member-managed LLC for LLCs that are not service partnerships.  For those that are, such as the PLLC in Castigliola, the S corporation is the business form to use to achieve a better tax result.  For an S corporation, “reasonable” compensation will need to be paid subject to S.E. tax, but the balance drawn from the entity can be received self-employment tax free.  But, for farming operations with land rental income, the manager-managed LLC can provide a better overall tax result than the use of an S corporation because of the ability to eliminate the net investment income tax.    

Of course, the self-employment tax and the net investment income tax are only two pieces of the puzzle to an overall business plan.  Other non-tax considerations may carry more weight in a particular situation.  But for some, this strategy can be quite beneficial.

The decision in Castigliola would appear to further bolster the manager-managed approach – an individual that is a “mere member” appears to now have an even stronger argument for limited partner treatment.  In addition, the court didn’t impose penalties on the PLLC because of reliance on an experienced professional for their filing position. 

Soroban Capital Partners LP lays down the rule that it’s not enough to simply hold a limited partnership interest under state law (in the context of a professional service business).  A limited partner must truly be acting as an investor and no more.   The case involves a limited partnership that performs professional services, so it's fairly easy for the IRS to assert s.e. tax.  The opinion really doesn't address whether you can be a passive investor with some services provided to the limited partnership and still have it exempt from s.e. tax.  It also doesn't address whether you can be both a general partner and a limited partner and avoid s.e. tax on the income distributive share attributable to the limited partner interest.  The answer to those last two questions, according to the analysis provided above, should be "yes" for farm and ranch clients.  

Will Steve Cohen now move to try to settle his case with the IRS?  Are the limited partners in his hedge fund business truly limited partner investors?  Doubtful.

Proper structuring of the LLC and careful drafting of the operating agreement is important. 

Ethics and 2024 Summer Seminars!

Tax Ethics

On December 15, I'll be conducting a 2-hour tax ethics program.  It will be online-only attendance.  If you are in need of a couple of hours of ethics, this will be a good opportunity to meet the ethics requirement.  I'll be covering various ethical scenarios that tax professionals encounter.  The session will be a practical, hands-on application of the rules, including Circular 230.  If you have attended or are registered to attend a KSU Tax Institute, you get a break on the registration fee. 

For more information you can click here: https://www.washburnlaw.edu/employers/cle/taxethics.html 

Also, you may register here:  https://form.jotform.com/232963813182156

Summer Seminars

On June 12 and 13, Paul Neiffer and I will be holding a farm tax and farm estate/business planning conference at the Keeter Center on the campus of the College of the Ozarks, just a bit south of Branson, MO.  This conference is in-person only.  On August 5 and 6, we will be doing another conference in Jackson Hole, WY, at the Virginian Resort.  Hold the dates  and be watching for more information.  This conference will be both in-person and online.  Registration will open for the seminars in January.  There is a room block established at the Virginian.

Hope to see you online at the ethics seminar and at one of the summer conferences.

Split-Interest Land Acquisitions – Is it For You? (Part 2)

Overview

Yesterday’s article looked at what a split-interest transaction is, how it works, and when it can be useful as part of an estate plan.  In particular, the focus of Part 1 was on removing after tax income from a family farming corporation and how it can work when farmland is purchased.

Today’s article looks at the relative advantages and disadvantages of the split-interest transaction, and what the rules are when property that is acquired in a split-interest transaction is sold.

Part 2 of split-interest transactions – it’s the topic of today’s post.

Advantages and Disadvantages

Advantages.  Because land is not depreciable, the most efficient form of acquisition is to use earnings exposed to a low tax rate.  A closely-held C corporation is a relatively efficient entity for creating after-tax dollars with the current tax rate at a flat 21 percent.  Even though C corporation after-tax dollars are used for the acquisition of most of the cost of land, the split-interest technique avoids the long-term negative aspect of having the farmland trapped inside the C corporation, and thus avoids the risk of double taxation of land appreciation. 

Even though corporate dollars are used to acquire the asset, the individual succeeds to full tax basis in the asset (reduced by any tax depreciation allowable to the corporation on the depreciable portion of the property).  The remainderman acquires basis in the real estate even though no economic outlay has occurred by that individual. 

Disadvantages.  The individual who buys the remainder interest must do so entirely from other sources of after-tax earnings.  The land produces no income to the remainderman during the period that the land is available for use by the corporation under the specified term certain.  Also, if the land is purchased on a contract or installment payment arrangement, each party must provide its contribution, either to the down payment or the contract. 

Note.  The party with the cash for the down payment may provide any portion or all of such down payment, with an adjustment for that party’s contribution to the contract.  The contract may provide for interest only payments by one party, until the other party’s contribution toward the purchase has been fully paid. 

Example.  Sow’s Ear, Inc. has been retaining equity of approximately $40,000 per year ($50,000 taxable income minus state and federal taxes) for a number of years.  Chuck, the corporate president would like to purchase additional land with the funds that the corporation has accumulated.   Chuck wants the corporation to buy the land with those available funds.  However, having the corporation purchase the land would trap up that land inside the corporation and potentially expose it to the double tax upon liquidation as well as eliminating capital gain rates if the corporation would have to sell the land. 

An alternative solution would be a split interest purchase.  Assume that the land could be purchased for $1 million, with $450,000 down and a contract at 5 percent for the balance, payable $52,988.26 annually for 15 years.  Chuck would like to farm for another 20 years via the corporation.  Assume that the monthly IRS purchased interest rate for a 20-year split-interest purchase requires the term interest holder to pay 58 percent of the total purchase price or $580,000.  Sow’s Ear, Inc. may pay $200,000 of the down payment.  It’s share of the remaining balance due is $380,000.  Chuck, as the remainder holder, is responsible for $420,000.  The balance due for the down payment may be made by either party.  If Sow’s Ear, Inc. borrows to satisfy the remaining down payment of $250,000, it will assume $130,000 of the note payable for the balance due ($580,000 less $200,000 cash less $250,000 remaining down payment).  Chuck will assume the remaining balance due of $420,000. 

Each party must pay interest that economically accrues on its share of the seller-financed debt, otherwise the below-market rate loan rules apply, which tie in with OID requirements.  The parties may determine the share of principal to be paid by each, as long as a total of $52,988.26 annually is paid to satisfy the requirements of the seller-financed note.  Because Chuck, as the remainderman, has no cash flow coming from the property for the next 20 years, he will have to obtain funds from sources other than rents from the property to fund his payments.  The deductibility of interest expense will be subject to the passive activity rules of I.R.C. §469.  The interest expense is a passive activity deduction, even though no rent is currently received by Chuck.  If Chuck has no passive income from other activities, the interest expense will create a passive loss carryover, to be available to offset net rental income after the term interest held by the corporation expires. 

Observation.  The split-interest technique is essentially limited to C corporations, because if two related individuals are involved the person acquiring the term interest is treated as having made a gift of the value of the term right to the purchaser of the reminder right.

 

Observation.  In times of low interest rates (i.e., low AFR factors that determine the percentage to be paid by each party), the corporate share will be smaller than occurs in periods when interest rates are higher.

Sale of Split-Interest Property

If a sale occurs during the split ownership of the property, the sale proceeds must be allocated between the corporate term holder and the individual remainderman based on the IRS interest rate and the remaining term certain periods as of the date of the sale.  After allocating the sale proceeds to each party, gain or loss is recognized by each party (the corporate term holder and the individual remainderman) by comparing the sale proceeds to the adjusted tax basis of the property.  The adjusted tax basis needs to reflect the nondeductible amortization adjustment occurring annually and the shift of this basis to the remainderman in accordance with I.R.C. §167(e)(3). 

Example.  Assume that RipTiller, Inc. and Dave Jr. (from the prior example) purchased another farm seven years ago for $200,000, with the corporation acquiring a 32-year term certain.  Assume that using interest rates in effect at that time, Dave Jr. was required to pay $25,000 and the corporation paid $175,000 toward the farm purchase price.  The corporate basis was further allocated as $20,000 attributable to depreciable tiling and $155,000 attributable to the land cost.  By the current year, the corporation would have depreciated about $9,000 of the $20,000 of tiling, leaving an adjusted basis of approximately $11,000.  The land basis of $155,000 would also have been reduced annually under straight-line amortization over the 32-year term certain.  Assume that about $4,800 per year of amortization occurred over the seven-year holding period of the corporation, resulting in a total reduction to the corporate basis of $33,600.  The amortization would be treated as land basis reductions to the corporation, and as land basis increases to Dave Jr.  Accordingly, at the time of the sale of the farm, the adjusted tax basis to each party is as follows:

Corporate Basis

                                                                                   Land               Tiling               Total

Basis at Purchase                                                     $155,000       $20,000             $175,000

            Deductible Depreciation                                                      ($9,000)           ($9,000)

            Statutory Amortization                               ($33,600)                                 ($33,600)

                 Adjusted Basis                                       $121,400         $11,000           $132,400

Dave Jr.’s Basis:

            At Purchase                                                     $25,000

            Statutory Increase for Amortization          $33,600

            Total Adjusted Tax Basis                               $58,600

If the farm is sold for $250,000, the term certain percentage and remainder percentage must be calculated for a term certain with 25 years remaining.  Assume that the current IRS mid-term annual AFR is 6.0 percent.  According to the IRS term certain table for 6.0 percent, the 25-year income right is to be allocated 76,7001 percent and the remainderman is to be allocated 23.2999 percent.  Accordingly, about $192,000 of the sale proceeds are allocable to the corporation and the remaining $58,000 is allocable to the individual.  The corporation would compare its $192,000 of approximate proceeds to its adjusted tax basis in the land and tiling of approximately $132,000.  In this example RipTiller, Inc. would report $60,000 of gain.  Dave Jr. would report a small capital loss ($58,000 allocated sale price vs. $58,600 adjusted tax basis). 

Observation.  Interest rates at the time of purchase compared to interest rates at the time of sale can have a major influence on the allocations under the split-interest rules.  In the example, if interest rates rise from the time of purchase to the time of sale, Dave Jr. would have a lower percentage of the sale price allocable to his remainder interest, and could incur a significant capital loss that was not immediately deductible.

Split-Interest Purchases with Unrelated Parties

The IRS has addressed the tax effects of split-interest purchases where the term holder and the remainder holder were unrelated.  In two Private Letter Rulings (200852013 (Sept. 24, 2008) and 200901008 (Oct. 1, 2008)) that appear to address the same set of facts, two unrelated buyers acquired several parcels of commercial real estate that included both depreciable buildings and land.    The first buyer acquired a 50-year term interest in the property, and the second buyer acquired a remainder interest in that same property.  The IRS determined that the buyer of the term interest was entitled to depreciate the commercial real estate (which the buyer of the term interest intended to use in its active conduct of renting commercial and residential property) ratably over the 50-year period of the term certain.  The portion of the taxpayer’s basis allocable to the buildings was held to be depreciable under the normal I.R.C. §168 MACRS recovery periods.  In addition, the IRS determined that the holding period for the buyer of the remainder interest began at the time of the purchase.

Observation.  A term certain remainder purchase arrangement of farmland (that is used in the taxpayer’s trade or business) where the two parties are unrelated could result in a term certain amortizable interest in the land. This is the case, according to the IRS, even though the farmland is not depreciable.  But see the Lomas case referenced in Part 1).  Examples of unrelated parties under I.R.C. §267 for these rules would include cousins and in-laws, such as a father-in-law, brother-in-law, or sister-in-law. 

Estate Tax Implications

For transactions that are between unrelated parties (as defined in I.R.C. §267), several federal estate tax advantages can be achieved.  If the “split” property is fairly valued (by a qualified appraiser), there is no gift upon creation of the split interest if IRS tables are used to value each party’s contribution.  Also, because the life estate interest ends upon the death of the life estate holder, there is no taxable transfer by that person that would trigger estate tax.  There is no inclusion in the life estate holder’s estate (and no interest subject to probate).  The property becomes fully vested in the remainder holder upon the life estate holder’s death.  As a result, there is no basis “step-up” to fair market value at the time of the life estate holder’s death in the hands of the remainder holder.  The basis of the property in the hands of the remainder holder is the cost of the remainder interest (the amount paid for the remainder interest).

Conclusion

Is a split-interest transaction for you? The answer, of course, is that it “depends.” For transactions involving individuals, the tax advantages (income tax as well as estate tax) are lost if the parties to the transaction are related.  Also, it’s important to make sure to the remainder holder provides consideration for the acquisition of the remainder interest (and not simply the life estate holder providing the financing to the holder of the remainder interest).  If that doesn’t happen, the IRS will likely claim that the life estate holder made a gift of a future interest that is subject to gift tax and can’t be offset by the present interest annual exclusion (currently $17,000 per year per donee).

Still uncertain is whether, for example, a split-interest purchase between unrelated parties (such as between a farm tenant that is looking to farm additional land and an investment firm). The IRS letter rulings seem to address this issue in a commercial context. Another issue in some states is that the strategy won’t work in some states if the investor is a corporation, limited liability company or trust that is disqualified from owning and/or operating agricultural land by statute.

For split-interest transactions involving a C corporation, if done correctly, the technique can be beneficial from a tax standpoint.

Split Interest Land Acquisitions – Is it For You? (Part 1)

In General

A split-interest transaction involves one party acquiring a temporary interest in the asset (such as a term certain or life estate), with the other party acquiring a remainder interest.  The temporary interest may either refer to a specific term of years (i.e., a term certain such as 20 years), or may be defined by reference to one or more lives (i.e., a life estate).  The remainder holder then succeeds to full ownership of the asset after expiration of the term certain or life estate. 

A split-interest transaction is often used as an estate planning mechanism to reduce estate, gift as well as generation-skipping transfer taxes.  But there are related party rules that can apply which can impact value for estate and gift tax purposes. 

Another way that a split-interest transaction may work is as a mechanism for removing after-tax income from a family corporation.  In addition, if the farmland is being purchased, the split-interest arrangement allows most of the cost to be covered by the corporation, but without trapping the asset inside the corporation (where it would incur a future double tax if the corporation were to be liquidated).   

Split-interest land transactions – it’s the topic of today’s post.

Split-Interest Transactions

The Hansen case.  In Richard Hansen Land, Inc. v. Comr., T.C. Memo. 1993-248, the Tax Court affirmed that related parties, such as a corporation and its controlling shareholder, may enter into a split-interest acquisition of assets.  The case involved a corporation that acquired a 30-year term interest in farmland with the controlling shareholder acquiring the remainder interest.  Based on interest rates in effect at the time, the corporation was responsible for about 94 percent of the land cost and the controlling shareholder individually paid for six percent of the land cost.  Under the law in effect at the time, the court determined that the term interest holder’s ownership was amortizable.  The corporation was considered to have acquired a wasting asset in the form of its 30-year term interest. 

Tax implications.  The buyer of the term interest (including a life estate) may usually amortize the basis of the interest ratably over its expected life.  That might lead some taxpayers to believe that they could therefore take depreciation on otherwise non-depreciable property. For instance, this general rule would seem to allow a parent to buy a life estate in farmland from a seller (with the children buying the remainder) to amortize the amount paid over the parent’s lifetime.  If that is true, then that produces a better tax result than the more common approach of the parent buying the farmland and leaving it to the children at death.  Under that approach no depreciation or amortization would be allowed.  However, the Tax Court, in Lomas Santa Fe, Inc. v. Comr., 74 T.C. 662 (1980), held that an amortization deduction is not available when the underlying property is non-depreciable and has been split by its owner into two interests without any new investment.  Under the facts of the case, a landowner conveyed the land to his wholly owned corporation, subject to a 40-year retained term of years.  He allocated his basis for the land between the retained term of years and the transferred remainder and amortized the former over the 40-year period.  As noted above, the court denied the amortization deduction.

In another case involving similar facts, Gordon v. Comr., 85 T.C. 309 (1985), the taxpayer bought life interests in tax-exempt bonds with the remainder interests purchased by trusts that the taxpayer had created.  The taxpayer claimed amortization deductions for the amounts paid for his life interests.  The Tax Court denied the deductions on the basis that the substance of the transactions was that the taxpayer had purchased the bonds outright and then transferred the remainder interests to the trusts.   

Related party restriction.  For term interests or life estates acquired after July 28, 1989, no amortization is allowed if the remainder portion is held, directly or indirectly, by a related party.  I.R.C. §167(e)(3). 

Note:  I.R.C. §167(e) does not apply to a life or other terminable interest acquired by gift because I.R.C. §273 bars depreciation of such an interest regardless of who holds the remainder.  I.R.C. §167(e)(2)(A).   This provision is the Congressional reaction to the problem raised in the Lomas Santa Fe and Gordon cases.  Under the provision, “term interest” is defined to include a life interest in property, an interest for a term of years, or an income interest held in trust. I.R.C. §§167(e)(5)(A); 1001(e)(2). The term “related person” includes the taxpayer’s family (spouse, ancestors, lineal descendants, brothers and sisters) and other persons related as described in I.R.C. §267(b) or I.R.C. §267(e).  I.R.C. §167(e)(5)(B).  It also encompasses a corporation where more than half of the stock is owned, directly or indirectly by persons related to the taxpayer.  Also, even if the transaction isn’t between related parties, amortization deductions could still be denied based on substance over form grounds.  See, e.g., Kornfeld v. Comr., 137 F.3d 1231 (10th Cir. 1998), cert. den. 525 U.S. 872 (1998).

If the acquisition is non-amortizable because it involves related parties, the term holder’s basis in the property (i.e., the corporate tax basis, in the context of a family farm corporation transaction) is annually reduced by the amortization which would have been allowable, and the remainder holder’s tax basis (i.e., the shareholder’s tax basis) is increased annually by this same disallowed amortization. I.R.C. §167(e)(3).    Thus, in a split-interest corporation-shareholder arrangement, the corporation would have full use of the land for the specified term of years, and the individual shareholder, as remainderman, would then succeed to full ownership after the expiration of the term of years, with the individual having the full tax basis in the real estate (but less any depreciation to which the corporation was entitled during its term of ownership, such as for tiling, irrigation systems, buildings, etc.).

On the related party issue, the IRS has indicated in Private Letter Ruling 200852013 (Sept. 24, 2008) that if the two purchasers are related parties, the term certain holder could not claim any depreciation with respect to the land or with respect to the buildings on the land during the period of the life estate/term interest. 

A couple of points can be made about this conclusion:

• The ruling is correct with respect to the land. That’s because I.R.C. §167(e)(1) contains a general rule denying any depreciation or amortization to a taxpayer for any term interest during the period in which the remainder interest is held, directly or indirectly, by a related person.

• However, the ruling is incorrect with respect to the conclusion that no depreciation would be available for the buildings on the land. R.C. §167(e)(4)(B) states that if depreciation or amortization would be allowable to the term interest holder other than because of the related party prohibition, the principles of I.R.C. §167(d) apply to the term interest.  Under I.R.C. §167(d), a term holder is treated as the absolute owner of the property for purposes of depreciation.  Thus, this exception would allow the term holder to claim depreciation with respect to the buildings but not the land, in the case of a related party term certain-remainder acquisition.

Observation.  The IRS guidance on this issue is confusing and, as noted, incorrect as to the buildings on the land.  It is true that the value paid for the term interest is not depreciable.  However, the amount paid for the building and other depreciable property remains depreciable by the holder of the property.  Thus, the term interest holder claims the depreciation on the depreciable property during the term.  The remainderman takes over depreciation after the expiration of the term.  Basis allocated to the intangible (the split-interest) is a separate basis, which is not amortizable.  Likewise, the basis allocated to the split-interest may not be attributed over to the depreciable property to make it amortizable. 

Allocation procedure.  To identify the proper percentage allocation to the term certain holder and the remainderman, the monthly IRS-published AFR interest rate is used, along with the actuarial tables of IRS Pub. 1457 (the most recent revision is June 2023).  The relevant interest rate is contained in Table 5 of the IRS monthly AFR ruling.

Example.  RipTiller, Inc. is a family-owned C corporation farming operation.  The corporation is owned by Dave Sr. and Dave Jr.  The corporation has a build-up of cash and investments from the use of the lower corporate tax brackets over a number of years.  The family would like to buy additional land, but their tax advisors have discouraged any land purchases within the corporation because of the tax costs of double tax upon liquidation.  On the other hand, both Dave Sr. and Dave Jr. recognize that it is expensive from an individual standpoint to use extra salaries and rents from the corporation to individually purchase the land. 

The proposed solution is to have the corporation acquire a 30-year term interest in the parcel of land, with Dave Jr. buying the remainder interest.  Assuming that the AFR at the time of purchase is 4.6 percent, and assuming a 30-year term, the corporation will pay for 74.0553 percent of the land cost and Dave Jr. will be obligated for 25.9447 percent.  RipTiller, Inc. may not amortize its investment, but it is entitled to claim any depreciation allocable to depreciable assets involved with this land parcel.  Also, each year, 1/30^th of the corporate tax basis in the term interest is decreased (i.e., the nondeductible amortization of the term interest reports as a Schedule M-1 addback, amortized for book and balance sheet purposes but not allowable as a deduction for tax purposes) and added to Dave Jr.’s deemed tax cost in the land.  As a result, at the end of the 30-year term, Dave Jr. will have full title to the real estate, and a tax cost equal to the full investment (although reduced by any depreciation claimed by the corporation attributable to depreciation allocations).      

Caution.  Related party split-interest purchases with individuals (e.g., father and son split-interest acquisition of farmland) should be avoided, due to the potentially harsh gift tax consequences of I.R.C. §2702 which treats the individual acquiring the term interest, typically the senior generation, as having made a gift of the value of the term ownership to the buyer of the remainder interest.  For this purpose, the related party definition is very broad and includes in-laws, nieces, nephews, uncles and aunts.  Similarly, any attempt to create an amortizable split-interest land acquisition, by structuring an arrangement between unrelated parties, must be carefully scrutinized in terms of analyzing the I.R.C. §267 related party rules and family attribution definitions.

Conclusion

In Part 2, I’ll take a deeper look at the relative advantages and disadvantages of of split-interest transactions with additional examples.

Reporting of Beneficial Ownership Information; Employee Retention Credit; Exclusion of Gain on Sale of Land with Residence; and a Farm Lease

Introduction

As I try to catch up on my writing after being on the road for a lengthy time, I have several items that seem to be recurring themes in what I deal with. 

Another potpourri of random ag law and tax issues – it’s the topic of today’s post.

New Corporate Reporting Requirements

The Corporate Transparency Act (CTA), P.L. 116-283, enacted in 2021 as part of the National Defense Authorization Act, was passed to enhance transparency in entity structures and ownership to combat money laundering, tax fraud and other illicit activities. In short, it’s an anti-money laundering initiative designed to catch those that are using shell corporations to avoid tax.  It is designed to capture more information about the ownership of specific entities operating in or accessing the U.S. market.  The effective date of the CTA is January 1, 2024.    

Who needs to report?  The CTA breaks down the reporting requirement of “beneficial ownership information” between “domestic reporting companies” and “foreign reporting companies.”  A domestic reporting company is a corporation, limited liability company (LLC), limited liability partnership (LLP) or any other entity that is created by filing of a document with a Secretary of State or any similar office under the law of a state or Indian Tribe.  A foreign reporting company is a corporation, LLC or other foreign entity that is formed under the law of a foreign country that is registered to do business in any state or tribal jurisdiction by the filing of a document with a Secretary of State or any similar office. 

Note:  Sole proprietorships that don’t use a single-member LLC are not considered to be a reporting company. 

Reporting companies typically include LLPs, LLLPs, business trusts, and most limited partnerships and other entities are generally created by a filing with a Secretary of State or similar office. 

Exemptions.  Exemptions from the reporting requirement apply for securities issuers, domestic governmental authorities, insurance companies, credit unions, certain large accounting firms, tax-exempt entities, public utility companies, banks, and other entities that don’t fall into specified categories.  In total there are 23 exemptions including an exemption for businesses with 20 or more full-time U.S. employees, report at least $5 million on the latest filed tax return and have a physical presence in the U.S.   But, for example, otherwise exempt businesses (including farms and ranches) that have other businesses such as an equipment or land LLC or any other related entity will have to file a report detailing the required beneficial ownership information.  Having one large entity won’t exempt the other entities. 

What is a “Beneficial Owner”?  A beneficial owner can fall into one of two categories defined as any individual who, directly or indirectly, either:

• Exercises substantial control over a reporting company, or
• Owns or controls at least 25 percent of the ownership interests of a reporting company

Note:  Beneficial ownership is categorized as those with ownership interests reflected through capital and profit interests in the company.

What must a beneficial owner do?  Beneficial owners must report to the Financial Crimes Enforcement Network (FinCEN).  FinCEN is a bureau of the U.S. Department of the Treasury that collects and analyzes information about financial transactions to combat domestic and international money laundering, terrorist financing and other international crimes.  Beneficial owners must report their name, date of birth, current residential or business street address, and unique identifier number from a recognized issuing jurisdiction and a photo of that document.  Company applicants can only be the individual who directly files the document that creates the entity, or the document that first registers the entity to do business in the U.S.  A company applicant may also be the individual who is primarily responsible for directing or controlling the filing of the relevant document by someone else. This last point makes it critical for professional advisors to carefully define the scope ot engagement for advisory services with clients.

Note:  If an individual files their information directly with FinCEN, they may be issued a “FinCEN Identifier” directly, which can be provided on a BOI report instead of the required information.

Filing deadlines.  Reporting companies created or registered in 2024 have 90 days from being registered with the state to file initial reports disclosing the persons that own or control the business. NPRM (RIN 1506-AB62) (Sept 28, 2023). If a business was created or registered to do business before 2024, the business has until January 1 of 2025 to file the initial report.  Businesses formed after 2024 must file within 30 days of formation.  Reports must be updated within 30 days of a change to the beneficial ownership of the business, or 30 days from when the beneficial owner becomes aware of or has reason to know of inaccurate information that was previously filed. 

Note:  FinCEN estimates about 32.6 million BOI reports will be filed in 2024, and about 14.5 million such reports will be filed annually in 2025 and beyond. The total five-year average of expected BOI update reports is almost 12.9 million.

Penalties.  The penalty for not filing is steep and can carry the possibility of imprisonment.  Specifically, noncompliance can result in escalating fines ranging from $500 per day up to $10,000 total and prison time of up to two years.     

State issues.  A state is required to notify filers upon initial formation/registration of the requirement to provide beneficial ownership information to the FinCEN.  In addition, states must provide filers with the appropriate reporting company Form.

Withdrawing an ERC Claim

Over the past year or so many fraudulent Employee Retention Credit claims have been filed. You may have heard or seen the ads from firms aggressively pushing the ability to claim the ERC.    It’s gotten so bad that the IRS stopped processing claims for the fourth quarter of 2023.  Many farming operations likely didn’t qualify for the ERC because they didn’t experience at least a 20 percent reduction in gross receipts on an aggregated basis (an eligibility requirement for the ERC) but may have submitted a claim.

Now IRS has provided a path for those that want to withdraw their claim so as not to be hit with a tax deficiency notice and penalties. IR 2023-169 (Sept. 14, 2023).

A withdrawal is possible for those that filed a claim but haven’t received notice that the claim is under audit.  Just file Form 943 and write “withdrawn” on the left-hand margin.  Make sure to sign and date the Form before sending it to the IRS. If your claim is under audit provide the Form directly to the auditor.  If you received a refund but haven’t cashed it, write “VOID and ERC WITHDRAWAL” and send it back to the IRS. 

How Much Gain on Land Can Be Excluded Under Home Sale Rule?

When you sell your principal residence, you can exclude up to $500,000 of gain on a joint return ($250,000 on a single return) if you have owned the home and used it as your principal residence for at least two out of the last five years immediately preceding the sale.  I.R.C. §121.  But how much land can be included with the sale of the home and have gain excluded within that $500,000 limitation?  The Treasury Regulations provide guidance. 

For starters, the land must be adjacent to the principal residence and be used as a part of the residence. Treas Reg. §1.121-1(b)(3).  In addition, the taxpayer must own the land in the taxpayer’s name rather than in an entity that the taxpayer has an ownership interest in (unless the entity is an “eligible entity” defined under Treas. Reg. §301.7701-3(1)).  Land that’s been used in farming within the two-year period before the sale isn’t eligible because its use in farming means it’s not been used as part of the residence. 

Note:  Sale of the principal residence and sale of the adjacent land is treated as a single sale for purposes of the gain limitation amount.  That’s true even if the sale occurs in different years but within the two-year time constraint.  Treas. Reg. §1.121-1(b)(3)(ii)(c).  Also, when computing the maximum limitation for the gain exclusion, the sale of the principal residence is excluded before any gain for the sale of the vacant land. Treas. Reg. §1.121-1(b)(3)(ii). 

For land that is eligible to be included with the residence, how much can be included?  It depends.  Land that contains a garden for home use and land that is landscaped as a yard can be included.  Also, local zoning rules might be instructive.  This all means that it’s a fact-based analysis.  There is no bright-line rule.  IRS rulings and caselaw illustrate that point. 

Written Farm Lease Expires by its Terms; No Holdover Tenancy

A recent case from Kansas illustrates how necessary it is to pay attention to the terms of a written farm lease.  Under the facts of the case, the plaintiff entered into a written farm lease with a landowner on January 10, 2018.  The purpose of the lease was the maintenance and harvesting a hay crop on the leased ground.  By its terms, the lease terminated on December 31, 2018, and contained a provision specifying that the parties could mutually agree in writing to extend the lease.  However, the parties did not extend the lease and it expired as of December 31, 2018.

In 2019, the landowner sold the farm to a third-party buyer.  After the sale, but before the buyer took possession, the plaintiff had the hay field fertilized.  During the summer of 2019, the new landowner hired the defendant to cut and bale the hay, which the defendant ultimately completed late one night. However, early the next morning the plaintiff entered the property and took some of the hay after it was harvested and baled.  The new owner called law enforcement and the plaintiff was informed not to return to the property.  But the plaintiff returned to the property and took more hay.  The plaintiff was criminally charged for multiple offenses.  Ultimately, the plaintiff received a diversion in lieu of prosecution for the charges (against the new owner’s wishes) and was required to provide restitution and perform community service.

The plaintiff claimed that he was entitled to the hay bales because he had a verbal lease and tried to tender a rent check after removing the bales.  The landowner refused to cash the check and moved cattle onto the hay ground.  The plaintiff sued for breach of contract, breach of duty of good and fair dealing, and tortious interference with a contract or business relationship.  The trial court rejected all of the claims and dismissed the case as a matter of law on the basis that the plaintiff did not have a valid lease after 2018.  The trial court denied a motion to reconsider.  On appeal, the appellate court affirmed noting that the lease had not been extended in writing and a holdover tenancy did not exist.  As for monetary damages, the new landowner recovered $27,000 from the plaintiff.  Thoele v. Lee, 2023 Kan. App. Unpub. LEXIS 381 (Kan. Ct. App. Sept. 15, 2023).

Coeur d’ Alene, Idaho, Conference – Twin Track

Overview

On August 7-8 in beautiful Coeur d’ Alene, ID, Washburn Law School the second of its two summer conferences on farm income taxation as well as farm and ranch estate and business planning.  A bonus for the ID conference will be a two-day conference focusing on various ag legal topics.    The University of Idaho College of Law and College of Agricultural and Life Sciences along with the Idaho State Bar and the ag law section of the Idaho State Bar are co-sponsoring.  This conference represents the continuing effort of Washburn Law School in providing practical and detailed CLE to rural lawyers, CPAs and other tax professionals as well as getting law students into the underserved rural areas of the Great Plains and the West.  The conference can be attended online in addition to the conference location in Coeur d’ Alene at the North Idaho College. 

More information on the August Idaho Conference and some topics in ag law – it’s the topic of today’s post.

Idaho Conference

Over two days in adjoining conference rooms the focus will be on providing continuing education for tax professionals and lawyers that represent agricultural clients.  All sessions are focused on practice-relevant topic.  One of the two-day tracks will focus on agricultural taxation on Day 1 and farm/ranch estate and business planning on Day 2.  The other track will be two-days of various agricultural legal issues. 

Here's a bullet-point breakdown of the topics:

Tax Track (Day 1)

• Caselaw and IRS Update
• What is “Farm Income” for Farm Program Purposes?
• Inventory Method – Options for Farmers
• Machinery Trades
• Easement and Rental Issues for Landowners
• Protecting a Tax Practice From Scammers
• Amending Partnership Returns
• Corporate Provided Meals and Lodging
• CRATs
• IC-DISCS
• When Cash Method Isn’t Available
• Accounting for Hedging Transactions
• Deducting a Purchased Growing Crop
• Deducting Soil Fertility

Tax Track (Day 2)

• Estate and Gift Tax Current Developments
• Succession Plans that Work (and Some That Don’t)
• The Use of SLATs in Estate Planning
• Form 1041 and Distribution Deductions
• Social Security as an Investment
• Screening New Clients
• Ethics for Estate Planners

Ag Law Track (Day 1)

• Current Developments and Issues
• Current Ag Economic Trends
• Handling Adverse Decisions on Federal Grazing Allotments
• Getting and Retaining Young Lawyers in Rural Areas
• Private Property Rights and the Clean Water Act – the Aftermath of the Sackett Decision
• Ethics

Ag Law Track (Day 2)

• Foreign Ownership of Agricultural Land
• Immigrant Labor in Ag
• Animal Welfare and the Legal System
• How/Why Farmers and Ranchers Use and Need Ag Lawyers and Tax Pros
• Agricultural Leases

Both tracks will be running simultaneously, and both will be broadcast live online.  Also, you can register for either track.  There’s also a reception on the evening of the first day on August 7.  The reception is sponsored by the University of Idaho College of Law and the College of Agricultural and Life Sciences at the University of Idaho, as well as the Agricultural Law Section of the Idaho State Bar.

Speakers

The speakers for the tax and estate/business planning track are as follows: 

Day 1:  Roger McEowen, Paul Neiffer and a representative from the IRS Criminal Investigation Division.

Day 2:  Roger McEowen; Paul Neiffer; Allan Bosch; and Jonas Hemenway.

The speakers for the ag law track are as follows:

Day 1:  Roger McEowen; Cody Hendrix; Hayden Ballard; Damien Schiff; aand Joseph Pirtle.

Day 2:  Roger McEowen; Joel Anderson; Kristi Running; Aaron Golladay; Richard Seamon; and Kelly Stevenson

Who Should Attend

Anyone that represents farmers and ranchers in tax planning and preparation, financial planning, legal services and/or agribusiness would find the conference well worth the time.  Students attend at a much-reduced fee and should contact me personally or, if you are from Idaho, contract Prof. Rich Seamon (also one of the speakers) at the University of Idaho College of Law.  The networking at the conference will be a big benefit to students in connecting with practitioners from rural areas. 

As noted above, if you aren’t able to attend in-person, attendance is also possible online. 

Sponsorship

If your business would be interested in sponsoring the conference or an aspect of it, please contact me.  Sponsorship dollars help make a conference like this possible and play an important role in the training of new lawyers for rural areas to represent farmers and ranchers, tax practitioners in rural areas as well as legislators. 

For more information about the Idaho conferences and to register, click here: 

Farm Income Tax/Estate and Business Planning Track:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html

Ag Law Track:  https://www.washburnlaw.edu/employers/cle/idahoaglaw.html

Buy-Sell Agreements – Part One

Overview

In today’s post, I look at the various types of buy-sell agreements, common triggering events and how they are funded.  In a later post, I will examine the impact of a buy-sell agreement on corporate valuation and discuss a recent federal appellate court decision that has opened the potential that a buy-sell agreement, if not adhered to during life, could result in enhanced estate value at death.

Buy-sell agreements – Part one of a two-part series.  It’s the topic of today’s post.

Buy-Sell Agreements in General

A buy-sell agreement is a frequently used mechanism by a closely-held farming or ranching business (as well as many non-farm businesses) to integrate the needs and capabilities of the business with the succession planning/transition objectives of the owners. A well-drafted buy sell agreement can be a very useful document to assist in the transitioning of a family business from one generation to the next. It can also be a useful device for assisting in balancing out inheritances among heirs by making sure the heirs interested in running the family business end up with control of the business and other heirs end up with non-control interests. In addition, utilized properly, a buy-sell agreement may also provide estate tax valuation discounts. 

A buy-sell agreement is typically a separate document, although some (or all) of its provisions may be incorporated in its bylaws, the partnership agreement, the LLC operating agreement and, on occasion, in an employment agreement with owner-employees.  For many small businesses, a well-drafted buy-sell agreement is perhaps just as important as a will or trust.  It can be the key to passing on the business to the next generation successfully. 

Types of Agreements

There are two basic types of buy-sell agreements – a cross-purchase agreement or a redemption agreement. 

Redemption.  A redemption agreement is also known as an “entity purchase” agreement.  It is a contract between the owners of the business and the business whereby each owner agrees to sell his interest to the business upon the occurrence of certain events. For redemption agreements, if I.R.C. §§302(b)-303 are not satisfied, the redemption is taxed as a dividend distribution (ordinary income without recovery of basis) to the extent of the stockholder’s allocable portion of current and accumulated earnings and profits, without regard to the stockholder’s basis in his shares. This can be a significant problem for post-mortem redemptions - the estate of a deceased shareholder would normally receive a basis in the shares equal to their value on the date of death or the alternate valuation date. Thus, dividend treatment can result in the recognition of the entire purchase price as ordinary income to a redeemed estate, whereas sale or exchange treatment results in recognition of no taxable gain whatsoever.

Cross-purchase.  This type of agreement is a contract between or among the owners (the business is not necessarily a party to the agreement) whereby each owner agrees to sell his shares to the other owners on the occurrence of specified events. With a cross-purchase agreements, unless the shareholder is a dealer in stock, any gain on the sale is a capital gain regardless of the character of the corporation’s underlying assets. I.R.C. §1221. For the estate that sells the stock shortly after the shareholder’s death, no gain is recognized if the agreement sets the sale price at the date of death value. I.R.C. §§1014; 2032. The purchasing shareholders increase their basis in their total holdings of corporate stock by the price paid for the shares purchased under the agreement, even if the shares are paid for with tax-free life insurance proceeds.

Other types.  Sometimes a “hybrid agreement” is utilized.  This type of agreement is a contract between the business and the owners whereby the owners agree to offer their shares first to the corporation and then to the other owners on the occurrence of certain events.  Under a “wait and see” type of buy-sell agreement, the identity of the purchaser is not disclosed until the actual time of purchase as triggered in the agreement. The corporation will have first shot at purchasing shares, then the remaining shareholders, then the corporation may be obligated to buy any remaining shares.

Note: If an S election is in place, the corporate income is taxed to the shareholders and can be withdrawn from the corporation to fund a cross-purchase agreement without triggering additional tax. If the triggering event is something other than death, a cross-purchase agreement is required to achieve an increased cost basis to the purchasing shareholder(s). A hybrid agreement requires the corporation to redeem only as much stock as will qualify for sale or exchange treatment under I.R.C. §303, and then requires the other shareholders to buy the balance of the available stock. This permits the corporation to finance part of the purchase price, to the extent required to pay estate taxes and expenses and assures sale or exchange treatment on the entire transaction. I.R.C. §303(b)(3).

A buy-sell agreement that imposes employment-related restrictions may create ordinary compensation income (without recovery of basis). I.R.C. §83. However, an agreement containing transfer restrictions that are sufficient to render the stock substantially non-vested (substantial risk of forfeiture) may prevent the current recognition of ordinary income.

Triggering Events

Common events that trigger the buy-sell agreement are death, disability, divorce, bankruptcy, termination of employment, resignation, or retirement.  Upon the occurrence of a trigger event, the purpose of the buy-sell agreement is to, among other things, prevent a departing shareholder from creating conflict over future policies of the business, eliminate the potential for the departed shareholder (or a surviving spouse) to benefit from the future success of the business and selling shares to “undesirable” parties to facilitate an inter-family transition of the business. 

Regardless of the event that triggers the buy-sell agreement, the departing shareholder (if the agreement is drafted properly) has certainty that his shares have a ready market.  This is important to shareholders in a closely-held farming (or other) business.  The issue (discussed in Part Two) is the valuation of the selling shareholder’s (or estate’s) shares.   Nevertheless, a buy-sell agreement can effectively provide a market for the ownership interests, limit transferability of those interests outside the immediate family and establish a procedure for buying a deceased owner’s interests which, in turn, can aid in establishing certainty as to the value of the shares for federal estate tax purposes. 

Conclusion

Part Two in this series will discuss valuation issues with a buy-sell agreement in the context of a small, closely-held business, focusing on the impact on corporate value when corporate-owned life insurance is used to buy out a deceased (or departing) shareholder.

Summer Seminars (Michigan and Idaho) and Miscellaneous Ag Law Topics

Overview

Later this week is the first of two summer conferences put on by Washburn Law School focusing on farm income taxation as well as farm and ranch estate and business planning.  This week’s conference will be in Petoskey, Michigan, which is near the northernmost part of the lower peninsula of Michigan.  Attendance can also be online.  For more information and registration click here:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html  On August 7-8, a twin-track conference will be held in Coeur d’Alene, Idaho. 

More information on the August Idaho Conference and some topics in ag law – it’s the topic of today’s post.

Idaho Conference

On August 7-8, Washburn Law School will be sponsoring the a twin-track ag tax and law conference at North Idaho College in Coeur d’ Alene, ID.  Over two days in adjoining conference rooms the focus will be on providing continuing education for tax professionals and lawyers that represent agricultural clients.  All sessions are focused on practice-relevant topic.  One of the two-day tracks will focus on agricultural taxation on Day 1 and farm/ranch estate and business planning on Day 2.  The other track will be two-days of various agricultural legal issues. 

Here's a bullet-point breakdown of the topics:

Tax Track (Day 1)

• Caselaw and IRS Update
• What is “Farm Income” for Farm Program Purposes?
• Inventory Method – Options for Farmers
• Machinery Trades
• Solar Panel Tax Issues – Other Easement and Rental Issues
• Protecting a Tax Practice From Scammers
• Amending Partnership Returns
• Corporate Provided Meals and Lodging
• CRATs
• IC-DISCS
• When Cash Method Isn’t Available
• Accounting for Hedging Transactions
• Deducting a Purchased Growing Crop
• Deducting Soil Fertility

Tax Track (Day 2)

• Estate and Gift Tax Current Developments
• Succession Plans that Work (and Some That Don’t)
• The Use of SLATs in Estate Planning
• Form 1041 and Distribution Deductions
• Social Security as an Investment
• Screening New Clients
• Ethics for Estate Planners

Ag Law Track (Day 1)

• Current Developments and Issues
• Current Ag Economic Trends
• Handling Adverse Decisions on Federal Grazing Allotments
• Getting and Retaining Young Lawyers in Rural Areas
• Private Property Rights and the Clean Water Act – the Aftermath of the Sackett Decision
• Ethics

Ag Law Track (Day 2)

• Foreign Ownership of Agricultural Land
• Immigrant Labor in Ag
• Animal Welfare and the Legal System
• How/Why Farmers and Ranchers Use and Need Ag Lawyers and Tax Pros
• Agricultural Leases

Both tracks will be running simultaneously, and both will be broadcast live online.  Also, you can register for either track.  There’s also a reception on the evening of the first day on August 7.  The reception is sponsored by the University of Idaho College of Law and the College of Life Sciences at the University of Idaho, as well as the Agricultural Law Section of the Idaho State Bar.

For more information about the Idaho conferences and to register, click here:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html and here:  https://www.washburnlaw.edu/employers/cle/idahoaglaw.html

Miscellaneous Agricultural Law Topics

Proper Tax Reporting of 4-H/FFA Projects

When a 4-H or FFA animal is sold after the fair, the net income should be reported on the other income line of the 1040.  It’s not subject to self-employment tax if the animal was raised primarily for educational purposes and not for profit and was raised under the rules of the sponsoring organization.  It’s also not earned income for “kiddie-tax” purposes.  But, if the animal was raised as part of an activity that the seller was engaged in on a regular basis for profit, the sale income should be reported on Schedule F.  That’s where the income should be reported if the 4-H or FFA member also has other farming activities.  By being reported on Schedule F, it will be subject to self-employment tax.

There are also other considerations.  For example, if the seller wants to start an IRA with the sale proceeds, the income must be earned.  Also, is it important for the seller to earn credits for Social Security purposes? 

The Importance of Checking Beneficiary Designations

U.S. Bank, N.A. v. Bittner, 986 N.W.2d 840 (Iowa 2023)

It’s critical to make sure you understand the beneficiary designations for your non-probate property and change them as needed over time as your life situation changes.  For example, in one recent case, an individual had over $3.5 million in his IRA when he died, survived by his wife and four children.  His will said the IRA funds were to be used to provide for his widow during her life and then pass to a family trust for the children.  When he executed his will, he also signed a new beneficiary designation form designating his wife as the primary beneficiary.  He executed a new will four years later and said the IRA would be included in the marital trust created under the will if no federal estate tax would be triggered, with the balance passing to the children upon his wife’s death.  He didn’t update his IRA beneficiary designation.

When he died, everyone except one son agreed that the widow got all of the IRA.  The son claimed it should go to the family trust.  Ultimately, the court said the IRA passed to the widow. 

It’s important to pay close attention to details when it comes to beneficiary designations and your overall estate plan.

Liability Release Forms – Do They Work?

Green v. Lajitas Capital Partners, LLC, No. 08-22-00175-CV, 2023 Tex. App. LEXIS 2860 (Tex. Ct. App. Apr. 28, 2023)

Will a liability release form hold up in court?  In a recent Texas case, a group paid to go on a sunset horseback trail ride at a Resort.  They signed liability release forms that waived any claims against the Resort.  After the ride was almost done and the riders were returning to the stable, the group rode next to a golf course.  An underground sprinkler went off, making a hissing sound that spooked the horses.  One rider fell off resulting in bruises and a fractured wrist.  She sued claiming the Resort was negligent and that the sprinklers were a dangerous condition that couldn’t be seen so the liability waiver didn’t apply.

The court disagreed, noting that the liability release form used bold capitalized letters in large font for the key provisions.  The rider had initialed those key provisions.  The court also said the form wasn’t too broad and didn’t’ only cover accidents caused by natural conditions. 

The outcome might not be the same in other states.  But, if a liability release form is clear, and each paragraph is initialed and the document is signed, you have a better chance that it will hold up in court.

Equity Theft

Tyler v. Hennepin County, No. 22-166, 2023 U.S. LEXIS 2201 (U.S. Sup. Ct. May 25, 2023)

The U.S. Supreme Court has ruled that if you lose your home through forfeiture for failure to pay property taxes, that you get to keep your equity.  The case involved a Minnesota county that followed the state’s forfeiture law when the homeowner failed to pay property tax, sold the property and kept the proceeds – including the owner’s equity remaining after the tax debt was satisfied.  The Supreme Court unanimously said the Minnesota law was unconstitutional. The same thing previously happened to the owner of an alpaca farm in Massachusetts, and a farm owner in Nebraska.  The Nebraska legislature later changed the rules for service of notice when applying for a tax deed, but states that still allow the government to retain the equity will have to change their laws.

Equity theft tends to bear more heavily on those that can least afford to hire legal assistance or qualify for legal aid.  Also, all states bar lenders and private companies from keeping the proceeds of a forfeiture sale, so equity forfeiture laws were inconsistent.  Now the Supreme Court has straightened the matter out. 

You won’t lose your equity if you lose your farm for failure to pay property tax.

The Climate, The Congress and Farmers

Farmers in the Netherlands are being told that because of the goal of “net-zero emissions” of greenhouse gases and other so-called “pollutants” by 2050, they will be phased out if they can’t adapt.  Could that happen in the U.S.?  The U.S. Congress is working on a Farm Bill, and last year’s “Inflation Reduction Act” funnels about $20 billion of climate funds into agriculture which could end up in policies that put similar pressures on American farmers.  Some estimates are that agricultural emissions will make up 30 percent of U.S. total greenhouse gas emissions by 2050.  But, fossil fuels are vital to fertilizers and pesticides, which improve crop production and reduce food prices. 

The political leader of Sri Lanka banned synthetic fertilizer and pesticide imports in 2021.  The next year, inflation was at 55 percent, the economy was in shambles, the government fell, and the leader fled the country.

Energy security, ag production and food security are all tied to cheap, reliable and efficient energy sources.  Using less energy will result in higher food prices, and that burden will fall more heavily on those least likely to be able to afford it. 

As the Farm Bill is written, the Congress should keep these things in mind.

Secure Act 2.0 Errors

In late 2019, the Congress passed the SECURE ACT which made significant changes to retirement plans and impacted retirement planning.  Guidance is still needed on some provisions of that law.  In 2022, SECURE ACT 2.0 became law, but it has at least three errors that need to be fixed. 

The SECURE ACT increased the required minimum distribution (RMD) age from 70 and ½ to age 72.  With SECURE ACT 2.0, the RMD increased to age 73 effective January 1, 2023.  It goes to age 75 starting in 2033.  But, for those born in 1959, there are currently two RMD ages in 2033 – it’s either 73 or 75 that year.  Which age is correct?  Congressional intent is likely 75, but te Congress needs to clearly specify. 

Another error involves Roth IRAs.  Starting in 2024, if you earn more than $145,000 (mfj) in 2023, you will have to do non-deductible catch-up contributions in Roth form.  But SECURE ACT 2.0 says that all catch-up contributions starting in 2024 will be disallowed.  This needs to be corrected.

There’s also an issue with SEPs and SIMPLE plans that are allowed to do ROTH contributions and how those contributions impact ROTH limitations. 

Congress needs to fix these issues this year.  If it does, it will likely be late in 2023.

Implications of SCOTUS Union Decision on Farming Businesses

Glacier Northwest, Inc. v. International Board of Teamsters Local Union No. 174, No. 21-1449, 2023 U.S. LEXIS 2299 (U.S. Sup. Ct. Jun. 1, 2023)

The Supreme Court recently issued a ruling that will make it easier for employers to sue labor unions for tort-type damages caused by a work stoppage.   The Court’s opinion has implications for ag employers. 

The Court ruled that an employer can sidestep federal administrative agency procedures of the National Labor Relations Board (NLRB) and go straight to court when striking workers damage the company’s property rather than merely cause economic harm.  The case involved a concrete company that sued the labor union representing its drivers for damages.  The workers filled mixer trucks with concrete ready to pour knowing they were going to walk away.  The company sued for damage to their property – something that’s not protected under federal labor law.  The Union claimed that the matter had to go through federal administrative channels (the NLRB) first. 

The Supreme Court said the case was more like an ordinary tort lawsuit than a federal labor dispute, so the company could go straight to court.  Walking away was inconsistent with accepting a perishable commodity. 

What’s the ag angle?  Where there are labor disputes in agriculture, they are often timed to damage perishable food products such as fruit and vegetables.  Based on the Court’s 8-1 opinion, merely timing a work stoppage during harvest might not be enough to be deemed economic damage, unless the Union has a contract.  But striking after a sorting line has begun would seem to be enough.

Digital Grain Contracts

The U.S. grain marketing infrastructure is quite efficient.  But there are changes that could improve on that existing efficiency.  Digital contracts are starting to replace paper grain contracts.  The benefits could be improved record-keeping, simplified transactions, reduced marketing costs and expanded market access. 

Grain traveling in barges down the Ohio and Mississippi Rivers is usually bought and sold many times between river and export terminals.  That means that each transaction requires a paper bill of lading that must be transferred when the barge was sold.  But now those bills of lading are being moved to an online platform.  Grain exporters are also using digital platforms. 

These changes to grain marketing could save farmers and merchandisers dollars and make the supply chain more efficient.  But a problem remains in how the various platforms are to be connected.  Verification issues also loom large.  How can a buyer verify that a purchased commodity meets the contract criteria?  That will require information to be shared up the supply chain.  And, of course, anytime transactions become digital, the digital network can be hacked.  In that situation, what are the safeguards that are in place and what’s the backup plan if the system goes down? 

Clearly, there have been advancements in digital grain trading, but there is still more work to be done.  In addition, not all farmers may be on board with a digital system. 

Bibliography – First Quarter of 2023

The following is a listing by category of my blog articles for the first quarter of 2023.

Bankruptcy

Failure to Execute a Written Lease Leads to a Lawsuit; and Improper Use of SBA Loan Funds

https://lawprofessors.typepad.com/agriculturallaw/2023/02/failure-to-execute-a-written-lease-leads-to-a-lawsuit-and-improper-use-of-sba-loan-funds.html

Chapter 12 Bankruptcy – Proposing a Reorganization Plan in Good Faith

https://lawprofessors.typepad.com/agriculturallaw/2023/02/chapter-12-bankruptcy-proposing-a-reorganization-plan-in-good-faith.html

Business Planning

Summer Seminars

https://lawprofessors.typepad.com/agriculturallaw/2023/03/summer-seminars.html

Registration Now Open for Summer Conference No. 1 – Petoskey, Michigan (June 15-16)

https://lawprofessors.typepad.com/agriculturallaw/2023/04/registration-now-open-for-summer-conference-no-1-petoskey-michigan-june-15-16.html

Civil Liabilities

Top Ag Law and Tax Developments of 2022 – Part 1

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ag-law-and-tax-developments-of-2022-part-1.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 8 and 7

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-8-and-7.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-2-and-1.html

Contracts

Top Ag Law and Developments of 2022 – Part 2

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ag-law-and-developments-of-2022-part-2.html

Failure to Execute a Written Lease Leads to a Lawsuit; and Improper Use of SBA Loan Funds

https://lawprofessors.typepad.com/agriculturallaw/2023/02/failure-to-execute-a-written-lease-leads-to-a-lawsuit-and-improper-use-of-sba-loan-funds.html

Double Fractions in Oil and Gas Conveyances and Leases – Resulting Interpretive Issues

https://lawprofessors.typepad.com/agriculturallaw/2023/03/double-fractions-in-oil-and-gas-conveyances-and-leases-resulting-interpretive-issues.html

Environmental Law

Here Come the Feds: EPA Final Rule Defining Waters of the United States – Again

https://lawprofessors.typepad.com/agriculturallaw/2023/01/here-come-the-feds-epa-final-rule-defining-waters-of-the-united-states-again.html

Top Ag Law and Developments of 2022 – Part 2

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ag-law-and-developments-of-2022-part-2.html

Top Ag Law and Developments of 2022 – Part 3

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ag-law-and-tax-developments-of-2022-part-3.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 10 and 9

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-nos-10-and-9.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 6 and 5

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-6-and-5.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 4 and 3

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-4-and-3.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-2-and-1.html

Estate Planning

Tax Court Opinion – Charitable Deduction Case Involving Estate Planning Fraudster

https://lawprofessors.typepad.com/agriculturallaw/2023/02/tax-court-opinion-charitable-deduction-case-involving-estate-planning-fraudster.html

Happenings in Agricultural Law and Tax

https://lawprofessors.typepad.com/agriculturallaw/2023/03/happenings-in-agricultural-law-and-tax.html

Summer Seminars

https://lawprofessors.typepad.com/agriculturallaw/2023/03/summer-seminars.html

RMD Rules Have Changed – Do You Have to Start Receiving Payments from Your Retirement Plan?

https://lawprofessors.typepad.com/agriculturallaw/2023/03/rmd-rules-have-changed-do-you-have-to-start-receiving-payments-from-your-retirement-plan.html

Common Law Marriage – It May Be More Involved Than What You Think

https://lawprofessors.typepad.com/agriculturallaw/2023/04/common-law-marriage-it-may-be-more-involved-than-what-you-think.html

The Marital Deduction, QTIP Trusts and Coordinated Estate Planning

https://lawprofessors.typepad.com/agriculturallaw/2023/04/the-marital-deduction-qtip-trusts-and-coordinated-estate-planning.html

Registration Now Open for Summer Conference No. 1 – Petoskey, Michigan (June 15-16)

https://lawprofessors.typepad.com/agriculturallaw/2023/04/registration-now-open-for-summer-conference-no-1-petoskey-michigan-june-15-16.html

Income Tax

Top Ag Law and Developments of 2022 – Part 3

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ag-law-and-tax-developments-of-2022-part-3.html

Top Ag Law and Developments of 2022 – Part 4

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-agricultural-law-and-tax-developments-of-2022-part-4.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 8 and 7

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-8-and-7.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-2-and-1.html

Tax Court Opinion – Charitable Deduction Case Involving Estate Planning Fraudster

https://lawprofessors.typepad.com/agriculturallaw/2023/02/tax-court-opinion-charitable-deduction-case-involving-estate-planning-fraudster.html

Deducting Residual (Excess) Soil Fertility

https://lawprofessors.typepad.com/agriculturallaw/2023/02/deducting-residual-excess-soil-fertility.html

Deducting Residual (Excess) Soil Fertility – Does the Concept Apply to Pasture/Rangeland? (An Addendum)

https://lawprofessors.typepad.com/agriculturallaw/2023/02/deducting-residual-excess-soil-fertility-does-the-concept-apply-to-pasturerangeland-an-addendum.html

Happenings in Agricultural Law and Tax

https://lawprofessors.typepad.com/agriculturallaw/2023/03/happenings-in-agricultural-law-and-tax.html

Summer Seminars

https://lawprofessors.typepad.com/agriculturallaw/2023/03/summer-seminars.html

RMD Rules Have Changed – Do You Have to Start Receiving Payments from Your Retirement Plan?

https://lawprofessors.typepad.com/agriculturallaw/2023/03/rmd-rules-have-changed-do-you-have-to-start-receiving-payments-from-your-retirement-plan.html

Registration Now Open for Summer Conference No. 1 – Petoskey, Michigan (June 15-16)

https://lawprofessors.typepad.com/agriculturallaw/2023/04/registration-now-open-for-summer-conference-no-1-petoskey-michigan-june-15-16.html

Real Property

Equity “Theft” – Can I Lose the Equity in My Farm for Failure to Pay Property Taxes?

https://lawprofessors.typepad.com/agriculturallaw/2023/03/equity-theft-can-i-lose-my-farm-for-failure-to-pay-property-taxes.html

Happenings in Agricultural Law and Tax

https://lawprofessors.typepad.com/agriculturallaw/2023/03/happenings-in-agricultural-law-and-tax.html

Adverse Possession and a “Fence of Convenience”

https://lawprofessors.typepad.com/agriculturallaw/2023/03/adverse-possession-and-a-fence-of-convenience.html

Double Fractions in Oil and Gas Conveyances and Leases – Resulting Interpretive Issues

https://lawprofessors.typepad.com/agriculturallaw/2023/03/double-fractions-in-oil-and-gas-conveyances-and-leases-resulting-interpretive-issues.html

Abandoned Rail Lines – Issues for Abutting Landowners

https://lawprofessors.typepad.com/agriculturallaw/2023/03/abandoned-rail-lines-issues-for-abutting-landowners.html

Regulatory Law

Top Ag Law and Developments of 2022 – Part 2

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ag-law-and-developments-of-2022-part-2.html

Top Ag Law and Developments of 2022 – Part 4

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-agricultural-law-and-tax-developments-of-2022-part-4.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 10 and 9

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-nos-10-and-9.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 8 and 7

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-8-and-7.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 6 and 5

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-6-and-5.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 4 and 3

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-4-and-3.html

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-2-and-1.html

Foreign Ownership of Agricultural Land

https://lawprofessors.typepad.com/agriculturallaw/2023/02/foreign-ownership-of-agricultural-land.html

Abandoned Rail Lines – Issues for Abutting Landowners

https://lawprofessors.typepad.com/agriculturallaw/2023/03/abandoned-rail-lines-issues-for-abutting-landowners.html

Secured Transactions

Priority Among Competing Security Interests

https://lawprofessors.typepad.com/agriculturallaw/2023/02/priority-among-competing-security-interests.html

Water Law

Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1

https://lawprofessors.typepad.com/agriculturallaw/2023/01/top-ten-agricultural-law-and-tax-developments-of-2022-numbers-2-and-1.html

Happenings in Agricultural Law and Tax

https://lawprofessors.typepad.com/agriculturallaw/2023/03/happenings-in-agricultural-law-and-tax.html