Friday, May 6, 2022

Joint Tenancy and Income Tax Basis At Death

Overview

Given the current level of the federal estate and gift tax applicable exclusion amount set at $12.06 million for decedent’s dying in 2022 and gifts made in 2022, the prospect of a taxable estate at death is a concern for very few.  What is much more important for most people, however, is income tax basis planning.  That’s because property that is included in a decedent’s estate at death receives an income tax basis equal to the property’s fair market value as of the date of death.  I.R.C. §1014.  As a result of this rule, much of current estate planning involves techniques to cause inclusion of property in a decedent’s estate at death.  Even though the property will be subjected to federal estate tax, the value will be excluded from tax by virtue of the unified credit that can offset up to $12.06 million of taxable estate.

Joint Tenancy Basics

Joint forms of property holding between husband and wife have been widely used among farm families because of certain supposed advantages, one of which is the simplicity of transferring property upon death.  A distinguishing characteristic of joint tenancy is the right of survivorship.  That means that the surviving joint tenant or tenants become the full owner(s) of the jointly held property upon the death of a fellow joint tenant regardless of the terms of the deceased joint tenant’s will. 

Upon a conveyance of real property to two or more persons, a tenancy-in-common is generally creates a tenancy in common unless it is clear in the deed or other conveyancing document that a joint tenancy is intended. 

Example:  Alec Trician conveys Blackacre is conveyed to “Michael and Kelsey, husband and wife.” Michael and Kelsey own Blackacre as tenants-in-common.  To own Blackacre as joint tenants, Blackacre needed to be conveyed to them as required by state law.  The typical language for creating a joint tenancy is to “Michael and Kelsey, husband and wife, as joint tenants with right of survivorship and not as tenants in common.”

Estate Tax Treatment of Joint Tenancy Property  

Non-spousal rule.  For joint tenancies involving persons other than husbands and wives, property is taxed in the estate of the first to die except to the extent the surviving owner(s) prove contribution for its acquisition. I.R.C. § 2040(a).  This is the “consideration furnished” rule.  As a result, property could be taxed fully at the death of the first joint tenant to die (if that person provided funds for acquisition) and again at the death of the survivor.  Whatever portion is taxed in the estate of the first to die also receives a new income tax basis based on the fair market value of that portion at the date of death.

Example:  Bob and Bessie Black, brother and sister, purchased a 1,000-acre Montana ranch in 1970 for $1,000,000.  Bob provided $750,000 of the purchase price and Bessie the remaining $250,000.  At all times since 1970, they have owned the ranch in joint tenancy with right of survivorship.  Bob died in 2022 when the ranch had a fair market value of $2,500,000.  Seventy-five percent of the date of death value, $1,875,000 will be included in Bob’s estate.

Bessie, as the surviving joint tenant will now own the entire ranch.  Her income tax basis in the ranch upon Bob’s death is computed as follows:

       $1,875,000 (Value included in Bob’s estate)

        + 250,000  (Bessie’s contribution toward purchase price)

       $2,125,000

Thus, if Bessie were to sell the ranch soon after Bob’s death for $2,500,000, she would incur a federal capital gain tax of $75,000, computed as follows:

       $2,500,000 (Sale price)

       - 2,125,000 (Bessie’s income tax basis)

          $375,000   Taxable gain

                    x.20    (Capital gain tax rate)

            $75,000  (Tax due)

Note:  While property held in joint tenancy is not be included in the “probate estate” for probate purposes, the value of the decedent’s interest in jointly held property is potentially subjected to federal estate tax and state inheritance or state estate tax to the extent the decedent provided the consideration for its acquisition. 

Martial joint tenancies.  For joint tenancies involving only a husband and wife, the property is treated at the first spouse’s death as belonging 50 percent to each spouse for federal estate tax purposes. I.R.C. § 2040(b).  This is known as the “fractional share” rule.  Thus, only one-half of the value is taxed at the death of the first spouse to die.  Although no federal estate tax is incurred on the property passing to the surviving spouse, only one-half receives a new income tax basis equal to fair market value at the death of the deceased spouse in the hands of the surviving spouse. It does not matter which spouse provided the consideration for the spousal joint property.  I.R.C. §1014.

Observation:  An estate planner should carefully analyze the effect of joint property holding on basis adjustment at the death of one of the joint owners.  Generally, only a one-half interest in qualified joint interests will receive a step-up in basis.  However, if the first spouse to die had owned all the property, a full step-up would have been obtained. 

If inception of the tenancy involved a gift by the decedent to the surviving spouse, the survivor’s basis in the property will equal the original transferred basis.  As a result, the sale of the property by the surviving spouse could result in a capital gain. 

Special rule.  In 1992, the Sixth Circuit Court of Appeals applied the consideration furnished rule to a husband-wife joint tenancy in farmland with the result that the entire value of the jointly held property was included in the gross estate of the husband, the first spouse to die. Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992).     The full value was subject to federal estate tax but was covered by the 100 percent federal estate tax marital deduction, eliminating federal estate tax.  In addition, the entire property received a new income tax basis which was the objective of the surviving spouse.  The court reached this result because of statutory changes to the applicable Internal Revenue Code sections that were made in the late 1970s.  To take advantage of those changes, the court determined, it was critical that the jointly held property at issue was acquired before 1977. 

Under the facts of the case, the farmland was purchased in 1955 for $38,500 exclusively with the husband’s funds.  The surviving wife sold the farmland in 1988 for $3,663,650 after her husband’s death in late 1987.  Under the pre-Tax Reform Act of 1976 rules on joint tenancy contribution, a decedent’s gross estate included all of the value of property held in joint tenancy with another expect the portion of that value contributed by the other person, instead of arbitrarily including one-half of the value of the joint tenancy property.  The surviving wife argued that there was nothing in any legislation that applied the 50 percent inclusion rule to pre-1977 joint interests, but that such interests were still subject to the full marital deduction under the 1981 Act.   

The Gallenstein court reasoned that the 1976 Act applied only to joint interests created after December 31, 1976, and that the 1981 amendments which resulted in the one-half taxability expressly applied to decedents dying after December 31, 1981.  The 1981 amendments did not repeal the January 1, 1977, effective date of the 1976 amendments, which did not apply to joint interests created before 1977.  Because the surviving spouse as joint tenant had made no contribution to the property, she was entitled to a full step-up in basis.  The result was that the entire gain on sale was eliminated because of the full basis step-up. 

In 1996 and 1997, the federal district court for Maryland reached a similar conclusion. Anderson v. United States, 96-2 U.S. Tax Cas. (CCH) ¶60,235 (D. Md. 1996); Wilburn v. United States, 97-2 U.S. Tax Cas. (CCH) ¶50,881 (D. Md. 1997).  Also, in 1997, the Fourth Circuit Court of Appeals followed Gallenstein as did a federal district court in Florida.  Patten v. United States, 116 F.3d 1029 (4th Cir. 1997), aff’g, 96-1 U.S. Tax Cas. (CCH) ¶ 60,231 (W.D. Va. 1996); Baszto v. United States, 98-1 U.S.Tax Cas. (CCH) ¶60,305 (M.D. Fla. 1997). 

In 1998, the Tax Court agreed with the prior federal court opinions.  Under the Tax Court’s reasoning, the fractional share rule cannot be applied to joint interests created before 1977.  Hahn v. Comm’r, 110 T.C. 140 (1998).  This is a key point.  If the jointly held assets had declined in value, such that death of the first spouse would result in a lower basis, the fractional share rule would result in a more advantageous result for the survivor in the event of sale if the survivor could not prove contribution at the death of the first to die. In late 2001, the IRS acquiesced in the Tax Court’s opinion.  Acq, 2001-42, I.R.B. 319.

Conclusion

While there are estate planning drawbacks for owing property in joint tenancy at death, particularly in estates with values greater than the unified credit exemption equivalent.  It also presents challenges where qualification for certain post-mortem estate planning techniques is critical, and because of it is an inflexible ownership structure.  However, as the unified credit exemption equivalent has increased dramatically since 2017, joint tenancy has gained popularity.  Also, for pre-1977 marital joint tenancies where one spouse provided all of the funds to acquire the property and that spouse dies, the full value of the property will be included in the decedent’s gross estate.  But, in many of these estates, the full value will be excluded from federal estate tax.    More importantly, the surviving spouse will receive an income tax basis equal to the value of the property at the time of the first spouse’s death.   In agricultural, many pre-1977 marital joint tenancies involving farmland exist. 

May 6, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, May 4, 2022

Ag Law (and Medicaid Planning) Court Developments of Interest

Overview

Agricultural law is a dynamic area of the law.  There is always something going on in the courts, with the IRS and in the economy that has relevance to legal issues.  With today’s post I look at some recent developments of importance to farmers and ranchers, including an interesting Texas case involving Medicaid planning.

Recent court developments involving agricultural producers and farm/ranch families. 

Hog is a “Good” Potentially Subject to State Product Liability Law 

Tyson Fresh Meats, Inc. v. Dykhuis Farms, Inc., et al., No. 3:21-CV-90 RLM-MGG, 2022 U.S. Dist. LEXIS 59710 (N.D. Ind. Mar. 31, 2022)

The plaintiff claimed it bought hogs from a company that subcontracted with the defendant to raise the hogs.  The defendant delivered 267 hogs to the plaintiff which processed the hogs and commingled the meat with other meat at its plant.  Two days later, the defendant told the plaintiff that the hogs hadn’t gone through a required withdrawal period for a certain supplement.  As a result, the plaintiff had to dispose more than 1.7 million pounds of “contaminated” fresh meat.  The plaintiff sued for negligence and breach of state (Indiana) product liability law.  The defendant claimed that it provided a service rather than a product and that hogs were not “products” subject to product liability law.  The defendant motioned for dismissal of the case, but the court held that the service-product distinction couldn’t be resolved on a motion to dismiss. 

On appeal, the appellate court held that “goods” under the Indiana Product Liability Law covered “all things” that are “movable” when contracted for, including “the unborn young of animals” and adult animals.  On the negligence claim, however, the appellate court determined that the plaintiff failed to adequately allege that the defendant owed the plaintiff a duty of care.  Thus, the plaintiff was not allowed to proceed with the negligence claim. 

No Standing to Challenge Hog Operation Permits 

Sierra Club v. Stanek, No. 123,023, 2022 Kan. App. Unpub. LEXIS 193 (Kan. Ct. App. Apr. 1, 2022)

The defendant granted four swine facility permits over the plaintiff’s objection. The plaintiff sought review under the Kansas Judicial Review Act (KJRA), claiming that the defendant misinterpreted the relevant statutes and regulations. The trial court agreed and reversed the defendant’s decision.  On appeal, the permittees requested that the defendant grant modified permits so that they could continue operations.  The defendant issued modified permits and the plaintiff sued.    The appellate court held that the plaintiff lacked standing to petition for judicial review, reversed the trial court’s decision and remanded the case with directions to dismiss the plaintiff’s petition and reinstate the original permits. 

Supreme Court Won’t Hear Kansas Case Involving Secret Filming. 

Kelly v. Animal Legal Defense Fund, cert. den., No. 21-760, 2022 U.S. LEXIS 2153 (U.S. Sup. Ct. Apr. 25, 2022)

In 2021, the U.S. Court of Appeals for the Tenth Circuit, held that a Kansas law making it a crime to take pictures or record videos at a covered facility (primarily a slaughterhouse) “without the effective consent of the owner and with the intent to damage the enterprise” was unconstitutional.  The plaintiffs claimed that the law violated their First Amendment free speech rights.  The State claimed that what was being barred was conduct rather than speech and that, therefore, the First Amendment didn’t apply.  But the court tied conduct together with speech to find a constitutional violation – it was necessary to lie to gain access to a covered facility and consent to film activities.  As such, the law regulated protected speech (lying with intent to cause harm to a business) and was unconstitutional.  The court determined that the State failed to prove that the law was narrowly tailored to a compelling state interest in suppressing the “speech” involved.  The dissent pointed out (consistent with the Eighth Circuit) that “lies uttered to obtain consent to enter the premises of an agricultural facility are not protected speech.”  According to the Eighth Circuit, the First Amendment does not protect a fraudulently obtained consent to enter someone else’s property.  The Tenth Circuit disagreed and held the Kansas law unconstitutional.  Animal Legal Defense Fund, et al. v. Kelly, 9 F.4th 1219 (10th Cir. 2021).  The state of Kansas sought U.S. Supreme Court review. Pet. for cert. filed, (U.S. Sup. Ct. Nov. 17, 2021).  On April 25, 2022, the U.S. Supreme Court declined to hear the case. 

Prior Occupancy of Home Not Required For Exclusion Under Medicaid Rules 

Texas Health & Human Services Commission v. Estate of Burt, No. 03-20-00462-CV, 2022 Tex. App. LEXIS 2556 (Tex. Ct. App. Apr. 21, 2022)

The decedent and his wife bought a home in 1974 and lived there until late 2010 when they sold it to their daughter.  They then moved into a rental property that the daughter owned.  In early 2017, the couple entered a skilled nursing facility and shortly thereafter bough a one-half interest in their original home to “secure home equity in a home that they could return to if one or both of them should be able to leave the nursing home.”  The same day, they filled out the plaintiff’s form designating the home as their place of residence and indicating an intent to return.  After the purchase, they had about $2,000 remaining in their bank accounts.  They then sought Medicaid benefits, effective immediately. 

After both the decedent and his wife died shortly thereafter, the application was denied due to a finding of “resources in excess of program limits” because the plaintiff included the couple’s interest in the home as an available countable resource for Medicaid purposes. After the last of them to die, a debt of $23,479.35 was left owing to the nursing facility.  Their daughter appealed the plaintiff’s decision to deny Medicaid benefits, but a hearing officer and the plaintiff’s Legal Services Attorney upheld the denial due to the couple’s inability to establish prior occupancy of the home as a principal place of residence.  As such, the plaintiff determined, none of the equity value of the home could be excludible for Medicaid eligibility purposes. 

The daughter sought judicial review, claiming that the home should have been excluded from her parent’s countable resources for Medicaid eligibility purposes under 42 U.S.C. §1382b(a)(1).  This statute provides that a Medicaid applicant’s home is not an available asset for Medicaid eligibility purposes and is defined as any personal residence in which the applicant has an ownership interest.  State (Texas) law contains an identical definition.  1 Tex Admin. Code §§358.103(38), (69).  Under federal regulations, “place of residence” is defined as “the dwelling the individual considers his or her established or principal home and to which, if absent, he or she intends to return.”  Program Operations Manual System, SI 01130.100A.2.  Again, state law on this point is identical, defining a home as the “place of residence of the applicant or applicant’s spouse if the applicant “occupies or intends to return to the home.”  1 Tex. Admin. Code §358.348(a)(1) mirroring 20 C.F.R. §416.1212.  The plaintiff adopted an identical regulation requiring prior occupancy consistent with the Texas statutory provision.  Accordingly, the plaintiff asserted that because the decedent and wife did not have any ownership interest in a home at the time they entered the nursing home, they had no excludible home to which they could intend to return to at that time.  In other words, the plaintiff’s subjective intent was to be ignored and the plaintiff read a “prior occupancy” requirement into the applicable regulations construing 42 U.S.C. §1382b(a)(1) and the comparable Texas provision.

The trial court ruled that the plaintiff’s interpretation was unreasonable and not supported by substantial evidence, reversed the plaintiff’s decision and remanded the case.  The plaintiff appealed, but the appellate court determined that the plaintiff’s interpretation requiring prior occupancy of a home was incorrect. While the plaintiff argued that because the couple bought their interest in the home after entering the nursing facility, they could not be viewed as “intending to return” to it and, as a result, it could not be considered their “home.”  The appellate court noted that “intent to return” in the federal regulation applied only to the continued exclusion of the home before the time the applicant left the property, and that the federal regulation specified that an applicant’s principal place of residence is the place the person considers to be the person’s established home – the subjective intent of the applicant(s). 

While there were no prior Texas appellate decisions directly on point, the appellate court did cite a local county district court opinion in a letter ruling where the court stated, “if Congress had intended to require prior occupancy, it would have been simple to state it.”  That appellate court went on to reason the purpose of Medicaid is better served by allowing an applicant to claim the home exemption for a home that a Medicaid recipient buys or inherits while in a nursing facility, as long as the recipient intends (subjectively) to return to the home upon discharge from the facility.  The appellate court found this reasoning persuasive, found a contrary Arkansas court opinion on the issue that held the opposite to be unpersuasive (Groce v. Director, Arkansas Department of Human Services, 82 Ark. App. 447, 117 S.W.3d 618 (Ark. Ct. App. 2003)), and concluded that there was no “prior actual residence requirement” under Medicaid.  Thus, the plaintiff’s regulatory interpretation was an improper reading of the statute.  As a result, the appellate court affirmed the trial court’s decision. 

Conclusion

The legal issues keep on rolling involving agriculture.  It will be interesting to see if the Texas Medicaid court decision is appealed.  As noted, there is a split of authority on that issue that has implications for long-term care planning.  I will do another recent development blog soon. 

May 4, 2022 in Contracts, Estate Planning, Regulatory Law | Permalink | Comments (2)

Sunday, May 1, 2022

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

Overview

The Washburn Law School Summer 2022 national conferences on ag income tax and ag estate and business planning are approaching.  The first one will be June 13-14 at the Chula Vista Resort near the Wisconsin Dells.  The second conference will be in Durango, Colorado, at Fort Lewis College on August 1-2.

Registration is now open for both the Wisconsin event in mid-June and the Colorado event in early August. 

Wisconsin Dells, Wisconsin

Here’s the link to the online brochure and registration for the event at the Chula Vista Resort on June 13-14:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html

A block of rooms is available for this seminar at a rate of $139.00 per night plus taxes and fees. To make a reservation call (855) 529-7630 and reference booking ID "#i60172 Washburn Law School." Rooms can be reserved at the group rate through May 15, 2022. Reservations requested after May 15 are subject to availability at the time of reservation.

An hour of ethics is provided at the end of Day 2.

The conference will also be broadcast live online for those that cannot attend in person.  Online attendees will be able to interact with the presenters, if desired. 

Here’s a rundown of the topics by day, for more detail see the registration at the link provided above:

Day 1 (at both Wisconsin and Durango)

  • Tax Update: Key Rulings and Cases
  • Reporting of WHIP and Other Government Payments
  • Fixing Bonus Elections and Computations
  • Research and Development Credits
  • Farm NOLs
  • The Taxability of Retailer Reward Programs; Tax Rules Associated with Demolishing Farm Structures
  • IRS-CI: Emerging Cyber Crimes and Crypto Tax Compliance
  • Reporting of machinery trade transactions
  • Inventory accounting issues
  • Early termination of CRP contracts;
  • Partnership reporting;
  • Weather-related livestock sales; and
  • Contribution margin analysis

Day 2 (Wisconsin)

  • Estate and Business Planning Caselaw and Ruling Update
  • The Use of IDGTs (and other strategies) For Succession Planning
  • Anticompetitive Conduct in Agriculture
  • Post-Death Dissolution of S Corporation Stock and Stepped-Up Basis; Last Year of Farming; Deferred Tax liability and Conversion to Form 4835
  • Agricultural Finance and Land Situation
  • Post-Death Basis Increase: Is GallensteinStill in Play?; Using an LLC to Make an S Election
  • Getting Clients Engaged in the Estate/Business Planning Process
  • Ethical Problems in Estate and Income Tax Planning 

Day 2 (Durango)

  • Estate and Business Planning Caselaw and Ruling Update 
  • The Use of IDGTs (and other strategies) For Succession Planning 
  • Estate Planning to Minimize Income Taxation: From the Mundane to the Arcane
  • Oil and Gas Royalties and Working Interest Payments: Taxation, Planning and Oversight
  • Economic Evaluation of a Farm Business 
  • Appropriation Water Rights - Tax and Estate Planning Issues
  • Ethically Negotiating End of Life Family Issues 

Here’s the link to the online brochure and registration for the event in Durango at Fort Lewis College on August 1-2:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html

Online Attendance

Both the Wisconsin and Colorado conferences will also be broadcast live online for those that cannot attend in person.  Online attendees will be able to interact with the presenters, if desired. For those attending online, please indicate on your registration whether you would like to have a hardcopy of the conference materials sent to you.

Other Points

There are many other important details about the conferences that you can find by reviewing the online brochures. 

Looking forward to seeing you there or having you participate online.  If you do tax, estate planning or business succession planning work for clients or are involved in production agriculture in any way, this conference is for you.  Each event will also have a presentation involving the farm economy that you won’t want to miss.  Also, if you aren’t needing to claim continuing education credits, you qualify for a lower registration rate.

I am looking forward to seeing you there. 

May 1, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Thursday, April 28, 2022

Proposed Estate Tax Rules Would Protect Against Decrease in Estate Tax Exemption

Overview

The Treasury has proposed regulations that would prevent certain decedents’ estate from being subject to federal estate tax if the federal estate and gift tax applicable exclusion amount drops to $5 million (adjusted for inflation) for deaths after 2025 as it is set to do so under current law.  The Tax Cuts and Jobs Act enacted in late 2017 set the applicable exclusion amount at $10 million for deaths occurring and taxable gifts made after 2017 (adjusted for inflation).  I.R.C. §2010(c)(3).  The amount, for 2022, is $12.06 million per person/estate. 

A proposed estate/gift tax regulation on the applicable exclusion amount – it’s the topic of today’s post.

Background

Historical.  Estate and gift taxes were unified into a single system in 1976 and remained unified through 2003. The systems are re-unified for transfers occurring after 2010. Under this unified system, gift taxes are calculated based on accumulated taxable gifts made by an individual during life. Estate taxes are calculated on the decedent’s taxable estate at death, reduced by gift taxes paid on post-1976 taxable gifts (except for gift taxes paid within three years of death). A “unified” estate and gift tax credit is available to offset estate tax liability and is a function of the amount of applicable exclusion available at death.  In other words, the credit will be an amount that offsets the tax liability to the extent of the applicable exclusion available to the decedent’s estate at death. 

Computation of federal estate tax.  A decedent’s taxable estate is determined by subtracting from the decedent’s gross estate (adjusted for gifts and gift tax within three years of death except for amounts covered by the federal gift tax annual exclusion), costs of estate administration, allowable losses, the marital deduction, and charitable deduction. Taxable gifts after 1976 (those not covered by the federal gift tax annual exclusion, marital deduction or charitable deduction) are included in the taxable estate for purposes of determining the amount of prior use of the unified credit and the point to begin figuring federal estate tax on the graduated tax schedule.

Potential problem.  Based on this manner of calculating a decedent’s taxable estate, a question arises if the applicable exclusion amount that applies at the time of a decedent’s death is different from the amount that applied with respect to any post-1976 taxable gifts made by the decedent during life.  For example, assume a donor made a large taxable gift in 2020 what was completely offset by the unified credit.  If the donor died in 2026 (under current law) when the applicable exclusion amount is lower, would those prior gifts now be deemed to be taxable gifts that are pulled back into the estate for estate tax purposes?  In other words, would those prior taxable gifts be “clawed back” and treated as includible in the decedent’s estate under I.R.C. §2001(b)? 

2019 final regulations.  In 2019, final regulations were issued specifying that gifts made at a time when the applicable exclusion exceeded the amount of the exclusion at death would not be pulled back into the estate at death.  84 Fed. Reg. 64995 (Nov. 26, 2019) creating Treas. Reg. §20.2010-1(c).  The regulations addressed the situation of persons that make lifetime gifts after 2017 and before 2025.  The basic idea of the final regulations is that a donor’s estate is not to be taxed on completed gifts that were not subject to gift tax when made because of a higher applicable exclusion amount than applies at the time of death.  In other words, if a person makes a $12.06 million gift in 2022 (the full exclusion amount) and dies after 2025, the applicable exclusion amount will be $12.06 million rather than $5 million (adjusted for inflation from 2011 to the year of death). 

Note:  Specifically, the final regulations specify that the portion of the unified credit allowed in computing estate tax that is attributable to the applicable exclusion amount is the sum of the amounts attributable to the exclusion amount that is allowed as a credit when computing the gift tax payable on gifts the decedent made during life. 

If a person makes a lifetime gift that is less than the full applicable exclusion amount for the year of the gift, but the gifted amount exceeds the exclusion amount for the year of death, there is no recapture. Instead, the exclusion for computing estate tax at death will be the amount of the exclusion for the year of death.  For example, if an individual makes a $5 million gift in 2022 (when the applicable exclusion amount for estate and gift tax purposes is $12.06 million) and dies after 2025 when, under current law, the exemption will be $5 million (adjusted for inflation from 2011), the individual’s estate tax liability will get the benefit of the exclusion as of the date of the gift.  In the example, that would be $12.06 million and a taxable gift amount of the difference between the exclusion at the time of the gift and the exclusion as of date of death will not be pulled back into the estate for estate tax purposes.

Note:  Under current law, the applicable exclusion amount is a “use it or lose it” concept.  It works to the benefit of a person that lives beyond 2025 to the extent gifts made after 2018 and before 2026 exceed the applicable exclusion amount at the time of death. 

The final regulations also clarify that the rule allowing the surviving spouse to “port” any unused amount of the applicable exclusion at the first spouse’s death (known as the deceased spouse unused exclusion amount (DSUEA) to be added to the surviving spouse’s exclusion amount is retained.  This means that the applicable exclusion amount for the first spouse to die will increase the exclusion available to the surviving spouse.  For instance, assume Mary dies in 2022.  The applicable exclusion amount for 2022 is $12.06 million. Assume that her husband, Dave, elects portability.  If Dave dies after 2025, his applicable exclusion will be the exclusion amount for the year of death (assume $5 million plus an inflation adjustment) plus the $12.06 million DSUEA from Mary’s estate.  If Dave were to make taxable gifts, any DSUEA is deemed to be applied to those gifts before his exclusion amount is applied.  If Dave dies after 2025, the DSUEA applied to his taxable gifts isn’t reduced.  The total amount of applicable credit that was used in computing Dave’s gift tax based on the DSUEA, plus the credit determined without claw-back would be available for computing estate tax in Dave’s estate.  Treas. Reg. §20.2010-1(c).

The 2019 regulations, however, didn’t address the issue of how to treat incomplete gifts such as retained life estates or transfers subject to powers of appointment.  These testamentary transfers are also included in the decedent’s gross estate at death (as “includable gifts”) and could be “clawed-back” into the estate at death if the applicable exclusion amount were lower at that time than it was at the time of the transfer. 

Note:  The 2019 regulations also didn’t address whether the post-2025 reduction in the applicable exclusion amount will impact allocations of the generation-skipping exemption made during 2018-2025.

Proposed Regulations

The proposed regulations remove these “includable gifts” from the estate tax computation.  NPRM Reg-118913-21 (Apr. 26, 2022); 87 Fed. Reg. 24918 (Apr. 27, 2022).  Specifically, the proposed regulation would remove from being clawed back into the decedent’s estate, the value of: (1) gifts that were subject to a retained life estate or subject to other powers or interests (See I.R.C.§§2035-2038 and I.R.C. §2042); (2) gifts made by enforceable promise to the extent unsatisfied at death; (3) transfers of certain applicable retained interests in corporations, partnerships or trusts. (I.R.C. §§2701-2702); and (4) transfers that would have been include in (1)-(3) above but for the transfer, relinquishment or elimination of an interest, power or property within 18 months of the decedent’s death by the decedent alone or in conjunction with any other person, or by any other person.  Prop. Treas. Reg. §20.2010-1(c)(3).  These transfers are removed from the possibility of claw back to the extent the taxable amount is 5 percent or less of the total amount of the transfer (as of the date of the transfer).   

The proposed regulations contain numerous explanatory examples.  Example 1, Prop. Treas. Reg. §20.2010-1(c)(3)(iii) is reproduced below and is based on the assumption that “the basic exclusion amount on the date of the gift was $11.4 million, the basic exclusion amount on the date of death is $6.8 million, and both amounts include hypothetical inflation adjustments. The donor's executor does not elect to use the alternate valuation date and, unless otherwise stated, the donor never married and made no other gifts during life.”

Example 1:

“Individual A made a completed gift of A's promissory note in the amount of $9 million. The note remained unpaid as of the date of A's death. The assets that are to be used to satisfy the note are part of A's gross estate, with the result that the note is treated as includible in the gross estate for purposes of section 2001(b) and is not included in A's adjusted taxable gifts. Because the note is treated as includible in the gross estate and does not qualify for the 5 percent de minimis rule in paragraph (c)(3)(ii)(A) of this section, the exception to the special rule found in paragraph (c)(3) of this section applies to the gift of the note. The credit to be applied for purposes of computing A's estate tax is based on the $6.8 million basic exclusion amount as of A's date of death, subject to the limitation of section 2010(d). The result would be the same if A or a person empowered to act on A's behalf had paid the note within the 18 months prior to the date of A's death.”

The Proposed Regulations also include examples of gifts to a grantor-retained annuity trust and a grantor retained income trust. 

Effective Date

The proposed regulation, once finalized, is applicable to estates of decedent’s dying on or after April 27, 2022.  The proposed rules are open for comments and requests for a public hearing for the 90-day period beginning April 27, 2022. 

Conclusion

The proposed regulation is an important one for larger estates that face potential estate tax liability because of prior taxable gifts.  If the applicable exclusion amount does drop after 2025, the IRS position will result in these estates not having an estate tax burden caused by prior tax-free gifts made when the exclusion was higher being pulled back into the estate and taxed at death because of a lower exclusion amount at that time.  Certain “includable gifts” may also escape claw back.

April 28, 2022 in Estate Planning | Permalink | Comments (0)

Saturday, April 9, 2022

Farm Economic Issues and Implications

Overview

A firm understanding of the economic context within which the farmers and ranchers operate is necessary for both tax planning and financial planning.  The creation and dissolution of legal entities, the restructuring of debt, and the use of various legal devices for the protection of assets from creditors and preserving inheritances cannot successfully be accomplished without knowledge of agriculture that transcends the applicable legal rules. 

Crop production, energy issues, monetary policy, issues in the meat sector and unanticipated outside shocks have farm-level impacts that professional advisors and counselors need to account for when representing farm and ranch clients.

Current economic issues impacting ag – it’s the topic of today’s post.

Projected Plantings (and Implications)

On March 31, the USDA released its “prospective plantings” report for the 2022 crops. https://www.nass.usda.gov/Publications/Todays_Reports/reports/pspl0322.pdf  The report projects farmers planting 91 million acres of soybeans and 89.5 million acres of corn.  The corn planting number is down 4 percent from last year, and is the lowest acreage estimate over the last five years.  The soybean projection is up four percent from 2021.  Total planted acres are projected to remain about the same as 2021.

Note:  The shift from corn acres to soybean acres was very predictable.  Farmers have calculators and can run the numbers with higher input costs (such as fertilizer).  Corn, as compared to soybeans, requires a greater amount of inputs which have risen in price substantially. 

Projected wheat planted acres is up one percent from 2021, but still is projected to be the fifth lowest total wheat planted acres since 1919.  Grain sorghum is projected to be down 15 percent (1.4 million acres) from 2021, with significant declines projected in Kansas and Texas.  Conversely, barley and sunflower planted acres is projected to increase 11 percent and 10 percent respectively from 2021.  With respect to sunflowers, however, the 2022 projection is still the fifth lowest planted area on record.  Cotton acreage is projected to be up about 800,000 acres.

Implication:  The projected planting numbers indicate that higher protein prices can be expected in the future.

Global Crops

The Russian war with Ukraine will have impacts on global grain trade and create additional issues for U.S. farmers and ranchers.  Russia and Ukraine are leading exporters of food grains.  But, Ukraine ports are closed and Russian imports are being avoided causing rising food prices. In the U.S., the rise is in addition to existing inflationary price increases for most good products.  Russia and Ukraine produce 19 percent of the world’s barley; 14 percent of the world’s wheat; and four percent of the world’s maize.  They also produce 29 percent of total world wheat exports and 19 percent of total world corn exports.  Those numbers are particularly important to countries that depend on imported grain from Russia and Ukraine, with a major issue being the loss of corn exports from Ukraine. 

Note:  U.S. corn exports are projected to rise, but U.S. wheat exports are not.

If the war triggers a global food crisis, the least developed countries that are also likely to be low-income or food-deficit countries are the most vulnerable to food shortages.  This would create a surge in malnutrition in these countries.  Presently, 50 countries rely on Russia and Ukraine for 30 percent of their wheat supply (combined), and 26 countries source at least 50 percent of their wheat needs from Russia/Ukraine.  Egypt and Turkey get over 70 percent of their wheat from Russia/Ukraine.  Russia supplies 90 percent of Lebanon’s wheat and cooking oil.  Grain shortages will hit the poorer African countries particularly hard.  These countries rely on imported bread to feed their expanding populations.  As a whole, in 2020, the  continent of Africa imported $4 billion worth of ag products from Russia (which supplied the majority of the continent’s wheat consumption. 

This combined data indicates an escalation of global food insecurity.  One estimate is that worldwide food and feed prices could rise by 22 percent which could, in turn, cause a surge in malnutrition in developing nations.  Since the war started, total world food output has decreased, resulting in a sharp drop in food exports from exporting countries.  Other food exporting countries have announced new limitations on food exports (or are exploring bans) to preserve domestic supplies.  This will have an impact on international grain markets and will likely have serious implications for the world’s wheat supply.  The extent of such disruptions is unknown at the present time. 

Note:  Russia is also a major fertilizer exporter, supplying 21 percent of world anhydrous exports, 16 percent of world urea exports and 19 percent of world potash exports.  Combined, Russia and Belarus provide 40 percent or world potash exports.  The Russia/Ukraine war will likely have long term impacts on fertilizer prices in the U.S. and elsewhere.  This will have impact crop planting decisions by farmers. 

Energy Policy

Incomprehensible energy policy in the U.S. since late January of 2021 and in Europe have been a financial boon to Russia.  The policy, largely couched in terms of ameliorating “climate change,” has resulted in the U.S. from being energy independent to begging foreign countries to produce more.  The restriction in U.S. production and distribution of oil has occurred at a time of increasing demand coming out of state government mandated shutdowns as a result of the China-originated virus.  The resulting higher energy prices have caused the prices of many products and commodities to increase. 

Monetary Policy

The U.S. economy is incurring the highest inflation in 40 years.  While the employment numbers are improving coming out of virus-related shutdowns, the labor force participation rate is not.  A higher rate of employment coupled with a decrease in the labor force participation rate may mean that workers are taking on multiple (lower paying) jobs in an attempt to stay even with inflation. 

The last time the government attempted to dig itself out of a severe inflationary situation the Federal Reserve raised interest rates substantially to “wring inflation out of the economy.”  The result for agriculture was traumatic, bringing on the farm debt crisis of the 1980s.  The current situation is similar with the Federal Reserve having backed itself into a corner with prolonged, historic low interest rates coupled with an outrageous increase in the money supply caused by massive government spending.  If the Federal Reserve attempts to get out of the corner by just raising interest rates, the end result will likely not be good.  The money supply must be reduced, or worker productivity gains must be substantial.  Higher interest rates are a means to reducing the money supply. 

Meat Sector

In the meat sector, the demand for beef remains strong.  Beef exports are steadily growing.  The current major issue in the sector is the disconnect between beef demand and the beef producer.  Currently, the large meat packers are enjoying record-wide margins.  Cattle producers are being signaled to decrease herd sizes because of the disconnect.  Legislation is being considered in the Congress with the intent of providing more robust and transparent marketing of live cattle.

On the pork side, demand is not as impressive but is improving.

For poultry, demand remains strong and flock sizes are decreasing largely because of the presence of Avian Flu. 

Some states have enacted labeling laws designed to protect meat consumers from deceptive and misleading advertising of “fake meat” products.  The Louisiana law has been held unconstitutional on free speech grounds. Turtle Island Foods SPC v. Strain, No. 20-00674-BAJ-EWD, 2022 U.S. Dist. LEXIS 56208 (M.D. La. Mar. 28, 2022).  Much of the advertising of “fake meat” products is couched not in terms of health benefits, but on reducing/eliminating “climate change.”  Government mandates have been imposed for the sake of “climate change” – a certain amount of ethanol blend in fuel; a certain amount of “renewable” energy to generate electricity, etc.). Could that also happen to the meat industry, but in a negative way?  A concern for the meat industry is whether the government will try to mandate that a certain percentage of meat cuts in a meat case consist of “fake meat” products based on a claim that doing so would further the “save the planet” effort. 

Water Issues

West of the Sixth Principal Meridian, access to water is critical for the success of many farming and ranching operations.  A dispute is brewing between Colorado and Nebraska over water in northeast Colorado that Nebraska lays claim to under a Compact entered into almost 100 years ago.  In the fertile Northeastern Colorado area, the State Engineer has shut-in almost 4,000 wells over the past two decades to maintain streamflow and satisfy downstream priority claims.  A similar number of wells have had their pumping rights limited in some way.  While this is a very diverse agricultural-rich area, water is essential to maintain production.  Given the rapid urban development in this area, the need for water for new subdivisions along the front range will trigger major political ramifications if there are any further reductions in agriculture’s water usage. 

The economic impact of water issues in Northeastern Colorado is already being felt.   The Colorado-Big Thompson Project collects, stores and delivers more than 200,000 acre-feet of supplemental water annually. Melting snowpack in the Colorado River headwaters on the West Slope is diverted through a tunnel beneath the Continental Divide to approximately 1,021,000 million residents and 615,000 acres of irrigated farmland in Northeastern Colorado. A unit (acre-foot) of Colorado Big Thompson water storage is presently selling for approximately $65,000.  Fifteen years ago, it was priced in the $6,000 range.  All other water shares are priced accordingly.  This dramatic increase in price has implications for the structure of farming operations, succession planning and estate valuation. 

Water access and availability will continue to be key to profitability of farms and ranches in the Plains and the West.

Tax Policy

In late March, the White House release its proposed 2023 fiscal year budget (October 1, 2022 – September 30, 2023).  At the same time, the Treasury release its “Greenbook” explanation of the tax provisions contained in the budget proposal.  Many of the proposals are the same as or similar to those included in bills in 2021 that failed to become law. 

Here’s a brief list of some of the proposals:

  • Top individual rate to 39.6 percent on income over $400,000 ($450,000 for married couples;
  • Corporate rate goes to 28 percent (87 percent increase on many farm corporations);
  • Raise capital gain rate to 39.6 percent on income over $1 million;
  • Capital gain tax on any transfer of appreciated property either during life or at death;
  • Partial elimination of stepped-up basis – if to spouse, then carryover; transfer of appreciated property to CRAT would be taxable;
  • Trust assets must be “marked-to-market” every 90 years beginning with any new trust after 1940. The rule would be the same for partnerships or any other non-corporate owned entity.  In addition, no valuation discount for partial interests, and a transfer from a trust would be a taxable event.  Exclusion of $1 million/person would apply.  Any tax on illiquid assets could be paid over 15 years or the taxpayer could elect to pay the tax when the property is sold or is no longer used as a farm (in that event, there would be no 15-year option);
  • All farm income (including self-rents) would be subject to the net investment income tax of 3.8 percent;
  • A minimum tax would apply to those with a net worth over $100 million;
  • Grantor-Retained Annuity Trusts (GRATs) must have minimum term of 10 years. This would essentially eliminate the use of a “zeroed-out” GRAT;
  • Any sale to a grantor trust is taxable and any payment of tax of the trust is a taxable gift;
  • Limitation on valuation discounts (related party rules);
  • R.C. §2032A maximum reduction would increase to $11.7 million
  • Trust reporting of assets would be required if the trust corpus is over $300,000 (or $10,000 of income);
  • Elimination of dynasty trusts;
  • Carried interest income would become ordinary income;
  • R.C. §1031 exchange tax deferral would be limited to $1 million;
  • Depreciation recapture would be triggered on the sale of real estate, which would eliminate the maximum 25% rate.

Note:  The provisions have little to no chance of becoming law, but if some or all were to become law, there would be significant implications for farm and ranch businesses.  Many of those implications would be negative for farming and ranching operations.

Conclusion

Farmland values remain strong.  Indeed, input, machinery costs and land values are outpacing inflation.  For those farmers that were able to pre-pay input expenses in 2021 for 2022 crops, the perhaps much of the price increase of inputs will be blunted until another round of inputs are needed in late 2022 for the 2023 crop.  Also, short-term loans were locked in before interest rates began rising.  That story will also likely be different in early 2023 when those loans are redone. 

The biggest risks to agriculture will continue to be from outside the sector.  Unexpected catastrophic events such as the Russian war with Ukraine, whether (or when) China will invade Taiwan, domestic monetary and fiscal policy, political developments at home and abroad, and regulation of agricultural activities remain the biggest unknown variables to the profitability of farming and ranching operations and agribusinesses. 

An awareness of the economic atmosphere in which farmers and ranchers operate is important to understand for practitioners to provide fully competent advice and counsel with respect to income tax, estate, business and succession planning for farmers and ranchers.

April 9, 2022 in Business Planning, Environmental Law, Estate Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Tuesday, April 5, 2022

Pork Production Regulations; Fake Meat; and Tax Proposals on the Road to Nowhere

Overview

Last week, there were two court major court developments of importance to agriculture.  In one, the U.S. Supreme court agreed to hear a case from the U.S. Court of Appeals for the Ninth Circuit involving California’s Proposition 12.  That law sets rules for pork production that must be satisfied for the resulting pork products to be sold in California.  In another development, a federal court in Louisiana held that state’s law designed to protect consumers from misleading and false advertising concerning meat products. 

The Supreme Court and Pork Production Regulations

National Pork Producers Council, et al. v. Ross, 6 F.4th 1021 (9th Cir. 2021), cert. granted, No. 21-468, 2022 U.S. LEXIS 1742 (U.S. Mar. 28, 2022) 

Background.  California voters approved Proposition 12 in 2018.  The new law took effect on January 1, 2022.  Proposition 12 bans the sale of whole pork meat (no matter where produced) from animals confined in a manner inconsistent with California’s regulatory standards (largely remaining to be established).  It also establishes minimum requirements on farmers to provide more space for egg-laying hens, breeding pigs, and calves raised for veal. Specifically, the law requires that covered animals be housed in confinement systems that comply with specific standards for freedom of movement, cage-free design and minimum floor space. The law identifies covered animals to include veal calves, breeding pigs and egg-laying hens.

The implementing regulations are to prohibit a farm owner or operator from knowingly causing any covered animal to be confined in a cruel manner, as specified, and prohibits a business owner or operator from knowingly engaging in the sale within the state of shell eggs, liquid eggs, whole pork meat or whole veal meat, as defined, from animals housed in a “cruel manner.”  In addition to general requirements that prohibit animals from being confined in a manner that prevents lying down, standing up, fully extending limbs or turning around freely, the measure added detailed confinement space standards for farms subject to the law. The alleged reason for the law was to protect the health and safety of California consumers and decrease the risk of foodborne illness and the negative fiscal impact on California.  Apparently, California believes that existing state and federal law regulating food products for health and safety purposes was inadequate (or the alleged reason for the law is false). 

Trial court.  In late 2019, several national farm organizations challenged Proposition 12 and sought a declaratory judgment that the law was unconstitutional under the Dormant Commerce Clause. 

Note:   The Dormant Commerce Clause bars states from passing legislation that discriminates against or excessively burdens interstate commerce.  It prevents protectionist state policies that favor state citizens or businesses at the expense of non-citizens conducting business within that state.  The clause is dormant because it is not state outright, but rather implied in the Constitution’s Commerce Clause of Article I, Section 8, Clause 3.

The plaintiffs also sought a permanent injunction preventing Proposition 12 from taking effect.  The plaintiffs claimed that Proposition 12 impermissibly regulated out-of-state conduct by compelling non-California producers to change their operations to meet California’s standards.  The plaintiffs also alleged that Proposition 12 imposed excessive burdens on interstate commerce without advancing any legitimate local interest by significantly increasing operation costs without any connection to human health or foodborne illness.  The trial court dismissed the plaintiffs’ complaint.  

Appellate court decision.  On appeal, the plaintiffs focused their argument on the allegation that Proposition 12 has an impermissible extraterritorial effect of regulating prices in other states and, as such, is per se unconstitutional.  This was a tactical mistake for the plaintiffs.  The appellate court noted that existing Supreme Court precedent on the extraterritorial principle applied only to state laws that are “price control or price affirmation statutes.”   Thus, the extraterritorial principle does not apply to a state law that does not dictate the price of a product and does not tie the price of its in-state products to out-of-state prices.  Because Proposition 12 was neither a price control nor a price-affirmation statute (it didn’t dictate the price of pork products or tie the price of pork products sold in California to out-of-state prices) the law didn’t have the extraterritorial effect of regulating prices in other states.  The appellate court likewise rejected the plaintiffs’ claim that Proposition 12 has an impermissible indirect “practical effect” on how pork is produced and sold outside California.  Upstream effects (e.g., higher production costs in other states) the appellate court concluded, do not violate the dormant Commerce Clause.   The appellate court pointed out that a state law is not impermissibly extraterritorial unless it regulates conduct that is wholly out of state.  Because Proposition 12 applied to California and non-California pork production the higher cost of production was not an impermissible effect on interstate commerce.  The appellate court also concluded that inconsistent regulation from state-to-state was permissible because the plaintiffs had failed to show a compelling need for national uniformity in regulation at the state level.  In addition, the appellate court noted that the plaintiffs had not alleged that Proposition 12 had a discriminatory effect on interstate commerce and, as such, had failed to plead a Dormant Commerce Clause violation. 

Supreme Court grants certiorari.  On March 28, 2022, the U.S. Supreme Court agreed to hear the case.  The issues before the Court are: (1) whether allegations that a state law has dramatic economic effects largely outside of the state and requires pervasive changes to an integrated nationwide industry state a violation of the Dormant Commerce clause, or whether the extraterritoriality principle is now a dead letter; and (2) whether the allegations, concerning a law that is based solely on preferences regarding out-of-state housing of farm animals, state a claim in accordance with Pike v. Bruce Church, Inc., 347 U.S. 132 (1970). In Pike, the Court said a state law that regulates fairly to effectuate a legitimate public interest will be upheld unless the burden on commerce is clearly excessive in relation to commonly accepted local benefits. 

In the current case, while California accounts for about 13 percent of U.S. pork consumption, essentially no pigs are raised there.  Thus, the costs of compliance with Proposition 12 fall almost exclusively on out-of-state hog farmers.  In addition, because a hog is processed into cuts that are sold nationwide in response to demand, those costs will be passed on to consumers everywhere, in transactions that have nothing to do with California. 

Meat Labeling Law Unconstitutional 

Turtle Island Foods SPC v. Strain, No. 20-00674-BAJ-EWD, 2022 U.S. Dist. LEXIS 56208 (M.D. La. Mar. 28, 2022)

Background.  In 2019, Louisiana enacted the Truth in Labeling of Food Products Act (“Act”), with the Act taking effect October 1, 2020.  Among other things, the Act prohibits the intentional misbranding or misrepresenting of any food product as an agricultural product via a false or misleading label; selling a product under the name of an ag product; representing food product as an meat or a meat product when the food product is not derived from a harvested beef, port, poultry, alligator, farm-raised deer, turtle, domestic rabbit, crawfish, or shrimp carcass. 

The LA Dept. of Ag and Forestry (LDAF) developed rules and regulations to enforce the Act with fines of up to $500 per violation per day but had not received any complaints nor brought any enforcement actions against anyone. Indeed, the LDAF determined that plaintiff’s product labels complied with the law. 

The plaintiff produces and packages plant-based meat products that are marketed and sold in LA and nationwide.  Plaintiff’s labels and marketing materials clearly state that its products are plant-based, meatless, vegetarian or vegan, and accurately list the products ingredients.  After the Act passed, the plaintiff refrained from using certain words and images on marketing materials and packages and removed videos from its website and social media to avoid prosecution under the Act. 

Trial court decision.  The plaintiff sued, challenging the constitutionality of the Act on the grounds that the Act violated its freedom of commercial speech.  The plaintiff claimed it would be very expensive to change its labeling and marketing nationwide.  The trial court determined that the plaintiff had standing because “chilled speech” or “self-censorship” is an injury sufficient to confer standing, and that the plaintiff had demonstrated a “serious intent” to engage in proscribed conduct and that the threat of future enforcement was substantial. 

On the merits, as noted, the plaintiff asserted that its conduct was protected commercial speech (both current and future intended) that the Act prohibited.  The trial court noted that commercial speech is not as protected as is other forms of speech.  To be constitutional, the government speech (the Act) must be a substantial governmental interest, advance the government’s asserted interest and not be any more excessive than what is necessary to further the government’s interest.  The trial court determined that the Act was more extensive than necessary to further the state’s interest.  While the interest in protecting consumers from misleading and false labeling is substantial, the defendant failed to establish that consumers were confused by the plaintiff’s labeling.  Thus, the Act failed to directly advance the State’s interest and was more extensive than necessary to further that interest.    The trial court also determined that the defendant failed to show why alternative, less-restrictive means, such as a disclaimer would not accomplish the same goal of avoiding consumer deception/confusion.  The trial court held the Act unconstitutional and enjoined its enforcement. 

“Greenbook” Released

On March 28, the White House released the details of its $6 trillion budget for the 2023 fiscal year (October 1, 2022 – September 30, 2023).  That same day, the Treasury released the Greenbook, its explanations of the revenue proposals.  Many of the provisions are those that were proposed in 2021, but did not become law.  Here’s a brief rundown of the provisions of most significance to farmers and ranchers:

  • Top individual rate to 39.6 percent on income over $400,000 ($450,000 for married couples;
  • Corporate rate goes to 28 percent (87 percent increase on many farm corporations);
  • Raise capital gain rate to 39.6 percent on income over $1 million;
  • Capital gain tax on any transfer of appreciated property either during life or at death;
  • Partial elimination of stepped-up basis – if to spouse, then carryover; transfer of appreciated property to CRAT would be taxable;
  • Transfers of property by gift or at death would be a realization event (eliminates the fair market value at death rule);
  • Trust assets must be “marked-to-market” every 90 years beginning with any new trust after 1940. The rule would be the same for partnerships or any other non-corporate owned entity.  In addition, no valuation discount for partial interests, and a transfer from a trust would be a taxable event.  Exclusion of $1 million/person would apply.  Any tax on illiquid assets could be paid over 15 years or the taxpayer could elect to pay the tax when the property is sold or is no longer used as a farm (in that event, there would be no 15-year option);
  • All farm income (including self-rents) would be subject to the net investment income tax of 3.8 percent;
  • A minimum tax would apply to those with a net worth over $100 million;
  • Long-term capital gains and qualified dividends taxed at ordinary income rates for taxpayers with taxable income exceeding $1 million;
  • Grantor-Retained Annuity Trusts (GRATs) must have minimum term of 10 years. This would eliminate the use of a “zeroed-out” GRAT; also, the remained interest in a GRAT at the time of creation must have a minimum value for gift tax purposes equal to the greater of 25 percent of the value of assets transferred to the GRAT or $500,000.  In addition, there would be limited ability to use a donor-advised fund to avoid the payout limitation of a private foundation;
  • Any sale to a grantor trust is taxable and any payment of tax of the trust is a taxable gift;
  • Limitation on valuation discounts (related party rules);
  • R.C. §2032A maximum reduction would increase to $11.7 million (from current level of $1.23 million);
  • Trust reporting of assets would be required if the trust corpus is over $300,000 (or $10,000 of income);
  • Elimination of dynasty trusts;
  • Carried interest income would become ordinary income;
  • No basis-shifting by related parties via partnerships;
  • Limitation of a partner’s deduction in certain syndicated conservation easement transactions;
  • R.C. §1031 exchange deferral would be limited to $1 million;
  • Depreciation recapture would be triggered on the sale of real estate, which would eliminate the maximum 25% rate;
  • Elimination of credit for oil and gas produced from marginal wells;
  • Repeal of expensing of intangible drilling costs;
  • Repeal of enhanced oil recovery credit;
  • Adoption credit refundable, and some guardianship arrangements qualify; and
  • Expand the definition of “executor” to apply for all tax matters.

The provisions have little to no chance of becoming law, but they are worth paying attention to. 

Conclusion

There’s never a dull moment in agricultural law and tax. 

April 5, 2022 in Business Planning, Estate Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Friday, April 1, 2022

Captive Insurance – Part Three

Overview

This week, I have been discussing captive insurance.  Part One set forth the definition of captive insurance and how a captive insurance company is treated for income tax purposes as well as how it might be used for estate planning and business succession.  Part Two examined IRS concerns with captive insurance and the results of litigation involving the concept.  Today, in Part Three, I take a look at some recent IRS administrative issues concerning captive insurance and the attempts of the IRS to “crack-down” on the use of the concept to achieve income tax savings and estate planning benefits.  On this point, the most recent developments have not gone well for the IRS.

Captive insurance and recent administrative/regulatory issues – it’s the topic of today’s post.

Administrative Issues

2015 IRS Notice.  Abusive micro-captives have been a concern to the IRS for several years. IRS initiated forensic audits of large captive insurance providers at least a decade ago which resulted in certain transactions making the “Dirty Dozen” tax scam list starting in 2014.  In 2015, the IRS issued a news release that notified taxpayers that it would be taking action against micro-captive insurance arrangements it believes are being used to evade taxes.  IR 2015-16 (Feb. 3, 2015).  Since that time, the IRS has been litigating the micro-captive insurance issue aggressively. 

2016 IRS Notice.  In 2016, the IRS issued a Notice which identified certain micro-captive transactions as having the potential for tax avoidance and evasion.  Notice 2016-66, 2016-47 IRB 745.  In the Notice, the IRS indicated that micro-captive insurance transactions that are the same as, or substantially similar to, the transactions described in the Notice would be considered “transactions of interest.”  Under the Notice, these transactions require information reporting as “reportable transactions” under Treas. Reg. §1.6011 and I.R.C. §§6011 and 6012 for taxpayers engaging in the transactions and their “material advisers.”  Thus, persons entering into micro-captive transactions were required to disclose such transactions to the IRS via Form 8886 and “material advisors” also had disclosure and maintenance obligations under I.R.C. §§6111-6112 and the associated regulations.  In addition, a “material advisor” had to file a disclosure statement (Form 8918) with the IRS Office of Tax Shelter Analysis by January 30, 2017, with respect to such transactions entered into on or after November 2, 2006.  Failure to make the required disclosures came with possible civil and/or criminal penalties.  On December 30, 2016, the IRS extended the disclosure deadline for micro-captive transactions to May 1, 2017.  Notice 2017-08.

Note:  After the issuance of the Notice, the IRS audits of micro-captive arrangements and litigation ramped up substantially.

A manger of captive insurance companies subject to the disclosure requirements challenged Notice 2016-66 in early 2017.  The Notice would have forced the manager to incur substantial compliance costs.  The manager claimed that the Notice constituted a legislative-type rule and, as such, was subject to the mandatory notice-and-comment requirements of the Administrative Procedures Act (APA).  5 U.S.C. §553, et seq.  The manager also claimed that the Notice was invalid as being arbitrary and capricious, and that the IRS failed to submit the rule contained in the Notice to Congress and the Comptroller General as the Congressional Review of Agency Rule-Making Act required.  5 U.S.C. §801.  The manager sought a declaration under the Declaratory Judgment Act (28 U.S.C. §2201) that the Notice was invalid and that an injunction barring the IRS from enforcing the disclosure requirements of the Notice should be issued. 

Note:  Since 2019, the IRS has offered a settlement framework for taxpayers under audit on micro-captive insurance arrangements.  IR 2019-157 (Sept. 16, 2019).  In 2020, the IRS made the settlement framework more restrictive and increased the number of examinations.  IR 2020-26 (Jan. 31, 2021) and IR 2020-241 (Oct. 22, 2020).  Under the 2020 framework, taxpayers are offered reduced accuracy-related penalties of 5, 10 or 15 percent (instead of 20 or 40 percent).  In exchange, a taxpayer must agree to have 90 percent of the premium deductions disallowed for all open tax years, as well as any captive-related expenses such as management fees.  The captive insurance company must also be liquidated, or else there will be a deemed distribution to the owners for the amount of premiums paid to the captive during all years. 

The trial court denied the plaintiffs’ motion for a preliminary injunction, reasoning that the plaintiffs were not likely to succeed on the merits because the claims were likely barred by the Anti-Injunction Act (AIA).  26 U.S.C. §7421. 

Note:  The AIA provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court.”  Instead, a tax can be challenged in court only after the plaintiff pays the disputed tax and files a claim for refund.

The IRS moved to dismiss the plaintiffs’ claims.  The trial court granted the motion and dismissed the case for lack of subject matter jurisdiction.  CIC Services, LLC v. Internal Revenue Service, No. 3:17-cv-110, 2017 U.S. Dist. LEXIS 181482 (E.D. Tenn. Nov. 2, 2017).  The appellate court affirmed.  CIC Services, LLC v. Internal Revenue Service, 925 F.3d 247 (6th Cir. 2019).  On further review, however, the U.S. Supreme Court reversed, vacated the appellate court’s decision, and remanded the case to the trial court.    CIC Services, LLC v. Internal Revenue Service, 141 S. Ct. 1582 (2021).  The Court unanimously held that the AIA did not bar pre-enforcement judicial review of the Notice.  The Court pointed out that while the Notice was “backed by” tax penalties, the plaintiffs’ suit challenged the Notice’s “reporting mandate separate from any tax.” On remand, the trial court set aside the Notice and ordered the IRS to return all documents that it had collected under the Notice.  The trial court stated, “While the IRS may ultimately be correct that micro-captive insurance arrangements have the potential for tax avoidance or evasion and should be classified as transactions of interest, the APA requires that the IRS examine relevant facts and data supporting that conclusion.”  CIC Services, LLC v. Internal Revenue Service, No. 3:17-cv-00110 (E.D. Tenn. Mar. 21, 2022). 

Shortly before the trial court’s remand decision in CIC Services, LLC, the U.S. Court of Appeals for the Sixth Circuit voided IRS Notice 2007-83, 2007-2 CB 960 that established reporting requirements for potentially abusive benefit trust arrangements or face the imposition of civil and/or criminal penalties for engaging in such a “listed transaction.”  Mann Construction, Inc. v. United States, No. 21-1500, 2022 U.S. App. LEXIS 5668 (6th Cir. Mar. 3, 2022), rev’g., 539 F.Supp. 3d 745 (E.D. Mich. 2021).  With Notice 2007-83, the appellate court concluded that the IRS had developed a legislative rule without going through the APA’s required notice and comment procedures.  The Congress had not created any exemption for the IRS from this rulemaking requirement.  Indeed, the appellate court pointed out in Mann Construction, Inc. that the U.S. Supreme Court had rejected the notion that tax law deserves a special “carve-out” from the APA’s notice and comment requirement.  Mayo Foundation for Medial Education & Research v. United States, 562 U.S. 44 (2011). 

Note:  Before getting pushed back by the Courts for rulemaking without following the APA’s rulemaking requirements, the IRS gave some indication that it was also looking at captive insurance company variations.  See IR-2020-226 (Oct. 1, 2020); FAA 20211701F (Feb. 5, 2021).

Filing Obligations

In the summer of 2020, the IRS issued I.R.C. §6112 letters to persons it believed to be a “material advisor” that had failed to report themselves for engaging in an “abusive” transaction.  Since the courts have now voided Notice 2016-66, the filing of Form 8918 and the associated penalties are currently not in play.  But the I.R.C. §6694 preparer penalties are still applicable for taking an unreasonable position on the return.  Also, the IRS could follow the APA’s notice-and-comment procedures and properly adopt its position taken in Notice 2016-66 in the future.  If IRS does, it appears to have attorneys trained to review captive insurance company issues.  Thus, tax practitioners would be well-advised to proceed with caution when engaging with clients interested in captive insurance and examine client files where captive insurance companies have already been established. 

Conclusion

The recent developments surrounding micro-captive arrangements have forestalled the IRS from treating them as “listed transactions” at least until the IRS complies with the APA’s notice and comment requirements.  That’s a big development on the penalty issue, but it doesn’t mean reporting requirements necessary to avoid penalties won’t come back in the future. 

In addition, the caselaw over the past few years provides helpful guidance concerning the proper structuring of captive/micro-captive insurance corporations to provide a more economical means of risk management to business such as farms and ranches.  Also, if structured properly, a micro-captive arrangement can be used to accomplish specific income tax as well as estate and business planning objectives of the owner(s). 

April 1, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, March 30, 2022

Captive Insurance – Part Two

Introduction

In Part One earlier this week, I introduced the concept of a captive insurance company. Part One can be found here: https://lawprofessors.typepad.com/agriculturallaw/2022/03/captive-insurance-part-one.html  In Part One, I looked at the income tax, estate and gift tax implications of captive companies and how they might be used as part of an overall income tax planning, estate planning and succession planning vehicle to minimize unique risks of the business.      

In Part Two today, I look at the IRS audit issues associated with captive insurance companies and how the courts have addressed the issues. 

Captive insurance companies, IRS audit issues and litigation. It’s the topic of today’s post.

IRS Scrutiny, Litigation and Other Developments

The IRS focus.  Abusive micro-captive corporations have been a concern to the IRS for several years.  The basic issue is where the line is between deductible captive insurance and non-deductible self-insurance.

Note:  The IRS focus centers on the fact that with an I.R.C. §831(b) election premiums can be deducted at ordinary income rates and can then be distributed to owners at capital gain rates.  To the extent claims are not paid, the premiums can be distributed from the captive in a manner that escapes transfer taxes.  Both of these issues, in turn, are centered on whether the captive company is insuring legitimate business risks and that “insurance” is actually involved. 

IRS audits.  IRS initiated forensic audits of large captive insurance providers at least a decade ago, and the IRS activity resulted in certain transactions making the “Dirty Dozen” tax scam list starting in 2014.  In 2015, the IRS put out a news release that notified taxpayers that it would be taking action against micro-captive insurance arrangement that it believes are being used to evade taxes.  IR 2015-16 (Feb. 3, 2015).  In 2016, the IRS issued a Notice which identified certain micro-captive transactions as having the potential for tax avoidance and evasion.  Notice 2016-66, 2016-47 IRB 745.  Since that time, the IRS has been litigating the micro-captive insurance issue aggressively. 

Court cases.  Taxpayers have won court cases involving IRS challenges to the tax treatment of and deductions associated with captive insurance companies.  The wins involved large captive insurance companies.  For instance, in Rent-A-Center v. Comr., 142 T.C. 1 (2014), the Tax Court determined that payments that a subsidiary corporation made to a captive insurance company were insurance expenses deductible under I.R.C. §162.  Likewise, in Securitas Holdings, Inc. v. Comr., T.C. Memo. 2014-225, the Tax Court determined that premiums paid to a brother-sister captive insurance company were deductible.  Also, in R.V.I. Guaranty Co. Ltd. and Subs v. Comr., 145 T.C. 209 (2015), the Tax Court held that insuring against losses in the residual value of an asset leased to third parties was insurance for federal income tax purposes. 

Note:  Importantly, in each of the cases involving taxpayer wins, the Tax Court determined that actual “insurance” was involved. 

But the IRS has won several prominent cases since ramping up its scrutiny.  In Avrahami v. Comr., 149 T.C. 144 (2017), the petitioners (a married couple) owned three shopping centers and several jewelry stores in Arizona.  Via these businesses, they deducted about $150,000 in insurance expenses in 2006.  The petitioners then formed a captive insurance company under the law of the Federation of Saint Kitts and Nevis (the birthplace of Alexander Hamilton).  After the captive insurance company was formed their deductible insurance expenses for the companies increased to over $1.1 million annually, and included coverage for terrorism risks and tax liabilities from an IRS audit. 

The Tax Court upheld the IRS determination that the expenses were non-deductible and that the elections the micro-captive company had made under I.R.C. §953(d) and 831(b) were invalid because the micro-captive company did not qualify as a legitimate insurance business.  The Tax Court noted that proper policy language, actuarial standards, and payment and processing of claims are required to operate as an insurance company. These features were lacking.  In addition, the Tax Court determined that there was inadequate risk distribution, and the actuary did not have any coherent explanation of how he priced the insurance policies.  Also, there had been no claims filed until two months after the IRS initiated an audit.  In addition, a majority of the investments of the micro-captive were in long-term illiquid and partially unsecured loans to related parties – the petitioners’ other entities.  This left little liquid fund from which to pay claims.  All of these facts indicated to the Tax Court that the captive was not a legitimate insurance company. 

Note:  It is important to establish that the captive insurance company was established to reduce or insure against risks, and not just to achieve tax benefits.  In additions, policies must be appropriately priced relative to commercial insurance.  The payment of excess premiums annually for a number of years while few or no claims are made inures against a finding of a legitimate business purpose for creating the captive. 

The next year, the Tax Court in Reserve Mechanical Corp. v. Comr., T.C. Memo. 2018-86, disallowed deductions for insurance premiums based largely on the same reasoning utilized in Avrahami.  The case involved an Idaho company engaged in manufacturing and distributing heavy machinery used for underground mining.  Its business activities were heavily regulated and subject to potential liability risk under various state and federal environmental laws.  To minimize the risk from its business operations in a more cost-effective manner, the owner(s) formed a captive insurance company under the laws of Anguilla, British West Indies to provide itself with an excess pollution policy.  The captive company also provided other policies covering business cyber risk. 

The Tax Court held that the micro-captive company was not a legitimate insurance company because its transactions were not “insurance transactions.”  The Tax Court also determined that the micro-captive didn’t qualify as a domestic corporation.  The Tax Court upheld the IRS’ determination that the company was subject to a 30 percent tax under I.R.C. §881(a) on fixed or determinable annual or periodical (FDAP) income the company received from U.S. sources.  The Tax Court determined that the income was not effectively connected with the conduct of a U.S. trade or business. 

In Syzygy Insurance Co. v. Comr., T.C. Memo. 2019-34, the petitioners had a family business that manufactured steel tanks.  Annual revenue averaged about $55 million.  The business obtained policies from a captive insurance company, but the arrangement, the Tax Court determined, did not resemble insurance transactions.  As it had in the 2018 case, the Tax Court noted that for a company to make a valid I.R.C. §831(b) election, it must transact in insurance.  As noted above, if insurance is actually involved, premiums paid are deductible. The Tax Court analyzed the policies and concluded that there was no risk distribution, the arrangement was not “insurance” in the commonly accepted sense of the term.  Thus, the premium payments were not deductible. They were neither fees or payments for insurance. The Tax Court also noted that the president of the family business had sent an email stating that one of the reasons for leaving the previous insurance arrangement was the decrease in premiums. Judge Ruwe wrote, “It is fair to assume that a purchaser of insurance would want the most coverage for the lowest premiums… The fact that [the president] sought higher premiums leads us to believe that the contracts were not arm’s-length contracts but were aimed at increasing deductions.”

Note:  To reiterate, business deductions must have a business purpose, and not be solely for the purpose of lowering income tax liability.

In early 2021, the Tax Court decided Caylor Land Development v. Comr., T.C. Memo. 2021-30.  In Caylor, the petitioner was a construction company.  The petitioner’s $60,000 annual insurance cost was deemed to be too high.  Beginning in late 2007 the company took out policies from a related micro-captive company formed under the laws of Anguilla.  Doing so caused the petitioner’s insurance bill to increase to about $1.2 million.  The petitioner paid $1.2 million to the captive insurance company on the day of formation and deducted that amount on its 2007 return.   Each year thereafter, the deducted consulting payments (legal, accounting and management fees) were about $1.2 million.  The micro-captive company did not include the $1.2 million in income.  The Tax Court held that the arrangement did not qualify as insurance for tax purposes because the micro-captive company did not provide insurance (because there was no risk distribution).  IN addition, the Tax Court concluded that the arrangement did not resemble any type of commonly accepted notion of insurance.  The Tax Court also upheld 20 percent accuracy related penalties for substantial understatement of tax and for negligence. 

Taxpayer victory – sort of.  In late 2021, the Tax Court entered an order in Puglisi et al. v. Comr, No. 13489 (Nov. 5, 2021). The IRS conceded the case before trial to avoid an adverse ruling on the merits.  The petitioners owned an egg farm in Delaware with more than 1.2 million egg-producing hens.  The farm owned a liability insurance policy but wasn’t able to buy insurance to insure against the Avian flu. 

Note:  In early 2022, reports of Avian influenza surfaced in flocks of chickens in Montana, Nebraska, South Dakota, Iowa and elsewhere.  The presence of this influenza results in the destruction of the flock at great cost to the owner(s). 

As a result, the petitioners formed a captive insurance company to provide that additional coverage.  The captive company was a Delaware corporation operaitng as a reinsurance company.  The egg farm bought insurance from a fronting company.  The fronting company then entered into a reinsurance arrangement with the captive company.  Under the reinsurance arrangement the captive insurance company reinsured 20 percent of all approved claims of the egg farm, and 80 percent of all approved claims of unrelated entities that the fronting company insured. The egg farm was organized as an LLC which resulted in deductions flowing through to the petitioners’ personal returns.  Before the IRS initiated an audit, the egg farm had submitted a total of five claims to the fronting company. 

The IRS audited and issued statutory notices of deficiency (taxes and penalties) exceeding $2.7 million (total) for 2015, 2016 and 2018.  Ultimately, the IRS conceded the deductions and sought an order from the Tax Court that the deficiency was a mere $18,587 for 2015.  The petitioners objected, wanting the Tax Court to rule on whether the fronting company was an insurance company for income tax purposes because the issue of the deductibility of premiums paid to the fronting company would be an issue that would continue to arise annually. and they wanted the issue resolved.  In addition, many other businesses paid insurance premiums to the fronting company that were reinsured, at least in part, by the petitioner’s captive insurance company.  The Tax Court refused to rule on the matter and entered a decision in line with the IRS’ concession.  Presently, it remains to be seen whether the IRS will challenge the petitioners’ captive insurance company in the future. 

Note:  It’s important to note that the IRS continued to maintain that the fronting company was not an insurance company for tax purposes, even though it conceded the tax deficiency issue. 

Conclusion

Captive insurance certainly has come under IRS scrutiny in recent years.  But, if it truly involves insurance and is providing risk-management for unique risks of the business with premiums set at reasonable rates, it is a legitimate concept.  The court cases illustrate those points and show the boundaries of what is an appropriate use of a captive insurance company and what is not.

In Part Three, I will turn my attention to IRS administrative attempts to tighten the screws on captive insurance transactions without following procedural law and the courts pushing the IRS back.  These developments have filing/disclosure implications for tax practitioners and “material advisors.”

March 30, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, March 28, 2022

Captive Insurance – Part One

Overview

Many businesses, including farming and ranching businesses, face rising insurance costs and higher self-insured risks for hazards that were not an issue in the past.  This is particularly true for many ag businesses that face ever-increasing environmental rules and regulations that can impair operational profitability, heightened cyber threats, as well as supply chain and labor issues.  As a result, some of these businesses have begun to investigate and utilize captive (and micro-captive) insurance. 

What is captive insurance and what are the benefits of it?  Where does it fit in the overall income tax and estate/business plan for a business, including farming and ranching operations?  What concerns might the IRS have with captive insurance, and what do those concerns mean for practitioners?

Utilizing captive insurance as part of an income tax and estate/business plan that also is designed to minimize business risk - it’s the topic of today’s post.  Part One of a three-part series. 

Captive Insurance Defined

A captive insurance company is an insurer that is a wholly owned subsidiary that providing risk-mitigation services for its parent company or a group of related companies.  A key to being a true captive insurance company is the provision of risk-mitigation.  Often, the reason for forming a captive insurance company is when a business (the parent company) is unable to find standard commercial insurance to cover risks that are unique to the business.  Without the creation of a captive insurance company, the business is left to self-insure against risks for which it is unable to acquire commercial insurance.  In this situation, a captive insurance company provides the ability to shift self-insured risks to the captive company with policies tailored to fit the unique parent’s unique needs.  The owners of the parent can retain control of the captive’s investments, and may also be able to achieve tax savings and wealth transfer benefits

Note:  Since 2000, the potential risks to a business from contract non-performance (business interruption), a loss of key suppliers and input supplies, cyber-attacks, labor shortages, and administrative and/or regulatory actions have increased substantially.  This is causing businesses (including farming and ranching operations) to search for cost-effective and tax efficient ways to manage these unique risks.   A captive insurance company is viewed as one approach that can satisfy an overall risk-mitigation strategy.  See, e.g., “Once Scrutinized, an Insurance Product Becomes a Crisis Lifeline,” The New York Times (Mar. 20, 2020). 

Income Tax Aspects

Insurance is a transaction that involves an actual insurance risk and involves risk-shifting and risk-distributing.  Helvering v. Le Gierse, 312 U.S. 521 (1941).  Insurance premiums are deductible as an ordinary and necessary business expense under I.R.C. §162(a) if paid or incurred in connection with the taxpayer’s trade or business.  Treas. Reg. §1.162-1(a).  However, amounts set aside in a loss reserve as a form of self-insurance are not deductible.  See, e.g., Harper Group v. Comr., 96 T.C. 45 (1991), aff’d., 979 F.2d 1341 (9th Cir. 1992).  As Judge Holmes stated in Caylor Land & Development, Inc. v. Comr., T.C. Memo. 2021-30, “the line between nondeductible self-insurance and deductible insurance is blurry, and we try to clarify it by looking to four nonexclusive but rarely supplemented criteria:

  • risk-shifting;
  • risk-distribution;
  • insurance risk; and
  • whether an arrangement looks like commonly accepted notions of insurance.”

On the other side of the equation, an insurance company includes premiums that it receives in income, and the company is generally taxed on its income just like any other corporation.  I.R.C. §831(a).  But an insurance company that receives premiums under a certain amount during a tax year can elect to be taxed only on investment income.  I.R.C. §831(b)(1)-(2). 

Note:  For premiums paid to be deductible, the captive must be respected as an insurance company for federal income tax purposes.  Otherwise, what is involved non-deductible self-insurance.  This means that qualified underwriting services must be used to determine the actual cost of similar coverage in the market or via an underwriting evaluation so that the policies are properly designed and the premiums are appropriate.  This is key to getting the desired tax treatment and withstanding an IRS attack.  Setting premiums too high coupled with claims that are less than anticipated will cause the captive’s stock value to rise. That value can be returned to shareholders in a tax-favorable manner as qualified dividends taxed at favorable capital gain rates.  Hence, the importance of the proper structuring of the captive to avoid an IRS attack and the imposition of severe penalties (explained further below).

Estate and Business Planning Aspects

Before the Congress modified I.R.C. §831, the captive or micro-captive corporation could fit rather easily into an estate or succession plan, and could be held in various types of entities depending upon the overall estate and business plan of the owner(s).  A straightforward approach, for example, was to have a parent (or parents) form a captive insurance company and name the children as the shareholders.  As the parents paid the premiums, they achieved insurance coverage for their unique need(s) and transferred wealth to the children.  Establishing the captive, however, must be justified by a legitimate business purpose of insuring risks of the business other than simply transferring wealth in a tax-efficient manner to the children.

Trust ownership.  A trust could be established to own the captive insurance company.  If the trust’s beneficiaries are the grantor’s children and/or grandchildren, it is possible to structure the trust such that the assets of the captive insurance corporation will not be included in the owner’s estate at death. 

LLC/FLP ownership.  Similarly, the captive corporation could be placed in a limited liability company (LLC) or a family limited partnership (FLP).  The ownership structure of the LLC or FLP could involve various classes of ownership held by various members of the owner(s) family.  This structure may be especially beneficial in the context of a small businesses such as a farm or ranch where the senior generation wants to maintain control over the business, investments, and distributions of the captive insurance corporation while simultaneously setting up valuation discounts for minority interest and/or lack of marketability.

Gift tax.  From a federal gift tax standpoint, income tax deductible premiums made for adequate and full consideration are not a gift from the owners of the insured to the owners of the captive insurance company.  Treas. Reg. §§25.2512-1(g)(1); 25-2512-8.  The “full and adequate consideration” test of I.R.C. §2512 applies in the estate tax context such that the premium payments are not pulled back into the decedent/transferor’s estate at death for federal estate tax purposes under I.R.C. §2036 or I.R.C. §2038.  This also means that the generation-skipping transfer tax (GSTT) would not apply.

Statutory modifications.  In late 2015, the Congress passed “extender” legislation that included new rules impacting certain captive insurance companies.  Under the new rules, effective for tax years beginning after 2016, the maximum amount of annual premiums that a captive insurance company may receive became capped (subject to an inflation adjustment).  The cap is $2.45 million for 2022.  In addition, a captive insurance company must satisfy one of two “diversification” tests that bear directly on the ability to transfer wealth to the next generation without transfer tax.  Under this requirement, the ownership of the underlying business of the captive must be within two percent of the ownership of the captive.  The new rule applies to all I.R.C. §831(b) captive insurance companies regardless of when formed. 

Under revised I.R.C. §831(b), a captive that makes an I.R.C. §831(b) election must satisfy one of the following two requirements designed to prevent it from being used as a wealth transfer tool (notice the second requirement is written in the negative – the captive must not satisfy it):

  • No more than 20 percent of the net written premiums (or, if greater, direct written premiums) of the company for the tax year is attributable to any one policyholder;

Note:  I.R.C. §831(b) was retroactively amended by the Consolidated Appropriations Act, 2018 (CAA) such that “policyholder” means “each policyholder of the underlying direct written insurance with respect to such reinsurance or arrangement.”  Thus, a risk management pool itself is not considered to be the policyholder.  Instead, each insured paying premiums into the pool is considered a policy holder.  As long as none of those insureds accounts for more than 20 percent of the total premiums paid to the captive, the 20 percent test is satisfied.  I.R.C. §831(b)(2)(D)

  • The captive company does not meet the 20 percent requirement and no person who holds (directly or indirectly) an interest in the company is a spouse or lineal descendant of a person who holds an interest (directly or indirectly) in the parent company who holds (directly or indirectly) aggregate interests in the company which constitute a percentage of the entire interests in the company which is more than a 2 percent percentage higher than the percentage interests in the parent company with respect to the captive held (directly or indirectly) by the spouse or lineal descendant.

Note:  Essentially, the second requirement means that if the spouse or lineal descendants’ ownership of the captive company is greater than 2 percent of their ownership of the parent company, the second requirement is not satisfied.

The CAA modified the second test (the ownership test) to eliminate spouses from the definition of “specified holder” unless the spouse is not a U.S. citizen.  Thus, the ownership test only applies to lineal descendants of either spouse, spouses that are not U.S. citizens, and spouses of lineal descendants.  I.R.C. §831(2)(B)(iii).  The CAA also added a new aggregation rule to apply to certain spousal interests such that any interest held, directly or indirectly, by the spouse of a specified holder is deemed to be held by the specified holder.  In addition, the CAA modified the ownership test to look at the aggregate amount of an interest in the trade, business, rights or assets insured by the captive, held by a specified holder, spouse or “specified relation.”  I.R.C. §831(b)(2)(B)(iv)(I).  The rule excludes assets that have been transferred to a spouse or other related person by bequest, devise or inheritance from a decedent during the taxable year of the insurance company or the preceding tax year.  Id.

Thus, in the estate planning/succession planning context if a parent (i.e., father or mother) or parents is (are) the sole owner of the parent company and the captive company, the captive company can make the I.R.C. §831 election.  That’s because no lineal descendant has any ownership in the captive company.  But, if a parent(s) is (are) the sole owner of the parent company and the and children own the captive company, the captive cannot make the I.R.C. §831 election (100 percent is more than 2 percent greater than zero percent).  The result is the same if the captive is held (indirectly) in a trust with the children as the beneficiaries.  But, for example, if the parent owns half of the parent company and half of the captive company with the children owning the other half of each entity, the captive company can make the I.R.C. §831 election. 

Note:  If the children meaningfully own the parent company, they can own the captive company.  The converse is also true. 

Given the modifications to I.R.C. §831(b) it remains possible to use a captive insurance company as part of an estate/business succession plan if the ownership of the parent and the captive is structured properly with the appropriate ownership percentages in both the parent and captive business entities.  For example, a captive company could be capitalized with cash from an intentionally defective grantor trust (IDGT) that has been established for the benefit of a child.  I recently posted an article on the use of an IDGT in estate planning.  You may read that article here:

https://lawprofessors.typepad.com/agriculturallaw/2022/03/should-an-idgt-be-part-of-your-estate-plan.html

The gift of funds to the IDGT is a completed gift for federal gift tax purposes and removes that value from the grantor’s estate at death.  The income the IDGT receives from the captive is taxed to the grantor, and the grantor deducts the premiums paid to the captive company and reports the net profits from the captive as a qualified dividend.  That is the case even though the cash flows from the parent company (the family business) to the captive insurance company and then to the IDGT and then on to the grantor’s child/children.  But, again, the ownership percentages of the parent and the captive insurance company must be carefully structured to stay within the borders of I.R.C. §831. 

As an alternative, as noted above, the captive insurance company could be held in an FLP and the parents could gift FLP interests to the children annually consistent with the present interest annual exclusion (presently $16,000 per donee per year (and, spouses can elect “split-gift” treatment)).  Each FLP interest entitles the owner a share of the captive company’s profits.  It may also be possible for the parents to claim valuation discounts on the gifts of interests in the FLP.  But, of course, the percentage ownerships of the parent company and the captive must stay within the “guardrails” of I.R.C. §831.

Conclusion

In Part Two I will examine the issues that give the IRS concern about captive insurance companies and discuss various court cases construing the IRS position.

March 28, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Friday, March 25, 2022

Registration Open for Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

Overview

Last December, I posted a “hold-the-date” announcement for the 2022 summer national farm income tax/estate and business planning conferences that Washburn Law School will be conducting this summer. Earlier this month I devoted a blog article to the itinerary.

Registration is now open for both the Wisconsin event in mid-June and the Colorado event in early August. 

Wisconsin Dells, Wisconsin

Here’s the link to the online brochure and registration for the event at the Chula Vista Resort on June 13-14:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html

A block of rooms is available for this seminar at a rate of $139.00 per night plus taxes and fees. To make a reservation call (855) 529-7630 and reference booking ID "#i60172 Washburn Law School." Rooms can be reserved at the group rate through May 15, 2022. Reservations requested after May 15 are subject to availability at the time of reservation.

An hour of ethics is provided at the end of Day 2.

The conference will also be broadcast live online for those that cannot attend in person.  Online attendees will be able to interact with the presenters, if desired. 

Durango, Colorado

Here’s the link to the online brochure and registration for the event at Fort Lewis College on August 1-2:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html

An hour of ethics is also provided at the end of Day 2 at this conference.

Just like the Wisconsin conference, this conference will also be broadcast live online for those that cannot attend in person.  Online attendees will be able to interact with the presenters, if desired. 

Other Points

There are many other important details about the conferences that you can find by reviewing the online brochures. 

Looking forward to seeing you there or having you participate online.  If you do tax, estate planning or business succession planning work for clients or are involved in production agriculture in any way, this conference is for you.  Each event will also have a presentation involving the farm economy that you won’t want to miss.  Also, if you aren’t needing to claim continuing education credits, you qualify for a lower registration rate.

See you there. 

March 25, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, March 16, 2022

Family Settlement Agreement – Is it a Good Idea?

Overview

A family settlement agreement is a way for heirs to agree to a distribution of the decedent’s estate that is different from how the decedent desired.  While most estates are handled and the decedent’s property is distributed in the manner the decedent wanted, sometimes there might be a mistake in the will or some other unanticipated result as a consequence of poor drafting of an estate plan.  In those instances, a family settlement agreement may be appropriate.

When will a family settlement agreement be effective to resolve a decedent’s estate and distribute estate property – it’s the topic of today’s post.

In General

Contract.  A family settlement agreement is a contract.  Thus, if it meets the requirements for a valid contract, it is a binding agreement that the probate court must respect.  It’s not up to the probate judge to approve or disapprove the document.  About the only issue a probate judge would deal with concerning a family settlement agreement is if there are creditors of the decedent’s estate and the funds available to pay estate debts. 

As a contract, a family settlement agreement must be agreed to by all of the heirs and beneficiaries, provide that the decedent’s will is not to be probated, and provide a plan for the distribution of the decedent’s assets that replaces the disposition of assets set forth in the decedent’s will.  In addition, it is critical that the terms of the agreement be negotiated as part of a transaction entered into at arm’s-length.  That means that the terms of the agreement shouldn’t simply be standard “boilerplate” terms that aren’t discussed by the family.  Also, it is important that the family members be represented by legal counsel, and it’s helpful that they have some understanding of business matters.  Legal representation s particularly important for a family member that is complaining about the disposition of assets under the terms of the decedent’s will.  It’s also important that the release language in the agreement be clear, and the agreement must evidence that the parties (heirs) were working to achieve final settlement of all claims.  If these factors are satisfied, the agreement is binding on the parties and will provide protection against future liability and claims. 

Appropriate use.  A family settlement agreement can be appropriate when surviving family members agree as to the disposition of a deceased family member’s estate that is different from how the decedent had specified in a testamentary instrument.  Often, they arise when a deceased parent has not devised property equally to all of the decedent’s children, but the children (and, perhaps a surviving spouse) agree that an equal division should be made.  In addition, a family settlement agreement might lead to a better tax result for the estate over what would have occurred based on how the decedent’s estate plan was drafted.  Or, perhaps the decedent’s will made a simple mistake – such as a specific devise of a tract of farmland to the wrong child as the farming heir.  A family settlement agreement can be an efficient way to “clean up” the error. 

Another common situation for the use of a family settlement agreement can occur with second (or subsequent) marriages and each spouse has their own child or children.  Consider the following example:

Example:  Sam and Lisa are married.  It is the second marriage for each of them, and they each have adult children from a prior marriage, but none from their marriage.  Sam farmed during his life and dies with a will that leaves all of his property to his children.  Under state law, Lisa is entitled to a “family allowance” and the use of their home that she can claim as her homestead.  But, Lisa would rather live near her children in a different state.  The problem is that if she moves from the homestead, she loses it along with her family allowance.  Sam’s children would like to have the homestead – 160 acres of irrigated farmland.  Via a family settlement agreement, Sam’s children and Lisa might be able to agree that instead of Lisa receiving a family allowance, she could receive annual payments for a number of years with which she could buy a home near her children.  Sam’s children could use the rental income from the farmland to fund the payments to Lisa, or sell the home and the farmland and use a part of the sale proceeds to fund the annual payments to Lisa. 

A family settlement agreement may also be used to prevent a will challenge by a disaffected heir that might result in a drawn-out probate proceeding, as well as a spendthrift heir likely to squander their inheritance and seek more from the estate. 

Recent Case

A recent case from Texas illustrates the use and enforceability of a family settlement agreement.  In Austin Trust Co. v. Houren, No. 14-19-00387-CV, 2021 Tex. App. 1955 (Tex. Ct. App. Mar. 16, 2021), the decedent (former Mayor of Houston, Texas, and real estate developer) died in 2014, having outlived his wife by 30 years.  The couple had five children.  The pre-deceased spouse’s will created a marital trust upon her death for the decedent, naming him the sole trustee and beneficiary for life.  The trust was funded with about $54 million, which represented her half of the couple’s community property.  Under the trust’s terms, he could also pay himself any amounts he deemed necessary for his “health, support, or maintenance in his accustomed standard of living.”  He could also utilize trust principal for this purpose, and he was also given a testamentary power of appointment over the balance of principal in the marital trust in favor of their children, their spouses, or unspecified charities.  In his will, he exercised the power and directed that the balance of trust assets passed to a trust for the benefit of the children.  The decedent’s other asset passed to his second wife and her two children. 

The marital trust terminated upon the decedent’s death and a bank became the trustee for purposes of administration and making final distributions.  The decedent’s attorney served as the executor of the estate.  Because the marital trust was a qualified terminable interest property (QTIP) trust, the decedent’s estate was entitled to recover from the marital trust and the trust for the children any federal estate tax that the decedent’s estate owed.  Thus, the bank (as trustee of the marital trust) would not make distributions until a federal estate tax return was filed and an estate tax closing letter was received from the IRS.  Because of this anticipated delay in distributions from the trust, the children expressed their desire for the marital trust to distribute its assets to their trust before the estate tax return was filed and a closing letter received.  To accommodate this desire without fear of any future claims, the decedent’s attorney set up a meeting with the couple’s children, bank and the children of the surviving wife.  The couple’s children and the bank were represented by their own legal counsel.  At the meeting the attorney proposed a family settlement agreement.  Various disclosures were made, including one that the plaintiff relied upon to claim that the decedent either owed the marital trust $37 million or breach a fiduciary duty by taking excessive distributions of principal totaling $37 million. 

The family settlement agreement released, “any and all liability arising from any and all Claims,” including “claims of any form of sole contributory concurrent, gross, or other negligence, undue influence, duress, breach of fiduciary duty, or other misconduct” and defined “covered activities” to include “(1) the formation, operation, management, or administration of the Estate,…or the Trusts, (2) the distribution of any property or asset of or by…the Estate,…or the Trusts, (3) any actions taken (or not taken) in reliance upon this Agreement or the facts listed in Article I,” (4) “any Claims related to, based upon, or made evident in the Disclosures,” and (5) “any Claims related to, based upon, or made evident in the facts set forth in Article I.”   

Ultimately, after review by the attorneys involved and disclosure and review by the parties, all of the parties signed the family settlement agreement agreeing to all of the release and indemnity language that it contained.  Funds then began to be distributed in mid-2015 and the federal estate tax return was filed in early 2016.  After the IRS closing letter was received in mid-2016, the balance of the estate’s assets were distributed except for a small amount to cover administration costs. The alleged debt was not listed as part of the estate.

The plaintiff sought repayment of the alleged debt that the estate owed.  The plaintiff based its claim on accounting entries in the marital trust’s general ledger.  The claim was denied on the basis that the entries represented distributions from the trust rather than receivables.  The plaintiff then changed amended its claim as one for breach of fiduciary duty against the estate on the basis of excessive distributions by the decedent from the marital trust.  The trial court disagreed.

On appeal, the plaintiff claimed that the trial court incorrectly determined that the heir’s had “released their right to collect any debt from the Executor or the Estate…by executing the … Family Settlement Agreement” and that the breach of fiduciary duty claim had also been released.  The attorney for the estate replied that the trial court had correctly determined that the family settlement agreement had “unambiguously and specifically released all clams” the plaintiff may have had against the parties to the family settlement agreement, including a breach of fiduciary claim.  The appellate court affirmed the trial court, upholding the family settlement agreement. 

The appellate court noted that public policy in Texas favored freedom to contract, and that the parties freely entered into the agreement with the full opportunity to be represented by legal counsel in furtherance of their own respective interests.  The court noted six factors used by Texas court to consider when determining the validity of a family settlement agreement:

  1. Whether the terms of the agreement were negotiated rather than being boilerplate terms that were not specifically discussed by the parties;
  2. Whether the complaining party was represented by counsel;
  3. Whether negotiations occurred as part of an arms-length transaction;
  4. Whether the parties were knowledgeable in business matters;
  5. Whether the release language was clear; and
  6. Whether the parties were working to achieve a final settlement of all claims to enable them to part ways.

The appellate court determined that all six factors were satisfied.  Accordingly, the appellate court did not have the determine whether a fiduciary duty had been breached because the parties had waived the claim.

Conclusion

While a family settlement agreement can be an efficient way to resolve family disputes, it must be carefully entered into and drafted properly.   The agreement in the Texas case was done properly. 

March 16, 2022 in Estate Planning | Permalink | Comments (0)

Friday, March 11, 2022

Farm Wealth Transfer and Business Succession – The GRAT

Overview

The Tax Cuts and Jobs Act (TCJA) significantly increased the federal estate and gift tax exemption, and it is presently at $12.06 million for deaths occurring or gifts made in 2022.  That effectively makes federal estate and gift tax a non-issue for practically all farming and ranching operations, with or without planning.  But it is for some, and business succession planning remains as important as ever. 

Earlier this week I wrote about one possible strategy - the Intentionally Defective Grantor Trust.  Today, I discuss another possible succession planning concept – the grantor-retained annuity trust (GRAT).  It’s another technique that can allow the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period.  The GRAT technique “freezes” the value of the senior family member’s highly appreciated assets at the value as of the time of the transfer to the GRAT, while providing the senior family member with an annuity payment for a term of years.  Thus, the GRAT can deliver benefits without potential transfer tax disadvantages. 

Transferring interests in a farming business (and other investment wealth) to successive generations by virtue of a GRAT – it’s the topic of today’s post.

GRAT Basics

A GRAT is an irrevocable trust to which assets are transferred.  In return, the grantor receives the right to a fixed annuity payment for a term of years, with the (non-charitable) remainder beneficiaries receiving any remaining assets at the end of the GRAT term.  The fixed payment is typically a percentage of the assets’ initial fair market value computed so as to not trigger gift tax.  In other words, the amount of the taxable gift on the transfer to the GRAT is the fair market value (FMV) of the property transferred less the value of the grantor’s retained annuity interest.  At the end of the grantor’s reserved term, the value of the remainder interest is included in the grantor’s estate for tax purposes.  See I.R.C. §2036; I.R.C. §2039. 

The term of the annuity is fixed in the instrument and is either tied to the shorter of the annuitant’s life or a specified term of years.  The annuity payment can be structured to remain the same each year or (as explained more further below) it can increase up to 120 percent annually.  However, once the annuity is established, additional property cannot be added to the GRAT.  Treas. Reg. §25.2702-3(b)(5).

Note:  The grantor receives the annuity amount annually regardless of the income that the GRAT’s assets produce.  Thus, the trustee’s job is to maximize the total return on the GRAT’s assets from income or principal appreciation.  If the GRAT income is insufficient to pay the annuity, the trustee must be required to invade the GRAT’s principal to do so.  Thus, the assets transferred to the GRAT must produce enough cash flow to pay the annuity amount or must be able to be liquidated by the trustee to pay the annuity.

Because a GRAT is a technique that is based largely on assumptions about what the interest rate will be, ideal assets to transfer to a GRAT are those that are likely to appreciate in value (such as real estate) at a rate exceeding the rate that the IRS applies (the I.R.C. §7520 rate) to the annual annuity payment the GRAT will make.  In that event, the appreciation in the GRAT assets will pass to the GRAT’s beneficiaries without triggering federal gift or estate tax to the grantor.  The actuarial value of the remainder interest in the GRAT that passes to the beneficiaries when the GRAT terminates is a gift to the remainder beneficiaries that is subject to gift tax.  But, if that actuarial value equals the value of the property transferred to the GRAT, there won’t be any gift tax. 

If the grantor outlives the term of the annuity term, the remainder passes to the beneficiaries with no additional estate tax. 

Example:  Faye, at age 55, funded an irrevocable trust with $1,000,000 in March of 2022.  The trust specified that Faye would receive an annual annuity of $50,000 for the next 10 years.  The March 2022 I.R.C. §7520 rate is 2.0 percent.   Based on the IRS specified formula, the value of Faye’s retained interest is $449,130 and the value of the remainder interest is $550,870.  The value of the remainder interest would be subject to gift tax upon the GRAT’s creation.  Because the funding of the GRAT involved a completed gift, when the GRAT terminates there will be no gift tax consequences.  The assets remaining in the GRAT are paid to the remainder beneficiaries without Faye incurring any additional gift tax.  If Faye were to die during the GRAT term with the right to receive further annuity payments, a portion of the GRAT will be included in her estate.  The included portion is that fraction of the GRAT which would be required to be invested at the I.R.C. §7520 rate in effect on Faye’s death to produce income equal to the required annuity payment.  If Faye is married and the right to the balance of the annuity payments passes to her spouse, the interest will qualify for the marital deduction if the spouse receives annuity payments that either pass outright to the surviving spouse or the surviving spouse’s estate, or will pass to a marital trust over which the spouse has a general power of appointment. 

Technical Requirements

Perhaps the most important part of a GRAT is that the trust instrument be drafted property to satisfy I.R.C. §2702.  If I.R.C. §2702 is satisfied, the grantor’s retained interest is a “qualified interest” and is subtracted from the value of the property gifted to the remainder beneficiaries.  If I.R.C. §2702 is not satisfied, the grantor’s retained interest is valued at zero and the entire value transferred to the remainder beneficiaries is a taxable gift.  To be a qualified interest, the grantor’s retained interest must be an interest consisting of the right to receive a fixed amount payable not less than annually that is a fixed percentage of the fair market value of the property in the GRAT determined on an annual basis.  The annuity’s term must be the shorter of the life of the grantor or a specified term of years (but see the discussion surrounding the Tax Court’s decision in Walton, infra.).

Note:  The value of the qualified annuity is determined via I.R.C. §7520.

It is critical to have an accurate appraisal of the assets/interests to be contributed to the GRAT.  If the appraisal is not accurate, the annuity may be determined to not be a qualified interest.  See Atkinson v. Comr., 309 F.3d 1290 (11th Cir. 2002), aff’g., 115 T.C. 26 (2000); C.C.A. 202152018 (Oct. 4, 2021).  This is a particular issue when a potential sale or merger is involved when valuing assets to be contributed to the GRAT. 

A GRAT must make at least one annuity payment every 12-month period that is paid to an annuitant from either the GRAT’s income or principal.  Treas. Reg. §25.2702-3(b)(1).  There is a 105-day window within which the GRAT can satisfy the annual annuity payment requirement.  This is the case if the annuity payment is based on the GRAT’s anniversary date.  Treas. Reg. §25.2702-3(b)(4).  The window runs from the GRAT creation date, which is based on state law.  Notes cannot be used to fund annuity payments, and the trustee cannot prepay the annuity amount or make payments to any person other than the annuitant during the qualified interest term.

Note:  The annuity payment may, alternatively, be based on the taxable year of the GRAT.  If so, the annuity must be paid in the subsequent year by the date on which the trustee must file the GRAT’s income tax return (without extension).  Treas. Reg. §25.2702-3(b)(4).   As noted, the annuity cannot be prepaid.  Treas. Reg. §25.2702-3(d)(4). 

The GRAT must be drafted to require the trustee to actually pay the annuity amount, it is not sufficient for the grantor to merely have a withdrawal right.  Treas. Reg. §25.2702-(3)(b)(1)(i). 

A GRAT is subject to a fixed amount requirement that takes the form of either a fixed dollar amount or a fixed percentage of the initial fair market value of the property transferred to the trust.  Treas. Reg. §25.2702-3(b)(1)(ii).  There is also a formula adjustment requirement that is tied to the fixed value of the trust assets as finally determined for gift tax purposes.  The provision must require adjustment of the annuity amount.  

Note:  The fixed amount need not be the same for each year, but one year’s amount may not vary by more than 120 percent from the amount paid in the immediately prior year.  Treas. Reg. §25.2702-3(b)(1)(ii). 

From a financial accounting standpoint, the GRAT is a separate legal entity.  The GRAT’s bank account is established using the grantor’s social security number as the I.D. number.  Annual accounting is required, including a balance sheet and an income statement.

Tax Consequences of Creating, Funding, Administering and Terminating a GRAT

Grantor trust status.  For income tax purposes, the GRAT is treated as a grantor trust because, by definition, the retained interest exceeds five percent of the value of the trust at the time the trust is created.  I.R.C. §673.  Thus, there is no gain or loss to the grantor on the transfer of property to the GRAT in exchange for the annuity.  There can be issues, however, if there is debt on the property transferred to the GRAT that exceeds the property’s basis.  Also, when a partnership interest is contributed there can be an issue with partnership “negative basis” (i.e., the partner’s share of partnership liabilities exceeds the partner’s share of the tax basis in the partnership assets).  

Note:  It is possible that a GRAT could be a grantor trust for some but not all purposes.  Generally, a GRAT should be a grantor trust for all purposes.  Language can be drafted into the GRAT document ensuring classification as a grantor trust for all purposes. 

Because the trust is a grantor trust, the grantor is taxed on trust income, including interest, dividends, rents and royalties, as well as pass-through income from business entity ownership.  The grantor also can claim the GRAT’s deductions.  However, the grantor is not taxed on annuity payments, and transactions between the GRAT and the grantor are ignored for income tax purposes.  A significant tax benefit of a GRAT is that the sale of the asset between the grantor and the GRAT does not trigger any taxable gain or loss.  The transaction is treated as a tax-free installment sale of the asset.  Also, the GRAT is permitted to hold “S” corporation stock as the trust is a permitted S corporation shareholder, and the GRAT assets grow without the burden of income taxes. 

Gift tax treatment.  For gift tax purposes, the value of the gift equals the value of the property transferred to the GRAT less the value of the grantor’s retained annuity interest.  In essence, the transferred assets are treated as a gift of the present value of the remainder interest in the property.  That allows asset appreciation to be shifted (net of the assumed interest rate that is used to compute present value) from the grantor’s generation to the next generation.

It is possible to “zero-out” the gift value so there is no taxable gift.  This occurs when the value of the grantor’s retained interest equals the value of the property transferred to the trust.  An interest rate formula determined by I.R.C. §7520 is used to calculate the value of the remainder interest.  If the income and appreciation of the trust assets exceed the I.R.C. §7520 rate, assets remaining at the end of the GRAT term that will pass to the GRAT beneficiaries.  The basic idea is to transfer wealth to the subsequent generation with little or no gift tax consequences. 

The grantor’s payment of taxes is not treated as a gift to the trust remainder beneficiaries.  Rev. Rul. 2004-64, 2004-27 I.R.B. 7.  Also, if the trustee reimburses (or has the power to reimburse) the grantor for the grantor’s payment of income tax, the reimbursement (or the discretion to reimburse) does not cause inclusion of the trust assets in the grantor’s estate.  But, it’s important that the trustee be an independent trustee. 

Underperforming GRAT.  If the GRAT underperforms (i.e., the GRAT assets fail to appreciate at a higher rate than the interest rate of the annuity payment), the GRAT can sell its assets back to the grantor with no income tax consequences (assuming the GRAT is a wholly-owned grantor trust).  Rev. Rul. 85-13, 1985-1 C.B. 184.  Then, the repurchased property can be placed in a new GRAT with a lower annuity payment.  The original GRAT would then pay out its remaining cash and collapse.   

Death of Grantor During GRAT Term

If the grantor dies before the end of the GRAT term, a portion (or all) of the GRAT is included in the grantor’s gross estate under I.R.C. §2036.  The amount included in the grantor’s estate is the lesser of the fair market value of the GRAT’s assets as of the grantor’s date of death or the amount of principal needed to pay the GRAT annuity into perpetuity (which is determined by dividing the GRAT annuity by the I.R.C. §7520 rate in effect during the month of the grantor’s death).   Rev. Rul. 82-105, 1982-1 C.B. 133.  

Example:  Bubba died in June 2018 with $700,000 of assets held in a 10-year GRAT.  At the time the GRAT was created in June of 2010 with a contribution of $1.5 million, the annuity was calculated to be $183,098.70 per year (based on an interest rate of 3.8 percent and a zeroed-out gift).   The amount included in Bubba’s gross estate would be the lesser of $700,000 (the FMV of the GRAT assets at the time of death) or $5,385,255.88 (the value of the GRAT annuity paid into perpetuity ($183,098.70/.034)).  Thus, the amount included in Bubba’s estate would be $700,000.   

To minimize the risk of assets being included in the grantor’s estate, shorter GRAT terms are generally selected for older individuals.  There is no restriction in the law as to how long a GRAT term must be.  For example, Kerr v. Comr., 113 T.C. 449 (1999), aff’d., 292 F.3d 490 (5th Cir. 2002) involved a GRAT with a term of 366 days, and there is no indication in the court’s opinion that the term was challenged.  In Priv. Ltr. Rul. 9239015 (Jun. 25, 1992), the IRS blessed a GRAT with a two-year term.  

Perhaps the risk of the grantor dying during the GRAT term has been minimized.  In Walton v. Comr., 115 T.C. 589 (2000), the Tax Court concluded that the value of an annuity payable over a term to the grantor and to the grantor’s estate if the grantor dies during the GRAT term is not reduced by the value of the contingent interest in the grantor’s estate.  The reason the Tax Court gave was because a fixed annuity payable to the grantor or the grantor’s estate does not constitute a “qualified interest” under I.R.C. §2702.  Thus, a GRAT may be created with a fixed term that will not end upon the grantor’s death, and the annuity that is paid to the grantor during life and to the estate at death during the GRAT’s term will be included in the value of the retained annuity interest – and, thus, give a value to the remainder interest.  The IRS may not agree with the result in Walton (particularly outside of the Eighth Circuit).  But, the Tax Court’s opinion is a full Tax Court opinion that is applicable nationwide.

GRAT Advantages and Disadvantages

Advantages.  For large transfers, a GRAT reduces the gift tax cost of transferring assets as compared to a direct gift.  Also, the GRAT receives grantor trust status which allows the grantor to borrow funds from the GRAT and the GRAT can borrow money from third parties (however, the grantor must report as income the amount borrowed).  Tech. Adv. Memo. 200010010 (Nov. 23, 1999)).  Also, the GRAT term can safely be as short as two years. 

Disadvantages.  Upon formation, some of the grantor’s applicable exclusion might be utilized.  But this likelihood has been reduced in recent years given the substantial increase in the federal estate and gift tax exemption amount.  Also, the grantor must survive the GRAT term to avoid having any part of the GRAT assets being included in the grantor’s gross estate (but see the discussion about the Walton case above).  Another potential disadvantage of a GRAT is that notes or other forms of indebtedness cannot be used to satisfy the required annuity payments.  Treas. Reg. §25.2702-3(d)(2).  In addition, the grantor continues to pay income taxes on all of the GRAT’s income that is earned during the GRAT term. 

When to Consider Using a GRAT

So, when should a GRAT be utilized as a part of an estate/business succession plan?  If the grantor has assets that are likely to appreciate more than the I.R.C. §7520 rate, it is a good way to transfer value to the grantor’s children.  Also, in situations where the unified credit exemption has already been used, a zeroed-out GRAT may still be used because it does not trigger a taxable gift to the remainder beneficiaries.   

Conclusion

The GRAT is another way to pass interests in the farming or ranching operation to the next generation.  While it’s not a technique for everyone, it can be helpful for those with substantial wealth a a desire to pass the business to the next generation.  Also, keep in mind that the present level of the federal estate and gift tax exclusion amount of $12.06 million is scheduled to “sunset” after 2025.  After that, under present law, the exclusion will drop to $5 million (in 2011 dollars) with an inflation adjustment. 

March 11, 2022 in Business Planning, Estate Planning | Permalink | Comments (0)

Monday, March 7, 2022

Should An IDGT Be Part of Your Estate Plan?

Overview

Because of the failure of the “Build Back Better” legislation last year, the federal estate tax remains a non-concern for the vast majority of people.  But, for some larger farming operations as well as some non-ag businesses and high-wealth individuals, planning to avoid the full impact of the federal estate tax is necessary.   

Note:  If the Congress does nothing, the federal estate and gift tax exemption will fall to $5,000,000 (in 2011) dollars beginning January 1, 2026. That will subject more estates to potential taxation.

If an estate planning goal is transferring business interests and/or investment wealth to a successive generation, one aspect of the estate plan might involve the use of an Intentionally Defective Grantor Trust (IDGT).  The IDGT allows the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period.  

The use of the IDGT for transferring asset values from one generation to the next in a tax-efficient manner – it’s the topic of today’s post.

What Is An IDGT?

In general.  An IDGT is an irrevocable trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death. Normally, an irrevocable trust is a tax entity distinct from the grantor and has its own income and deductions (net of distributions paid to beneficiaries) reported on its own income tax return.  Because of the irrevocable nature of the trust, the assets transferred to the trust are generally removed for the grantor’s estate for federal estate purposes. Conversely, a grantor trust is a trust where the income is taxed to the grantor because the grantor is treated as the owner for federal and state income tax.  Thus, a separate return need not be prepared for the trust, but the trust assets are generally included in the grantor’s estate at death. 

An IDGT is characterized by having advantages of both an irrevocable trust for estate tax purposes and a grantor trust for income tax purposes.  For federal income tax purposes, the trust is designed to be a grantor trust under I.R.C. §§671-678.  That means that the grantor (or a third party) retains certain powers causing the trust to be treated as a grantor trust for income tax purposes.  For example, common IDGT provisions include (1) a power exercisable by the grantor (in a non-fiduciary capacity) to reacquire trust assets by substituting assets of equivalent value. I.R.C. §675(4)(C); (2) a power held by a non-adverse party to add to the class of beneficiaries (other than the grantor’s after-born or after-adopted children). I.R.C. §674(a); or (3) a power to enable the trustee to loan money or assets to the grantor from the trust without adequate security. I.R.C. §675(2).

However, those retained powers do not cause the trust assets to be included in the grantor’s estate under I.R.C. §§2036-2042.  This is what makes the trust “defective.”   The seller (grantor) and the trust are treated as the same taxpayer for income tax purposes.  However, an IDGT is defective for income tax purposes only - the trust and transfers to the trust are respected for federal estate and gift tax purposes.  For example, the transfer of property to the trust qualifies for the gift tax annual exclusion of §I.R.C. §2503(b)(1)-(2).  In addition, grantor trust status still applies even though the grantor retains a withdrawal power over income and/or corpus.  See, e.g., Priv. Ltr. Rul. 200606006 (Oct. 24, 2005); Priv. Ltr. Rul. 200603040 (Oct. 24, 2005); Priv. Ltr. Rul. 200729005 (Mar. 27, 2007). 

Note:  The IDGT’s income and appreciation accumulates inside the trust free of gift tax and also free of generation-skipping transfer tax (if the grantor allocates the grantor’s generation-skipping transfer tax exemption to the assets transferred to the trust). 

The IDGT transaction is structured so that a completed gift occurs for gift and estate tax purposes, with no resulting income tax consequences (because the trust is a grantor trust).  

Note:  Because the transfer is a completed gift, the trust receives a carryover basis in the gifted assets.

How Does An IDGT Transaction Work?

Gift.  One approach to funding an IDGT is by the grantor gifting assets to the trust.  If the value of the assets transferred are less than the applicable exclusion amount (presently $12.06 million for deaths or gifts made in 2022 - $24.12 million for a married couple), gift tax is not triggered on the transfer, but the applicable exclusion would be reduced by the amount of the gift.  Form 709 would need to be filed reporting the gift and showing the reduction in the applicable exclusion unified credit. 

Note:  A variant of the outright gift approach involves a part-gift, part-sale transaction.  This is done where it is beneficial to leverage the amount of assets transferred to the IDGT, preserve the applicable exclusion or retain income.    

Sale and note.  Another technique to fund an IDGT involves the grantor selling highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note (such as a self-canceling installment note).  There is no capital gains tax on the sale.  In addition, the trust is an eligible S corporation shareholder.   I.R.C.  §1361(c)(2)(A).   The grantor is also not taxed on the interest payments received from the trust.   Rev. Rul. 85-13, 1985-1 C.B. 184.  The installment sale also freezes the value of appreciation on assets sold at the Applicable Federal Rate (AFR).  This is a particularly effective strategy in a low interest rate environment. 

The grantor should make an initial “seed” gift of at least 10 percent of the total transfer value to the trust so that the trust has sufficient capital to make its payments to the grantor.  The sale (or other transaction) between the trust and the grantor are not income tax events, and the trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.

Interest on the installment note is set at the Applicable Federal Rate (AFR) for the month of the transfer that represents the length of the note’s term.  I.R.C. §1274.

Note:  The mid-term AFR for March of 2022 is 1.73 percent (semi-annual compounding).  Rev. Rul. 2022-4, 2022-10 I.R.B.

The installment note can call for interest-only payments for a period of time and a balloon payment at the end, or it may require interest and principal payments.   Given the current low interest rates, it is reasonable for the grantor to expect to receive a total return on the IDGT assets that exceeds the rate of interest.  Indeed, if the income/growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note taken back by the grantor, the “excess” growth/income is passed on to the trust beneficiaries free of any gift, estate and/or Generation Skipping Transfer Tax (GSTT).

The IDGT technique became popular after the IRS issued a favorable letter ruling in 1995 that took the position that I.R.C. §2701 would not apply because a debt instrument is not an applicable retained interest. Priv. Ltr. Rul. 9535026 (May 31, 1995).  I.R.C. §2701 applies to transfers of interests in a corporation or a partnership to a family member if the transferor or family member holds and “applicable retained interest” in the entity immediately after the transfer.  However, an “applicable retained interest” is not a creditor interest in bona fide debt.   The IRS, in the same letter ruling also stated that a debt instrument is not a term interest, which meant that I.R.C. §2702 would not apply.  If the seller transfers a remainder interest in assets to a trust and retains a term equity interest in the income, I.R.C. §2702 applies which results in a taxable gift of the full value of the property sold.  For instance, a sale in return for an interest only note with a balloon payment at the end of the term would result in a payment stream that would not be a qualified annuity interest because the last payment would represent an increase of more than 120 percent over the amount of the previous payments. 

Note:  For a good article on this point see Hatcher and Manigualt, “Using Beneficiary Guarantees in Defective Grantor Trusts,” 92 Journal of Taxation 152 (Mar. 2000).

A crucial aspect of the installment note from an income tax and estate planning/business succession planning standpoint is that it must constitute bona fide debt.  If the debt amounts to an equity interest, then I.R.C. §§2701-2702 apply and a large gift taxable gift could be created or the transferred assets will end up being included in the grantor’s estate.  In Karmazin v. Comr., T.C. Docket No. 2127-03 (2003), the IRS took the position that I.R.C. §§2701-2702 applied to the sale of limited partnership interests to a trust which would cause them to have no value for federal gift tax purposes on the theory that the notes the grantor received were equity instead of debt.  The case was settled before trial on terms favorable to the taxpayer (the only adjustment was a reduction of the valuation discount from 42 percent to 37 percent) with the parties agreeing that neither I.R.C. §2701 or I.R.C. §2702 applied.  However, IRS resurrected the same arguments in Estate of Woelbing v. Comr., T.C. Docket No. 30261-13 (filed Dec. 26, 2013).  The parties settled the case before trial with a stipulated decision entered on Mar. 25, 2016, that resulted in no additional gift or estate tax.  The total amount of the gift tax, estate tax, and penalties at issue was $152 million. 

Another concern is that I.R.C. §2036 causes inclusion in the grantor’s estate of property the grantor transfers during life for less than adequate and full consideration if the grantor retained for life the possession or enjoyment of the transferred property or the right to the income from the property, or retained the right to designate the persons who shall possess or enjoy the property or the income from it.  But, again, in the context of an IDGT, if the installment note represents bona fide debt, the grantor does not retain any interest in the property transferred to the IDGT and the transferred property is not included in the grantor’s estate at its date-of-death value.

All of the tax benefits of an IDGT turn on whether the installment note is bona fide debt.  Thus, it is critical to structure the transaction properly to minimize the risk of the IRS taking the position that the note constitutes equity for gift or estate tax purposes.  That can be accomplished by observing all formalities of a sale to an unrelated party, providing sufficient seed money, having the beneficiaries personally guarantee a small portion of the amount to be paid under the note, not tying the note payments to the return on the IDGT assets, actually following the scheduled note payments in terms of timing and amount, making the note payable from the trust corpus, not allowing the grantor control over the property sold to the IDGT, and keeping the term of the note relatively short.  These are all indicia that the note represents bona fide debt.      

Pros and Cons of IDGTs

Value freezing.  An IDGT has the effect of freezing the value of the appreciation on assets that are sold to it in the grantor’s estate at the low interest rate on the installment note payable.  Additionally, as previously noted, there are no capital gain taxes due on the installment note, and the income on the installment note is not taxable to the grantor. 

Note:  Any valuation discount will increase the effectiveness of the sale for estate tax purposes. 

Payment of income tax liability.  If the grantor uses funds from outside the IDGT to pay the tax liability on income generated by the assets in the IDGT, that has the effect of leaving more assets in the IDGT for the remainder beneficiaries that would result if the trust were a standard irrevocable trust.  It also reduces the grantor’s taxable estate in an amount equal to the income taxes that the grantor pays and helps to preserve the trust by not reducing it with the trust’s payment of the income taxes. 

Because the grantor pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, the grantor is not treated as making a gift of the amount of the income tax to the trust beneficiaries for gift tax purposes.  Rev. Rul. 2004-64, 2004-27 I.R.B. 7.  However, there is a difference in the estate tax treatment depending on the trust’s language.  For instance, if the trust’s language (or state law) requires the trustee to reimburse the grantor for the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, then the full value of the trust’s assets is includible in the grantor’s gross estate via I.R.C. §2036(a)(1) for federal estate tax purposes  This is true even though the trust’s beneficiaries are not treated as making a gift of the amount of the income tax to the grantor.  Id.   Conversely, if the trust language gives the trust the discretion to reimburse the grantor for that portion of the grantor’s income tax liability attributable to the trust’s income, the discretion (whether exercised or not) will not (by itself) cause the value of the trust’s assets to be includible in the grantor’s gross estate.  But such discretion combined with other facts (such as a pre-existing arrangement regarding the trustee’s exercise of discretion) could cause inclusion of the trust assets in the grantor’s estate.  Id. 

Life insurance.  An IDGT can purchase an existing life insurance policy on the life of the grantor without subjecting the policy to taxation under the transfer-for-value rule. Rev. Rul. 2007-13, 2007-1 C.B. 684.

Grantor’s death during term of note.  On the downside, if the grantor dies during the term of the installment note, the note is included in the grantor’s estate. 

Income tax basis.  There is no stepped-up basis in trust-owned assets upon the grantor’s death. 

Cash flow.  Because trust income is taxable to the grantor during the grantor’s life, the grantor could experience a cash flow problem if the grantor does not earn sufficient income. 

Funding.  There is possible gift and estate tax exposure if insufficient assets are used to fund the trust.  As noted above, 10 percent seed funding is recommended to reduce the risk that the sale will be treated as a transfer with a retained interest by the grantor.    

Administrative Issues with IDGT’s

An IDGT is treated as a separate legal entity.  That means that a separate bank account must be opened for the IDGT so that it can receive the “seed” gift and annual cash inflows and outflows. The grantor’s Social Security number is used for the bank account.   An amortization schedule will need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.

Conclusion

Structured properly an IDGT can be a useful tool in the estate planner’s arsenal for moving wealth from one generation to the next with minimal tax cost.  That’s especially true for highly appreciating assets and family business assets.  It can be used to shift large amounts of wealth to heirs and create estate tax benefits.  The trust language should be carefully drafted to provide the grantor with sufficient retained control over the trust to trigger the grantor trust rules for income tax purposes, but insufficient control to cause inclusion in the grantor’s estate.  In other words, the trust language must contain sufficient provisions requiring the trust to be deemed a revocable trust for income tax purposes, but an irrevocable trust (as a completed transfer) for estate tax purposes. 

Given the highly technical nature of the IDGT rules, it is critical to get good legal and tax counsel before trying the IDGT strategy.

March 7, 2022 in Business Planning, Estate Planning | Permalink | Comments (0)

Saturday, March 5, 2022

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

Overview

In December, I posted a “hold-the-date” announcement for the 2022 summer national farm income tax/estate and business planning conferences that Washburn Law School will be conducting this summer.  The itineraries for each event are now finalized and registration will open soon.  Some have already booked their lodging and made travel plans.  The events are the highest quality, most practical professional tax and legacy planning conferences for practitioners with farm and ranch clients you can find anywhere in 2022.  Both conferences will also be simulcast live online in the event you aren’t able to attend in person.  In addition, each conference provides one hour of ethics for attorneys, CPAs and other tax practitioners. 

On June 13 and 14, the conference will be held at the Chula Vista Resort near the Wisconsin Dells.  On August 1 and 2, the conference will be at Fort Lewis College in Durango, Colorado.

In today’s article, I detail the speakers and the itineraries for each location.  2002 summer seminars – it’s the topic of today’s post.

The Speakers

In addition to myself, the following make the line-ups for the conferences:

Wisconsin Dells 

Joining me on Day 1 will be Paul Neiffer.  Paul is a CPA with CliftonLarsonAllen out of Walla Walla Washington.  He and I have worked together on numerous tax conferences for the past decade.  He specializes in income taxation, accounting services, and succession planning for farmers and agribusiness processors.  He is also a contributor at agweb.com and writes the Farm CPA Today blog. 

Also making presentations at the Wisconsin Dells conference will be Carlos Ramon, Dr. Allen Featherstone and Prof. Peter Carstensen.  Here are their brief bios:

Carlos Ramon.  Carlos is the Program Manager, Cyber & Forensic Services, with the IRS Criminal Investigation Division (IRS-CID).  He has over nineteen years of federal law enforcement experience, the last 16 of which have been with the IRS-CID.  With IRS-CID, Carlos has served (among other things) as an ID Theft Coordinator, and Program Manager for Cyber and Forensic Services. He is specially trained in different IRS-CI programs responsible for investigating criminal violations of the Internal Revenue Code and related financial crimes involving tax, money laundering, public corruption, cyber-crimes, identity theft, and narcotics.  Carlos holds a bachelor’s degree in Animal Science from Penn State University, a master’s in business administration from the Inter American University of Puerto Rico, and a Doctorate in Business Administration in Management Information System from the Ana G Mendez University. 

Dr. Allen M. Featherstone.  Dr. Featherstone is the Department Head of the Agricultural Economics Department at Kansas St. University where he also is the Director of the Master in Agribusiness Program.  His academic focus is on agriculture finance and his production economics research has investigated issues such as ground water allocation in irrigated crop production, comparison of returns under alternative tillage systems, the costs of risk, interactions of weather soils, and management on corn yields, analysis of the returns to farm equity and assets, and analysis of the optimizing behavior of Kansas farmers, examining the stability of estimates using duality, and examining the application of a new functional forms for estimating production relationships.

Peter C. Carstensen.  Prof. Carstensen is Professor of Law Emeritus at the University of Wisconsin School of Law.  From 1968-1973, he was an attorney at the Antitrust Division of the United States Department of Justice assigned to the Evaluation Section, where one of his primary areas of work was on questions of relating competition policy and law to regulated industries.  He has been a member of the faculty of the UW Law School since 1973.  He is also a Senior Fellow of the American Antitrust Institute.  His scholarship and teaching have focused on antitrust law and competition policy issues.  IN 2017, he published Competition Policy and the Control of Buyer Power, which received the Jerry S. Cohen Memorial Fund Writing Award for best antitrust book of 2017. 

Durango

The Day 1 lineup and topics are the same at the Durango event as they are at the Wisconsin Dells event.  Joining me on Day 2 at Durango will be the following:

Timothy P. O’Sullivan.  Tim is a senior partner with the Foulston law firm in Wichita, Kansas.  He represents clients primarily in connection with their estate and tax planning and the administration of trusts and estates. As part of his practice, Mr. O’Sullivan crafts wills, testamentary trusts, revocable living trusts, irrevocable trusts, dynasty or other types of generation-skipping trusts, “special needs” trusts, financial and healthcare powers of attorney, living wills, premarital agreements, stock purchase or buy-sell agreements, strategic gifting and estate tax planning, asset protection planning, governmental resource planning (e.g., Medicaid and SSI), family business succession plans, premarital agreements, IRA, 401k or other tax deferred beneficiary designations and deferral strategies, life insurance structures, family limited partnerships and limited liability companies, grantor retained annuity trusts (GRATs), private annuities, self-canceling installment notes (SCINs) and other instruments and estate planning techniques. A substantial portion of Mr. O’Sullivan’s practice also involves advising clients on strategies and provisions which enhance the preservation of family harmony in the estate planning process.

Mary Ellen Denomy.  Mary is a CPA with a specialty in oil and gas accounting, valuations and audits.  She is an Accredited Petroleum Accountant, Certified Fraud Deterrent Analyst and Master Analyst in Financial Forensics.  She has spoken across the country on oil and gas issues, been interviewed frequently and has testified as a successful expert.  Mary Ellen is a former member of the Board of the National Association of Royalty Owners (NARO), the Board of Examiners of the Council of Petroleum Accountants Societies, Past President of NARO-Rockies and former Trustee of Colorado Mountain College.  She is currently a licensed CPA in both Colorado and Arizona.

Mark Dikeman.  Mark is the Associate Director of the Kansas Farm Management Association as part of the Department of Agricultural Economics at Kansas State University.  Mark is responsible for implementing and maintaining an Extension educational farm business management program for commercial farms, resulting in the development of financial and production information to be used for comparable economic analysis by the farms as well as for research, policy and teaching.

John Howe.  John practices law in Grand Junction, Colorado with the law firm of Hoskin, Farina and Kampf.  John was raised in Southwestern Colorado and attended the Colorado School of Mines, graduating in 1983 with a bachelor’s degree in geophysical engineering. After a short stint in the oil and gas exploration industry, John attended the University of Colorado School of Law, graduating in 1989.  Following graduation, he clerked for Justice William H. Erickson of the Colorado Supreme Court and has practiced water and real estate law in Grand Junction for more than thirty years.

Michael K. Ramsey.  Mike is a partner in the firm of Hope, Mills, Bolin, Collins & Ramsey LLP located in Garden City, Kansas.  His law practice includes water rights, landowner oil and gas rights, agricultural business and estate planning.  Mike is a partner in an irrigated farming operation located in southwest Kansas. He has spoken on water law topics in Kansas to attorneys, financial institutions, utility company board members, agricultural producers, legislative committees and others. His clients have included users of surface and groundwater for irrigation, livestock, industrial and municipal purposes and groundwater management districts.  He a co-author with Peck, J. and Pitts, D. of "Kansas Water Rights: Changes and Transfers," 57 J.K.B.A. 21 (July 1988) and author of "Kansas Groundwater Management Districts: A Lawyer's Perspective," Vol. XV No. 3 Kan. J. of Law & Pub. Policy 517 (2006).  Mike’s law degree is from the University of Kansas School of Law.

Andrew Morehead.  Andy is a Public Accountant and Certified Financial Planner with a farm and small business practice in Eaton, Colorado and Torrington, Wyoming. He is a Past President of the National Society of Accountants, and is also a Past President of the Public Accountants Society of Colorado.  Andy is a former cattle rancher and farm equipment dealer in western Wyoming, and has taught at various tax-related professional continuing education programs for many years.

Shawn Leisinger.  Shawn is the Associate Dean for Centers and External Programs where he oversees development of Center programs and events that are held throughout the year. He also coordinates all continuing legal education programs sponsored by Washburn Law and other special events.  Shawn joined Washburn University School of Law on a full-time basis in 2010. Previously he served as Assistant General Counsel to the Kansas Corporation Commission Oil and Gas Conservation Division and as Assistant Shawnee County (Kansas) Counselor. Leisinger has coached the Washburn Law American Bar Association Client Counseling competition team since 2003 and the Negotiation competition team since 2008. He has also taught the Interviewing and Counseling and the Professional Responsibility courses and regularly teaches continuing legal education sessions.

Daily Schedules

Wisconsin Dells.  Here is how the topical sessions break out each day at the Wisconsin Dells conference (the speaker for each topic is indicated in parenthesis after the title of each session):

Day 1:

8:00 a.m.-8:05 a.m. – Welcome and Announcements

8:05 a.m.-9:05 a.m. - Tax Update – Key Rulings and Cases from the Past Year (or so) (McEowen)

This opening session begins with a review of the most significant recent income tax cases, IRS rulings and other tax administrative developments.  This session will help you stay on top of the ever-changing interpretations of tax law that impact your clients.   

9:05 a.m.-9:35 a.m. - Reporting of WHIP and Other Government Payments (Neiffer)

Farmers that participate in federal farm programs have unique tax reporting requirements and the programs have unique tax rules that apply.  This session will provide a review of the basic tax rules surrounding farm program payments, including new USDA programs that have been created for farmers in recent years.  Also reviewed will be the options for deferring revenue protection policies.

9:35 a.m.-9:55 a.m. (Morning Break)

9:55 a.m.-10:20 a.m. - Fixing Bonus Elections and Computations (McEowen)

The TCJA made several changes to bonus depreciation and the IRS issued a Revenue Procedure in 2019 allowing modifications of a bonus election.  Final regulations were published in late 2020 that withdrew a “look-through” rule for partnerships and clarify the application of I.R.C. §743(b) adjustments.  This session brings tax preparers up-to-date on dealing with changes to bonus elections and related computations.

10:20 a.m.-10:50 a.m. - Research and Development Credits (Neiffer)

Beginning in 2022, taxpayers must provide particular information when claiming a refund for research and development credits under I.R.C. §41 on an amended return.  What information is required?  What business components must be identified, and how are research activities performed to be documented?  How can an insufficient claim be perfected?  These issues and more will be addressed.

10:50 a.m.-11:20 a.m. – Farm NOLs (Neiffer)

In 2021, the IRS issued guidance on how farm taxpayers are to handle carryback elections related to farm net operating losses (NOLs) in light of all of the legislative rule changes in recent years.  This session reviews the guidance and illustrates how a farm taxpayer can elect to not apply certain NOL rules of the CARES Act, and how the COVID-Related Tax Relief Act (CTRA) election can be revoked. 

11:20 a.m.-Noon  -  The Taxability of Retailer Reward Programs; Tax Rules Associated with Demolishing Farm Structures (McEowen)

This session addresses the tax issues associated with farm clients receiving “rewards” from retailers that they transact business with.  How are the “rewards” to be reported?  Is the information that the retailer provides to the farmer correct?  This session sorts it out.  In addition, this session covers the proper tax treatment of demolishing farm structures.  Significant weather events in recent months in large areas of farm country destroyed or significantly damaged many farm structures.  When those structured are beyond repair and are demolished, what is the proper way to handle it for tax purposes? 

Noon-1:00 p.m. – Lunch

1:00 p.m.  – 2:15 p.m. IRS-CI: Emerging Cyber Crimes and Crypto Tax Compliance (Ramon)

This session explains how to identify a business email compromise and/or data breach and how to respond to it.  The session will also identify what the Dark Web is and how it is utilized for cybercrimes and identity theft.  Likewise, the session will help attendees to recognize the general terminology and tax treatment pertaining to virtual/crypto currency. In addition, the session will allow participants to gain a better understanding of the efforts by IRS-Criminal Investigation to combat cyber criminals and illicit activity.

2:15 p.m. – 2:45 p.m.  Potpourri – Part 1 (McEowen and Neiffer)

This session includes discussion of numerous tax issues of importance to farmers and ranchers.  The topics covered include how machinery trade transactions are handled and reported on Form 4797 and Form 4562; inventory accounting issues (what is included in inventory; how the Uniform Capitalization Rules impact inventory accounting; when accrual accounting is required; inventory valuation methods; and crop accounting).  Also covered will be the tax treatment of early termination of CRP contracts; partnership reporting; weather-related livestock sales; and contribution margin analysis

2:45 – 3:05 p.m. - Afternoon Break

3:05 p.m. – 4:25 p.m. Potpourri (cont.) (McEowen and Neiffer)

The potpourri session continues…and concludes.

Day 2:

7:30 a.m. – 8:00 a.m. – Registration

8:00 a.m. – 8:05 a.m. – Welcome and announcements

8:05 a.m. – 9:00 a.m. - Estate and Business Planning Caselaw and Ruling Update (McEowen)

Day 2 begins with a review of the big developments in the courts and with the IRS involving estate planning, business planning and business succession.  Stay on top of the issues impacting transition planning for your clients by learning how legal, legislative and administrative developments impact the estate and business planning process.

9:00 a.m. – 9:50 a.m. – The Use of IDGTs (and other strategies) For Succession Planning (McEowen)

Estate planning with intentionally defective grantor trusts (IDGTs) can have many advantages. This session will discuss the ins and outs of IDGTs, including how they may be a part of developing comprehensive estate plans and how they can be tax “effective” for federal estate tax purposes.

9:50 – 10:10 a.m. – Morning Break

10:10 a.m. – 11:25 a.m. – The Ag Economy and the Impact on Farm/Ranch Clients (Part 1)

Between the Upper and Nether Stone: Anticompetitive Conduct Grinding Down Farmers (Carstensen)

Enforcement of antitrust and related competition laws has become a major focus of the Biden Administration.  One primary area of concern is agriculture.  Farmers face significant risks of harm in their supply markets.  The impacts come from a variety of places: equipment which they cannot repair because of restraints imposed by the manufacturer, seeds and other inputs sold by a limited number of suppliers who restrict resale and lower cost distribution, increased prices of fertilizer associated with increased concentration in the production of that input.  On the output side, there is increased concentration in the markets into which farmers sell many of their crops and livestock.  Recently litigation has highlighted how a cartel of poultry integrators exploited growers, consumers, and workers.  Similar claims are pending in other output markets.  This presentation will provide a survey of the issues and the potential for positive or negative impact on farmers and their bottom line.

11:25 a.m. – Noon - Post-Death Dissolution of S Corporation Stock and Stepped-Up Basis; Last Year of Farming; Deferred Tax liability and Conversion to Form 4835 (McEowen)

Noon – 1:00 p.m. – Luncheon

1:00 p.m. – 2:15 p.m. - The Ag Economy and the Impact on Farm/Ranch Clients (Part 2)

Agricultural Finance and Land Situation – (Featherstone)

The current agricultural finance situation and land will be discussed.  Information will be provided on past, recent, and future developments.  Information on the income situation, the financial health of farm operations, and current land market trends will be provided.

2:15 – 2:55 p.m. – Post-Death Basis Increase – Is Gallenstein Still in Play?; Using an LLC to Make an S Election – (McEowen)

Can surviving spouses in non-community property states get a full basis step-up in jointly held property when the first spouse dies?  Gallenstein may still apply for some clients – what are those situations and what does it mean?  Also, the session will examine the procedures involved and the Forms to be filed when an S election is made via a limited liability company. 

2:55 p.m. – 3:15 p.m. Afternoon Break

3:15 p.m. – 3:25 p.m. – Getting Clients Engaged in the Estate/Business Planning Process – (McEowen)

In this brief session, a checklist will be provided designed to assist practitioners in getting clients engaged in the estate, business and succession planning process.  What can be done “jump start” the process for clients?

3:25 p.m. – 4:25 p.m.  – Ethical Problems in Estate and Income Tax Planning – (McEowen)

This session focuses on ethical situations that practitioners often encounter when counseling clients on estate/business planning or income tax planning.  The governing ethical rules are often not carefully tailored for estate and tax planners/preparers, and competing responsibilities often bedevil the professional.  So, how can the estate planning and/or income tax preparer stay “within the rails”?  This session will address the primary rules including the application of relevant portions of Circular 230.

Durango Seminar

Day 1:

8:00 a.m.-8:05 a.m. – Welcome and Announcements

8:05 a.m.-9:05 a.m. - Tax Update – Key Rulings and Cases from the Past Year (or so) (McEowen)

This opening session begins with a review of the most significant recent income tax cases, IRS rulings and other tax administrative developments.  This session will help you stay on top of the ever-changing interpretations of tax law that impact your clients.  

9:05 a.m.-9:35 a.m. - Reporting of WHIP and Other Government Payments (Neiffer)

Farmers that participate in federal farm programs have unique tax reporting requirements and the programs have unique tax rules that apply.  This session will provide a review of the basic tax rules surrounding farm program payments, including new USDA programs that have been created for farmers in recent years.  Also reviewed will be the options for deferring revenue protection policies.

9:35 a.m.-9:55 a.m. - Morning Break

9:55 a.m.-10:20 a.m. - Fixing Bonus Elections and Computations (McEowen)

The TCJA made several changes to bonus depreciation and the IRS issued a Revenue Procedure in 2019 allowing modifications of a bonus election.  Final regulations were published in late 2020 that withdrew a “look-through” rule for partnerships and clarify the application of I.R.C. §743(b) adjustments.  This session brings tax preparers up-to-date on dealing with changes to bonus elections and related computations.

10:20 a.m.-10:50 a.m. - Research and Development Credits (Neiffer)

Beginning in 2022, taxpayers must provide particular information when claiming a refund for research and development credits under I.R.C. §41 on an amended return.  What information is required?  What business components must be identified, and how are research activities performed to be documented?  How can an insufficient claim be perfected?  These issues and more will be addressed.

10:50 a.m.-11:20 a.m. – Farm NOLs (Neiffer)

In 2021, the IRS issued guidance on how farm taxpayers are to handle carryback elections related to farm net operating losses (NOLs) in light of all of the legislative rule changes in recent years.  This session reviews the guidance and illustrates how a farm taxpayer can elect to not apply certain NOL rules of the CARES Act, and how the COVID-Related Tax Relief Act (CTRA) election can be revoked. 

11:20 a.m.-Noon  -  The Taxability of Retailer Reward Programs; Tax Rules Associated with Demolishing Farm Structures (McEowen)

This session addresses the tax issues associated with farm clients receiving “rewards” from retailers that they transact business with.  How are the “rewards” to be reported?  Is the information that the retailer provides to the farmer correct?  This session sorts it out.  In addition, this session covers the proper tax treatment of demolishing farm structures.  Significant weather events in recent months in large areas of farm country destroyed or significantly damaged many farm structures.  When those structured are beyond repair and are demolished, what is the proper way to handle it for tax purposes? 

Noon-1:00 p.m. – Luncheon

1:00 p.m.  – 2:15 p.m. IRS-CI: Emerging Cyber Crimes and Crypto Tax Compliance (Ramon)

This session explains how to identify a business email compromise and/or data breach and how to respond to it.  The session will also identify what the Dark Web is and how it is utilized for cybercrimes and identity theft.  Likewise, the session will help attendees to recognize the general terminology and tax treatment pertaining to virtual/crypto currency. In addition, the session will allow participants to gain a better understanding of the efforts by IRS-Criminal Investigation to combat cyber criminals and illicit activity.

2:15 p.m. – 2:45 p.m.  Potpourri – Part 1 (McEowen and Neiffer)

This session includes discussion of numerous tax issues of importance to farmers and ranchers.  The topics covered include how machinery trade transactions are handled and reported on Form 4797 and Form 4562; inventory accounting issues (what is included in inventory; how the Uniform Capitalization Rules impact inventory accounting; when accrual accounting is required; inventory valuation methods; and crop accounting).  Also covered will be the tax treatment of early termination of CRP contracts; partnership reporting; weather-related livestock sales; and contribution margin analysis

2:45 – 3:05 p.m. - Afternoon Break

3:05 p.m. – 4:25 p.m. Potpourri (cont.) (McEowen and Neiffer)  

The potpourri session continues…and concludes.

DAY 2: 

7:30 a.m. – 8:00 a.m. – Registration

8:00 a.m. – 8:05 a.m. – Welcome and announcements

8:05 a.m. – 9:00 a.m. - Estate and Business Planning Caselaw and Ruling Update (McEowen)

Day 2 begins with a review of the big developments in the courts and with the IRS involving estate planning, business planning and business succession.  Stay on top of the issues impacting transition planning for your clients by learning how legal, legislative and administrative developments impact the estate and business planning process.

9:00 a.m. – 9:45 a.m. – The Use of IDGTs (and other strategies) For Succession Planning (McEowen)

Estate planning with intentionally defective grantor trusts (IDGTs) can have many advantages. This session will discuss the ins and outs of IDGTs, including how they may be a part of developing comprehensive estate plans and how they can be tax “effective” for federal estate tax purposes.

9:45 a.m. – 10:05 a.m.  – Morning Break

10:05 – 11:00 a.m. – Estate Planning to Minimize Income Taxation:  From the Mundane to the Arcane (O’Sullivan)

With the failure of the Biden legislative agenda in 2021 that would have had a deleterious effect on many estate planning techniques, and with estate and gift tax reduction techniques continuing to be relevant (for the immediate future) to a small minority of the population, income tax reduction techniques continue to be the major tax focus of the estate planner’s regimen.  This session will initially address simple, well understood but infrequently utilized- estate planning strategies, and then gravitate to more advanced complex techniques both within and without non-grantor trusts. These techniques can substantially reduce the income taxation burden on beneficiaries of estate plans while carrying out the grantor’s/testator’s other important estate planning goals, including asset protection, maintenance of plan integrity, flexibility and charitable giving.  Learn the techniques that can be implemented for particular clients.

11:00 a.m. – Noon – Oil and Gas Royalties and Working Interest Payments:  Taxation, Planning and Oversight (Denomy)

This presentation will cover how to properly report royalties and working interest payments on current tax returns.  We will then begin to look at estate planning recommendations for your clients.  Also discussed will be issues that you may be able to advise your clients about concerning whether they are being paid according to their agreements.  The session concludes with what it means to be called to be an expert as your client’s CPA.

Noon – 1:00 p.m. - Luncheon

1:00 p.m. – 1:50 p.m. - Economic Evaluation of a Farm Business (Dikeman)

This session will address key components of analyzing the economic health of a farm business.  How much did a farm really make?  Evaluating the economic performance of an agricultural business can be complicated.  With prepaid expenses and generous depreciation options, it is difficult to gauge farm performance especially by looking only at a tax return.  This session will look at the impact of income tax management decisions on the economic performance of a farm business.

1:50 p.m. – 3:05 p.m. – Appropriation Water Rights - Tax and Estate Planning Issues (Mike Ramsey; Andy Morehead; John Howe)

The panel will explore the nature and types of appropriation water rights that practitioners may encounter with their clients, jurisdictional differences and whether the rights are real or personal property interests.  Common ownership, conveyance and title problems will be discussed. Valuation issues will be addressed. There will be discussion about IRC Section 1031 exchanges and depletion issues with examples commonly encountered in sale and transfer transactions.   Concerning estate planning and estate, gift and generation skipping taxation, the potential use and utility of SLATS (spousal lifetime interest trusts), IDGTs (intentionally defective grantor trusts) and IRC Sections 2032A and 6166 will be covered. The emphasis will be on identification of issues with reference materials for further study.  

3:05 -3:25 p.m. – Afternoon Break

3:25 – 4:25 p.m. - Ethically Negotiating End of Life Family Issues (Leisinger)

This ethics exercise takes a look at the sometimes complex processes and issues that arise at end of life for family members.  Participants will be given confidential information and motivations from two different children of a parent who is at end of life and needing to liquidate assets to pay for nursing home care and other expenses.  Ethical rules for attorneys will be discussed and applied to the negotiation exercise and outcomes that participants will be asked to complete as part of the program. 

Conclusion

Registration will open soon for both events and will be available through my website – washburnlaw.edu/waltr.  I will also post here when registration is open and provide the link for you.  Again, if you aren’t able to attend in person, you may attend online.  Also, if you are a law student or undergraduate student interested in attending law school, please contact me personally for details on a discounted registration rate.

March 5, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Friday, February 25, 2022

Tax Consequences When Farmland is Partitioned and Sold

Overview

I have had farm and ranch families tell me over years that they didn’t need to do estate/succession planning for various reasons and that they would simply “let the children figure it out.”  My retort to that is that if you do that, it’s likely that a judge will figure it out.  Indeed, one of those situations where a judge gets involved is when the parents have left farmland in co-equal ownership to multiple children after the last of the parents to die. 

What is a partition and sale action and what are the tax consequences – it’s the topic of today’s post.

Partition and Sale Action

Partition and sale of land is a legal remedy available if co-owners of land cannot agree on whether to buy out one or more of the co-owners or sell the property and split the proceeds.  It is often the result of a poorly planned farm or ranch estate where the last of the parents to die leaves the farm or ranch land equally to all of the kids and not all of them want to farm or they simply can’t get along.  Because they each own an undivided interest in the entire property, they each have the right of partition and sell to parcel out their interest.  See, e.g., Lowry v. Irish, No. 2019-0269-SG, 2020 Del. Ch. LEXIS 290 (Del. Chanc. Ct. Sept. 18, 2020). But, that rarely is the result because they aren’t able to establish that the tract can be split exactly equally between them in terms of soil type and slope, productivity, timber, road access, water, etc.  So, a court will order the entire property sold and the proceeds of sale split equally.  Tolle v. Tolle, 967 N.W.2d 376 (Iowa Ct. App. 2021); Koetter v. Koetter, No. A-17-1066, 2018 Neb. App. LEXIS 300 (Ct. App. Dec. 18, 2018). 

Note:  The court-ordered sale is most likely an unhappy result, and it can be avoided with appropriate planning in advance. 

Tax Consequences - Basics

What are the tax consequences of a partition and resulting sale?  A partition of property involving related parties comes within the exception to the “related party” rule under the like-kind exchange provision. This occurs in situations where the IRS is satisfied that avoidance of federal income tax is not a principal purpose of the transaction. Therefore, transactions involving an exchange of undivided interests in different properties that result in each taxpayer holding either the entire interest in a single property or a larger undivided interest in any of the properties come within the exception to the related party rule. But, as noted, this is only true when avoidance of federal income tax is not a principal purpose of the transaction.

As for the income tax consequences on the sale of property in a partition proceeding to one of two co-owners, such a sale does not trigger gain for the purchasing co-owner as to that co-owner’s interest in the property.

Is a Partition an Exchange?

If the transaction is not an “exchange,” it does not need to be reported to the IRS, and the related party rules are not involved.  If the property that is “exchanged” is dissimilar, then the matter is different.  Gain or loss is realized (and recognized) from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or extent. Treas. Reg. §1.1001-1(a). In the partition setting, that would mean that items of significance include whether debt is involved, whether the tracts are contiguous, and the extent to which they differ.

IRS ruling.  In 1954, the IRS ruled that the conversion of a joint tenancy in capital stock of a corporation into tenancy in common ownership (to eliminate the survivorship feature) was a non-taxable transaction for federal income tax purposes.  Rev. Rul. 56-437, 1956-2 C.B. 507. See also Priv. Ltr. Rul. 200303023 (Oct. 1, 2002); Priv. Ltr. Rul. 9633034 (May 20, 1996).  Arguably, however, the Revenue Ruling addressed a transaction distinguishable from a partition of property insomuch as the taxpayers in the ruling owned an undivided interest in the stock before conversion to tenancy in common and owned the same undivided interest after conversion. 

Partition as a Severance

A severance is not a sale or exchange.  A partition transaction, by parties of jointly owned property, is not a sale or exchange or other disposition.  See, e.g., Priv. Ltr. Rul. 200328034 (Oct. 1, 2002).  It is merely a severance of joint ownership. For example, assume that three brothers each hold an undivided interest as tenants-in-common in three separate tracts of land.  None of the tracts are subject to mortgages.  They agree to partition the ownership interests, with each brother exchanging his undivided interest in the three separate parcels for a 100 percent ownership of one parcel. None of them assume any liabilities of any of the others or receive money or other property as a result of the exchange. Each continues to hold the single parcel for business or investment purposes. As a result, any gain or loss realized on the partition is not recognized and is, therefore, not includible in gross income.  Rev. Rul. 73-476, 1973-2 C.B. 301.  However, in a subsequent letter ruling issued almost 20 years later, the IRS stated that the 1973 Revenue Ruling on this set of facts held that gain or loss is “realized” on a partition. It did not address explicitly the question of whether the gain or loss was “recognized” although the conclusion was that the gain was not reportable as income.  Priv. Ltr. Rul. 200303023 (Oct. 1, 2002).

To change the facts a bit, assume that two unrelated widows each own an undivided one-half interest in two separate tracts of farmland. They transfer their interests such that each of them now becomes the sole owner of a separate parcel.  Widow A’s tract is subject to a mortgage and she receives a promissory note from Widow B of one-half the amount of the outstanding mortgage.  Based on these facts, it appears that Widow A must recognize gain to the extent of the FMV of the note she received in the transaction because the note is considered unlike property.  Rev. Rul. 79-44, 1979-2 C.B. 265.

Based on the rulings, while they are not entirely consistent, gain or loss on a partition is not recognized (although it may be realized) unless a debt security is received, or property is received that differs materially in kind or extent from the partitioned property. The key issue in partition actions then is a factual one. Does the property received in the partition differ “materially in kind or extent” from the partitioned property or is debt involved?

Single or contiguous tracts?  It may also be important whether the partition involves a single contiguous tract of land or multiple contiguous tracts of land. However, in two other private rulings, the taxpayer owned a one-third interest in a single parcel of property with two siblings as tenants-in-common.  Priv. Ltr. Ruls. 200411022 and 200411023 (Dec. 10, 2003).  The parties agreed to partition the property into three separate, equal-valued parcels with each person owning one parcel in fee. The property was not subject to any indebtedness. The IRS ruled that the partition of common interests in a single property into fee interests in separate portions of the property did not cause realization of taxable gain or deductible loss.  Rev. Rul. 56-437, 1956-2 C.B. 507.

What about undivided interests?  Is there any difference taxwise between a partition with undivided interests that are transformed into the same degree of ownership in a different parcel and an ordinary partition of jointly owned property? Apparently, the IRS doesn’t think so.  In one IRS ruling, the taxpayers proposed to divide real property into two parcels by partition, and the IRS ruled that gain or loss would not be recognized. Ltr. Rul. 9327069 (Feb. 12, 1993).  Likewise, in another ruling, a partition of contiguous properties was not considered to be a sale or exchange.  Ltr. Rul. 9633028 (May 20, 1996). The tracts were treated as one parcel.

Conclusion

The partition of the ownership interests of co-owners holding undivided interests in real estate is often an unfortunate aspect of poor planning in farm and ranch estates.  That problem can be solved with appropriate planning.  If that planning is not accomplished during life, then it's likely that a judge will sort it out after death.  At least the tax consequences of a partition don’t appear to present a problem if the partition amounts to simply a rearrangement of ownership interests among the co-owners. 

February 25, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Tuesday, February 22, 2022

Nebraska Revises Inheritance Tax; and Substantiating Expenses

Overview

There have been several important developments in ag law and tax over the past couple of weeks worth noting.  So, before they pile up even further, I thought I would provide a quick update for you. 

A few recent developments touching ag law and tax – it’s the topic of today’s post.

Nebraska  - “The Good Life” Becomes a Better Place to Die

In 1895, Illinois was the first state to adopt a progressive inheritance tax on collateral heirs (an heir that is not in a direct line from the decedent, but comes from a parallel line.  The law was challenged as a violation of equal protection under the Constitution, but was upheld in 1898 in Magoun v. Illinois Trust and Savings Bank, et al., 170 U.S. 283 (1898).  As a result of the court’s decision, Nebraska adopted a progressive county-level inheritance tax in 1901.  The state’s inheritance tax system has changed little since that time.  Presently, Nebraska is the only state that uses the tax as a local government revenue source. 

But, this session the Nebraska Unicameral has passed (with only one vote in opposition) a bill that the Governor signed into law on February 17 revising the state’s county inheritance tax system (a tax on the privilege to inherit wealth). 

Note:  The lone vote in opposition to the bill was cast by a Senator from a district that has had counties in recent years where the inheritance tax generated zero revenue for the county.  It’s pretty easy to vote against a bill lowering (or eliminating a tax) when it doesn’t affect one’s constituents in the first place.

LB 310 changes the inheritance system for decedent’s dying after 2022.  Amounts passing to a surviving spouse remain exempt, and for “Class I relatives (near relatives – basically those persons up and down the decedent’s line), the 1 percent rate doesn’t change, but the exemption goes to $100,000 from the prior level of $40,000 per person.  For Class II relatives (aunts and uncles, nieces and nephews, and other lineal descendants of these relatives), the tax rate drops from 13 percent to 11 percent and the exemption increases from $15,000 per person to $40,000 per person.  For Class III “relatives” (everyone else), the rate is 15 percent, down from 18 percent, and the exemption will be $25,000 instead of the prior $10,000 amount.  Also included in the revised system is a provision exempting inheritances by persons under age 22 from all tax. 

Note:  Under LB 310, step-relatives are treated in the same manner as blood relatives with respect to the tax rate and exemption amounts based on their classification. 

The new inheritance tax system does require an estate’s personal representative to submit a report regarding inheritance taxes to the county treasurer of a county in which the estate is administered upon the distribution of any estate proceeds.  The Nebraska Department of Revenue must prepare a form for the personal representative’s report which will include information about the amount of the inheritance tax generated and the number of persons receiving property.  The report must also disclose the number of persons who do not reside in Nebraska that receive property that is subject to inheritance tax. 

More Substantiation Cases

In recent days, the U.S. Tax Court has issued a couple of opinions involving the expense substantiation rules of I.R.C. §274.  As we are in the midst of tax season, it is a good reminder that deductions are a matter of legislative “grace.”  If you claim a business deduction, you must substantiate it under the applicable rule(s).  Some types of expenses require more substantiation that do other expenses. 

Business Deductions Properly Denied 

Sonntag v. Comr., T.C. Sum. Op. 2022-3

The petitioners, a married couple, both had sources of income. The husband operated a music studio from a shed in their backyard. They used an electronic application to track their business expenses and receipts. On their joint 2017 return, they reported $247,201 in income from Form W-2. They claimed Schedule C deductions of $47,385, resulting in a business loss of $28,835. The deductions included amounts for travel expenses; air fare; meals and entertainment; bank charges; batteries; books and publications; a briefcase; credit card interest and fees; camera parts; costume cleaning; stage costumes; catering for special events; labor; office supplies; fees for physical training; postage/shipping; personal hygiene products; prop expenses; “research” admission fees; cable fees; Apple Music and Spotify subscriptions; Netflix subscriptions; studio supplies; cell phone expense; tools; and legal services. The IRS disallowed $37,800 of the deductions which included $11,713 of travel expenses; $5,763 of meal and entertainment expenses; and $20,324 of other expenses.

The Tax Court agreed with the IRS. Personal care expenses were properly denied. The credit card and annual fee expenses involved multiple personal transactions and weren’t substantiated as business expenses. The stage costume expense was not deductible because the husband testified that the shoes and clothes could also be worn as personal wear. The catering expenses were not properly substantiated, and the physical training expenses were also determined to be personal in nature as were the hygiene products. The research expenses were determined to be inherently personal. The cell phone expense was properly disallowed - some of the expense had been allowed. Other expenses were also disallowed for lack of substantiation – bank charges; batteries; books and publications; briefcase; camera parts; office supplies; and legal services. The claimed travel expenses were properly disallowed for failure to meet the heightened substantiation requirements of I.R.C. §274(d). Still other expenses were properly disallowed as both personal and unsubstantiated, including costume cleaning; labor; props; studio supplies; tools; and postage/shipping. 

Unreimbursed Employee Expenses Properly Substantiated 

Harwood v. Comr., T.C. Memo. 2022-8

The petitioner was a construction worker that worked for various employers over the tax years in issue. His work required him to leave home for significant “chunks of time.” He sought to deduct unreimbursed expenses for meals and entertainments, lodging, vehicle and other unreimbursed expenses that he incurred during his employment. The IRS disallowed a portion of the claimed deductions. The Tax Court upheld the petitioner’s deductions, noting that he had properly substantiated his travel, meals and lodging while away from home. He corroborated the amount, time, place and business purpose for each expenditure as I.R.C. §274(d) and Treas. Reg. §1.274-5T(b)(2)(ii)-(iii) requires. He also substantiated the auto expenses by documenting the business use and total use by virtue of a contemporaneous log. He also was “away from home” because his employment was more than simply temporary or only for a short period of time. The petitioner also proved that the dd not receive or have the right to receive reimbursement from his employer. 

Conclusion

The Nebraska modification of the county-level inheritance tax is step in the right direction for tax policy that has often ignored the inheritance tax.  On the unreimbursed business expense deduction issue, it’s imperative to maintain good records.  And not all expenses fall under the same substantiation rules.  That’s a key point that was brought out by the Tax Court last year in Chancellor v. Comr., T.C. Memo. 2021-50.  In Chancellor, the Tax Court pointed out that expenses that fall under the I.R.C. §274(d) umbrella cannot be substantiated (estimated) under the Cohan rule.  See Cohan v. Comr., 39 F.2d 540 (2nd Cir. 1930).  So, it’s important to understand which expenses are covered by the rule and those that aren’t, and what it takes to properly substantiate them.  But even if the Cohan rule applies it’s not a certainty that it will be a successful defense to an IRS audit.   

February 22, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Thursday, February 3, 2022

The “Almost Top 10” of 2021 (Part 7) [Medicaid Recovery and Tax Deadlines]

Overview

With today’s article, I conclude my journey through the big developments of 2021 that didn’t make my “Top 10” list.  In Part 7 today, I look at two cases that are presently before the U.S. Supreme Court.  One case involves a state’s right to take tort recoveries from Medicaid beneficiaries.  The other case addresses whether courts can excuse a missed statutory income tax filing deadline.  Both of these issues are important – one for Medicaid planning, and asset protection strategies; the other case might be critical for determining when principles of fairness might apply when an income tax deadline is missed.   

The conclusion of the “Almost Top Ten” of 2021 – it’s the topic of today’s post.

State Medicaid Recovery

Gallardo v. Marstiller, 963 F.3d 1167 (11th Cir. 2020), cert. granted sub nom., Gallardo v. Dudek, 141 S. Ct. 2884 (2021)

Background

Planning for long-term health care needs is a recommended part of estate planning for many people.  This is particularly true for farm and ranch (and other small) businesses where the desire is to transition the business into subsequent generations of the family.  Without a plan in place, spending $100,000 annually on a long-term care bill could cause a business succession plan or family estate planning goals to not be met as desired.  Medicaid planning is part of long-term care planning. 

Medicaid is the joint federal/state program that is the primary public assistance available to help pay for long-term care – if the beneficiary has little to no “available” assets.  In addition, once a state provides Medicaid benefits to a beneficiary, the state can seek reimbursement (“recovery”) from the beneficiary’s estate upon death to a certain extent for benefits paid during life.  That is designed to protect, at least in part, the taxpaying public.  A state may also obtain reimbursement from third parties for Medicaid expenses paid to injured beneficiaries.  But, to what extent?  That’s the issue that is presently before the U.S. Supreme Court.

In Gallardo, the plaintiff was severely injured in 2008 after being hit by a pickup truck when she got off a school bus.  She still remains in a persistent vegetative state.  The state (Florida) Medicaid program (e.g., Florida taxpayers) paid $862,688.77 for her medical care.  Her parents sued the truck driver and the school district which resulted in a settlement of $800,000.  Of that amount, $35,367.52 was designated as being for past medical expenses.  None of it was designated as being for future medical expenses.  The state Medicaid agency neither participated in or agreed to the settlement terms, but 42 U.S.C. §1396k(a)(1)(A) requires the state Medicaid program to be reimbursed from any third party because Medicaid is to be a “payor of last resort” for medically necessary goods and services provided to a recipient.  Indeed, state law provides for a superior lien with respect to third-party benefits regardless of whether the Medicaid beneficiary has been made whole or other creditors have been paid.  Fla. Stat. §409.910(1).  But, the state’s recovery is not to be in excess of the amount of medical assistance paid by Medicaid.  42 U.S.C. §1396a(a)(25)(H).  Under Florida’s formula, in the event of a beneficiary’s tort recovery, the state gets 50 percent of the recovery (after fees and costs) up to the total amount provided in medical assistance by Medicaid.  Thus, the state asserted a lien for $862,688.77 on the tort action and any future settlement – even though the settlement specified that $35,367.52 was for past medical expenses.  During an administrative hearing, the state claimed entitlement to the amounts it paid to the beneficiary from the portion of the settlement representing compensation for the plaintiff’s future medical expenses.  The plaintiff sued for a declaration that, under federal law, the state couldn’t be reimbursed from any part of the settlement other than that representing compensation for past medical expenses - $35,367.52.  The trial court granted the plaintiff’s motion for summary judgment, finding that state law was preempted by federal law.   The state Medicaid agency appealed. 

Note:  During the pendency of the appeal, the Florida Supreme Court held in a different case that state federal law authorizes the state to be reimbursed out of personal injury settlements only from the portion representing past medical expenses.  Giraldo v. Agency for Health Care Administration, 248 So. 3d 53 (Fla. 2018). 

The appellate court reversed, determining that federal law does not preempt state law permitting a state Medicaid agency to seek reimbursement from portions of a settlement that represent all future medical care (as well as past), and that the parties’ allocation to past and future medical care didn’t bind the state agency.  This was particularly the case, the appellate court noted, because the parties to the settlement did not seek the state Medicaid agency’s input on the settlement allocation.  Indeed, the appellate court determined that federal Medicaid law merely bars a state from attaching its lien against any part of a settlement that is not designated as payments for medical care (to the extent of Medicaid benefits provided).  The appellate court also upheld the state’s reimbursement formula. 

Conclusion

The U.S. Supreme Court agreed to hear the case, and oral argument was held in early January of 2022.  It will be interesting to see how the Court decides the case.  Certainly, however the Court decides will potentially “tee-up” the issue for state legislatures to address how their respective state Medicaid recovery statutes are worded and what policy is desired when third-party payments to Medicaid beneficiaries are involved.

Missed Tax Deadline

Boechler, P.C. v. Commissioner, 967 F.3d 760 (8th Cir. 2000), cert. granted, 142 S. Ct. 55 (2021)

Background

In 2015, the IRS notified the plaintiff (a law firm) about the failure to file employee tax withholding forms.  The plaintiff didn’t respond, and the IRS imposed a 10 percent intentional disregard penalty of $19,250.  The plaintiff challenged the penalty in a Collection Due Process (CDP) hearing, which resulted in the penalty being imposed, with interest.  On July 28, 2017, the IRS Office of Appeals mailed its CDP hearing determination to sustain the proposed levy on the plaintiff’s property to collect the penalty plus interest.  That plaintiff received the notice on July 31, 2017, which informed the plaintiff that the deadline for submitting a petition for another CDP hearing was 30 days from the date of determination – August 28, 2017.  As an alternative, the plaintiff could petition the Tax Court to review the determination of the IRS Office of Appeals.  But, again, the statutory time frame for seeking Tax Court review involved filing a petition with the Tax Court within 30 days of the determination.  I.R.C. §6330(d)(1).  The plaintiff filed its petition with the Tax Court on August 29, 2017 – one day late.  Accordingly, the IRS moved to dismiss the plaintiff’s petition on the grounds that the Tax Court lacked jurisdiction.  The plaintiff, however, claimed that the statute was not jurisdictional (even though the statute says “(and the Tax Court shall have jurisdiction with respect to such matter).”  Instead, the plaintiff claimed that the filing deadline was subject to “equitable tolling” and that the 30-day deadline should be computed from the date the notice was received.  The Tax Court disagreed with the plaintiff and issued an order dismissing the case for lack of jurisdiction – I.R.C. §6330(d)(1) was jurisdictional. 

Note: When equitable tolling is applied, a court has the discretion to ignore a statue of limitations and allow a claim if the plaintiff did not or could not discover the “injury” until after the expiration of the limitations period, despite due diligence on the plaintiff’s part.   

Appellate Decision

The plaintiff appealed.  The appellate court pointed out that a statutory time limit is generally jurisdictional when the Congress clearly states that it is and noted that the Ninth Circuit had recently held that the statute was jurisdictional.  Duggan v. Comr., 879 F.3d 1029 (9th Cir. 2018).  The appellate court went on to state that the “statutory text of §6330(d)(1) is a rare instance where Congress clearly expressed its intent to make the filing deadline jurisdictional.”   On the plaintiff’s claim that pegging the 30-day timeframe to the date of determination was a Due Process or Equal Protection violation, the appellate court disagreed.  The appellate court, on this issue, noted that the plaintiff bore the burden to establish that the filing deadline is arbitrary and irrational.  Ultimately, the appellate court determined that the IRS had a rational basis for starting the clock on the 30-day timeframe from the date of determination because it streamlines and simplifies enforcement of the tax code.  Measuring the 30 days from the date of receipt, the appellate court pointed out, would cause the IRS to be unable to levy at the statutory uniform time and, using the determination date as the measuring stick safeguards against a taxpayer refusing to accept delivery of the notice as well as supports efficient tax enforcement.   

U.S. Supreme Court

The U.S. Supreme Court, on September 30, 2021, agreed to hear the case. Both the plaintiff and the IRS are focused on test for equitable tolling set forth in United States v. Kwai Fun Wong, 575 U.S. 402 (2015).  That case involved 28 U.S.C. §2401(b), a statute that establishes the timeframe for bring a tort claim against the United States.  There a slim 5-4 majority held that a rebuttable presumption of equitable tolling applied.  The presumption can be rebutted if the statute shows that the Congress “plainly” gave the time limits “jurisdictional consequences.”  In that instance, time limits would be jurisdictional and not subject to equitable tolling.   

The beef comes down to how to read the statute.  The statute at issue, I.R.C. §6330(d)(1) states in full:

“(1) PETITION FOR REVIEW BY TAX COURT

The person may, within 30 days of a determination under this section, petition the Tax Court for review of such determination (and the Tax Court shall have jurisdiction with respect to such matter).”

The IRS asserts that “such matter” refers to the petition that has been filed with the Tax Court that meets the 30-day deadline.  This is the view that the appellate court adopted as did the Ninth Circuit in Duggan.  However, the plaintiff claims that “such matter” refers to “such determination” and, in turn, “determination under this section” with no additional jurisdictional requirement involving timely filing.  According to this view, the Tax Court’s jurisdiction is not limited to IRS determinations for which a petition is filed with the Tax Court within 30 days.  As such, equitable tolling can apply.  Indeed, this is the view that the D.C. Circuit utilized in Myers v. Commissioner, 928 F.3d 1025 (D.C. Cir. 2019) in a case involving a whistleblower tax statute that is similarly worded. 

Conclusion

It will be interesting to see how the Court interprets the statute.  Clearly, based on the facts, equitable tolling should not apply.  The plaintiff negligently didn’t respond to the notice, negligently missed the filing deadline and then came up with a creative argument to try to bail itself out of a bad result created by that negligence.  No colorable argument can be made that the plaintiff was confused about the deadline.  Clearly, if the Court allows for equitable tolling in this case, given the facts of the case, there will be an increase in cases that argue for equitable tolling to be applied. 

However, the Congress did create an unclear antecedent in the statue.  Maybe that’s not as bad as a dangling participle, but the poor drafting has landed a case in the Supreme Court’s lap. 

This concludes my journey through the “Almost Top 10” of 2021.  Now back to “regular programming.”

February 3, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Tuesday, January 25, 2022

The “Almost Top Ten” (Part 4) – Tax Developments

Overview

Today’s article is the fourth in a series discussing what I view of significant developments in 2021 that weren’t quite big enough to make my “Top Ten” list.  This time I discuss for tax four tax developments that occurred in 2021 that weren’t quite big enough to make the “Top Ten.”

More significant developments of 2021 in ag law and tax – it’s the topic of today’s post.

Estate Tax Closing Letter Doesn’t Preclude Later Exam of Form 706

C.C.A. 202142010 (Apr. 1, 2021)

IRS Letter 627, an estate tax return closing letter, is issued to an estate and specifies the amount of the net estate tax, the state death tax credit or deduction, and any generation transfer tax for which an estate is liable. The position of the IRS, however, is that the letter is not a formal closing agreement.  Thus, the issuance of the letter does not bar the IRS from reopening or reexamining the estate tax return to determine estate tax liability if:  (1) there is evidence of fraud, malfeasance, collusion, concealment or misrepresentation of a material fact; (2) there is a clearly defined, substantial error based on an established IRS position; or (3) another circumstance indicating that a failure to reopen the case would be a serious administrative omission. Thus, when the IRS issues Letter 627 after accepting the return as filed, the issuance does not constitute an examination and IRS may later examine Form 706 associated with the estate that received the letter. 

IRS Supervisor Review - “Immediate Supervisor” is Person Who Actually Supervised Exam

Sand Investment Co., LLC v. Comr., 157 T.C. No. 11 (2021)

Under the Internal Revenue Code (Code), an IRS examining agent must obtain written supervisory approval to the agent’s determination to assess a penalty on any asserted tax deficiency. Under I.R.C. §6751(b)(1), the approval must be from the agent’s “immediate supervisor” before the penalty determination if “officially communicated” to the taxpayer. In a partnership audit case under the 1982 Tax Equity and Fiscal Responsibility Act (TEFRA), supervisory approval generally must be obtained before the Final Partnership Administrative Adjustment (FPAA) is issued to the partnership. See, e.g., Palmolive Building Investors, LLC v. Comr., 152 T.C. 75 (2019). If an examiner obtains written supervisory approval before the FPAA was issues, the partnership must establish that the approval was untimely. See, e.g., Frost v. Comr., 154 T.C. 23 (2020). 

In this case, the IRS opened a TEFRA examination of the petitioner’s 2015 return. The IRS auditor’s review was supervised by a team manager. While the audit was ongoing, the agent was promoted and transferred to a different team, but continued handling the audit still under the supervision of the former team manager. Ultimately, the agent asserted an accuracy-related penalty against the petitioner and the former team manager signed the approval form. The next day, the auditor sent the petitioner several documents indicating that a penalty might be imposed. Two days later the new team manager also signed the auditor’s penalty approval form. The petitioner challenged the imposition of penalties because the new team manager hadn’t approved the penalty assessment before the auditor sent the penalty determination to the petitioner. The Tax Court held that the supervisor who actually oversaw the agent’s audit of the petitioner was the “immediate supervisor” for purposes of the written supervisory approval requirement of I.R.C. §6751(b)(1). There was no evidence that the new team manager had any authority to supervise the agent’s audit of the petitioner. 

Meal Portion of Per Diem Allowance Eligible to be Treated As Attributed to a Restaurant. 

IRS Notice 2021-63, 2021-49 IRB 835

Under I.R.C. §274(n)(1) and Treas. Reg. §1.274-12, a deduction of any expense for food or beverages generally is limited to 50 percent of the amount otherwise deductible (i.e., as an ordinary and necessary business expense that is not lavish or extravagant under the circumstances). However, the Consolidated Appropriations Act, 2021, provides that that the full cost of such an expense is deductible if incurred after Dec. 31, 2020, and before Jan. 1, 2023, for food or beverages "provided by a restaurant." Meals obtained from a grocery or convenience store do not qualify.  The IRS, with this notice, specified that a taxpayer may treat the meal portion of a per diem rate or allowance paid or incurred after Dec. 31, 2020, and before Jan. 1, 2023, for meals purchased while traveling away from home as being attributable to food or beverages provided by a restaurant. 

Note:   The Notice is effective for expenses incurred by an employer, self-employed individual or employees described in I.R.C. §62(a)(2)(B) through (E) after December 31, 2020, and before January 1, 2023.

Credit Card Reward Dollars May Be Taxable

Anikeev, et ux. v. Comr., T.C. Memo. 2021-23

The petitioners, husband and wife, spent over $6 million on their “Blue Cash” American Express credit cards (“Blue Card”) from 2013 to 2014.  They used their Blue Cards to accumulate as many reward points as possible, which they did by using the cards to buy Visa gift cards, money orders or prepaid debit card reloads that they later used to pay the credit card bill. The credit card earned then five percent cash back on certain purchases after spending in $6,500 in a single calendar year. Before purchases were sufficient for them to reach the five percent level, the card earned one percent cash back on certain purchases. Rewards were issued in the form of “rewards dollars” that could be redeemed for gift cards and statement credits.

In 2013, the petitioners charged over $1.2 million for the purchase of Visa gift cards, reloadable debit cards and money orders.  In 2014 they charged over $5.2 million primarily for the purchase of Visa gift cards.  They then used the Visa gift cards to buy money orders which they used to pay the American Express bills. 

They redeemed $36,200 in rewards dollars from the card as statement credits in 2013 and $277,275 in 2014. The petitioners did not report these amounts as income for either year. The IRS audited and took the position that the earnings should have been reported as “other income.” The petitioners claimed that when a payment is made by a seller to a customer, it’s generally seen as a “price adjustment to the basis of the property” – the “rebate rule.” Rev. Rul. 79-96, 1976-1 C.B. 23.  Under this rule, a purchase incentive is not treated as income. Instead, the incentive is treated as a reduction of the purchase price (and associated reduction of basis) of what is purchased with the rewards or points. Thus, points and cashback earned on spending are viewed as a price adjustment. The petitioners, citing this rule, pointed out that the “manner of purchase of something…does not constitute an accession of wealth. The IRS, conversely, asserted that the rewards were taxable upon receipt because the petitioners did not purchase goods or services for which a rebate or purchase price adjustment could be applied.  Instead, the IRS claimed that the petitioners purchased cash equivalents – Visa gift cards; reloadable debit cards; and money orders.  See, e.g., Tech. Adv. Memo. 200437030 (Apr. 30, 2004).  As cash equivalents, the rewards paid to the petitioners as statement credits were an accession to wealth and, thus, gross income under I.R.C. §61. 

The Tax Court agreed that gift cards were a “product” – they couldn’t be redeemed for cash and were not eligible for deposit into a bank account.  Likewise, the Tax Court determined that that Visa gift cards provided a service to the petitioners via a product stating that, “[p]roviding a substitute for a credit card is a service via a product which is commonly sold via displays at drug stores and grocery stores.”  Thus, the portion of their reward dollars associated with gift card purchases weren't taxable under the “rebate rule.”  However, the Tax Court held that the petitioners’ direct purchases of money orders and reloads of cash into the debit cards using their credit card was different in that the petitioners were buying “cash equivalents” rather than a rebate on a purchase. They were not a product subject to a price adjustment and were not used to obtain a product or service. Because there was no product or service obtained in connection with direct money order purchases and cash reloads, the reward dollars associated with those purchases were for cash infusions.

The Tax Court also noted that the petitioners’ practice would most often have been ignored if it had not been for the petitioners’ “manipulation” of the rewards program using cash equivalents. Thus, the longstanding IRS rule of not taxing credit card points didn’t apply. Thus, the Tax Court held that reward points become taxable when massive amounts of cash equivalents are purchased to generate wealth – buying money orders and funding prepaid debit cards with a credit card for cash back, and then immediately paying the credit card bill.

Note:   The Tax Court also stated that it would like to see some reform in this area providing guidance on the issue of credit card rewards and the profiting from buying cash equivalents with a credit card. 

January 25, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Thursday, January 20, 2022

Other Important Developments in Agricultural Law and Taxation (Part 2)

Overview

I recently concluded a five-part series on what I viewed as the “Top Ten” agricultural law and agricultural tax developments of 2021.  There were many “happenings” in ag law and tax in 2021 which meant that there were still some significant developments that didn’t make the “Top Ten.”  In yesterday’s article, I began discussing some of those.  Today’s article continues with another important court decision in 2021 that just wasn’t quite big enough to make the “Top Ten” list.

The “Almost Top 10” of 2021, the second article in a series – it’s the topic of today’s post.

Estate Planning Mistake Costs Family Multi-Million Dollar Charitable Deduction

Estate of Warne v. Comr., T.C. Memo. 2021-17

Warne is yet another case that points out how skilled and knowledgeable estate planners must be to ensure that tax rules are clearly understood and properly accounted for in carrying out client goals.  In Warne , improper planning reduced a charitable deduction for an estate by $2.5 million. The case involved the transfer to charity of majority interests in limited liability companies (LLCs) owning real estate, and the resulting reduction in the otherwise available charitable deduction for those interests. 

What’s the issue?  At its core, Warne involved the issue of the application of a control premium for ownership interests in entities.  An estate tax valuation issue that has been battled in the courts and addressed by the IRS for over 60 years is whether a block of stock in an entity that carries with it control of the entity’s operating and dividend policy, corporate salaries and particularly the ability to compel the entity’s liquidation should be valued at a premium above the underlying asset value if offered to the public. See, e.g., Rev. Rul. 59-60, 1959-1 C.B. 242; Rev. Rul. 67-54, 1967-1 C.B. 269; Turner v. Comr., T.C. Memo. 1964-161. 

Background.  Assuming that a control premium applies to value a block of stock, should it be applied to stock that is split due to language contained in a decedent’s will, trust or other estate planning documents?  The issue has arisen in the context of the marital deduction.  In Estate of Chenoweth, 88 T.C. 1577 (1987), the decedent owned 100 percent of the stock of a corporation.  He left 51 percent of the stock to his surviving wife.  The Tax Court held that a control premium should be added to the amount passing to the wife – the marital deduction legacy.  But it was not to be spread across 100 percent of the stock.  The Tax Court determined that the value of the shares that passed to her should be valued with a control premium of 38 percent over the per share value of the same shares that were included in the decedent’s gross estate.  The block of stock funding the marital deduction was valued as a separate block without regard to the context from which it was separated.  As a result, the Tax Court applied a control premium to the block of stock that funder the marital deduction, and also applied a minority interest discount to the stock that funded the non-marital bequest. 

Note:  The principle of Chenoweth is this - where a transfer to a surviving spouse is unrestricted but is less that the decedent’s entire interest in property, the value of the interest passing to the surviving spouse is to be valued as a separate interest in property and not as an undivided portion of the decedent’s entire interest.  Valuation, for purposes of the marital deduction, does not have to be the same as for purposes of the gross estate.

The IRS has applied the principle of Chenoweth in Priv. Ltr. Rul. 9050004 (Aug. 31, 1990) and Tech, Adv. Memo. 9403005 (Oct. 14, 1993).These IRS determinations involved the valuation of partial interests distributed to a surviving spouse or to a marital trust.  In the 1995 private letter ruling, a qualified terminable interest property (QTIP) interest under a marital deduction formula will was funded with 49 percent of the stock in a closely-held corporation, with 51 percent passing to another trust.  The IRS concluded that the stock funding the QTIP should be subject to a minority interest discount when determining the value of the marital deduction.  The 1994 private letter ruling involved the valuation of a minority interest of closely-held stock that passed to the decedent’s surviving spouse.  The IRS determined that, when valuing the decedent’s gross estate, the decedent’s stock was to be valued as a single interest, but when valuing the marital deduction, the value of the minority interest passing to the surviving spouse should reflect a minority interest discount. 

Clearly, the same result obtained in Chenoweth and the private letter rulings could apply in the context of a charitable bequest.  Indeed, this is what happened in Warne where it appears the estate planners drafted the client right into a costly trap. 

Facts of Warne.  In Warne, a married couple started investing in real estate in the 1970s, continuing to acquire properties during their remaining lifetimes. Their estate plan involved them transferring ownership of the properties to five separate LLCs. The LLCs also held various leased fee interests associated with the properties. In 1981, they created a Family Trust with the wife named as trustee. The Family Trust became the majority interest holder of the five LLCs. The husband died in 1999 and the wife in 2014 with the Family Trust included in her estate. In late 2012, the wife gifted fractional interests in the LLCs to her sons and granddaughters.

Upon the wife’s death, the Family Trust owned majority interests in each of the five LLCs. Remainder interests were transferred to the wife’s children and grandchildren as well as a sub-trust of the family trust. She also left 75 percent of her interest in an LLC that the Family Trust owned 100 percent of to the family charitable foundation. The remaining 25 percent was left to a church. Her estate valued the LLCs by applying discounts for lack of control and lack of marketability. The estate also claimed a charitable deduction for the full 100 percent value of the LLC interests donated to charity which matched the value of that LLC that was included in the decedent’s gross estate.

The IRS challenged the amount of the discounts and also reduced the charitable deduction because of the split donation of the LLC interests between the foundation and the church. On the valuation of the LLC interests, the Tax Court noted that the LLC operating agreements gave much control to the holder of the majority interest, including the power to unilaterally dissolve the LLC and appoint and remove managers. The Tax Court was inclined to allow no discounts, but the parties had stipulated that some discount for lack of control applied. Hence, the Tax Court determined that a lack of control discount of four percent should apply. The Tax Court also allowed a five percent discount for lack of marketability.

On the charitable donations, the Tax Court noted that the proper valuation focused on what the charities received. Because each charity received only a fractional interest in the LLC, the Tax Court reasoned that a discount should apply. The Tax Court accepted the parties’ stipulated discount of 27.385 percent for the 25 percent LLC interest donated to the church and a four percent discount for the 75 percent LLC interest donated to the charitable foundation. The effect of the discounts reduced the total charitable contribution by more than $2.5 million. 

Implications.  What was overlooked in Warne was the decades of caselaw and IRS rulings mentioned above indicating that a minority interest discount could likely apply to the transfer of what ultimately was passage of the entire estate to charity.  The key to understanding the discount issue in the case is not what was transferred to the charity.  It is in understanding what the charity received.  The interests were split, with each charity receiving a minority interest, but with 100 percent of the decedent’s estate passing to charity.  The court didn’t explain why the interests were split between the family foundation and the church, but the result of structing the estate plan that way didn’t work.  That was very flawed estate planning.  I doubt the client wanted it that way – there wouldn’t have been litigation if that were the case. 

To maximize a charitable contribution deduction, full ownership in entities must be transferred to a single charitable beneficiary.  The gifted interests should not be split.  In Warne, the trust could have given a full 100 percent ownership interest in an entity to the foundation, and then some other interest or interests could have been given to the church. 

When the matter involves the marital deduction, the estate plan should attempt to have both spouses in a minority position so that shares of stock applied to the marital deduction would be at the same value as the value of the stock in the decedent’s gross estate.  When doing estate planning for a farmer/rancher (or other person) that holds majority control of a closely-held business (such as a farm or ranch), the goal is to shelter the full unified credit amount (currently $12.06 million) in a credit shelter trust while still obtaining the desired funding of the marital bequest (which carries out the marital deduction) from the other stock.  To avoid underfunding the marital bequest, consideration should be given to issuing or recapitalizing enough non-voting stock to allow the marital bequest to be funded with voting stock, or have the marital bequest always receive a controlling interest. 

Conclusion

Estate planning is very complicated when a closely-held family business is involved, such as a farm or a ranch.  It will become even more complex if the Congress lowers the federal estate tax exemption, or simply does nothing.  Simply by doing nothing, the exemption is set to fall to $5 million (in inflation-adjusted dollars) at the start of 2026.  Thankfully, the estate tax and trust provisions proposed last summer did not become law.  Will pieces of those proposals come back in 2022?  Time will tell.

If the goal is to keep the family farm or ranch in the family as a viable economic operation in the hands of subsequent generations, don’t short-change estate planning. 

I will continue the journey through other significant 2021 developments in ag law and tax next time.

January 20, 2022 in Estate Planning | Permalink | Comments (0)

Tuesday, January 18, 2022

Other Important Developments in Agricultural Law and Taxation

Overview

I recently concluded a five-part series on what I viewed as the “Top Ten” agricultural law and agricultural tax developments of 2021.  There were many “happenings” in ag law and tax in 2021 which meant that there were still some significant developments that didn’t make the “Top Ten.”  In today’s post I start discussing some of those.  This will also be a multi-part series, and the developments are in no particular order.

The “Almost Top 10” of 2021, the first article in a series – it’s the topic of today’s post.

Bankruptcy Trustee Cannot Retain Fee

In re Doll, No. 21-cv-00731-RBJ, 2021 U.S. Dist. LEXIS 232612 (D. Colo. Dec. 6, 2021)

The debtor filed Chapter 13 in late 2017, and failed to get the bankruptcy court to confirm his plan. The debtor made $29,900 in plan payments to the standing trustee. From that amount, the debtor’s counsel received $19,800 and $7503.30 was paid to the state for property taxes. The trustee paid the balance of $2,596.70 to himself in partial satisfaction of the statutory 10 percent fee. The debtor sought the return of the amount the trustee paid himself based on 11 U.S.C. §1326 and its difference to the comparative Chapter 12 provision of 11 U.S.C. §1326(a)(1). The debtor pointed out that a trustee is allowed to retain fees when a debtor’s Chapter 12 plan is not confirmed, but not in a Chapter 13. The bankruptcy court allowed the standing trustee to be compensated and the debtor appealed.

The district court agreed with the debtor, noting that 11 U.S.C. §1326(a)(2) provides, “if a plan is not confirmed, the trustee shall return any such payments not previously paid out and not yet due and owing to creditors.” The district court reasoned that if the payments must be returned, the fees collected from such payments must be returned. That language, the district court noted, was in contrast to the Chapter 12 language providing that “if a plan is not confirmed, the trustee shall return any such payments to the debtor, after deducting…the percentage fee fixed for such standing trustee.” The court reversed the reversed the bankruptcy court and remanded the case with instructions for the bankruptcy court to order the trustee to return the fee.  

Note:  While the district court expressed concern that a standing trustee may not be compensated for his efforts in situations such as this, the district court found the issue to be one for the Congress to address.

LLC Gifts Recharacterized

Smaldino v. Comr., T.C. Memo. 2021-127

Estate planning is a complicated process, and it gets more complicated as assets increase in number and value.  If a family business is involved, the complexity is increased further.  In this case, the Tax Court pointed out how important it is to carefully do estate planning correctly.  At its core, the case involved a gift by a husband to his wife and then to an irrevocable trust.  Because the plan wasn’t implemented and/or administered properly, the IRS recast the transaction and the court agreed, with severe tax consequences.  

Facts of the case.  The couple had a real estate portfolio of nearly $80 million including numerous rental properties that they owned and operated.  They agreed that the real estate should pass to the husband’s children and grandchildren from his prior marriage.  To accomplish that goal, he put 10 of the real estate properties into a family limited liability company (LLC) that he formed in 2003 (and for which he was designated as the manager) but which remained inactive until late 2012 when he had a health scare that finally motivated him to get his affairs in order.  The LLC, in turn, was placed into a revocable trust of which he was the trustee. In 2013, he transferred approximately eight percent of class B member interests in the LLC to an irrevocable trust (dynasty trust) that he had created a few months earlier for the benefit of his children and grandchildren. He named his son as trustee. 

At about the same time as the transfer to the dynasty trust, the petitioner transferred approximately 41 percent of the LLC membership interests to his wife (in an amount that roughly matched her then available federal estate and gift tax exemption), who then in turn transferred the same interests to the dynasty trust the next day.  As a result, the dynasty trust owned 49 percent of the LLC.  Simultaneously, the petitioner amended the LLC operating agreement to provide for guaranteed payments to himself and identified the dynasty trust as the LLC’s sole member.  On his 2013 gift tax return, the petitioner reported only his direct transfer of LLC interests to the dynasty trust and not those of his wife.  A valuation report dated four months after the transfers to the dynasty trust stated that the 49 percent interest in the LLC had a value of $6,281,000.  The federal estate and gift tax exemption was $5,250,000 in 2013.  The IRS asserted that the petitioner had underreported the 2013 taxable gifts by not reporting the wife’s gift to the dynasty trust, and asserted a gift tax deficiency of $1,154,000. 

The Tax Court agreed with the IRS, concluding that the wife’s gift to the dynasty trust should be treated as a direct gift by the petitioner for numerous reasons.  The Tax Court noted that the wife was not a “permitted transferee” under the LLC operating agreement and, thus, could not have owned the LLC interest.  The Tax Court also pointed out that the petitioner had amended the LLC operating agreement on the same day of his transfer of LLC member units to the dynasty trust to reflect himself as the sole member.  The Tax Court also pointed out that the transfers of the wife’s LLC member interest were undated – they only had “effective” dates, and that the assignments were likely signed after the valuation report was prepared four months later.  This meant that the wife had no real ownership rights in the LLC.  In addition, the Tax Court pointed out that the 2013 LLC income tax return did not allocate any income to the wife even though the petitioner claimed that she had an ownership interest for one day.  The LLC’s return and associated Schedules K-1 listed the petitioner as a 51 percent partner and the dynasty trust as a 49 percent partner for the entire year.  The petitioner’s wife was not listed as a partner for any part of the year

Take home planning pointers.  The case is a good one for learning what not to do when setting up a trust and transferring LLC interests as part of an estate plan.  The wife’s holding of the LLC interests for a day (at most) before the transfer to the LLC and then her transferring the exact same interests received as a gift to the dynasty trust is not a good approach.  It shows a lack of respect for the transaction.  The wife’s testimony at trial that she had no intent to hold the interest contradicted the alleged substance of the transaction.  It also shows that she didn’t understand the planning that was being engaged in – that’s the fault of the attorneys involved.  Also, the husband‘s failure to report the gift to his wife on a gift tax return was further demonstration that he didn’t respect that transfer.  With the amount of wealth involved in the case, a team of professionals should have been engaged, and all formalities of the various transactions should have been closely followed.  This includes providing written consent for the wife’s admission as an LLC member; providing the dates that documents were actually signed; not transferring the precise amount to the trust as was initially gifted; and having more time pass between the date of the gift to the wife and her subsequent transfer.  There was also no amended and restated LLC operating agreement to reflect her ownership (however brief).  Also, tax returns did not properly reflect what the taxpayers were doing.  

From a broader perspective, it simply is a bad idea to not do estate planning until health emergencies arise.  The same is true for other significant life events.  By waiting until estate planning is absolutely necessary, estate planning can be rushed and not be done as thoroughly as it otherwise should be.  Estate planning is a process that takes time. The rushed process in the case was probably a factor in the IRS succeeding in its assertion of the “step transaction” doctrine. 

There’s also another point from the timing involved in the case that has relevance to estate planning in 2020-2021.  While I can’t be positive from reading the court’s opinion, it appears that the estate planning was done in late 2012, at least from the standpoint of document drafting, and then completed in 2013.  2012/2013 was a time when there was concern by many that the federal estate tax exemption would drop from $5 million to $1 million.  Thus, many clients were worried about being faced with a “use-it-or-lose-it” situation not unlike the situation in 2021 going into 2022.  The point is that this uncertainty in the law surrounding estate planning creates an substantial increase in work for estate planners to accomplish in a short timeframe.  That combination can lead to a lack of thoroughness in the estate planning drafting and/or review process.  It is possible that this was part of the problem that led to the unfortunate tax result of the case.

Note:  Following legal formalities is important, such as creating and signing essential documents.  Also, consistency in tax reporting is critical.  In addition, thorough estate planning should involve a “team approach.”  The attorneys drafting the legal documents and providing legal counsel; tax practitioners that can review the tax consequences of the plan; financial and insurance professionals.  The more “eyes” that see an estate plan, the less chance that steps will be overlooked and/or mistakes made.

A key question in the case involved the timing of the transfers to the wife and then to the dynasty trust.  How long should she have held those transfers before retransferring them to avoid IRS successfully asserting the step-transaction doctrine?  In one case, six days was enough for holding assets as part of an overall estate plan before they were retransferred.  See Holman v. Comr., 130 T.C. 170 (2008), aff’d., 601 F.3d 763 (8th Cir. 2010).  In any event, the transaction must have economic substance if the transaction is to be respected taxwise. 

Conclusion

In the next article, I will look further at other developments of 2021 that weren’t quite significant enough on a national scale to make the 2021 Top Ten list.

January 18, 2022 in Bankruptcy, Estate Planning | Permalink | Comments (0)