Thursday, November 21, 2019

Co-Tenancy or Joint Tenancy – Does it Really Matter?

Overview

For many farmers and ranchers, the land is the most significant asset that is owned, at least in terms of value.  Land value often predominates in a farmer or rancher’s estate.  How the land is titled is important.  Holding title in the proper form facilitates estate planning in accordance with expressed goals and can ease the tax burden upon death or upon subsequent transfer of the property by the heir or heirs.  Conversely, failing to title property appropriately can undermine estate planning expectations, create family disharmony and result in a higher tax burden.

The distinction between co-tenancy and joint tenancy and why it matters – it’s the topic of today’s post.

Tenancy-In-Common

A tenant in common holds an undivided interest in property that does not terminate upon the tenant predeceasing surviving co-tenants.  Upon the death of a tenant in common, that person’s interest passes under that person’s will (or in accordance with state law if there is no will (or trust)) to heirs of the deceased cotenant.  For federal estate and state inheritance/estate tax purposes, only the portion of the property owned by the deceased tenant in common is subject to tax. 

Joint Tenancy

The distinguishing characteristic of joint tenancy is the right of survivorship, with the surviving joint tenant or tenants taking all upon the death of a fellow joint tenant regardless of the terms of the deceased joint tenant’s will.  In other words, when a joint tenant dies, the deceased joint tenant’s share in the property passes to the surviving joint tenant (or surviving joint tenants).  It does not pass to the heir of the deceased joint tenant (tenants).  Upon the death of the last of the joint tenants to die, the joint tenancy is extinguished.    

In addition, upon a conveyance of real property, transfer to two or more persons generally creates a tenancy in common unless it is clear in the deed or other conveyancing document that a joint tenancy is intended.  A joint tenancy is created by specific language in the conveyancing instrument.  That specific language, often referred to as “magic words of conveyance,” clearly denotes the survivorship feature of a joint tenancy.  In addition, unless the conveyancing instrument is clear in its intent to create a joint tenancy, the legal presumption is against joint tenancy and that a tenancy-in-common was created.  For example, assume that O conveys Blackacre to “A and B, husband and wife.”  The result of that language is that A and B own Blackacre as tenants in common.  To own Blackacre as joint tenants O needed to convey Blackacre as required by state law to create a joint tenancy.  The language for creating a joint tenancy is typically to “A and B as joint tenants with rights of survivorship” or to “A and B as joint tenants with right of survivorship and not as tenants in common.”

Except for husband-wife joint tenancies, the survivorship feature may generate an unacceptable property disposition pattern upon death.  However, on the death of the first of the joint tenants to die, probate may be simplified or eliminated with title obtained by the surviving joint tenant perfected by showing non-liability for taxes and by proving the death of the decedent by affidavit or death certificate.  This is possible in most (but not all) states.

When it cannot be determined that two (or more) joint tenants have died other than at the same time an interesting problem may arise.  Most states have enacted a simultaneous death statute to handle just such a situation.  Such statutes typically provide that the jointly held property is to be divided into as many equal shares as there were joint tenants and that the share allocable to each joint tenant is to be distributed as if such joint tenant had survived all of the other joint tenants.

A major estate planning limitation of the joint tenancy form of property ownership is that the survivorship right of joint tenancy precludes the use of the life estate-remainder arrangement for the non-marital portion of the estate to reduce the death tax burden upon the survivor’s death.  The entire property, therefore, will pass to the survivor and may be taxed again in the survivor’s estate.  In addition, another problem with joint tenancy is that each joint tenant has a right to sever the joint tenancy relationship unilaterally (except for tenancies by the entirety).  As a result, a joint tenant furnishing consideration for acquisition of the property in effect grants to the other tenant a revocable interest that could be partitioned and severed at any time.  Consequently, each co-owner has the power to amend or destroy the other’s estate plan.

Joint tenancy is not a cure-all for tax planning but, depending upon the circumstances, it may be a convenient means of owning and passing property.  For total estates of each of the husband and wife under $22.8 million (for 2019), there is no federal estate tax liability.  Therefore, joint ownership may serve a useful purpose as a will substitute in the first estate for estates that are not potentially subject to federal estate tax.  However, since it is not known which joint tenant will die first, the estate of the surviving joint tenant will be subject to probate as an intestate estate (where death occurs without a will), unless the survivor prepares a will or otherwise disposes of the property.  For combined spousal estates exceeding $22.8 million (for 2019) in value, joint tenancy ownership may expose a portion of the total estate of the surviving joint tenant to additional taxes, causing an otherwise unnecessary reduction of the estate assets passing to the heirs or other beneficiaries.

Recent Case

A recent case from Texas illustrates the difference between tenancy-in-common and joint tenancy.  It also illustrates how misunderstandings about how property is titled can create family problems.  In, Wagenschein v. Ehlinger, 581 S.W.3d 851 (Tex. Ct. App. 2019), a married couple had seven children.  The parents also owned a tract of land.  Upon the last of the parents to die, each child held an undivided one-seventh interest as tenants in common in the tract.  In 1989, the heirs sold the land and but executed a deed reserving a royalty interest.  The deed reservation read as follows:  “THERE IS HEREBY RESERVED AND EXCEPTED from this conveyance for Grantors and the survivor of Grantors, a reservation until the survivor's death, of an undivided one-half (1/2) of the royalty interest in all the oil, gas and other minerals that are in and under the property and that may be produced from it. Grantors and Grantors' successors will not participate in the making of any oil, gas and mineral lease covering the property, but will be entitled to one-half (1/2) of any bonus paid for any such lease and one-half (1/2) of any royalty, rental or shut-in gas well royalty paid under any such lease. The reservation contained in this paragraph will continue until the death of the last survivor of the seven (7) individuals referred to as Grantors in this deed.” 

An oil and gas company drilled a producing well in 2010 and began paying royalties to the heirs. As each heir died, the credited their royalty interest to the surviving heirs of each deceased heir.  That had the effect of increasing the respective royalty payments of the surviving heirs.  There were no problems until 2015.  In 2015, a child of a deceased heir sued claiming that the deed crediting the royalty reservation to “Grantors and Grantors’ successors created a “tenancy in common” and not a “joint tenancy”.  If the deed created a tenancy in common, the children of the deceased heirs, rather than the surviving heirs, would inherit their parents’ royalty interests.  The trial court disagreed, noting that while the deed used “successor”, it only did so once and clearly and unambiguously reserved the royalty interest to the heirs and the “survivor[s]” of the heirs, rather than their “successors”, “heirs” or “beneficiaries.”  As such, the trial court concluded that the deed unambiguously created a joint tenancy with the right of survivorship, rather than an a tenancy in common that the children of the deceased heirs could inherit.   Thus, as each heir died, their interest in the tract passed to the surviving siblings, not their children.  On appeal, the appellate court affirmed. 

Conclusion

Properly titling property is important for various reasons – not the least of which is to fulfill expectations on property passage.  In the Texas case, confusion over how property was titled resulted in a family lawsuit.  Regardless of how the case would have been decided, some in the family would not be pleased.   

November 21, 2019 in Estate Planning, Real Property | Permalink | Comments (0)

Friday, November 8, 2019

Ag Law In The Courts

Overview

This month’s installment of legal developments in the courts involving agriculture features odors, estate planning and a farm program regulation. Farmers, ranchers, rural landowners and agribusinesses sometimes find themselves in disputes with other private parties or state or federal government agencies.  Once a month I try to feature a several developments that illustrate the problems that can arise and how they are resolved.

The November installment of ag law in the courts – that’s the focus of today’s post.

The Case of the Obnoxious Odors

Agricultural production operations and ag businesses sometimes produce offensive odors (at least to some).  While neighbors might complain and state and local governments may try to regulate, the question is really one of the relative degree of offensiveness.

In Chemsol, LLC, et al. v. City of Sibley, 386 F. Supp. 3d 1000 (N.D. Iowa 2019), the plaintiffs owned and operated a milk drying facility. Allegations arose that the facility made the local town, the defendant in the case, smell like “rotten eggs, dried blood, rotten animal carcasses (boiling, burning and decomposing), vomit, human waste and dead bodies.” The defendant enacted an odor ordinance in 2013 which prohibited the creation or maintenance of a nuisance," and defined nuisance to include "offensive smells.”  The ordinance barred the following:  “The erecting, continuing or using of any building or other place for the exercise of any trade, employment or manufacture which, by occasioning noxious exhalations, offensive smells or other annoyances, becomes injurious and dangerous to the health, comfort or property of individuals or the public.” In 2015 the town increased the penalties for violating the ordinance from $100 per offense to $750 for a "first offense," and $1,000 for repeated violations. In 2016, the ordinance was amended to clarify that: "[N]uisance" shall mean whatever is injurious to health, indecent, or unreasonably offensive to the senses, or an obstruction to the free use of property, so as essentially to interfere unreasonably with the comfortable enjoyment of life or property. *** Offensive Smells: The erecting, continuing or using of any building or other place for the exercise of any trade, employment or manufacture which, by occasioning unreasonably noxious exhalations, unreasonably offensive smells or other unreasonable annoyances, becomes injurious and dangerous to the health, comfort or property of individuals or the public.” (emphasis added).

From 2012 to 2016 the plaintiffs did not receive any citations under the odor ordinance. In 2016 the plaintiffs began receiving citations but didn’t pay or appeal the associated fines. Abatement of the nuisance was negotiated, but the odors problems persisted. The plaintiffs received 36 citations in 2016 (16 before the abatement hearing and 20 after), four citations in 2017 and one citation in 2018. The plaintiffs chose to reduce odors by drying less product. The plaintiffs sued on the basis that the ordinance violated their due process by causing them to lose business and become unable to sell the business due to bad publicity. The plaintiffs also alleged a constitutional taking had occurred and that the town had tortuously interfered with business operations. The defendant moved for summary judgment and the court agreed.

The court noted that the plaintiffs did not build the plant on any promise or assurance that the defendant would not be enact such an ordinance, and it was within the defendant’s jurisdiction to enact such an ordinance for a facility within the defendant’s limits. The court also determined that the ordinance did not rise to a regulatory taking because economic use of the plaintiffs’ property remained. The court also concluded that the defendant did not act improperly in enforcing the ordinance or in speaking to potential buyers. 

The Case of Crop Insurance Coverage Computation

Under the crop insurance program of the 2014 Farm Bill, crop insurance coverage for low yield losses was to be determined based on actual production history (APH). However, APH is determined by excluding abnormally low-yield years in the computation.  In this case, JL Farms v. Vilsack, No. 2:16-cv-02548-CM-GEB, 2019 U.S. Dist. LEXIS 106789 (D. Kan. Jun. 26, 2019), the Risk Management Agency (RMA) determined that the 2015 winter wheat crop was not excludible from the APH. Thus, the insurer did not exclude the 2015 yield data from the plaintiff’s insurance pay-out computation.

On review by the National Appeals Division ("NAD") of the United States Department of Agriculture. The NAD hearing officer determined that the NAD lacked jurisdiction. On further review the NAD Director again determined that the NAD did not have jurisdiction, but that the RMA had discretion to implement the exclusion. The plaintiff then sought judicial review of the RMA’s decision and the NAD Director’s decision of lack of jurisdiction. The trial court determined that the NAD did have jurisdiction over the matter and remanded the matter to the NAD Director for reconsideration of the exclusion of the 2015 wheat crop from the plaintiff’s APH. The trial court also referenced a recent decision by the U.S. Court of Appeals for the 10th Circuit holding that the Congress intended the exclusion to be available for the 2015 crop year (winter wheat planted in 2014). 

The Ruling on the Reformed Trust

Trusts are very popular tools that are used in estate planning.  One of the key benefits is that they provide a great deal of flexibility to adjust to unknown events that might occur in the future.  One way in which that is done is by including a power of appointment in a trust.  A power of appointment gives the holder of the power the ability to direct the assets of the trust in a certain manner and in a certain amount.  Essentially, the power of appointment gives the person that creates the power in someone else the ability to determine how the property will be distributed at some point in the future.  Basically, the power creates the ability to defer deciding the ultimate distribution of trust assets.  For example, assume that a husband dies and leaves property in trust for his surviving wife and their children.  When the surviving spouse dies, the trust specifies that the remaining trust assets are to pass equally to the children, unless the surviving spouse exercises the power of appointment that was included in the husband’s trust.  At the time of the husband’s death, $2 million worth of assets was included in the trust and the couple had two children, each equally situated in life.  However, when the surviving spouse dies years later, perhaps the children aren’t so equally positioned anymore – one is rather well off and the other is struggling.  The exercise of the power of appointment can give the surviving spouse the ability to “unbalance” the disposition of the trust assets and leave more assets to the child with greater needs. 

A general power of appointment is one that is exercisable in favor of the decedent, his estate, his creditors or the creditors of his estate.  I.R.C. §2041(b)(1). It also means a power that is exercisable in favor of the individual possessing the power, his estate, his creditors, or the creditors of his estate.  I.R.C. §2514(c). Generally, the lapse of a power of appointment during the life of the individual who has the power of appointment is a release of the power.  I.R.C. §2041(b)(2)But, this rule only applies to a lapse of powers during any calendar year to the extent that the property which could have been appointed by exercise of such lapsed powers exceeded the greater of $5,000 or 5% of the aggregate value of the assets out of which the exercise of the lapsed powers could have been satisfied.  I.R.C. §§2041(b)(2); 2514(e).  In addition, generally the exercise or release of a general power of appointment is a transfer of property by the individual possessing such power.  I.R.C. §2514(c).  When that occurs, it can result in a taxable gift to the trust and/or inclusion of the assets in the power holder’s estate.  If large dollar values are involved, that can be a disastrous result.

A recent IRS ruling involved a trust that contained a general power of appointment that had been drafted incorrectly.  The question was whether that error could be corrected without triggering gift tax or causing the property to be included in the power holder’s estate.  In Priv. Ltr. Rul. 201941023 (May 29, 2019), the settlor created an irrevocable trust for the benefit of his six children. The purpose of the trust was to provide for his descendants and reduce transfer taxes by keeping trust assets from being included in a primary beneficiary’s gross estate. Under the trust terms, each child had his or her own separate trust (collectively, Children’s Trusts; individually, Child’s Trust). Each child was the primary beneficiary of his or her Child’s Trust.

Unfortunately, the trust had a drafting error pertaining to the withdrawal provision – it didn’t limit the general power of withdrawal right of a primary beneficiary over assets contributed to the trust to the greater of $5,000 or five percent of the value of the trust assets as I.R.C. §2041(b)(2) required. Thus, any lapse of a primary beneficiary’s withdrawal right would be a taxable transfer by that particular primary beneficiary under I.R.C. §2514 to the extent that the property that could have been withdrawn exceeded the greater of $5,000 or five percent of the aggregate value of the assets. Also, the portion of each child’s trust relating to the lapsed withdrawal right that exceeded the greater of $5,000 or five percent of trust asset value would be included in the primary beneficiary’s estate.

A subsequent estate planning attorney discovered the error in the original drafting upon review of the estate plan. Consequently, the trustee sought judicial reformation to correct the drafting error on a retroactive basis, and the court issued such an order contingent on the IRS favorably ruling. The IRS did favorably rule that the reformation didn’t cause the release of a general power of appointment with respect to any primary beneficiary. The purpose of the reformation, the IRS determined, was to correct a scrivenor’s error and did not alter or modify the trust in any other manner.  That meant that none of the children would be deemed to have released a general power of appointment by reason of the lapse of a withdrawal right that they held with respect to any transfer to their trust.  Thus, no child would be deemed to have made a taxable gift to their trust and no part of any child’s trust would be included in any child’s estate. 

Perhaps there is a “kindler and gentler” IRS after all – at least on this point. 

Conclusion

These are just a small snippet of what’s been going on in the courts and IRS recently that can impact agricultural producers and others involved in agriculture.  Each day brings something new. 

November 8, 2019 in Civil Liabilities, Estate Planning, Insurance | Permalink | Comments (0)

Monday, October 7, 2019

The Importance of Income Tax Basis “Step-Up” At Death

Overview

2013 marked the beginning of major law changes impacting estate planning.  Those changes were continued and, in some instances, enhanced by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017.  In particular, the “applicable exclusion amount” was enhanced such that (for deaths in 2019) the associated credit offsets the first $11.4 million in taxable estate value (or taxable gifts).  Consequently, the vast majority of estates are not impacted by the federal estate tax.  The “stepped-up” basis rule was also retainedI.R.C. §1014.  Under that rule, property included in the estate at death gets an income tax basis in the hands of the heirs equal to the property’s fair market value (known as “stepped-up” basis).  Much estate planning now emphasis techniques to cause property inclusion in a decedent’s estate at death to get the basis increase. 

What are the planning steps to achieve a basis increase?  What about community property?  These are the issues addressed in today’s post.

Basis “Step-Up” Considerations – First Things First

As noted above, under present law, the vast majority of estates do not face federal estate tax at death.  Thus, obtaining a basis increase for assets included in the gross estate is typically viewed as more important.  Consequently, an initial estate planning step often involves a comparison of the potential transfer tax costs with the income tax savings that would arise from a “step-up” in basis.  Unfortunately, this is not a precise science because the applicable exclusion adjusts be for inflation or deflation and could change dramatically depending on the whim of politicians. 

It’s also important to note that a basis increase is of no tax help to the owner of the property that dies.  The only way to capture the income tax benefits of the stepped-up basis adjustment is for the recipients of those assets to dispose of them in a taxable transaction. The degree of the benefit is tied to the asset.  Farm and ranch land may never be sold or may only be sold in the very distant future.  A basis adjustment at death is also beneficial if the asset involved is depreciable or subject to depletion.  An additional consideration is whether the asset involved is an interest in a pass-through entity such as a partnership or an S corporation.

Exceptions To “Stepped-Up” Basis

There are exceptions to the general rule of date- of-death basis.  For example, if the estate executor elects alternate valuation under I.R.C. §2032, basis is established as of the alternate valuation date (typically six months after death).  Also, if the estate executor elects special use valuation under I.R.C. §2032A, the lower agricultural use value of the elected property as reported on the federal estate tax return establishes the basis in the hands of the heirs.  For deaths in 2019, the maximum statutory value reduction for elected land is $1,160,000. 

In addition, for land subject to a qualified conservation easement that is excluded from the gross estate under I.R.C. §2031(c), a “carryover” basis applies to the property.  Also not receiving a basis increase at death is property that constitutes income in respect of a decedent (such as unrecognized interest on U.S. savings bonds, accounts receivable for cash basis taxpayers, qualified retirement plan assets, and IRAs, among other things).  There’s also a special basis rule that involves appreciated property that was gifted to the decedent within one year of death, where the decedent transferred the property back to the original donor of such property (or the spouse of the donor).  The donor receiving the property back will take as a basis the basis that the decedent had in the property immediately before the date of death. I.R.C. §1014(e).  The property basis won’t step-up to fair market value at the date of the decedent’s death.

Community Property Considerations 

The advantage of community property.  On the basis step-up issue, estates of persons living in community property states have an advantage over estates of persons domiciled in separate (common law) property states.  Under community property law, all assets acquired during marriage by either spouse, except gifts, inheritances, and assets acquired with separate property, are considered to be owned equally by the spouses in undivided interests.  The title of an asset is not definitive in terms of ownership in community property states like it is in common law states. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. 

The ownership portion of the couple’s community property that is attributable to the surviving spouse by virtue of I.R.C. §1014(b)(6) gets a new basis when the first spouse dies if at least one-half of the community property is included in the decedent’s estate for federal estate tax purposes.  This became the rule for deaths after 1947.  Restated differently, there is a basis adjustment of both the decedent’s and surviving spouse’s one-half of community property at death if at least one-half of the community property was included in the decedent’s gross estate under the federal estate tax rules – which would normally be the result.  The federal tax law considers the surviving spouse’s share to have come from the decedent.  The result is a 100 percent step-up in the basis of the property.  Conversely, in a common law property state, property that one spouse owns outright at death along with only 50 percent of jointly owned property is included in the estate of the first spouse to die (and receives a basis adjustment) unless the rule of Gallenstein v. Comr., 975 F.2d 286 (6th Cir. 1992) applies to provide a 100 percent basis step-up for property acquired before 1977.   

Community property spousal trusts.  Three common law property states, Alaska, South Dakota and Tennessee, authorize the creation of “community property trusts” for married couples that establish via the trust an elective community property system.  See, Alaska Stat. Ann. §34.77.100; Tenn. Code Ann. Ch. 35-17-101 – 35-17-108; S.D. Cod. Laws. Ch. 55-17-1 – 55-17-14.   In these states, married couples can classify property as community property by transferring the property to a qualifying trust.  

Under the Alaska provision (enacted in 1998), at least one trustee must be an individual who resides in Alaska or a trust company or bank with its principal place of business in Alaska.  The trust is irrevocable unless it provides for amendment or revocation.  Certain disclosures must be made for the trust to be valid, and the trust must contain specific language declaring that the property contained in the trust is to be community property.  Resident married couples can also execute an agreement to create community property for property that is not held in trust.

The Tennessee provision was enacted in 2010 and allows married couples to convert their property to community property by means of a “Community Property Trust.”  Again, the idea of the trust is to achieve a 100 percent basis step-up for all of the trust property at the death of the first spouse.  Comparable to the Alaska provision, at least one trustee must be an individual that resides in Tennessee or a company that is authorized to act as a fiduciary in Tennessee.   

Under the South Dakota law (enacted in 2016), property contained in “South Dakota Spousal Trust” is considered to be community property even if one spouse contributed more than 50 percent of the property to the trust.  At least one trustee must be a South Dakota resident, which could be one of the spouses.  S.D. Cod. Laws §§55-17-1; 55-3-41.  The trust must state that the trust property is intended to be community property and must specify that South Dakota law applies.  S.D. Cod. Laws §55-17-3.  Both spouses must sign the trust.  S.D. Cod. Laws §55-17-1.  Nonresidents can also utilize such a trust if a trustee is a qualified person that resides in South Dakota.  In addition, significant disclosures are required between the spouses and both must consent and execute the trust.  S.D. Cod. Laws §§55-17-11; 55-17-12.  The trust can be either revocable or irrevocable if the trust language allows for amendment or revocation.  S.D. Cod. Laws. §55-17-4. 

Transfer of farmland.  Can farmland that is owned in joint-tenancy, tenancy-by-the-entirety, or co-tenancy in a common law property state be transferred to a Community Property Trust created under the laws of these states and be treated as community property in order to achieve a full stepped-up basis at the death of the first spouse?  Normally the law of “situs” (e.g. the location of where land is located) governs the legal status of the land transferred to a trust that is administered in another state.  Neither the Alaska, South Dakota, nor Tennessee laws clearly address the legal nature of farmland that is transferred to such a trust from a common law property state, and there appears to be no caselaw or IRS rulings that address the question.  Thus, a preferable planning approach might be to transfer the out-of-state farmland to an entity such as a limited liability company or family limited partnership followed by a transfer of the interests in the entity to the trust.  Perhaps doing so would avoid questions concerning the property law and income tax basis issues associated with the out-of-state farmland.

The UDCPRDA.  Presently, sixteen states (Alaska; Arkansas; Colorado; Connecticut; Florida; Hawaii; Kentucky; Michigan; Minnesota; Montana; New York; North Carolina; Oregon; Utah; Virginia and Wyoming) have enacted the Uniform Disposition of Community Property Rights at Death Act (“UDCPRDA”).  The UDCPRDA specifies how property that was acquired while the spouses resided in a community property state passes at death if the spouses then reside in a common law property state.  The UDCPRDA preserves the community property nature of the property, unless the couple has taken some action to sever community property rights.  It does so by specifying that upon the death of the first spouse, one-half of the community property is considered the property of the surviving spouse and the other half is considered to belong to the deceased spouse.  This should achieve a full basis step-up due to the unlimited marital deduction of I.R.C. §2056, however there aren’t any cases or IRS rulings on the impact of the UDCPRDA on basis step-up under I.R.C. §1014(b)(6).

Other Techniques

The disparate treatment of community and common law property under I.R.C. §1014 has incentivized estate planners to come up with techniques designed to achieve a basis “step up” for the surviving spouse’s common law property at the death of the first spouse.

One way to achieve the basis increase is to give each spouse a power of appointment over the other spouse’s property which causes, on the death of the first spouse, the deceased’s spouse’s property to be included in the decedent’s estate by virtue of I.R.C. §2033 (if owned outright) and I.R.C.§2038 if owned in a revocable trust.  The surviving spouse’s property would also be included in the decedent’s estate by virtue of I.R.C. §2041. The power held by the first spouse to die terminates upon the first spouse’s death and would be deemed to have passed at that time to the surviving spouse.

Another technique involves the use of a joint exempt step-up trust (JEST).  In essence, both spouses contribute their property to the JEST that holds the assets as a common fund for the benefit of both spouses. Either spouse may terminate the trust while both are living, with the result that the trustee distributes half of the assets back to each spouse. If there is no termination, the joint trust becomes irrevocable upon the first spouse’s death. Upon the first spouse’s death, all assets are included in that spouse’s estate.  Upon the first spouse’s death, assets equal in value to the first spouse’s unused exclusion will be used to fund a bypass trust for the benefit of the surviving spouse and descendants. These assets will receive a stepped-up basis and will not be included in the surviving spouse’s estate.  Any asset in excess of the funding of the bypass trust will go into an electing qualified terminable interest property (QTIP) trust under I.R.C. §2056(b)(7).  If the first spouse’s share of the trust is less than the available exclusion, then the surviving spouse’s share will be used to fund a bypass credit shelter trust.  These assets will avoid estate taxation at the surviving spouse’s death.

The JEST technique comes with caution.  Because the surviving spouse (the donor) could revoke the joint revocable living trust at any time, the surviving spouse arguably has dominion and control over the trust assets during the year before and up to the time of the decedent spouse’s death.  That could mean that I.R.C. §1014(e) applies to disallow a basis increase in the surviving spouse’s one-half interest in the trust due to retained control over the trust assets within a year of death.  See, Priv. Ltr. Ruls. 9308002 (Nov. 16, 1992) and 200101021 (Oct. 2, 2000). 

Conclusion

For the vast majority of people, avoiding federal estate tax at death is not a concern.  Some states, however, do tax transfers at death and the exemption in those states is often much lower than the federal exemption.  But, achieving an income tax basis at death is of primary importance to many people.  Community property has an advantage on this point, and other planning steps might be available to receive a full basis step-up at death.  In any event, estate and income tax basis planning is a complex process for many people, especially those with farms and ranches and other small businesses that are trying to make a successful transition to the next generation.  Competent legal and tax counsel is a must.

October 7, 2019 in Estate Planning, Income Tax | Permalink | Comments (0)

Tuesday, October 1, 2019

Issues in Estate Planning – Agents, Promises and Trustees

Overview

When one thinks of estate planning, visions of wills and/or trusts come to mind and maybe even a power of attorney for financial and health care decisions.  Those are the standard documents.  If a spouse is also involved in the process, then the coordination of the language in the documents for each spouse is also critical to ensure that the couple’s property passes as desired after the last of them dies.

But, beyond the basic documents and coordinated planning, there are numerous legal issues that can arise.  Those can include issues associated with someone else acting on one’s behalf; promises to pass property at death; and the process for replacing a trustee of a trust.  Some recent court cases dive into each of these issues.

Legal issues arising during the estate planning process – it’s the topic of today’s post.

Signing Documents On Behalf Of Someone Else

In In re Estate of Moore, No. 115,628, 2019 Kan. LEXIS 321 (Kan. Sup. Ct. Sept. 6, 2019), the decedent appointed the defendant (her ex-daughter in law) as her power of attorney. The plaintiff (the decedent’s son) had a long history of poor financial decisions, including losing 440 acres that the decedent pledged as security for him. More than $100,000 of the decedent’s money was lent or just straight up taken out of her accounts by the plaintiff. An attorney was hired to keep the plaintiff from obtaining the decedent’s “homeplace.” A transfer on death deed was created to move the property to the defendant so that it could later be transferred to the decedent’s grandsons (the children of both parties).

In May of 2004 the deed was read to the decedent, and the legal description was double checked. One of the grandsons asked if that decedent wanted them to have the property, which she answered “yes.”  In the presence of five witnesses the decedent asked the defendant to sign for her. The deed was notarized and filed. The decedent died on September 15, 2009. On November 7, 2012, the defendant executed a warranty deed conveying the homeplace to the grandsons. In 2014 the plaintiff filed petition for determination of descent asserting that the homeplace should have been in the estate. The grandsons countered that the property passed to them by transfer on death deed and was not in the estate.

The trial court initially found for the plaintiff based on the fact that the defendant could not benefit herself with that right. The defendant filed a motion to reconsider and claimed that the she did not sign the deed with her power of attorney but as an amanuensis – at the direction or dictation of someone else. The trial court agreed as did the appellate court. On further review, the state Supreme Court also agreed. The plaintiff challenged the validity of the signature by amanuensis noting that the defendant signed the transfer on death for the decedent and the added "by Maureen Miles, Power of Atty." The Supreme Court noted that state (KS) common law recognizes as valid a signature made by a person at the direction of someone else. The Court noted that the evidence was clear that the deed was properly signed by amanuensis. There were six witnesses that testified that the decedent asked the defendant to sign the deed for her. The plaintiff failed to present evidence to the contrary. The Court also rejected the plaintiff’s claim that the signature was not properly acknowledged. The deed was notarized after the defendant signed it for the decedent. The notary attached a notation indicating this intricacy. The deed was filed 3 days later. The deed conformed to state law by being signed; designating a beneficiary; acknowledged by a notary; and recorded in the office of the register of deeds prior to the decedent’s death. The Court found the deed signed by amanuensis to be proper even though the notary acknowledged the defendant’s power of attorney. The Court also rejected the plaintiff’s undue influence claim by concluding that the plaintiff failed to rebut the presumption that the decedent was competent in accordance with the general competency test for testamentary capacity. The decedent had strong motivations to ensure that the plaintiff did not receive her property, and the defendant transferred the property to the decedent’s grandsons before the litigation and did not benefit from the transaction. 

Promises, Promises...

In a recent Idaho Supreme Court decision, Turcott v. Estate of Bates, 443 P.3d 197 (Idaho 2019), the Court dealt with the legal force of an apparent promise not to change a will before death.  Under the facts of the case, in the late 1990’s the decedent executed a will devising the decedent’s farm to the decedent’s daughter and son equally. From 2007 until 2014 the daughter and her husband moved to the farm. They built a home on the farm and spent a lot of time and money maintaining the farm. In 2014, the decedent remarried and revoked the will. The decedent then placed the farm in a trust listing his new wife and himself as beneficiaries. The new will stated, "I purposefully have excluded my daughter as a devisee of my estate and my daughter shall take nothing from my estate." In 2016, the daughter sought to enforce the validity of the first will based on a promise that the will would not be changed or revoked before death. The trial court dismissed the plaintiff’s claim for the alleged promise to maintain the will. The plaintiff then filed an amended petitioner seeking quantum meruit damages for the work the plaintiff performed on the farm. The trial court awarded the plaintiff $136,402.50 in damages for unjust enrichment, but the plaintiff appealed on the basis that the amount was too low. On further review, the appellate court affirmed and did not award attorney fees because the appeal was not frivolous. 

How Long Does a Trustee Serve?

In Waldron v. Suasan R. Winking Trust, No. 12-18-00026-CV, 2019 Tex. App. LEXIS 5867 (Tex. Ct. App. Jul. 10, 2019), the plaintiff was the beneficiary of a trust that her parents created. The appointed trustee of the trust resigned and the appointed successor trustee (a bank) refused to serve as trustee. The trust instrument specified that if the successor trustee failed to serve that any bank or trust company could be appointed trustee by the serving of written notice signed by the grantor. However, the plaintiff could not find a bank or trust company willing to serve as trustee, so the plaintiff filed an action seeking to have an individual appointed as trustee. The trial court made such an appointment.

The plaintiff later filed an action to be appointed trustee due to improper conduct of the individual that had been appointed as trustee. That individual did not object to being removed as trustee upon appointment of another qualified trustee. The plaintiff subsequently sought to have another person appointed as trustee. This eventually happened, but the plaintiff asserted that the trial court ignored the trust language allowing for immediate termination of the trustee without cause by written letter if both grantors were legally disabled or deceased. Immediate termination would have saved the plaintiff from paying additional expenses for professional serviced.  The appellate court noted that the trust language did not provide a procedure for appointing a successor trustee when a bank or trust company could not be found to serve. Thus state (TX) law applied and left the decision of a successor trustee up to the court. State law also specified that an existing trustee’s fiduciary duties were not discharged until the trustee had been replaced by a successor trustee. As a result, the appellate court affirmed the trial court’s decision. 

Conclusion

Estate planning is a complex process in many situations.  Precision of drafting language is critical, but it depends on client clarity as to goals and objectives and attention to changes in applicable law.  Even then, however, landmines may still exist.  This is why “boilerplate” language and “boilerplate” forms printed off the web can be dangerous to use.  Get and keep good estate planning counsel.

October 1, 2019 in Estate Planning | Permalink | Comments (0)

Friday, July 19, 2019

ESOPs and Ag Businesses – Part One

What Is An ESOP?

In existence since the 1970s, an employee stock ownership plan (ESOP) is a type of qualified retirement plan that is designed to provide employees with ownership in the company by investing (primarily) in shares of stock of the employer-company.  According to data from the National Center for Employee Ownership, there are about 7,000 ESOPs in the United States covering approximately 14 million employees.    

Does an ESOP work for employees of a farming/ranching operation or an agribusiness?  In part one of a two-part series, today’s post lays out the basics of an ESOP – how it’s established and the potential benefits.   In part two next week I will examine potential problem areas as well as how the new tax law (as of the beginning of 2018) impacts the use of an ESOP.

ESOPs in agriculture – it’s the topic of today’s blog post. 

General Structure

An ESOP involves employee ownership of the business.  There are several ways that an employee can obtain ownership in the business.  One is to buy stock in the company.  Other ways involve an employee being gifted stock, receiving stock as a bonus or obtaining it via a profit-sharing plan.  But, the most common way for an employee to obtain ownership in the business is by use of an ESOP. 

In the typical ESOP transaction, the company establishes the plan by means of a trust fund – an “employee benefit trust” (hopefully with competent tax and legal counsel) and appoints an ESOP trustee.  The trustee then negotiates with a selling shareholder to establish the terms of the sale of the shareholder’s stock to the ESOP.  The company borrows the necessary funds from a third-party lender on the ESOP’s behalf and loans the funds to the ESOP which uses the funds to buy the stock from the selling shareholder with the seller receiving cash and taking a note for the balance.  The company will make annual (tax-deductible) contributions of cash to the ESOP which the ESOP uses to repay the inside loan.  The company uses the payment received from the ESOP to make payments on the third-party loan. 

An alternative approach is for the company to have the trust borrow money to buy stock with the company making contributions to the plan so that the loan can be paid back.  Unlike other retirement plans, an ESOP can borrow money to buy stock.  Consequently, an ESOP can buy large percentages of the company in a single transaction and repay the loan over time using company contributions.      The trustee is appointed by the company’s board of directors to manage the trust and can be an officer or other corporate insider.  Alternatively, the trustee can be an independent person that is not connected to the corporation as an officer or otherwise.  It is advisable that an external trustee be used to negotiate the terms and execute the transaction involving the purchase of shares of stock from a selling shareholder.   The trustee has the right to vote the shares acting in a fiduciary capacity.  However, the ESOP may require that certain major corporate transactions (i.e., mergers, reorganizations, and significant asset sales) involve the participation of ESOP participants in terms of instructing the trustee with respect to voting the stock shares that are allocated to their accounts.  I.R.C. §409(e)(3).  ESOP participants do not actually own the shares, the trust does.  Thus, an ESOP participant has only the right to see the share price and number of shares allocated to their account on an annual basis.  They have no right to see any internal financial statements of the company. 

The ESOP shares are part of the employees’ remuneration.  The shares are held in the ESOP trust until an employee either retires or otherwise parts from the company.  The trust is funded by employer contributions of cash (to buy company stock) or the contributions of company shares directly.

Retirement Plan Characteristics

An ESOP is a qualified retirement plan that is regulated by I.R.C. §4975(e)(7) as a defined contribution plan.  As such, ESOPs are regulated by ERISA which sets minimum standards for investment plans in private industry.  Only corporations can sponsor an ESOP, but it is possible to have non-corporate entities participate in an ESOP.  An ESOP must include all full-time employees over age 21 in the plan and must base stock allocations on relative pay up to $265,000 (2016 level) or use some type of level formula.  ESOPs are provided enhanced contribution limits, which may include the amount applied to the repayment of the principal of a loan incurred for the purposes of acquiring employer securities.  Employers are allowed to deduct up to an additional 25 percent of the compensation paid or accrued during the year to the employees in the plan as long as the contributions are used to repay principal payments on an ESOP loan. I.R.C. §404(a)(9)(A). 

In addition, an employer with an ESOP may deduct up to another 25 percent of compensation paid or accrued to another defined benefit contribution plan under the general rule of I.R.C. §404(a)(3).

 In addition, contributions made to the ESOP applied to the repayment of interest on a loan incurred for the purpose of acquiring qualifying employer securities are also deductible, even though in excess of the 25 percent limit. I.R.C. §404(a)(9)(B).  But, these two provisions, do not apply to an S corporation. I.R.C. §404(a)(9)(C). As a qualified retirement plan, an ESOP must satisfy I.R.C. §401(a) to maintain its tax-exempt status.  While an ESOP is not subject to the normal ERISA rules on investment diversification, the fiduciary has a duty to ensure that the plan’s investments are prudent. In addition to basic fiduciary duties designed to address the concern of an ESOP concentrating retirement assets in company stock, it is not uncommon for a company with an ESOP to also have a secondary retirement plan for employees.

What Happens Upon Retirement or Cessation of Employment?

When one the employee retires or otherwise parts from the company, the company either buys the shares back and redistributes them or voids the shares.  An ESOP participant is entitled to a distribution of their account upon retirement or other termination of employment, but there can be some contingencies that might apply to delay the distribution beyond the normal distribution time of no later than the end of the plan year.  For plan participants that terminate employment before normal retirement age, distributions must start within six years after the plan year when employment ended, and the company can pay out the distributions in installments over five years, with interest.  If employment ceased due to death, disability or retirement, the distribution must start during the plan year after the plan year in which the termination event occurred, unless elected otherwise.  If the ESOP borrowed money to purchase employer securities, and is still repaying the loan, distributions to terminating employees are delayed until the plan year after the plan year in which the loan is repaid.  In addition, no guarantee is made that the ESOP will contain funds at the time distributions are required to begin to make the expected distributions.

What Are The Benefits of an ESOP?

For C corporations with ESOPS, the selling shareholder avoids the “double tax” inherent in asset sales because the sale is a stock sale.  As such, gain can be potentially deferred on the sale of the stock to the ESOP. To achieve successful deferral, the technical requirements of I.R.C. §1042 must be satisfied and the ESOP, after the sale, must own 30 percent or more of the outstanding stock of the company and the seller must reinvest the sale proceeds into qualified replacement property (essentially, other securities) during the period beginning three months before the sale and ending 12 months after the sale.  If the replacement property is held until the shareholder’s death, the gain on the sale of the stock to the ESOP may permanently avoid tax. 

Corporate contributions to the ESOP are deductible if the contributions are used to buy the shares of a selling shareholder.  As a result, an ESOP can be a less costly means of acquiring a selling shareholder’s stock than would be a redemption of that stock.  Also, the ESOP does not pay tax on its share of the corporate earnings if the corporation is an S corporation. Thus, an S corporation ESOP is not subject to federal income tax, but the S corporation employees will pay tax on any distributions they receive that carry out the resulting gains in their stock value.

From a business succession/transition standpoint, an ESOP does provide a market for closely-held corporate stock that would otherwise have to be sold at a discount to reflect lack-of marketability of the stock, although the lack of marketability must be considered in valuing the stock.  Indeed, one of the requirements that an ESOP must satisfy is that it must allow the participants to buy back their shares when they leave the company (a “repurchase obligation”).     

Compared to a traditional 401(k) retirement plan, ESOP company contribution rates tend to be higher, and ESOPS tend to be less volatile and have better rates of return.   

Conclusion

In part two next week, I will look at the potential drawbacks of an ESOP and why the U.S. Department of Labor (DOL) gets concerned about them.  That discussion will include a recent DOL ESOP investigation involving a major ag operation. It will also involve a look at how the Tax Cuts and Jobs Act impacts ESOPs. 

July 19, 2019 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, July 3, 2019

Summer Tax and Estate Planning Seminar!

Overview

On August 13-14 Washburn University School of Law along with co-sponsors Kansas State University Department of Agricultural Economics and WealthCounsel, LLC will be conducting the 2019 National Summer Farm Income Tax/Estate and Business Planning Conference in Steamboat Springs, CO. This is a great opportunity for practitioners with agricultural clients as well as agricultural producers to get two days of in-depth education/training on issues that impact the agricultural sector.

The Steamboat Springs seminar, it’s the topic of today’s post.

Speakers and Agenda

This is the 15th summer that I have been conducting a national event, with that first one held in beautiful Ely, Minnesota.  Sometimes there is more than one during the summer, with the event usually held at a very nice location so that attendees can enjoy the area with their families if they choose to do so.   This summer is no exception.  Steamboat Springs is a lovely place on the western side of the Rocky Mountain National Park.

The speakers this year in addition to myself are Paul Neiffer, Stan Miller and Timothy O’Sullivan.  Paul has taught with me for several years at this event (and others) and many of you are familiar with him.  Stan is a partner in a law firm in Little Rock, Arkansas and the founder of WealthCounsel, LLC.  Stan will be speaking on the second day and will be addressing the necessary planning steps to assist farm and ranch families keep the business going into the future.  Also, on the Day 2, Tim O’Sullivan will provide the key details on long-term care planning, and dealing with family disharmony and its impact on the tax and estate planning/business succession planning process.  Tim has an extensive estate planning practice with Foulston Siefkin, LLP in Wichita, Kansas.  He is particularly focused and has expertise in the areas of Elder Law and Trusts and Estates. 

On the first day, Paul and myself will go through the current, key farm income tax issues.  Of course, the I.R.C. §199A deduction will be a big topic.  Just a couple of weeks ago, the Treasury released the draft proposed regulations on how the deduction applies in the context of agricultural/horticultural cooperatives and patrons.  We will take a deep dive into that topic, for sure.  Many questions remain.  We will also numerous other topics and provide insight into discussions in D.C. on specific issues and the legislative front.  It will be a full day. 

You can see the full agenda here:  http://washburnlaw.edu/employers/cle/farmandranchtax.html

Accommodations

The event will be held at the beautiful Steamboat Grand Hotel.  A roomblock is established for the conference.  Information on the hotel can be found here:  https://steamboatgrand.com/ For those brining families, there are many sights to see and places to visit in the town and the surrounding area. 

Registration

You can register for both days or just a single day.  Also, the conference is live streamed in the event you are not able to attend in person.  Just click on the conference link provided above to learn more.  You can register here:  http://washburnlaw.edu/employers/cle/farmandranchtaxregister.html

Additional Opportunity

On Monday, August 12 I will be participating in another conference at the Steamboat Grand Hotel focusing on conservation easements.  That event is sponsored by several land trusts.  Contact me personally about that conference if you are interested in learning more.

Conclusion

I hope to see you in Steamboat Springs next month!  If you can’t attend in person, we trust you will benefit from watching the live presentation online.

July 3, 2019 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Tuesday, June 25, 2019

Wayfair Does Not Mean That a State Can Always Tax a Trust Beneficiary

 

Overview

Last year, the U.S. Supreme Court decided South Dakota v. Wayfair, 138 S. Ct. 2080 (2018), upholding South Dakota’s ability to collect taxes from online sales by sellers with no physical presence in the state.  That decision was the latest development in the Court’s 50 years of precedent on the issue.  Based on that opinion, some states with an income tax took an aggressive stance against trust beneficiaries residing in their states.  These states claimed that Wayfair meant that the mere presence in the state of a trust beneficiary allowed the state to tax the beneficiary’s trust income.  North Carolina was one of those states.

The Supreme Court unanimously rejected North Carolina’s position.  In so holding, the Court outlined Due Process limitations that apply to a state’s ability to tax. 

The limitations on a state’s taxing authority – that’s the topic of today’s post.

The “Nexus” Requirement

In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided.  Later, in Quill Corporation v. North Dakota, 504, U.S. 298 (1992), the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement. 

In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction.  That’s what got North Carolina (and some other states) excited – the ability to tax trust income on the basis that a beneficiary’s presence in the state satisfied the nexus requirement.  But, the key point is that the “substantial nexus” test of Brady remains.  Likewise, the other three requirements of Brady remain – fair apportionment; no discrimination against interstate commerce, and; fairly related to services that the state provides.  In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce.  The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – limited application (based on transactions or dollars of sales); not retroactive; the state was a member of the Streamlined Sales and Use Tax Agreement; the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden. 

Taxing an Out-Of-State Trust?

In the North Carolina case, the trust at issue was a revocable living trust created in 1992 with a situs of New York. The primary beneficiaries were the settlor’s descendants. None of the descendants lived in North Carolina at the time of the trust’s creation. The trust was divided into three separate trusts in 2002, one for each of the settlor’s children. The beneficiary of one of the sub-trusts was a North Carolina resident at that time. The trustee was replaced in 2005 with a successor trustee who resided in Connecticut. North Carolina tax returns were filed for tax years 2005-2008 for the accumulated trust income, that was distributed to the beneficiaries, including the non-North Carolina beneficiaries. In 2009, the trust filed a claim for a refund of North Carolina taxes in an amount slightly exceeding $1.3 million. The trust claimed that N.C. Gen. Stat. §105-160.2, which assesses tax on the amount of taxable income of the estate or trust that is for the benefit of a North Carolina resident, was unconstitutional on Due Process and Commerce Clause grounds. The defendant denied the claim, and the hearing officer later dismissed the case for lack of jurisdiction.

The trial court dismissed the request for injunctive relief with respect to the refund claim, but denied the defendant’s motion to dismiss the constitutional claims. The trial court then granted summary judgment for the trust on the constitutional claim and ordered the defendant to refund the taxes paid on its accumulated income.

On appeal, the appellate court affirmed. Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 248 N.C. 212, 789 S.E.2d 645 (N.C. Ct. App. 2016)The appellate court determined that the trust failed to have sufficient minimum contacts (as required by the Due Process Clause) with North Carolina to subject the trust to North Carolina income tax. The court cited both International Shoe Co. v. Washington, 326 U.S. 310 (1945) and Quill Corp. v. North Dakota, 504 U.S. 298 (1992) to support its position on this point. The trust did not have any physical presence in the state during the tax years at issue, contained no North Carolina property or investments, had no trust records that were created or kept in North Carolina, and the place of trust administration was not in North Carolina. Basing the imposition of state tax on a beneficiary’s domicile, by itself, did not establish sufficient minimum contacts with the state to satisfy the Due Process Clause and allow North Carolina to tax a non-North Carolina trust. The appellate court held that Brooke v. Norfolk, 277 U.S. 27 (1928) was controlling. In that case, a Maryland resident created a testamentary trust with a Maryland situs for a Virginia beneficiary. Virginia assessed tax on the trust corpus, but the Court held the assessment to be unconstitutional.

On further review, the state Supreme Court affirmed.  Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 371 N.C. 133, 814 S.E.2d 43 (N.C. Sup. Ct. 2018)The state Supreme Court noted that a key to the case was that the trust beneficiary did not receive trust distributions during the years at issue. As such, the North Carolina statute violated the Due Process Clause of the U.S. Constitution.

The North Carolina Supreme Court’s decision was delivered 13 days before the U.S. Supreme Wayfair decision, and was based on the controlling U.S. Supreme Court decision at that time – Quill.  Consequently, the North Carolina Department of Revenue, based on Wayfair, sought U.S. Supreme Court review.  On January 11, 2019, the U.S. Supreme Court agreed to hear the case.  North Carolina Department of Revenue v. Kimberley Rice Kaestner Trust 1992 Family Trust, 139 S. Ct. 915 (2019). 

U.S. Supreme Court Decision

In a unanimous decision, the U.S. Supreme Court affirmed, holding that the North Carolina law violated Due Process.  North Carolina Department of Revenue v. Kimberley Rice Kaestner Trust 1992 Family Trust, No. 18-457, 2019 U.S. LEXIS 4198 (U.S. Sup. Ct. Jun. 21, 2019).  The Court noted that a taxpayer must have “some minimum connection” with the state, and that a rational relationship must exist between the income the state wants to tax and the state.  There must be a fiscal relationship to benefits that the state provides.  That’s a Due Process limitation.  As applied to a trust, and based on Brooke v. Norfolk (cited above), the Court seemed to suggest that whether a trust beneficiary’s in-state contacts are relevant on the nexus question is tied to whether the beneficiary has a “right to control, possess, enjoy or receive trust assets.”  Applying that rationale to the trust at issue, the court determined there was an insufficient nexus between the North Carolina beneficiary and the state for the state to have jurisdiction to tax the trust.  The beneficiary never received an income distribution from the trust for the years at issue and didn’t have a right to demand trust distributions and had no power of assignment.  It was the trustee, under the terms of the trust, that had the sole discretion over distributions.  Indeed, the trust assets could ultimately end up in the hands of other beneficiaries.  But, the Court did not foreclose the ability of a state to tax trust income where the trust gives the resident beneficiary a certain right to trust income. 

Implications.  The Court’s decision does leave in its wake considerations for drafters of trust instruments.  For starters, a purely discretionary trust (e.g., a trust giving the trustee sole discretion over trust distributions) can bar a state from taxing a beneficiary’s income distribution.  That’s especially true when combined with “spendthrift” language that bars the beneficiary from assigning their beneficial interest in the trust.  This type of trust language typically works well when there is a need to place limitations on a beneficiary’s rights and access to trust assets.  While the Court didn’t address the impact of a giving a beneficiary a power of appointment over trust assets in a discretionary trust, it would seem that if such a power is present and exercised, the state would have the ability to tax the beneficiary at least in the year the power is exercised.

The facts of the case indicated that the beneficiary had the right to receive either a share or all of the trust assets upon reaching a particular age, but the right was contingent.  What if the trust language had made the future right not contingent?   Would the Court have concluded that a state has the ability to tax the beneficiary then? 

The Court also pointed out that nexus means something different depending on whether it is being applied to the grantor/settlor of the trust, the trustee or a beneficiary.  A resident trustee satisfies the nexus requirement as does a resident grantor/settlor (with respect to a revocable trust).  But, does that mean that a trust grantor/settlor can be taxed based solely on having created the trust in that particular state?  Maybe that challenge will be forthcoming in the future.

Conclusion

State taxation of trusts varies greatly from state to state in those states that have a state income tax.  A trust’s situs in a state certainly permits that state to subject the trust to the state’s income tax as a resident.  But, a trust may be tied to a state in other ways via a grantor, trustee, assets, or a beneficiary.  In addition, whether a trust is a revocable or irrevocable trust can make a difference. For instance, the Illinois definition of  “resident” includes “an irrevocable trust the grantor of which was domiciled in this State at the time such trust became irrevocable.”  35 ILCS/1501(A)(20)(D); see also, Linn v. Department of Revenue, 2 N.E.3d 1203 (Ill. Ct. App. 2013).  Indeed, a trust may have multiples states asserting tax on the trust’s income. 

However, due process requires that before a state can tax a trust’s income, the trust must have a substantial enough connection (e.g., nexus) with the state.  In addition, while a trust could be subject to state income tax based on its residency, the trust has grantors and trustees and beneficiaries and assets that can all be located in different states – and can move from state-to-state (at least to a degree).  That last point makes the Court’s decision relevant even to those practitioners in states without an individual income tax. 

June 25, 2019 in Estate Planning, Income Tax | Permalink | Comments (0)

Tuesday, June 11, 2019

Recent Developments in Farm and Ranch Business Planning

Overview

The organization of the farming business is important to those farm and ranch families that are wanting to transition the business to the next generation.  Other families don’t have heirs that are interested in continuing the family business.  For them organizational issues are important from a present tax and farm program payment limitation standpoint (perhaps), but not necessarily that critical for future business succession.

In today’ post, I take a look at some recent developments relevant to entity structuring.  These developments point out just a couple of the various issues that can arise in different settings.

S Corporation Basis Required to Deduct Losses

An S corporation shareholder reports corporate income or loss on their personal income tax return for the year in which the corporate year ends.  I.R.C. §1366(a). Losses or deductions passed through to the shareholder first reduce stock basis. After stock basis has been reduced to zero, remaining loss amounts are applied against debt basis.  I.R.C. §1367(b)(2)(A).  In a year where losses decrease stock and debt basis to zero, the losses can be deducted only if the shareholder increases basis before the end of the corporation’s tax year.

One way to increase basis is to lend money to the S corporation.  But, the loan transaction must be structured properly for a basis increase to result.  For example, in In Litwin v. United States, 983 F.2d 997 (10th Cir. 1993), the court allowed the principal shareholder and principal investor in a Kansas corporation involved in the provision and installation of certain fuel systems for motor vehicles a bad debt deduction for amounts loaned to the corporation.  Why?  Because the shareholder’s loan was tied to his desire to remain a shareholder/employee and he personally guaranteed the large loans that exceeded his investment.  In other words, he was at-risk and his business motives outweighed his investment motives. 

But, a couple of recent developments reveal the wrong way to structure loan transactions if a basis increase is desired.  In Messina v. Comr., T.C. Memo. 2017-213, the petitioners, a married couple, formed an investment advisory firm. They also each owned 40 percent of the outstanding stock of an S corporation. The S corporation subsequently became the 100 percent owner of another business that elected to be a qualified subchapter S subsidiary (QSUB). The QSUB borrowed money from an unrelated third party to finance the acquisition of another business. The petitioners then formed another S corporation that they were the sole owners of. They then used that second S corporation to buy the debt of the QSUB. The petitioners claimed that they could use the QSUB debt that the second S corporation held to increase their tax basis in the first S corporation so that they could deduct losses that passed through to them from the first S corporation. The petitioners claimed that the second S corporation was to be ignored because it was merely acting as an agent or conduit of the petitioners (an incorporated pocketbook of the petitioners). Thus, the petitioners claimed that they had made an actual economic outlay with respect to the acquisition of the QSUB debt to their financial detriment. As such, the petitioners claimed that the second S corporation should be ignored, and its debt actually ran directly between the first S corporation and its shareholders, of which they owned (combined) 80 percent.

The IRS disallowed the loss deduction due to insufficient basis and the Tax Court agreed. The Tax Court determined that there was no evidence to support the claim that the second S corporation was operating as the petitioners’ incorporated pocketbook. The Tax Court noted that the second S corporation had no purpose other than to acquire the debt of the QSUB, and the petitioners did not use the second S corporation to pay their expenses of the expenses of the first S corporation. There also was no evidence that the second S corporation was the petitioners’ agent because the corporation operated in its own name and for its own account. The Tax Court also held that the petitioners had not made any economic outlay except to the second S corporation. As such, the second S corporation could not be ignored, and the petitioners could not use its debt to increase their tax basis. The Tax Court noted that 2014 IRS final regulations and I.R.C. §1366(d)(1)(B) require that shareholder loans must run directly between the S corporation and the shareholder. 

More recently, another court determined that an S corporation shareholder failed to achieve a basis increase on loan transaction.  In Meruelo v. Comr., No. 18-11909, 2019 U.S. App. LEXIS 13305 (11th Cir. May 6, 2019), the taxpayer was a shareholder in an S corporation that bought a condominium complex in a bankruptcy sale. To fund its operations, the S corporation accepted funds from numerous related entities. Ultimately, lenders foreclosed on the complex, triggering a large loss which flowed through to the taxpayer. The taxpayer deducted the loss, claiming that the amounts that the related entities advanced created stock basis (debt basis) allowing the deduction. The IRS disallowed the deduction and he Tax Court agreed. The appellate court affirmed on the grounds that the advances were not back-to-back loans, either in form or in substance. In addition, the related entities were not “incorporated pocketbooks” of the taxpayer. There was no economic outlay by the taxpayer that would constitute basis. There also was no contemporaneous documentation supporting the notion that the loans between the taxpayer and the related entities were back-to-back loans (e.g., amounts loaned to a shareholder who then loans the funds to the taxpayer), and an accountant’s year-end reclassification of the transfers was not persuasive. While the taxpayer owned many of the related entities, they acted as business entities that both disbursed and distributed funds for the S corporation’s business expenses. The appellate court noted the lack of caselaw supporting the notion that a group of non-wholly owned entities that both receive and disburse funds can be an incorporated pocketbook. To generate basis, the appellate court noted, a loan must run directly between an S corporation and the shareholder. 

The Peril of the Boilerplate

The use of standard, boilerplate, drafting language is common.  However, there rarely are situations where “one-size-fits-all” language in documents such as wills, trusts, and formative documents for business entities will work in all situations.  That point was clear in another recent development. 

In a recent IRS Private Letter Ruling (directed to a specific taxpayer upon the taxpayer’s request), a multi-member LLC elected to be treated for tax purposes as an S corporation. Later, the shareholders entered into an operating agreement that governed the rights of shareholders. Section 10 of the agreement provided that, “Upon dissolution…the proceeds from the liquidation of the Company’s assets shall be distributed…to the Members in accordance with their respective positive Capital Account Balances; and, the balance, if any, to the Members in accordance with their respective Percentage interests.” The language is “boilerplate” and was intended to meet the substantial economic effect provisions of Treas. Reg. §1.704-1(b)(1) and protect special allocations of the partnership.

Unfortunately, the language did not require that the distributions be equal to a “per share” basis in all situations. Instead, they could be disproportionate upon liquidation to the extent of differences in their capital accounts at the time of liquidation.  That proved to be a problem.  The LLC engaged in a reorganization and sought a ruling on whether the language created a second class of stock that would terminate the S election. The IRS determined that the fact that the rights were not strictly proportionate created more than a single class of stock in violation of I.R.C. §1362(b)(1)(D) and terminated the S election as of the date of the adoption of the operating agreement. However, the IRS determined that the termination was inadvertent, and the S status of the LLC was restored retroactively. Priv. Ltr. Rul. 201918004 (Nov. 15, 2018).

Trusts – Is the End in Sight?

When does a trust end?  Either by its terms or when there is no longer any purpose for it.  Those are two common ways for a trust to end.  This was an issue in a recent case from Wyoming.  In re Redland Family Trust, 2019 WY 17 (2019), involved a family trust.  The case had been before the Wyoming Supreme Court on multiple occasions. The trust was created in 1989 and amended in 1995. The amendment provided for the appointment of a successor trustee; always required the service of two trustees; created a marital trust for the survivor of the settlors; and revised the buyout provision. The grantors and their five children made contributions to the trust. Upon the death of one of the grantors in 2007 one of the children was appointed as co-trustee. Ligation arose when the surviving grantor’s property was not conveyed to the trust and then again involving removal of the trustees, and an appointed trustee moved to have the trust terminated due to the administrative difficulties to administer, family dysfunction, and because the trust no longer served its purpose. The defendants, (including the co-trustee that resigned) asserted that termination was moot and moved to have the new co-trustee removed. The trial court did not remove the co-trustee and found that the trust was still valid. The trial court found that the co-trustee did not violate any fiduciary duties and that the defendants failed to show gross and willful misconduct to justify her removal. Further the trial court found that the co-trustee’s claims that the trust was invalid should have been raised in the original trust challenge. The trial court determined that the primary reason for the trust (to keep the lands and leases together for the Redland family) had not been frustrated and that the trust remained administratively functional and was not "unlawful, contrary to public policy, or impossible.

On appeal, the Wyoming Supreme Court affirmed. The Court determined that the trust still had a purpose - to keep the ranch holdings together to conduct business. Even though the other purpose of minimizing tax consequences had failed, consolidation of ranch holdings remained a legitimate purpose. The Court also determined that the co-trustee did not violate her fiduciary duties, her duties of impartiality or loyalty, and that her actions did not amount to gross and willful misconduct. In addition, the Court found that the duty of impartiality did not require the trustee to treat all beneficiaries fairly, but simply to act in the best interest of the beneficiaries and equally defend the intentions of the settlors. While the Court could find no precedent with respect to the duty of loyalty the Court held that merely seeking termination of the trust was not a breach of loyalty. In addition, the Court determined that hostility between parties did not warrant removal. 

Conclusion

There are various ways to structure business arrangements.  Not every structure is right for each family situation, but there’s a unique business plan that will do well for you – once you figure out what your goals and objectives are and have a solid understanding of your factual setting.  But, peril lurks.  Today’s post examined just a couple of the issues that can arise.  Make sure to have good planners assisting. 

June 11, 2019 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Friday, May 24, 2019

Where Does Life Insurance Fit In An Estate Plan For A Farmer or Rancher?

Overview

During life, many farmers and ranchers are focused on building their asset base, making sure that the business transitions successfully to the next generation, and preserving enough assets for the next generation’s success.  Historically, farm and ranch families haven’t widely used life insurance, but it can play an important role in estate, business and succession planning.  It can also help protect a spouse (and dependents, if any) against a substantial drop in income upon the death of the farm operator.  It can also provide post-death liquidity and fund the buy-out of non-farm heirs.

Planning with life insurance for farmers and ranchers – that’s the topic of today’s post.

During Life

A primary purpose of life insurance during the life of the insured farm operator is to provide for the family in the event of death.  In that sense, life insurance can provide the necessary capital to build an estate.  But, it can also protect income and capital of the farming or ranching business which could be threatened by the operator’s death.  Selling off farm assets, including land, to pay debts after the operator’s death will threaten continuity of the business.  Life insurance is a means of providing the necessary liquidity to protect against the liquidation of operating assets.

Unfortunately, my experience has been that many legal and tax professionals often overlook the usefulness of insurance as part of the overall plan.  This can leave a gaping hole in the estate and business plan that otherwise need not be there.  The result is that many farm and ranch families may feel that “the land is my life insurance.”  But, what if funds are needed to be unexpected expenses at death?  What about debt levels that have increased in recent years?  Is it really good to have to liquidate a tract or tracts of land to pay off expenses associated with death and retire burdensome debt?

So how can life insurance be utilized effectively during life?  That depends on the economic position of the operator, the asset value of the operation and the legal and tax rules surrounding the ownership of life insurance.  Of course, the cost of life insurance must be weighed against options for accumulating funds for use post-death.  Also, consideration must be given to the amount of insurance needed, the type of life insurance that will fit the particular situation, and who the insured(s) will be. 

From an economic standpoint, life insurance tends to provide a lower return on investment than other alternative capital investments for a farmer or rancher.  It’s also susceptible to inflation (not much of an issue in recent years) because of the potentially long time before there is a payout under the policy.  But, also from an economic standpoint, life insurance proceeds are generally not included in the beneficiary’s gross income.  I.R.C. §101(a)(1).

For younger farmers and ranchers, premium payments can be reduced by putting a term policy in place to cover the beneficiary’s premature death.  The term policy can later be converted to a permanent policy.  That’s a key point.  The use of and plan for life insurance is not static.  Life insurance wanes in importance as a mechanism to help build wealth as the farm operation matures and becomes more financially successful and stable.  The usage and type of life insurance will change over the life cycle of the farm or ranch business.   

After Death

From a tax standpoint, life insurance proceeds are included in the insured’s gross estate if the proceeds are received by or for the benefit of the estate.  As such, they are potentially subject to federal estate tax.  However, the current $11.4 million exemption equivalent of the unified credit (per person) takes federal estate tax off the table for the vast majority of farming and ranching estates.  In addition, if the proceeds are payable to the estate, they also become subject to creditors’ claims as well as probate and estate administration costs.  If the beneficiary is legally obligated to use the proceeds for the benefit of the estate, the proceeds are included in the estate regardless of whether the estate is the named beneficiary.  It makes no difference who took the policy out or who paid the premiums.  But, the proceeds are included in the decedent’s gross estate only to the extent they are actually used to discharge claims.  See, e.g., Hooper v. Comr., 41 B.T.A. 114 (1940); Estate of Rohnert v. Comr., 40 B.T.A. 1319 (1939); Prichard v. United States, 255 F. Supp. 552 (5th Cir. 1966)

But, there is a possible way to have the funds available to cover the obligations of the decedent’s estate without having the insurance proceeds being included in the estate.  That can be accomplished by authorizing the beneficiary to pay charges against the estate or by authorizing the trustee of a life insurance trust to use the proceeds to pay the estate’s obligations, buy the assets of the estate at their fair market value, or make loans to the estate.  Treas. Reg. §20.2042-1(b)(1).  In that situation, the proceeds aren’t included in the decedent’s estate because there is no legal obligation (i.e., duty) of the beneficiary (or trustee if the policy is held in trust) to use the proceeds to pay the claims of the decedent’s estate.  See, e.g., Estate of Wade v. Comr., 47 B.T.A. 21 (1942).  However, achieving this result requires careful drafting of policy ownership language along with the description of how the policy proceeds can be used to avoid an IRS claim that the decedent retained “incidents of ownership” over the policy at the time of death.  I.R.C. §2042.  In addition, the policy holder’s death within three years of transferring the policy can cause inclusion of the policy proceeds in the decedent’s estate.  I.R.C. §2035

Other Uses of Life Insurance

Loan security.  Life insurance can be pledged as security for a loan.  This means that a farmer or rancher can use it as collateral for buying additional assets to be used in the business.  In this event, the full amount of the policy proceeds will be included in the decedent’s gross estate, but the estate can deduct any outstanding amount that is owed to the creditor, including accrued interest.  It makes no difference whether the creditor actually uses the insurance proceeds to pay the outstanding debt. 

Funding a buy-sell agreement.  For those farming and ranching operations where the desire is that the business continue into subsequent generations as a viable economic unit, ensuring that sufficient liquid funds are available to pay costs associated with death is vitally important to help ease the transition from one generation to the next.  Having liquid funds can also be key to buying out non-farm heirs so that they do not acquire ownership interests in the daily operational aspects of the business.  Few things can destroy a successful generational transition of a farming or ranching business more effectively than a sharing of managerial control of the business between the on-farm and off-farm heirs.  Life insurance proceeds can be used fund a buy-out of the off-farm heirs.  How is this accomplished?  For example, an on-farm heir of the farm operator could buy a life insurance policy on the life of the operator.  The policy could name the on-farm heir as the beneficiary such that when the operator dies the proceeds would be payable to the on-farm heir.  The on-farm can then use the proceeds to buy-out the interests of the off-farm heirs.  In addition, the policy proceeds would be excluded from the operator’s estate. 

There are other approaches to the addressing the transition of the farming/ranching business.  Of course, one way to approach the on-farm/off-farm heir situation is for the parents’ estate plans to favor the on-farm heirs as the successor-operators.  But, this can lead to family conflict if the younger generation perceives the parents’ estate plans as unfair.  Whether this point matters to the parents is up to them to decide.  Another approach is to leave property equally to the on-farm and the off-farm heirs.  But, this approach splits farm ownership between multiple children and their families and can result in none of the families being able to derive sufficient income from their particular ownership interest.  This causes the ownership interest to be viewed as a “dead” asset.  Remember, off-farm heirs often prefer cash as their inheritance.  Sentimental ownership of part of the family farming or ranching operation may last for a while, but it tends to not to be a long-term feeling for various reasons.  Sooner or later a sale of the interest will be desired, real estate will be partitioned and the future of the family farming operation will be destroyed.  A life insurance funded buy-out can be a means to avoiding these problems. 

Conclusion

Today’s post merely introduced the concept of integrating life insurance in the estate/business plan of a farmer or rancher.  Other considerations involving life insurance include a determination of the appropriate type of life insurance to be purchased, the provisions to be included in a life insurance contract, and the estate tax treatment of life insurance.  Ownership planning is also necessary.  As you can see, it gets complex rather quickly.  However, the use of life insurance as part of an estate plan can be quite beneficial. 

May 24, 2019 in Business Planning, Estate Planning | Permalink | Comments (2)

Wednesday, May 22, 2019

What’s the Best Entity Structure For the Farm or Ranch Business?

Overview

The question often arises with farm and ranch clients that engage in estate, business or succession planning as to what the optimal entity structure is for the business?  There’s no easy, one-size-fits-all answer to that question.  It simply depends on numerous factors.  In fact, the question is best answered by asking a question in return – what do you want the farming or ranching business to look like after you and your spouse are gone?  What are your goals and objectives.  If planning starts from that standpoint, then it is often much easier to get set on a path for creating an “optimal” entity structure.

Some thoughts on structuring the farming or ranching business – that’s the topic of today’s post

Food For Thought

In many planning scenarios it is useful to create a checklist of points to consider that are relevant in the entity selection decisionmaking process.  The next step would then be to apply those points to the goals and objectives of the parties.  For starters, consider the following:

C corporations.  The following are relevant to C corporations:

  • A C corporation can be formed tax free if property is exchanged for stock; the transferors (as a group) hold 80 percent or more of the stock immediately after the exchange of property for stock; and the formation is for a business purpose.
  • C corporate income is subject to tax at a flat rate of 21 percent.
  • A C corporation is not eligible for the 20 percent qualified business income deduction of I.R.C. §199A that is available to a sole proprietor or the member of a pass-through entity (such as a partnership or S corporation).
  • While gain that is realized on the sale of stock of a farming corporation can’t be excluded under the special rules that apply to qualified small business stock (I.R.C. §1202), if the stock is that of a corporation engaged in processing activities, the gain can be excluded. There are other rules that can limit (or eliminate) this capital gain exclusion.
  • When a C corporation converts to S corporation status, the built-in gains (BIG) tax applies to the built-in gains on income items.  I.R.C. §1374(a). The Tax Cuts and Jobs Act (TCJA) didn’t eliminate the BIG tax, but it did lower it to 21 percent. 
  • A C corporation has good flexibility in establishing its capitalization structure as well as how it allocates income, losses, deductions and credits.
  • A C corporation is potentially subject to additional penalty taxes if too much earnings are accumulated without legitimate, well documented business reasons, or If too much income is passive.
  • The alternative minimum tax presently doesn’t apply to C corporate income.
  • A corporation for the farming operating entity will limit farm program payment limitations to a single $125,000 limit at the entity level.  That amount will then be divided by the number of shareholders.  If a pass-through entity is the operating entity, the number of payment limits will be determined by the number of members of the entity.  
  • A C corporation can deduct state income tax. This should be contrasted with the TCJA limitation on the deduction of such taxes for individuals that is pegged at $10,000 (including real property taxes on property that is not used in the conduct of the taxpayer’s trade or business).  I.R.C. §164(b)(6).   
  • A C corporation can provide employees with the tax-free fringe benefits of meals (limited to 50 percent by I.R.C. §274(n)) and lodging that are supported by legitimate business reasons (and satisfy other conditions). This benefit is not available to sole proprietors and partners in a partnership. See, e.g., Rev. Rul. 69-184, 1969-1 C.B. 256.  That is also the result for S corporation employees who own, directly or indirectly, more than 2% of the outstanding stock of the S corporation may not receive certain otherwise tax-free fringe benefits (including meals and lodging).  See I.R.C. §1372. Attribution rules apply for determining who is considered to be an S corporation shareholder.  I.R.C. §318.
  • A farming or ranching C corporation can generally use the cash method of accounting.
  • In some states, a C corporation cannot own or operate agricultural land unless members of the same family own a majority of the corporate stock. State laws differ on the specific rules barring C corporations from being involved in agriculture, and some states don’t have such rules.
  • A C corporation faces the potential of a double layer of tax upon liquidation.
  • The C corporation generally does provide good estate planning opportunities. In other words, it tends to be a good organizational vehicle for transitioning ownership from one generation to the next.

What About Income Tax Basis?

Given the currently high level of the federal estate tax exemption equivalent of the unified credit (11.4 million per decedent for deaths in 2019), income tax basis planning is high on the priority list.  Thus, when federal estate tax is not a potential concern, planning generally focuses on making sure that property is included in a decedent’s estate.  This raises some basic planning rules that must be considered:

  • For property that is included in a decedent’s estate for purposes of federal estate tax, the basis of that property in the hands of the person inherits the property is generally the fair market value (FMV) as of the date of the decedent’s death.  I.R.C. §Sec. 1014(a)(1)). 
  • But, the “stepped-up” basis rule (to the date-of-death value) doesn’t apply to property that is income in respect of a decedent (IRD) under §691. R.C. §1014(c).  An item is IRD something that decedent was entitled to as gross income but wasn’t’ included in income due to death in accordance with the decedent’s method of accounting.  See Treas. Reg. §1.691(a)-1(b).  Farmers and ranchers have some common occurrences of IRD such as…
    • Deferred gain to be reported from installment sales and deferred sales of crops and livestock;
    • The portion (on a pro rata) basis or crop-share rentals due at the time of death;
    • Receivables for a cash basis farmer;
    • Unpaid wages;
    • The value of commodities stored at an elevator (cooperative). Reg. §1.691(a)-2(b), Example 5 (canning factory and processing cooperative).
    • Accrued interest income on Series E/EE bonds;
  • When a decedent’s estate makes an election under I.R.C. §2032A to value ag land in the estate at its value as ag property (known as the “special use” value) rather than at its fair market value, the basis of the land in the hands of the heir is the special use value. There is no basis “step-up” to fair market value at the time of death.  Treas. Reg. §§1014(a)(3); 1.1014-3(a).
  • While the income of a pass-through entity is taxed only at the owner level, and the pass-through income increases the owner’s tax basis in the owner’s interest in the pass-through entity, a C corporation pays tax at the corporate level and then tax is also paid at the shareholder level on dividends or proceeds of liquidation. In addition, C corporate income does not increase the shareholder’s stock basis.

Just Starting Out – Creating a New Entity

If an organizational structure is initially being put into place, again there are numerous factors to consider in determining whether the farming or ranching business should operate as a C corporation or a pass-through entity.  In addition, to those factors pointed out above, the following factors should also be considered:

  • Is it anticipated that the primary or sole shareholder will hold the corporate stock until death?
  • Where will the business be incorporated and do business? If the business will be a C corporation, does the state of incorporation or other states in which the corporation will do business have a state income tax?
  • What tax bracket(s) will apply to the shareholders?
  • If the underlying business of the corporation would qualify for the 20 percent qualified business income deduction of I.R.C. §199A, what’s the differential between the corporate tax rate of 21 percent and the individual rate less the 20 percent deduction? Will that full 20 percent deduction be available if the entity weren’t a C corporation?  This can involve a rather complex analysis.
  • What type of assets are involved? Will they appreciate in value?  If so, the corporate tax rate of 21 percent plus the second layer of tax on gain of the appreciated asset value at the shareholder level upon liquidation (or on a qualified dividend) will exceed the maximum 23.8 percent capital gain rate that applies to an individual (20 percent rate plus an additional 3.8 percent on passive gain under Obamacare.  I.R.C. §1411
  • Is it anticipated that the business will retain earnings or pay it out in the form of compensation, rents or other expenses? Growing businesses tend to retain earnings.  Paid-out earnings of a C corporation are taxed again at the shareholder level.
  • Is income expected to fluctuate widely? If so, remember that the C corporate tax rate is a flat 21 percent. 
  • Will there be sufficient funds to pay consistent income to the owners of the business? If so, that can mean that (if a C corporation structure is utilized) shareholder-employees can receive tax benefits at the individual level.  If a corporate-level loss is incurred in doing so, that loss can be used to offset future taxable income. 
    • Under the TCJA, losses can offset up to 80 percent of pre-NOL taxable income.
    • The loss (for a farming corporation) can be carried back two years.  I.R.C. §172(b)(1)(B). 
  • From an accounting and tax planning standpoint, is a fiscal year desired? A C corporation can have a fiscal year-end and the individual shareholders can have a calendar year-end.

Conclusion

So, what is the best entity structure for your farming or ranching operation?  The discussion above merely scratches the surface of a very complex matter.  However, if you clearly articulate your goals and objectives for the future of your business to your planners, and provide complete information on assets, liabilities, land ownership, current arrangements, family data and dynamics, cropping and livestock history and tax history, then a good plan can be put in place that can, at least in the short-term satisfy your objectives.  Then, there must be a commitment to routinely review and update the plan as necessary.  There is no “one-size-fits-all” business plan, and plans aren’t static.  There is cost involved, of course, but the successful operations realize that the cost is a small compared to the benefits.

May 22, 2019 in Business Planning, Estate Planning | Permalink | Comments (0)

Tuesday, May 14, 2019

2019 National Ag Tax/Estate and Business Planning Conference in Steamboat Springs!

Overview

This summer Washburn Law School is sponsoring its summer national ag tax and estate and business planning conference in Steamboat Springs, Colorado on August 13-14.  The event will be held at the beautiful Steamboat Grand Hotel, and is co-sponsored by the Department of Agricultural Economics at Kansas State University and WealthCounsel.  Registration is now open for the two-day event, and onsite seating is limited to the first 100 registrants.  However, the event will be live streamed over the web for those who can’t make it to Steamboat. 

Key Ag Tax and Planning Topics

The QBID.  As we historically have done at this summer event, we devote an entire day to ag income tax topics and an entire second day to planning concepts critical to farm and ranch families.  Indeed, on Aug. 13, myself and Paul Neiffer will begin the day with a dive back into the qualified business income deduction (QBID) of I.R.C. §199A and take a look at the experience of the past filing season (that largely continues uninterrupted this year).  For many clients, returns were put on extension in hopes that issues surrounding the QBID, or the DPAD/QBID for patrons of cooperatives would get resolved.  Plus, software issues abounded, and the IRS issued conflicting (and some incorrect) information concerning the QBID.  In addition, the season began with errors in Pub. 225, the Farmers’ Tax Guide.  Some states even piggy-backed the IRS errors for state income tax purposes and coupling.  That made matters very frustrating.

On the QBID discussion, we will take a close look at the rental issue.  That seems to be a rather confusing matter for many practitioners.  Is there an easy way to separate rental situations so that they can be easily analyzed?  We will break it down as simply as possible and explain when to use the safe-harbor – it’s probably not nearly as often as you think.  What is an I.R.C. §162 trade or business activity?  How do the passive loss rules interact with the QBID? 

For farmers that are patrons of ag cooperatives, how is the DPAD/QBID to be calculated?  What information is needed to properly complete the return?  Where does what get reported?  My experience so far this tax season in seminars is that it is taking me about three hours just to recap and review the QBID and go through practitioner questions that came in during tax season and share how they were answered.  The discussion has been great, and at the end of the discussion, you will have a better handle on how the QBID works for your clients.  Is it really as complicated as it seems?

Selected ag topics.  After a brief break following the QBID discussion, we will get into various ag-related tax topics and how the changes brought about by the TCJA impact ag returns.  What were the problem areas of applying the new rules during the filing season?  What are the key tax issues that farm and ranch clients are presently facing.  Currently, disaster issues loom large in parts of the Midwest and Plains.  Also, Farm Bill-related issues associated with CCC loans and the impact on the PLC/ARC decision are important.  What about how losses are to be treated and reported?  Those rules have changed.  Depreciation rules have also been modified.  But, is it always in a client’s best interests to maximize the depreciation deduction?  What about trades?  The reporting of personal property trades has changed dramatically.  How do those get reported now?  What are the implications for clients?  

Cases and Rulings

Of course, the day wouldn’t be complete without going through the key rulings and cases from the prior year.  There are always many important developments in the courts and with the IRS.  Some are even amusing!  It’s always insightful to learn from the mistakes of others, and from others that are blazing the trail for others to follow.  We will work through all of the key ag-related cases and rulings from the past 12-18 months.

Other

We will have specific session focusing on depreciation, the passive loss rules (and how to report on the return); ag disasters; and the 2018 Farm Bill.  Day 1 will be a full day. 

Ag Estate and Business Planning

On August 14, we turn our attention to planning concepts for the farm and ranch family.  Joining me on Day 2 will be Stan Miller, the founder of WealthCounsel, LLC.  In addition to providing estate and business planning education, WealthCounsel, LLC also provides drafting software.  In addition, Timothy O’Sullivan joins the Day 2 teaching team.  Tim has a longstanding practice in Wichita, Kansas, where he focuses on estate planning and the administration of trusts and estates.

Recent developments.  Day 2 begins with a rapid summary of the development that impact estate and business planning.  For most clients, the issue is not tax avoidance given the presently high levels of the applicable exclusion.  Rather, the issue is including property in the estate to achieve a stepped-up basis.  I will go through recent developments impacting the basis planning issue and other developments impacting charitable giving as well as retirement planning. 

Other issues.  Tim O’Sullivan will devote a session to dealing with family disharmony and how to keep it from cratering a good estate plan. Tim will also have a separate session on incorporating good long-term care planning into the overall family estate and business plan.  This is a very important topic for many farm and ranch families – particularly those that want to keep the family business in tact for future generations.  I will have separate sessions on charitable giving; planning for second (and subsequent) marriages; and common estate planning mistakes.  To round out Day 2, Stan Miller will devote a session to techniques that can professionals can implement to preserve family held farms and ranches for future generations.  This will be a timely topic given the many variables that farmers and ranchers must handle to help their operations continue to be successful.

Registration

 For more information about the event and to register, click here:  http://washburnlaw.edu/employers/cle/farmandranchtax.html

A room block for the conference is available at the Steamboat Grand Hotel and is accessible from the page at the link provide above or here:  https://group.steamboatgrand.com/v2/lodging-offers/promo-code?package=49164&code=WASH19_BLK

If you can’t attend, the conference is live streamed.  Information about signing up for the live streaming is also available on the first link provided above.

Conservation Easement Seminar

I will also be presenting at another CLE/CPE event in Steamboat on Monday, August 12 immediately preceding our two-day conference.  That event is sponsored by the Colorado Cattlemen’s Agricultural Land Trust, the Eagle Valley Land Trust, and the Yampa Valley Land Trust, and focuses on the legal, real estate and tax issues associated with conservation easement donations.  I will provide more information about that event as it becomes available.

Conclusion

This two-day seminar is a high-quality event this summer in a beautiful location.  If you are in need of training on ag tax and planning related issues, this is the event for you.  In addition, the full day on conservation easements preceding the two-day conference is an excellent opportunity to dig into a topic that IRS is looking at closely.  It’s important to complete these transactions properly and this conference will lay out the details as to how to do it properly. 

I hope to see you either in-person in Steamboat Springs later this summer or via the web.  It will be a great event for your practice!

May 14, 2019 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, May 8, 2019

Heirs Liable For Unpaid Federal Estate Tax 28 Years After Death

Overview

In recent months, several court decisions have involved the issues of executors and beneficiaries of an estate being held personally liable for the unpaid taxes of the estate.  Sometimes a statute of limitations defense can be raised to fend off personal liability.  Sometimes it cannot be raised.  The matter can also be complicated when the estate makes an election to pay the estate tax in installment over (essentially) 15 years rather than filing the return and paying the federal estate tax nine months after the decedent’s death.

Personal liability of heirs for unpaid federal estate tax – that’s the topic of today’s post

Recent Case

Family trust.  In United States v. Johnson, No. 17-4083, 2019 U.S. App. LEXIS 9317 (10th Cir. Mar. 29, 2019), the decedent died in 1991, survived by her four children.  Before death, the decedent had established a trust that named two of her children as the successor trustees of her trust and the personal representatives of her estate. The decedent funded the trust with stock in a closely-held corporation that operated a hotel with a Nevada gambling license.  Her will directed that the residue of her estate after payment of expenses and claims be transferred to the trust and administered in accordance with the trust’s terms.  The children were also the beneficiaries of the decedent’s life insurance policies value at approximately $370,000.  The decedent died on September 2, 1991.

Installment payment election.  As reported on a timely filed federal estate tax return, the gross estate was valued at almost $16 million and the estate tax liability was approximately $6.9 million.  The federal estate tax paid with the estate tax return was $4 million.  An installment payment election was made in accordance with I.R.C. §6166 for the balance of the estate tax liability which allowed that portion of the tax to be paid in 10 annual installments starting in 1997 (after five years of interest-only payments) and ending in 2006.  Upon receiving the filed estate tax return, the IRS took note of the election and assessed the estate for unpaid estate tax on July 13, 1992.  In late 1992, all of the remaining trust assets (primarily hotel stock) were distributed to the children.  The hotel stock was distributed to the trust beneficiaries because Nevada law governing casino ownership via trust required it.  All of the children entered into a distribution agreement (governed by Utah law) acknowledging that they were equally responsible for the unpaid federal estate tax as it became due and equally liable for any additional tax that might result from an audit. 

IRS lien.  In 1995, the IRS took the position that the estate’s gross value had been underreported by approximately $3.5 million.  Ultimately, a settlement was reached whereby the estate agreed to pay additional federal estate tax of $240,381.  In 1997, shortly before the due date of the first estate tax installment, the IRS informed the personal representatives of alternatives to personal liability for unpaid deferred estate tax.  As a result, the personal representatives executed an I.R.C. §6324A lien which all four children signed along with an agreement restricting the sale of stock in a hotel which comprised the largest asset of the decedent’s estate.  That restriction was to be in effect while the lien was in effect.  In 2002, the hotel filed bankruptcy and a sale of all hotel assets was approved.  In 2003, the IRS informed the personal representatives that if they defaulted, the entire balance of estate tax would be immediately due.  Shortly thereafter the estate defaulted on its federal estate tax liability after having paid a total of $5 million of the amount due.  After attempting to collect via levies against the estate, trust and the children, and learned of the distribution agreements in mid-2005.  The IRS filed suit in 2011 naming all of the children as defendants and seeking to recover over $1.5 million in unpaid federal estate tax from them personally.    

Litigation.  The trial court held that the heirs who received trust distributions were not liable as beneficiaries or transferees under I.R.C. §6324(a)(2).  However, the trial court also determined that the personal representatives could be liable under 31 U.S.C. §3713 and I.R.C. §2036(a) as successor trustees up to the value of the trust assets that were included in the decedent’s gross estate via I.R.C. §2034-2042.  The personal representatives claimed that the assets were included in the estate via I.R.C. §2033.  The trial court determined that the assets were included in the estate via I.R.C. §2033 because the decedent never lost the beneficial ownership of them during her lifetime (i.e., the assets had not been transferred as required by I.R.C. §2036).  Thus, the personal representatives were not personally liable for the unpaid estate tax as trustees.  In addition, the court determined that the personal representatives were not liable under 31 U.S.C. §3713 because liability was discharged upon execution of the I.R.C. §6324 lien.  The IRS also claimed it had rights as a third-party beneficiary of the 1992 distribution agreement whereby they agreed to be equally liable for any additional taxes resulting from an audit.  The trial court determined this claim was untimely under Utah law (6-year statute of limitations) and rejected the IRS claim that federal law should apply. 

Tenth Circuit decision.  On appeal, the appellate court held that federal law applied on the contract-based claim and was governed by the 10-year statute of limitations of I.R.C. §6502.  That’s because the court concluded that the government was acting in its sovereign capacity.  Accordingly, the 10-year statute of limitations applied. When the federal government is enforcing its rights, it is not bound by a state’s statute of limitations even with respect to lawsuits that are brought in state courts.  It makes no difference whether the claim at issue arose under federal or state statutes or the common law.

Likewise, the transferee liability claim was timely because the limitations period applicable to the I.R.C. §6324(a) transferees was the same as the limitations period that applied to the estate.  Because the 10-year limitations period that normally applies to the collection of estate tax was suspended by the installment payment election, the government’s claim was timely.  See, e.g., §6503(d); United States v. Botefuhr, 309 F.3d 1263 (10th Cir. 2002).  The appellate court also held that the children were liable for unpaid estate tax to the extent of any life insurance proceeds they received from the estate.  United States v. Johnson, No. 17-4083, 2019 U.S. App. LEXIS 9317 (10th Cir. Mar. 29, 2019).  The appellate court also held, reversing the trial court, that the beneficiaries weren’t entitled to attorney fees and costs because the government’s position was “substantially justified under I.R.C. §7430(c)(4)(B). Indeed, the government received a judgment for the full amount of the estate tax liability asserted.

Conclusion

It’s worth noting that the decedent in Johnson died in 1991.  The Tenth Circuit’s decision was in 2019.  That show’s how long matters can get drawn out if an installment payment election is made and there is unpaid tax liability.  The government is not simply going to go away. 

May 8, 2019 in Estate Planning | Permalink | Comments (0)

Friday, April 26, 2019

Summer 2019 Farm and Ranch Tax and Estate/Business Planning Seminar

Overview

This summer, Washburn University School of Law will be sponsoring a two-day Farm and Ranch Tax and Estate/Business Planning Seminar in Steamboat Springs, CO.  The event will be on August 13-14 at the Steamboat Grand Hotel.  This seminar presents an extensive, in-depth coverage and analysis of tax and estate/business problems and issues involving farm and ranch clients over two-days.  Attendance can either be in-person or via online over the web.

In today’s post, I outline the coverage of the topics at the seminar and the presenters as well as related information about registering.  Steamboat Springs – Summer of 2019!

Topics and Speakers

On Day 1 (August 13), Paul Neiffer (CPA with CliftonLarsonAllen and author of the FarmCPA blog) will be presenting with me.  We will start the day with a discussion of the I.R.C. §199A (QBI) deduction.  Many issues surfaced during the 2018 tax filing season concerning the QBI deduction.  The IRS produced contradictory statements concerning the deduction and the tax software companies also struggled to keep the software up with the developments.  During this opening session, Paul and I will walk through QBI deduction issues as applied to farm and ranch clients and address many questions with detailed answers – a very real “hands-on” approach that is practitioner-friendly.

During the next session on Day 1, I Paul and I will take two hours to cover a potpourri of selected farm income tax topics.  Those issues that are the present “biggies” will be addressed as well as current issues that practitioners are having with the IRS involving ag clients. 

After lunch on Day 1, I will highlight some of the most important recent cases and rulings for farm and ranch taxpayers, and what those developments mean as applied on the farm and in the farm economy.  Any new legislation will also be addressed, whether it’s income tax or other areas of the law (such as bankruptcy) that impact ag clients.

We will then devote an hour to common depreciation issues and how the rules have changed and are to be applied post-TCJA.  What are the best depreciation planning techniques?  We will work through the answers. 

Following the afternoon break, I will dive into the passive loss rules.  What do they mean?  How do they apply to a farm client?  How do they interact with the QBI deduction?  What is a real estate professional?  How to the grouping rules work?  These questions (and more) will be answered and numerous examples will show how the rules work in various contexts.

Day 1 finishes out with Paul covering tax and planning issues associated with the 2018 Farm Bill and the choices farm clients have and how the new rules work.  I will then cover the tax rules associated with ag disasters and casualties.  There are many of those issues for clients that will show up during the 2019 tax filing season, especially for farm/ranch clients in the Midwest and Plains states. 

On Day 2, our focus turns to farm and ranch estate and business planning.  I will begin the day with an update of the key recent developments that impact the estate and succession planning process.  What were the key cases of the past year?  What about IRS rulings and pronouncements?  I will cover those and show you how they apply to your clients.

Day 2 then continues with a key session on how to use estate planning concepts to minimize family disharmony.  This session is presented by Tim O’Sullivan with Foulston Siefken LLP in Wichita, KS.  Tim has a broad level of experience in estate planning and the handling of decedent’s estates.  This is a “must attend” session for estate planners and deals with a topic that is often overlooked as an element in putting together a successful estate and business transition plan.

After the morning break on Day 2, I will cover the tax and legal issues associated with the use of trusts.  Trusts are an often-used tool for farm and ranch clients, but what is the correct type for your client?  The answer to that question is tied to the facts.  Also, can a state tax a trust beneficiary or the trust itself if there isn’t any physical connection with the state?  It’s an issue presently before the U.S. Supreme Court.  By the time of the seminar, we will likely have an answer to that question.

How does the TCJA impact charitable giving?  What are the new charitable planning techniques?  What factors are important?  I will address these questions and more in the session leading up to lunch.

After the lunch break on Day 2, I will deal with an unfortunate, but important topic- what is appropriate estate and business planning in second marriage situations?  If the plan doesn’t account for this issue, significant disruptions can occur, and expectations may not be met.  This is an important session dealing with a topic that tends to be overlooked.

I will then provide a breather from some heavy topics with a lighter (and fun) one – what are common estate and business planning mistakes?  What classic situations have you dealt with in your practice over the years?  Mistakes are frequent, but some seem to occur over and over.  Can they be identified and prevented?  That’s the goal of this session.

Tim O’Sullivan then returns for another session.  This time, Tim does a deep dig into long-term health care planning.  How can farm and ranch assets and resources be preserved?  What are the applicable rules?  What if only one spouse needs long-term care?  Should assets be transferred?  If so, to whom?  This is a very important session designed to give you the tools you need for your long-term care planning toolbox. 

Day 2 finishes with a key session by Stan Miller on how estate and business planning concepts can be used to help make sure the family farm survives for families that want it to survive as a viable economic unit.  Stan is a founder of WealthCounsel, LLC and a principal in the company.  Stan has a long background in estate and business planning.  He is also a partner with ILP + McChain Miller Nissman in Little Rock, Arkansas.  This session is a great capstone session for the day that will bring the day’s discussion together and get down to how the concepts discuss throughout the day can be used to help the farming and ranching business of a client survive the ups and downs of the economy, as well as family situations.

Other Details

The seminar will be held on Tuesday and Wednesday, August 13-14 at the Steamboat Grand Hotel, in Steamboat, Colorado.  It is co-sponsored by the Kansas State University Department of Agricultural Economics and WealthCounsel, LLC.  You can find more registration information here:  http://washburnlaw.edu/employers/cle/farmandranchtax.html

On another note, on Monday, August 12, also in Steamboat, I will be participating in another seminar (also in Steamboat Springs) sponsored by the Colorado Cattlemen’s Agricultural Land Trust, the Eagle Valley Land Trust, and the Yampa Valley Land Trust.  Half of the day will concern legal issues associated with conservation land trusts.  The other half of the day will address real estate issues associated with conservation land trusts.  These issues are very important in many parts of the country in addition to Colorado.  As further details are provided, I will pass those along.  This all means that there will be three full days of tax and legal information available this coming August in Steamboat Springs. 

Conclusion

As I noted above, the seminar can be attended either in-person on online via the web.  Registration will open up soon, so get your seat reserved.  Steamboat Springs, CO is a beautiful area on the western slope of the Colorado Rockies. 

Hope to see you there!!

April 26, 2019 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (1)

Tuesday, April 2, 2019

Thrills With Wills – When is a Will “Unduly Influenced”?

Overview

To be valid a will must satisfy certain requirements.  One of those requirements is that the will is the product of the decedent’s intent.  No one else can be allowed to unduly influence the decedent’s intent.   

In ag settings, challenges to wills sometimes arise.  The battles frequently involve the disposition of farmland that has been held in the family for many years or perhaps generations.  As a result, tensions and emotions run high because the future of the family farm may be at stake.  But, what does “undue influence” mean?  In what situations may it be present?

Will challenges and undue influence – that’s the topic of today’s post.

Basic Will Requirements

Every state has statutory requirements that a will must satisfy in order to be recognized as valid in that particular jurisdiction.  For example, in all jurisdictions, a person making a will must be of sound mind; generally must know the extent and nature of their property; must know who would be the natural recipients of the assets; must know who their relatives are; and must know who is to receive the property passing under the will.  A testator lacking these traits is deemed to not have testamentary capacity and is not competent to make a will.  These persons are more susceptible to being influenced by family members and others desirous of increasing their share of the estate of the decedent-to-be.  If that influence rises to the level of being “undue,” the will resulting from such influence will not be validated. 

Testamentary Capacity and Undue Influence

Cases involving will challenges are common where the testator is borderline competent or is susceptible to influence by others.  However, the fact that the testator was old or in poor health does not, absent other evidence, give rise to a presumption that the testator lacked testamentary capacity or was subject to undue influence. For example, in a 2008 Wyoming case, Lasen v. Andersen, et al., 187 P.3d 857 (Wyo. 2008), the decedent’s daughter and her husband sued to quiet title to the decedent’s farm.  Other family members asserted various defenses and also claimed an interest in the farm.  A bank was also involved in the litigation.  The trial court ruled against the daughter and granted the bank’s counterclaim. The trial court determined that the daughter and her husband had unduly influenced the decedent by continually pressing the decedent to change his will in their favor.  The trial court also determined that the daughter and her husband had improperly pressured the decedent to change his power-of-attorney and execute the deed to the farm at issue in the case.  The appellate court agreed, noting that the daughter was the party that executed the second deed involving the farm and that her husband did not obviate the first deed that had been executed and delivered. 

But, undue influence was not established in In re Estate of Rutland, 24 So. 3d 347 (Miss. Ct. App. 2009).  In this case, the court held that the trial court improperly set aside the decedent’s 2002 will which devised an 88-acre farm.  The court determined that the decedent had testamentary capacity based on the evidence presented and that the evidence was insufficient to support a finding of undue influence and there was no abuse of a confidential relationship.  If a confidential relationship had been present, a presumption of undue influence would have arisen. 

In a 1993 Kansas case, In re Estate of Bennett, 19 Kan. App. 2d 154, 865 P.2d 1062 (1993), the court held that a person challenging the will must establish undue influence by clear and convincing proof and that the decedent possessed testamentary capacity despite being unable to comprehend the purchasing power of her estate.  The surviving widow received approximately $50 million from her husband’s estate after they had lived as near paupers for many years.  She changed her will after inheriting the vast sum and the disaffected family members sued on the basis that the subsequent will was the product of undue influence.  It was not. 

Recent case.  In In re Estate of Caldwell, No. E2017-02297-COA-R3-CV, 2019 Tenn. App. LEXIS 114 (Tenn. Ct. App. Mar. 7, 2019), the decedent executed a will in 1999 that named the plaintiff, his son, as a devisee of his farm along with his nephew.  At the time the will was executed, the plaintiff and nephew lived on the farm.  Approximately nine years later the defendant, the decedent’s daughter, began to reestablish a relationship with the decedent and the plaintiff. The defendant did not learn that the decedent was her biological father until she was 35 years old and that she was a half-sister of the plaintiff by virtue of having the same father – the decedent. 

In 2012 the decedent suffered a stroke that slowed his speech and resulted in limited mobility in one arm. The plaintiff took care of the decedent during the evenings and farmed during the day.  The defendant often prepared meals and cleaned for the decedent. In November of 2012 the decedent executed a second will. The 2012 will revoked the 1999 will and devised the farm to the defendant.  The 2012 will also named the defendant the executor of the estate.  The defendant would drive the decedent to the attorney’s office but did not stay for the meetings. The attorney noted that the decedent spoke slower, but had no issue expressing his intent. The decedent wished to keep the property in the family and wanted the defendant and nephew to always have a place to live. The decedent also desired to make amends with the defendant for not playing a role in the first 35 years of her life. The 2012 will was properly witnessed and executed in late November. In January of 2013 the decedent quitclaim deeded the farm to the defendant. Again, at this time the attorney did not believe that the decedent had any mental capacity issues.  

The decedent died in 2015 and the plaintiff submitted the 1999 will to probate.  The defendant submitted the 2012 will to probate, and the plaintiff responded by bringing legal action for conversion; fraud; misrepresentation and deceit; unjust enrichment; and breach of fiduciary duty. The plaintiff sought punitive damages and injunctive relief that would prevent the defendant from taking any action against the estate.  After a three-day bench trial, the trial court determined that the decedent had the requisite testamentary capacity and that the 2012 will was not a product of undue influence. 

On appeal, the appellate court affirmed.   The appellate court found that the evidence showed that decedent was of sound mind and had testamentary capacity at the time the 2012 will was executed – he knew what property he owned and understood how he wanted to dispose of it at his death.  On the plaintiff’s undue influence claim, the appellate court determined that a confidential relationship did not exist between the defendant and the decedent based on a clear and convincing standard.  As such, undue influence would not be presumed and the evidence demonstrated that the decedent received independent advice and was not unduly influenced in executing the 2012 will. 

Conclusion

Family fights over the family farm are never a good thing.  Sometimes the matter may involve claims of undue influence or lack of testamentary capacity to execute a will that is the linchpin of the estate plan.  Care should be taken to avoid situations that can give rise to such claims. 

April 2, 2019 in Estate Planning | Permalink | Comments (0)

Friday, March 29, 2019

More Recent Developments in Agricultural Law

Overview

The developments in agricultural law and taxation keep rolling in.  Many of you have requested more frequent posts on recent developments, so today’s post is devoted to just a handful that are important to farmers, ranchers and the professionals that represent them.  In today’s post I take a look at a couple of recent farm bankruptcy cases, the use of a trust to hold farm and ranch property, and the rights of grazing permit holders on federal land.

Selected recent developments in agricultural law and tax – it’s the topic of today’s post.

Bankruptcy

Times continue to be difficult in agriculture with bankruptcy matters unfortunately taking on increased significance.  In one recent case, In re Wulff, No. 17-31982-bhl, 2019 Bankr. LEXIS 388 (Bankr. E.D. Wis. Feb. 11, 2019), the debtor filed Chapter 12 bankruptcy and submitted a complete list of creditors. One of the creditors did not receive notice of the bankruptcy because of a bad address but became aware of the debtor’s bankruptcy upon attempting to collect on their account after the proof of claim deadline had passed. There were multiple plans submitted to the court that were rejected for various reasons, but every plan submitted accounted for the creditor that did not have notice. Ultimately, the debtor’s plan was confirmed. After confirmation, the creditor attempted to file a proof of claim and the trustee objected. The creditor maintained that it filed as soon as receiving notice of the proceedings. The court allowed the claim, but that the creditor had not established grounds for an extended timeframe to file the proof of claim. Even so, the court noted that the debtor’s initial plan and amended plans all accounted for the creditor’s claim. All the plans were consistent with the creditor’s late-filed proof of claim. Thus, the court confirmed the debtor’s reorganization plan with the late-filed proof of claim upon a finding that it was consistent with the plan. 

In another bankruptcy case, In re Smith, Nos. 17-11591-WRS, 18-1068-WRS, 2019 Bankr. LEXIS 234 (Bankr. M.D. Ala. Jan. 29, 2019), the debtor filed bankruptcy in 2017. At the time of filing, the debtor had a 2006 loan secured by his farmland that had matured. Instead of foreclosing, the creditor bank and the debtor negotiated a renewal in 2012. Another creditor, an agricultural cooperative, held a 2009 lien. In determining priority, the court held that the bank’s liens were prior to the cooperative’s liens. The court determined that the 2012 renewal of the bank note, even if the bank new of the cooperative’s lien, did not cause the bank to lose priority. While the court noted that sometimes an advancement on an existing mortgage causes the underlying mortgage to lose priority over subsequent liens, the court determined that the 2012 renewal was not an advancement. There was no evidence that additional funds were loaned to the debtor by the bank. In addition, the court determined that the bank’s lowering of the interest rate on the obligation did not cause the creditor to lose priority. 

Trusts and Estate Planning

Trusts are a popular tool in estate planning for various reasons.  One reason is that a trust can help consolidate farming and ranching interests and aid in the succession planning process.  The benefit of consolidating farm and ranch property in trust was the issue of a recent Wyoming case.  In re Redland Family Trust, 2019 WY 17 (2019), involved a family that has been involved in contentious litigation over a family trust. The case had been before the Wyoming Supreme Court on multiple occasions. The trust was created in 1989 and amended in 1995. The amendment provided for the appointment of a successor trustee; always required the service of two trustees; created a marital trust for the survivor of the settlors; and revised the buyout provision. The grantors and their five children made contributions to the trust. Upon the death of one of the grantors in 2007 one of the children was appointed as co-trustee.  Ligation arose when the surviving grantor’s property was not conveyed to the trust and then again involving removal of the trustees, and an appointed trustee moved to have the trust terminated due to the administrative difficulties to administer, family dysfunction, and because the trust no longer served its purpose. The defendants, (including the co-trustee that resigned) asserted that termination was moot and moved to have the new co-trustee removed.

The trial court did not remove the co-trustee and found that the trust was still valid. The trial court found that the co-trustee did not violate any fiduciary duties and that the defendants failed to show gross and willful misconduct to justify her removal. Further the trial court found that the co-trustee’s claims that the trust was invalid should have been raised in the original trust challenge. The trial court determined that the primary reason for the trust (to keep the lands and leases together for the Redland family) had not been frustrated and that the trust remained administratively functional and was not "unlawful, contrary to public policy, or impossible.

On appeal, the Wyoming Supreme Court affirmed. The Court determined that the trust still had a purpose - to keep the ranch holdings together to conduct business. Even though the other purpose of minimizing tax consequences had failed, consolidation of ranch holdings remained a legitimate purpose. The Court also determined that the co-trustee did not violate her fiduciary duties, her duties of impartiality or loyalty, and that her actions did not amount to gross and willful misconduct. In addition, the Court found that the duty of impartiality did not require the trustee to treat all beneficiaries fairly, but simply to act in the best interest of the beneficiaries and equally defend the intentions of the settlors. While the Court could find no precedent with respect to the duty of loyalty the Court held that merely seeking termination of the trust was not a breach of loyalty. In addition, the Court determined that hostility between parties did not warrant removal. 

Rights of Grazing Permittees

In the U.S. West, the ability to graze on federally owned land is essential to economic success.  An understanding of those rights is essential, and many legal battles in the West involve associated rights and responsibilities on federal land.  One of those issues involves the erection of improvements.  In Johnson v. Almida Land & Cattle Co., LLC, 2019 Ariz. App. Unpub. LEXIS 140 (Ariz. App. Ct. Jan. 31, 2019), the defendant owned a grazing allotment and was permitted to graze cattle on the allotted Forest Service land in Arizona. Consistent with the grazing permit, the defendant erected an electric fence on the allotment. In June 2011, the plaintiff collided with the fence while riding an off-road motorcycle, when he turned off a Forest Service road onto an unmarked, unimproved “two-track route” which the fence crossed. The plaintiff brought sued for negligence and the defendant moved for summary judgment on the basis that it owed no duty of care to the plaintiff. The trial court granted the motion, agreeing that there was no duty of care under the Restatement (Second) of Torts.

On appeal, the appellate court determined that the issue was whether a federal permittee owes a duty of care to the public with respect to construction of improvements on the land. Determination of that issue, the appellate court reasoned, was dependent on state law. On that point, the appellate court found that a criminal statute will establish a tort duty if the statute is designed to protect the class of persons in which the plaintiff is included, against the risk of the type of harm which has in fact occurred as a result of its violation, regardless of whether the statute mentions civil liability. The relevant AZ criminal statute held that a person commits a misdemeanor of public nuisance if that person knowingly and unlawfully obstructs a “public highway,” “public thoroughfare,” “roadway” or “highway.” The appellate court held that this public nuisance statute prohibiting the obstruction of certain types of pathways, also created a tort duty in those who erect improvements that impact those paths. Based on this interpretation, the court held that AZ law establishes a public policy giving rise to a tort duty with respect to the obstruction of certain types of public pathways. Consequently, a permittee on federal land owes a duty of care to the public when it erects an improvement across a publicly accessible route. However, the appellate court held that the facts were insufficient to determine, as a matter of law, whether the route at issue qualified as a “public highway,” “public thoroughfare,” “roadway” or “highway.” Consequently, the appellate court reversed on the duty of care issue and remanded to determine if the route fell within the scope of the relevant statutes. 

Conclusion

Agricultural law is a “goldmine” of issues that landowners, producers and their legal and tax counsel must stay on top of.  It’s a dynamic field.  In a few more weeks, I will dig back into the caselaw for additional key recent developments.

March 29, 2019 in Bankruptcy, Business Planning, Estate Planning, Regulatory Law | Permalink | Comments (0)

Monday, March 25, 2019

Sale of the Personal Residence After Death

Overview

Upon death, particularly the death of the surviving spouse, the estate executor may need to dispose of the decedent’s personal residence.  When that happens, numerous tax considerations come into play.  There are also some planning aspects to handling the personal residence. 

The sale of the personal residence after death – that’s the topic of today’s post.

Income Tax Basis Issues

Upon death, the executor may face the need to dispose of the decedent’s personal residence.  The starting point to determining any tax consequences of the disposition involves a determination of income tax basis.  If the residence was included in the decedent’s gross estate, the tax basis will be determined in accordance with fair market value as of the date of the decedent’s death under the willing buyer-willing seller test. I.R.C. §1014.  That is based largely on sales of comparable properties, and requires more than a simple market analysis by a real estate agent. 

If the decedent was the first of the two spouses to die, a determination of how the residence was titled at death will need to be made.  For a residence held in joint tenancy or tenancy in common, only the value of the decedent’s share of the residence will be included in the decedent’s estate and receive a basis step-up to fair market value.  Id.  In common-law property states where the residence is owned in joint tenancy between the spouses, the property is treated at the first 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, one-half of the value is taxed at the death of the first spouse to die and one-half receives a new income tax basis.  However, in 1992 the Sixth Circuit Court of Appeals applied the “consideration furnished rule” to a husband-wife joint tenancy involving farmland. Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992).    The result was that the entire value of the land acquired before 1977 was included in the estate of the first spouse to die. That meant that the full value was subject to federal estate tax, but was covered by the 100 percent federal estate tax marital deduction.  The entire property received a new income tax basis which was the objective of the surviving spouse.  Other federal courts have reached the same conclusion.

If the residence is community property, the decedent’s entire interest will receive a basis step-up to fair market value.  If the residence is held in joint tenancy with rights of survivorship, the decedent’s interest passed by the survivorship designation to the designated survivor.

Loss Potential

If a surviving spouse sells the marital home shortly after the first spouse’s death, the survivor will often realize a loss largely due to the expenses incurred with respect to the sale.  If the survivor realizes a gain, then, the survivor is eligible for the $250,000 exclusion of gain.  I.R.C. §121.  That exclusion is a maximum of $500,000 if the sale occurs within two years of the first spouse’s death.  

Residence Held in Trust

A revocable trust is a common estate planning tool.  If the decedent’s personal residence was held in a revocable trust and passed to the surviving spouse upon the first spouse’s death under the terms of the trust to continue to be held in trust, the house receives a full step-up (or down) in basis to the current fair market value at the death of the surviving spouse.  If the house is distributed outright to a beneficiary (or beneficiaries) and then the beneficiary immediately sells the home, a loss generally will be a nondeductible personal loss unless the home is first converted to a rental property before it is sold.  This is a key point that may require some planning to allow for rental use for a period of time before sale.

If the residence must be sold by the estate or trust to pay debts or to satisfy cash distributions to beneficiaries, any loss on the sale might be deductible.  That loss could potentially offset other income of the trust or estate, or it could flow through to the beneficiaries.  However, the IRS position is that an estate or a trust cannot claim such a loss unless the residence is a rental property or is converted to a rental property before it is sold. This position has not been widely supported by the courts which have determined that a trust or estate can claim such a loss if no beneficiaries use the home as a residence after the decedent’s death and before it is sold.  It is important to get good tax counsel on this issue.  It’s an issue that comes up not infrequently.

Conclusion

The sale of the personal residence after death presents numerous tax issues.  With a modest level of planning, negative tax consequences can be avoided and helpful tax provisions can be taken advantage of.

March 25, 2019 in Estate Planning, Income Tax | Permalink | Comments (0)

Friday, March 15, 2019

Can The IRS Collect Unpaid Estate Tax From The Beneficiaries?

Overview

If the federal estate tax isn’t paid when due nine months after the date of the decedent’s death, is a person that receives property from the decedent’s estate personally liable for the unpaid tax? Does it matter how the person received the property - either by gift, as a surviving joint tenant or as a beneficiary of the estate?  How long does the IRS have to collect the tax?  These are all important questions, especially with respect to a farmer’s estate where present economic and financial conditions may have dissipated estate property such that the estate no longer has assets and funds with which to pay the tax, or where the assets have already been distributed.

The personal liability of estate beneficiaries for federal estate tax – that’s the topic of today’s post.

Establishing Liability

With the present level of the exemption from federal estate tax pegged at $11.4 million for deaths in 2019, it’s very unlikely that any particular estate will have to worry about federal estate tax.  But, this enhanced level of exemption (it was, in essence, doubled by the late 2017 tax legislation) is set to expire at the end of 2025 and go back to the pre-2018 level of $5 million (adjusted for inflation).  Also, it is possible that a change in the political winds come 2020, could reduce the exemption below $5 million.  That would make it far more relevant again for many farm and ranch families.

When a decedent’s estate has a federal estate tax liability, it is due nine-months after the date of death.  I.R.C. §6075(a).  A six-month extension is available.  But, if the tax is not paid when it is due, any transferee, surviving tenant or beneficiary of the estate is personally liable for the unpaid estate tax to the extent the property they received was included in the decedent’s gross estate under I.R.C. §2034 through I.R.C. §2042I.R.C. §6324(a)(2). The IRS also has a special lien for any unpaid gift tax.  I.R.C. §6324(b).  These liens arise automatically – no assessment, notice or demand for payment or filing is required.  The lien attaches to the gross estate and lasts for the earlier of ten years from the date of the decedent’s death or until the tax is paid. I.R.C. §6324(a).  The lien attaches to the extent of tax shown to be due by the return and of any deficiency in tax found to be due.  Treas. Reg. §301.6324-1(a)(1). 

The IRS must prove that an unpaid tax exists at the time of death and that a beneficiary received property that was included in the decedent’s gross estate at death.  I.R.C. §§ 2035-2042 list the various types of property and the rules governing how those types of property are included in the decedent’s gross estate for estate tax purposes.  Each beneficiary of estate property is personally liable for any unpaid estate tax based on the property they received from the estate and to the extent of the property’s value at the time of the decedent’s death.  I.R.C. 6324(a)(2).  See also Baptiste v. Comr., 29 F.3d 433 (8th Cir. 1994), aff’g. in part and rev’g. in part 100 T.C. 52 (1993); Baptiste v. Comr., 29 F.3d 1533 (11th Cir. 1194), aff’g., 100 T.C. 252 (1993).

Procedurally, the IRS is not required to follow the normal process for collecting a deficiency when it moves to assert the lien against a transferee of estate property.  See, e.g., United States v. Geniviva, 16 F.3d 522 (3rd Cir. 1994).  The special estate tax lien is also not subject to the filing and notice requirements of the general IRS lien of I.R.C. §6321I.R.C. §6323(a).  Thus, buyers, holders of security interests, other lien holders and judgment lien creditors may not be protected unless I.R.C. §6324 provides protection.  Rev. Rul. 69-23, 1969-1 CB 302.

Some property is exempt from the IRS lien.  Included in the exempt list is any part of the decedent’s gross estate that is used to pay charges against the estate or pay administrative costs.  I.R.C. §6324(a)(1).  The lien also doesn’t apply to any part of the decedent’s property that is transferred to a bona fide buyer or holder of a security interest, except that the lien attaches to any consideration received. I.R.C. §§6324(a)(2)-(3).  Also, any property that is released via certificate is exempt.  I.R.C. §6325; Treas. Reg. §301.6324-1(a)(2)(iv). 

Recent Case

The issue of liability of estate beneficiaries for unpaid estate tax came up in a recent case from South Dakota.  In United States v. Ringling, No. 4:17-cv-04006-KES, 2019 U.S. Dist. LEXIS 28146 (D. S.D. Feb. 21, 2019), the defendants were the daughters and one grandson of the decedent. The decedent died in late 1999 leaving his estate equally to his daughters and providing a specific bequest of farmland to one of the daughters as part of her co-equal share of the estate.  The will named the daughters as co-personal representatives of his estate. The estate included farmland and crops among other assets.  In 1999, the federal estate tax exemption equivalent of the unified credit was $650,000 and the top rate was 55 percent.

In 1996, the decedent entered into an agreement with his grandson to buy additional farmland. Under that agreement, the decedent bought the land and the grandson was to pay the decedent $32,000 via an installment contract. Ten days before his death in 1999, the decedent forgave the remaining balance due on the contract of $27,600.96. Also, in 1996 the decedent conveyed a warranty deed to his grandson for the family farm along with irrigation equipment and permits, retaining a life estate and the right to receive the rent income and profits from the farm during his life. After death, the farm was appraised at $345,700. Six days before death, the decedent and his grandson entered into a contract for deed of additional farmland. This contract called for the grandson to pay $90,000 to the decedent, with $10,000 to be paid before or at the time of deed execution and the balance to be paid in 20 equal installments. The grandson would not take possession until March 1, 2000. At the time of the decedent’s death in late 1999, the unpaid balance on the contract was $80,093.30.

In early 2008, the estate filed Form 706 reporting a gross estate of $834,336 and a net estate tax due of $28,939. No payment accompanied the filing. On Form 706, the estate reported assets as three pieces of farmland; co-op shares; stocks; bonds; two contracts for deed; cash; bank accounts; certificates of deposit (CDs); two life insurance policies; a corn crop that had been gifted to the grandson; the decedent’s pickup truck; a van; and other miscellaneous property.  The Form 706 reported that each of the daughters received $121,988 and that the grandson received $416,116. Later in 2008, the IRS agreed that the estate tax was $28,939, but that a late filing penalty of $6,511.27 and a failure to pay penalty of $7,234.75 should be added on. In addition, the IRS assessed interest of $23,189.78. The total amount the IRS asserted due was $65,874.80. In 2010, the estate requested an abatement of the penalties and interest. The IRS denied the request. In 2013, the IRS sent the defendants Form 10492 Notice of Federal Taxes Due with respect to the estate. Later in 2013, the IRS filed a Notice of Federal Tax Lien on the farmland.  The Notice was also sent to the estate. A hearing was not requested. Beginning in 2010, the defendants had made some payments on the estate tax liability, but as of mid-2018 over $63,000 remained due. The IRS then sued seeking payment from the daughters and the grandson personally via I.R.C. §6324(a)(2) and sought summary judgment. Only one daughter filed a response in opposition to summary judgment. 

The court noted that each of the daughters and the grandson jointly owned property with the decedent at the time of his death.  The jointly owned property also included a checking account on which one of the daughters continued to write checks after the decedent’s death.  Under I.R.C. §2040, the court noted, the decedent’s gross estate included all property that he and any other person held as joint tenants with rights of survivorship.   The two life insurance policies were included in the estate by virtue of I.R.C. §2042.  Various gifts were also included in the gross estate under I.R.C. §2035.  These included the decedent’s transfer of the corn crop and CDs to the grandson, as well as the forgiveness of the balance due on the contract for deed.  These were all included in the estate because they had been transferred within three years of death.  Also included in the decedent’s gross estate was the decedent’s retained life estate in the family farm that he had transferred to his grandson.  The retained life estate caused the farm to be included in the gross estate and made it subject to the special estate tax lien as I.R.C. §6324(a)(2) property. 

The court held that the defendants were personally liable for the unpaid federal estate tax as transferees of estate property and that they did not receive the property free and clear of estate tax liabilities. The court noted that transferee liability is not limited to those receiving a gift or bequest under a decedent’s will or via the administration of a revocable trust. Rather, liability extends to recipients of all property included in the gross estate including transferees who received lifetime gifts that are included in the gross estate under I.R.C. §2035 because they were made within three years of death; gift recipients whose gift was a discharge of indebtedness to the decedent; transferees who receive the property as surviving join tenants; property passing to remaindermen when the decedent had a life tenancy in the property; and life insurance proceeds on the life of the decedent.

The one daughter that filed a response to the IRS summary judgment motion asserted that the government was barred by the statute of limitations.  After all, she noted, the decedent died in 1999 and the IRS didn’t file suit to collect the tax until early 2017.  However, under I.R.C. §6324(a)(2), personal liability for unpaid estate tax can be asserted by the IRS ten years from the date the assessment is made against the estate.  I.R.C. §6502(a)(1).  See also United States v. Botefuhr, 309 F.3d 1263 (10th Cir. 2002).  The assessment was made in 2008 (remember the estate didn’t file Form 706 until 2008) and the IRS sued in 2017, nine years into the 10-year timeframe for doing so and 18 years after the decedent’s death.  The daughter challenging the government’s motion didn’t dispute these facts.  Now, the court’s decision finding the daughters and grandson personally liable for the unpaid estate tax comes just over 19 years after the decedent’s death.   

Conclusion

The clear lesson of the case is that federal estate tax liability just doesn’t go away if the estate doesn’t pay it.  In addition, the IRS has a lengthy timeframe to collect the tax.  Proper pre-death planning can, of course, help to either minimize or eliminate the tax.  Also, if the exemption from federal estate tax were to drop in the future, more farms, ranches and small businesses would get caught in its snare.  That was certainly the result for the South Dakota farming operation in the recent case.

March 15, 2019 in Estate Planning | Permalink | Comments (0)

Wednesday, March 13, 2019

Real Estate Professionals and Aggregation – The Passive Loss Rules

Overview

Last April I devoted a post to the general grouping rules under I.R.C. §469https://lawprofessors.typepad.com/agriculturallaw/2018/04/passive-activities-and-grouping.html   Those rules allow the grouping of passive investment activities with other activities in which the taxpayer materially participates.   Thus, for example, an investor in an ethanol plant might be able to group the losses from that investment with the taxpayer’s farming activity. Grouping may make it more likely that the taxpayer can avoid the passive loss rules and fully deduct any resulting losses.

But, there’s another grouping rule – one that applies to a taxpayer that has satisfied the tests to be a real estate professional and it’s only for purposes of determining material participation in rental activities.  This election is an all-or-nothing election – either all of the taxpayer’s rental activities are aggregated or none of them are. 

The aggregation election for real estate professionals – that’s the focus of today’s post.

Real Estate Professional

In last Thursday’s post, https://lawprofessors.typepad.com/agriculturallaw/2019/03/passive-losses-and-real-estate-professionals.html  I detailed the rules under I.R.C. §469 pertaining to a real estate professional.  To qualify as a “real estate professional” two test must be satisfied:  (1) more than 50 percent of the personal services that the taxpayer performs in trades or business for the tax year must be performed in real property trades or businesses in which the taxpayer materially participates; and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.  I.R.C. §469(c)(7).  If the two tests are satisfied, as noted above, the rental activity is no longer presumed to be passive and, if material participation is present, the rental activity is non-passive.  I.R.C. §469(c)(7)(A)(i).Another way of putting is that once the tests of I.R.C. §469(c)(7) are satisfied it doesn’t necessarily mean that rental losses are non-passive and deductible, it just means that the rental losses aren’t per se as passive under I.R.C. §469(c)(2) See, e.g., Gragg v. United States, 831 F.3d 1189 (9th Cir. 2016); Perez v. Comr., T.C. Memo. 2010-232.  An additional step remains – the taxpayer must materially participate in each separate rental activity (if there are multiple activities). 

Note:  The issue of whether a taxpayer is a real estate professional is determined on an annual basis.  See, e.g., Bailey v. Comr., T.C. Memo. 2001-296.  In addition, when a joint return is filed, the requirements to qualify as a real estate professional are satisfied if either spouse separately satisfies the requirements.  I.R.C. §469(c)(7)(B). 

Is Separate Really the Rule?

As noted above, if a taxpayer has multiple rental activities, the taxpayer must materially participate in each activity.  That can be a rather harsh rule.  But, there is an exception.  Actually, there are two.  If material participation test cannot be satisfied, the taxpayer can use a relaxed rule of active participation.  I.R.C. §469(i).  That rule allows the deduction of up to $25,000 of losses (subject to an income phase-out).  In addition, the taxpayer can make an election to aggregate all of the rental activities that the taxpayer is involved in for purposes of meeting the material participation test.  Treas. Reg. §1.469-9(g)(1).  This aggregation election is available to a taxpayer that has satisfied the requirements to be a qualified real estate professional under I.R.C. §469(c)(7).  See, e.g., C.C.A. 201427016 (Jul 3, 2014).

Points on aggregation.  Aggregation only applies to the taxpayer’s rental activities.  Activities that aren’t rental activities can’t be grouped with rental activities. In addition, it’s only for purposes of determining whether the material participation test has been met.  Because the election only applies to rental activities, time spent on non-rental activities won’t help the taxpayer meet the material participation test for the rental activities.  This makes the definition of a “rental activity” important.  I highlighted the designated rental activities in last Thursday’s post.  One of them is that the real estate must be used in a rental activity rather be realty that is held in the taxpayer’s trade or business where the average period of customer use for the property is seven days or less.  Temp. Treas. Reg. §1.469-1T(e)(3)(ii); see also Bailey v. Comr., T.C. Memo. 2001-296.   

By election only.  Aggregation is accomplished only by election.  Treas. Reg. §1.469-9(g)(3).  It’s not enough to simply list all of the rental activities of the taxpayer in a single column on Schedule E.  In Kosonen v. Comr., T.C. Memo. 2000-107, the petitioner owned seven residential rental properties.  As of the beginning of 1994, he had non-deductible suspended losses of $215,860 from his properties.  He put in almost 1,000 hours in rental activities in each of 1994 and 1995.  On this 1994 return, he listed each rental property and loss separately on Schedule E and reported a combined loss of $56,954 on line 42 of Schedule E – the line where a taxpayer that is materially participating in rental activities reports net income or loss from all rental activities.  He also reported the loss on line 17 of Form 1040 and subtracted it from other income to compute his adjusted gross income.  He also filed Form 8582 to report the $56,954 loss.  However, he didn’t attach an aggregation statement to the return noting that he was electing to treat his rental real estate activities as a single activity.  He also didn’t combine his 1994 Schedule E rental real estate losses with his previously suspended losses.  The IRS noted that had a proper election been made that the petitioner would have satisfied the material participation requirement.  But, the IRS took the position that an election had not been made and as a result the material participation requirement had to be satisfied with respect to each separate activity.  Because he could meet the material participation test in any single activity by itself, the IRS asserted, the resulting losses were suspended and couldn’t offset active income.  The Tax Court agreed with the IRS.  While the form of his entries on the return were consistent with an aggregation election, the Tax Court held that his method of reporting net losses as active income was not clear notice of an aggregation election.  The fact that the IRS had not yet issued guidance on how to make an aggregation election didn’t eliminate the statutory requirement to aggregate, the Tax Court concluded.     

Attached statement.  To satisfy the statutory election requirement, the election statement attached to the return should clearly state that an election to aggregate rental activities is being made via I.R.C. §469(c)(7)(A) and that the taxpayer is a qualifying taxpayer in accordance with I.R.C. §469(c)(7)(B).   

Late election relief.  It is possible to make a late election via an amended return.  In Rev. Proc. 2011-34, 2011-24 I.R.B. 875, the IRS said a late election can be made in situations where the taxpayer has filed returns that are consistent with having made the election.  In that event, the late election applies to all tax years for which the taxpayer is seeking relief.  The late election is made by making the election in the proper manner as indicated above as an attachment to the amended return for the current tax year.  The attachment must identify the tax year(s) for which the late election is to apply, and explain why a timely election wasn’t initially made.  The opportunity to make a late election is important.  See, e.g., Estate of Ramirez, et al. v. Comr., T.C. Memo. 2018-196. 

Binding election.  The aggregation election cannot be revoked once it is made – it is binding for the tax year in which it is made and for all future years in which the taxpayer is a qualifying real estate professional.  If intervening years exist in which the taxpayer was not a qualified real estate professional, the election has no effect in those years and the taxpayer’s activities will be evaluated under the general grouping rule of Treas. Reg. §1.469-4.  Treas. Reg. §1.469-9(g)(1). 

Years applicable.  If the election hasn’t been made in a year during which the taxpayer was a qualified real estate professional, it can still be made in a later year.  But, the election is of no effect if it is made in a year that the taxpayer doesn’t satisfy the requirements to be a real estate professional.  Treas. Reg. §1.469-9(g)(1).  In other words, the election may be made in any year in which the taxpayer is a qualifying taxpayer for any tax year in which the taxpayer is a qualifying taxpayer. In addition, the failure to make the election in one year doesn't bar the taxpayer from making the election in a later year.  Treas. Regs. §§1.469-9(g)(1) and (3).  

Revocation.  While the aggregation election is normally binding, the aggregation election can be revoked for a year during which the taxpayer’s facts and circumstances change in a material way.  If that happens, the election can be revoked by filing a statement with the original tax return for that year.  According to the regulations, the statement must provide that the I.R.C. §469(c)(7)(A) election is being revoked and describe the material change in the taxpayer’s factual situation that justifies the revocation.  Treas. Reg. §1.469-9(g)(3). 

Rental real estate activities held in limited partnerships.  What happens if the taxpayer makes the election to aggregate all real estate rental activities but not all of the taxpayer’s interests in real estate activities are held individually by the taxpayer?  The regulations address this possibility and use an example of an interest in a rental real estate activity held by the taxpayer as a limited partnership interest.  Treas. Reg. §1.469-9(f)(1). The result is that the effect of the aggregation election doesn’t necessarily apply in this situation.   Instead, the taxpayer’s combined rental activities are deemed to be a limited partnership interest when determining material participation and the taxpayer must establish material participation under one of the tests that apply to determine the material participation of a limited partner contained in Treas. Reg. 1.469-5T(e)(2).  Treas. Reg. §1.469-9(f)(1). But, there is a de minimis exception that applies if the taxpayer’s share of gross rental income from all limited partnership interests in rental real estate is less than 10 percent of the taxpayer’s share of gross rental income from all of the taxpayer’s interests in rental real estate for the tax year.  In this situation, the taxpayer can determine material participation by using any of the tests for material participation in Treas. Reg. §1.469-5T(a) that apply to rental real estate activities.  Treas. Reg. §1.469-9(f)(2).  This is also the rule if the taxpayer has an interest in a rental real estate activity via an LLC.  An LLC interest is not treated as a limited partnership interest for this purpose.  Thus, the taxpayer can use any of the seven tests for material participation contained in Treas. Reg. §1.469-5T(a).  See, e.g., Garnett v. Comr., 132 T.C. 368 (2009); Hegarty v. Comr., T.C. Sum. Op. 2009-153; Newell v. Comr., T.C. Memo. 2010-23; Thompson v. Comr., 87 Fed. Cl. 728 (2009), acq. in result only, A.O.D. 2010-002 (Apr. 5, 2010); Chambers v. Comr., T.C. Sum. Op. 2012-91. 

It should be noted that in its 2017-2018 Priority Guidance Plan, the IRS stated that it planned to finalize regulations under I.R.C. §469(h)(2).  That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations.  Those regulations were initially issued in temporary form and became proposed regulations in 2011.  Until the IRS takes action to effectively overturn the Tax Court decisions via regulation, the issue will boil down (as it has in the Tax Court cases referenced above) to an analysis of a particular state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership.

Effect on losses.  The aggregation election also impacts the handling of losses.  Once the aggregation election is made, prior year disallowed passive losses from any of the aggregated real estate rental activities can be used to offset current net income from the aggregated activities regardless of which activity produces the income or prior year loss.  At least this is the position take in the preamble to the regulations.  See Preamble to T.D. 8645 (Dec. 21, 1995).  This is the result even if the disallowed prior year losses occurred in tax years before the aggregation election was made.  Treas. Reg. §1.469-9(e)(4).   

Any suspended losses remain suspended until substantially all of the combined activities (by virtue of the election) are disposed of in a fully taxable transaction. This would be an issue if a rental real estate activity with a suspended loss is aggregated with other rental real estate activities.  Those suspended losses would not be deductible until the entire aggregated activity (now treated as a single activity) is disposed of.  Thus, depending on the amount of the suspended losses at issue, it may not be a good idea to make the aggregation election in this situation.  Likewise, it also may not be a good idea to make the aggregation election if the taxpayer has positive net income from rental real estate activities and passive losses from activities other than rental real estate activities.  If the election is made in this situation, the rental activities won’t be passive, and the taxpayer won’t be able to use the losses from the other passive activities to offset the income from the rental real estate activities.  The losses could then end up being suspended and non-deductible until the entire (combined) activity is disposed of. 

Conclusion

The aggregation election is an election that is available only for real estate professionals and can make satisfying the material participation test easier.  That can allow for full deductibility of losses from rental real estate activities.  But, the terrain is rocky.  Good tax advice and planning is essential.

March 13, 2019 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Friday, March 1, 2019

Valuing Non-Cash Charitable Gifts

Overview

Donations to charity can provide a tax deduction for the donor.  Normally, the tax deduction is tied to the value of the property donated to a qualified charity.  That’s an easy determination if the gift is cash.  But what if the gift consists of property other than cash?  How is that valued for charitable deduction purposes?

Valuing non-cash gifts to charity – that’s the topic of today’s post.

Basic Rules

When a charitable contribution of property other than money is made, the amount of the contribution is generally the fair market value (FMV) of the donated property at the time of the donation.  Treas. Reg. §1.170A-1(c)(1).  What is FMV?  It’s “the price at which the property would change hands between a willing buyer and seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”  Treas. Reg. §1.170A-1(c)(2).  Sometimes FMV is relatively easy to determine under this standard.  Other times, it’s not as easy – especially if the non-cash gift is a unique asset.  In that situation, the IRS has two approaches to arrive at FMV: the comparable sales method; and the replacement value of the donated property.  In a relatively recent Tax Court case, these valuation approaches to a substantial non-cash donation to charity were on display.

Recent Case

In Gardner v. Comr., T.C. Memo. 2017-165, the petitioner was a big-game hunter that had been on numerous safaris and other big-game hunts around the world.  In one two-year period he had been on over 20 safaris.  Like many big-game hunters, he provided the meat from his kills to the local community and then had taxidermists prepare the hide for eventual display in the “trophy room” of his home.  Some of the displays were full body mounts, others were wall hangings or rugs.  These types of displays are the most attractive and desirable in the hunting business.  His trophy room was, at one point, featured in a hunting publication, “Trophy Rooms Around the World.”

Ultimately, the petitioner downsized his collection by donating 177 of the “less desirable” pieces in his collection to a charity (an ecological foundation). None of the donated specimens were of “record book” quality.  Before making the donation, he had the donated specimens appraised.  Based on that FMV appraisal, he claimed a charitable deduction of $1,425,900. That figure was derived from his appraiser’s computation of the replacement cost of each donated item – what it could cost him to replace each item with an item of similar quality.  Replacement cost was computed by projecting the out-of-pocket expenses for the petitioner to travel to a hunting site; take part in a safari; kill the animal; remove and preserve the carcass; ship the carcass to the U.S.; and pay for taxidermy services to prepay the specimen for display.  The petitioner’s appraiser gave every one of the donated items a quality rating of “excellent” for specimen quality and taxidermy quality.  For provenance, the appraiser listed the items as “meager.”  The appraiser, however, did not provide any evidence for the rational of why he utilized the replacement cost approach.  

On audit, the IRS valued the donated specimens at $163,045 based on their expert’s report.  The expert appraiser for the IRS had been a licensed taxidermist for more than 30 years and was a certified appraiser specializing in taxidermy items.  He characterized the donated items as mostly “remnants and scraps” of a trophy collection – what’s left over after mounting an animal or “what’s left over when you’re done mounting an animal.”  He testified that there was an active market among taxidermists for such items to either complete projects or mount them for their own collections.  That market, the IRS expert noted, has been expanded by the internet and allowed a ready determination of market value.  Indeed, the IRS expert found 504 comparable sales transactions via traditional auctions and internet auction sites.  This wasn’t the situation, the IRS expert asserted, where world-class trophy mounts were involved with a thin to non-existent market (which would support the use of the replacement cost approach).  Thus, based on the comparable sale approach, the IRS arrived at the $163,045 value. 

The matter ended up in the Tax Court, and the Tax Court first noted that it had previously determined how to value hunting specimens donated to charity in 1992.  In Epping v. Comr., T.C. Memo. 1992-279, the Tax Court reasoned that if an active market exists, the general rule is to use comparable sales to arrive at a value of the donated property.  The Epping case involved “an assortment of animal mounts, horns, rugs, and antlers.”  The Tax Court in that case determined that there was an active market in hunting specimens with substantial comparable sales.”  However, the Tax Court also noted that replacement cost is appropriate when the donated property is unique, and no evidence of comparable sales exists.  Thus, to be able for a taxpayer to use replacement cost to value the donated items, the taxpayer must show that there is no active market for the comparable items and that there is a correlation between the replacement cost and FMV.  That’s a tough hurdle to clear in many situations.

In the present case, the Tax Court, was persuaded by the IRS expert’s testimony that the 177 donated items were neither of “world-class” nor museum quality.  Instead, the Tax Court agreed that they were mostly “remnants, leftovers, and scraps” of the petitioner’s collection.  In addition, the Tax Court noted that the petitioner’s own testimony indicated that he wanted to “downsize” his collection by getting rid of unwanted items.  The Tax Court also noted that photographs of the specimens provided by his expert indicated that the donated specimens were not high quality, and none were of record-book quality.  In addition, the Tax Court noted that the IRS expert had established an active market for items similar to those the petitioner donated.  Thus, the Tax Court determined that the specimens were commodities rather than collectibles and would be appropriately valued based on the market price for similar items – the IRS approach.  To further support the use of the comparable sales approach, the Tax Court concluded that the petitioner did not really attempt to challenge the IRS expert’s data and didn’t introduce any evidence of market prices for comparable items.  The petitioner failed to prove that the FMV of the 177 donated items exceeded the $163,045 value that the IRS established.         

Conclusion

Valuing non-cash charitable gifts can be tricky.  Establishing FMV of the donated property must be backed up with sufficient evidence that supports the valuation approach.  Truly unique items that lack a ready market may be able to be valued under the replacement cost approach.  A good appraiser goes a long way to making that determination.  As the Tax Court stated, “To paraphrase Ernest Hemingway, there is no hunting like the hunting for tax deductions.”

March 1, 2019 in Estate Planning, Income Tax | Permalink | Comments (0)

Monday, February 25, 2019

Estate Planning in Second Marriage Situations

Overview

A married couple’s estate planning goals and objectives often dovetail - benefit the surviving spouse for life with the remaining property at the death of the surviving spouse passing to the children.  But, estate planning when a second marriage (either as a result of death or divorce) is involved is more complex, especially when each spouse has children from the prior marriage.  The estate planning techniques of first marriage situations often don’t work when a second marriage is involved.  But, the IRS recently blessed a second marriage estate planning technique.

Estate planning for second marriages – that’s the topic of today’s post.

Second Marriage Estate Plans

Potential problem areas.  Blended families are not uncommon.  When I first started practicing law, I was tasked with developing an estate plan for an older married couple.  Each one of them had outlived their prior spouse and each of them had children from that prior marriage.  They each had a separate farming/ranching operation.  It was imperative to them that their respective children carry on the farming/ranching business that was associated with each of them.  In this situation, the common estate plan for a married couple wouldn’t work.  It was no longer appropriate to balance ownership of all assets equally between the couple and then via reciprocal (i.e., mirror) wills leave a portion of the assets to the surviving spouse outright with the balance in a “credit-shelter” trust and the remainder at the death of the surviving spouse split between all of the kids (from both prior marriages).  This standard approach could have resulted in children of one family eventually owning the other family’s farming/ranching operation.  That would not have been a good result.

It's also common in first marriages for the spouses to own the home and land as joint tenants with right of survivorship. Upon the death of the first spouse, the jointly held asset automatically passes to the surviving spouse.  While that results in the surviving spouse having complete ownership of the asset, that is often not a desirable outcome in a second marriage situation.  The survivor could leave the asset at death to their children of the first marriage. 

Beneficiary designations can also lead to a similar problem as jointly held property.  The spouse is often named as the beneficiary of life insurance, retirement plans/accounts, etc.  But, this can become a problem upon death and the subsequent remarriage of the surviving spouse. 

Potential solution.  One approach that is used in second (and subsequent) situations involves a revocable trust that is funded either during the grantor’s life or at death or via beneficiary designations (or some combination).  The grantor can amend or revoke the trust at any time before death, and on death the trust becomes irrevocable and continues for the surviving spouse’s benefit and the benefit of the children of the first marriage.  The trust income can be paid to the surviving spouse during life and the trust assets remaining at the surviving spouse’s life pass to the grantor’s children of the first marriage.  A “spendthrift” provision can be added to the trust to provide additional assurance that the assets ultimately land in the correct hands, and are not dissipated by creditors, etc.  In addition, the trust allows the grantor to maintain post-death control over the assets of the family from the first marriage.  The assets are not left outright to the surviving spouse of the second marriage, and the surviving spouse cannot change the estate plan to exclusively benefit the survivor’s own children, for example.

Handling Retirement Plans 

In second marriage situations, can an individual retirement account (IRA) also be placed in a trust so that account income benefits the surviving spouse of the second marriage for life with the account balance passing to the children of the pre-deceased spouse’s first marriage?  The tax code complicates matters, but a recent IRS private letter ruling shows how it can be accomplished. 

In general, annual required minimum distributions must be taken from traditional IRAs at the required beginning date (RBD) – April 1 of the year after the year in which the account owner turns 70 ½.  I.R.C. §401(a)(9)(C)(i)(l).  Special rules apply when the IRA owner dies after the RBD.  In that case, any balance remaining in the account is distributed in accordance with certain rules. For example, if the account owner didn’t designate a beneficiary, the post-death payout period is determined by what the deceased owner’s life expectancy was at the time of death.  Treas. Reg. §1.401(a)(9)-(5).  If the IRA owner named a non-spouse as the beneficiary, the account balance is paid out over the longer of the remining life expectancy of the designated beneficiary or the remaining life expectancy of the IRA owner.  Id. 

If the IRA owner designated the spouse as the IRA’s sole designated beneficiary, the required distribution for each year after death is determined by the longer of the remining life expectancy of the surviving spouse or the remaining life expectancy of the deceased spouse based on their age at the time of death.  Id. This can allow payouts to be “stretched.”  But, naming the surviving spouse as the beneficiary of an IRA also gives the surviving spouse the ability to treat the IRA as their own.  That means that the surviving spouse can name their own beneficiaries – not necessarily a good result in second marriage situations where each spouse has children of a prior marriage. 

Trust as a beneficiary.  Can a trust be named the beneficiary of the retirement plan so that the surviving spouse doesn’t have complete control over the account funds?  In general, the answer is “no.”  Treas. Reg. §1.401(a)(9)-4, Q&A 3.  However, a trust beneficiary (with respect to the trust’s interests in the IRA owner’s benefits) is treated as the designated beneficiary of an IRA if certain conditions are satisfied for the period during which the RMDs are being determined by treating the trust beneficiary as the designated beneficiary of the IRA owner.  See Treas. Reg. §1.401(a)(9)-4, Q&A 5(b).

Recent IRS ruling.  In Priv. Ltr. Rul. 201902023 (Oct. 15, 2018), the decedent created a revocable living trust during life.  The trust contained a subtrust to hold the benefits and distributions from his retirement plans (and other assets).  He died after attaining his RBD and after distributions from his IRA had started.  The revocable trust and the subtrust became irrevocable upon his death.  His IRA named the trust as the beneficiary.  The terms of the trust specified that property held by the subtrust were to be “held, administered, and distributed” for the sole benefit of his (younger) surviving spouse.  Upon her death, the trust specified that the retirement plan (along with the remaining assets of the subtrust) were to be divided equally between his children or their descendants.

The IRS noted that the trust identified the surviving spouse as the sole beneficiary of the subtrust in accordance with Treas. Reg. §1.401(a)(9)-4, Q&A 5(b)(3).  In addition, the trust required the trustee to pay the surviving spouse any and all funds in the subtrust that the trustee withdrew, including RMDs, and there could be no accumulation for any other beneficiary.  That satisfied the requirements of Treas. Reg. §1.401(a)(9)-4, Q&A-5 (valid trust under state law; trust is irrevocable or becomes so on death of account owner; the trust identifies the beneficiary; and the plan administrator is given appropriate documentation) and the surviving spouse was treated as the sole designated beneficiary of the IRA.  Thus, the IRS concluded that the payment to the two trusts (first to the revocable trust and then to the subtrust) was permitted by Treas. Reg. §1.401(a)(9)-4. Q&A-5(d) which says that if the trust beneficiary is named as the beneficiary of the account owner’s interest in another trust, that beneficiary will be treated as having been designated as the beneficiary of the first trust and, be deemed to be the IRA account owner for distribution purposes.    

In addition, the IRS determined that because the surviving spouse had a longer life expectancy that did the decedent, the applicable distribution period for the IRA should be based on her life expectancy.   This means that via the trust and the subtrust, the surviving spouse received RMDs as if she were the designated sole beneficiary.  Upon her death, any remaining assets of the subtrust will be distributed to the pre-deceased spouse’s children or their descendants.

Conclusion

Unique estate and business planning issues present themselves in second marriage situations.  Along with a well-drafted marital agreement, other steps should be taken to ensure the continued viability of separate farming/ranching operations that are brought into the subsequent marriage while simultaneously benefiting each spouse’s children of the prior marriages appropriately at the death of their respective parent.  Included in this planning is the treatment of retirement accounts.  The recent IRS ruling illustrates one way to leave an IRA to the spouse of a second marriage and avoid negative consequences.   

February 25, 2019 in Estate Planning | Permalink | Comments (0)