Sunday, October 13, 2024
Accumulated Earnings; Starting in Farming; Ag Data and Selling the Farm and Residence
Overview
The legal and tax issues that farmers and ranchers can potentially face are practically innumerable. Today I have pulled four more out of the hat to briefly discuss. The first one is one that can occur if you have a C corporation and retain too much of the corporate earnings in the corporation. The next one discusses the possibility of using the funds in a 401(k) as start-up capital for a farming business. Will it work? What might be a trigger for the IRS to examine? Then I turn my attention to Ag Data. With any technology there are pros and cons. What might some of those be for Ag Data? Finally, I briefly discuss how to best utilize the home-sale gain exclusion rule when selling a farm.
More food for thought on the topic of ag law and taxes – it’s the topic of today’s post.
Accumulated Earnings Tax
The accumulated earnings tax is a tax you may not have heard about. But, if your farming business is in a C corporation or an S corporation that used to be a C corporation, it’s a tax you should be aware of.
The accumulated earnings tax is a 20 percent penalty that is imposed when a corporation retains earnings over $250,000 that are beyond the reasonable needs of the business instead of paying dividends. Not paying dividends avoids the shareholder-level tax on dividends.
Whether a purpose exists to avoid the shareholder-level tax is a subjective determination based on the facts and circumstances. Don’t unreasonably accumulate corporate earnings while not paying dividends. Also, don’t use corporate earnings for investments unrelated to the farming business. Corporate loans to a shareholder for personal purposes are a “no-no” as is the use of corporate funds for a shareholder’s personal benefit.
Make sure you document why you are retaining earnings. Such reasons as needing cash to buy more farmland or insuring against business risks or buying out a senior member of the family business are fine.
But, again, make sure you record your reasons for the accumulations in your corporate annual meeting minutes and other corporate documents. And remember, if the accumulated earnings tax applies, it’s in addition to what the corporate tax liability is. It’s a pure penalty.
Using a 401(k) for Start-Up Capital
One of the drawbacks to starting in farming on a full-time basis is the lack of capital. But you just might have a substantial asset that you could tap to create the necessary working capital.
If you have a 401(k), you might be able to use the funds to start a farming business. To do this, you will need to create a C corporation to establish a 401(k) plan and then roll over your current 401(k) at the old employer into the new 401 (k) plan. The new plan will then buy shares in the corporation and become an owner. The money put into the corporation will then become the working capital that the corporation can use to buy equipment and plant crops and so forth.
There is no limit on how much stock the 401(k) can buy. This means that unlike borrowing money from a 401(k) which is limited to $50,000 or cashing in the plan and paying taxes and a 10 percent penalty on the funds received, you can maximize the amount of capital you put into the farm business.
The IRS has noted some abuses with these transactions. Some people have set up a corporation simply to buy a motor home for example. If you do that and get audited, you can expect the IRS to disallow the purchase for tax purposes. But if you use the cash to create a farming entity and will be actively farming, there should be no issue with using your 401(k) to fund it. Actively farming – that’s the key.
Ag Data and Proof of Damages
Farmers have several reasons to collect ag data about their farming practices. One of those might be to prove damage to crops in court. In one recent case, the management of a lake dam increased the lake level and made farm field tile in the area ineffective to drain significant rainfalls. The result was that water ponded in the fields and significantly reduced crop yields. But could the farmer prove his damages in terms of lost yield and revenue?
With harvesting data, the court was able to see exactly where the flooded areas of the fields were and how flooding specifically affected yields. The data showed that flooding, and not soil type, was the reason for the lower yields in the flooded parts of the fields. Drone photos were also used to confirm the yield data. The court could see how the pictures of the fields matched the harvest data. Comparison data from nearby fields that did not drain into the lake watershed was also used to show what the yield would have been without the elevated lake level.
The court awarded the farmer almost $500,000 in damages for crop loss and field tile. Ag data helped make the case and will be an important part of many ag tort cases in the future.
The case is Houin v. Indiana Department of Natural Resources, 205 N.E.3d 196 (Marshall Co. Cir. Ct. 2021), aff'd. in part and rev'd in part, Indiana Department of Natural Resources v. Houin, 191 N.E.3d 241 (Ind. Ct. App. 2022).
Utilizing the Home Sale Exclusion When Selling the Farm
When selling the farm, how much land can be carved out and sold with the farm home to qualify for a special tax break?
For married taxpayers that file jointly up to $500,000 of gain that is attributable to the sale of the taxpayer’s principal residence can be excluded from income. It’s one-half of that amount for a taxpayer that files as a single person. But what if the farm sale also involves the residence? How much (if any) of the farmland and outbuildings can be included with the residence to fill up that $500,000 amount?
Under current tax regulations, farmland can be treated as part of the principal residence if it is adjacent to land containing the home and is used as part of or along with the home. What is the practical application of those requirements? The IRS rulings and court decisions indicate that the barnyard and areas used in connection with the home can be included as the “residence” portion of the sale. Also, local zoning rules can come into play. For many farm sales, an acre or two can likely be included with the home.
Of course, each situation is dependent on the facts and the outcome depends on the particular situation. But, if the facts support it, including at least some adjacent land with the principal residence can be a significant tax-saving technique. It’s best to fill up that $500,000 amount if your facts allow you to do it.
Conclusion
It’s harvest season, so for those of you in harvest be careful and use common sense. I have been on the road quite a bit recently – from North Dakota to Iowa to western Nebraska. This week my travels take me to Idaho for an all-day tax seminar followed by a day of Steelhead fishing on the Salmon River. Hopefully, I’ll get some good pictures to share with you. Then it’s on to west Texas for two-days of tax lecturing. Then a couple of events in Kansas before the fall KSU Tax Institutes begin. I have also mixed in a couple of events for high school students – trying to plant seeds in the minds of young people of the need for well-trained rural attorneys. I enjoy their questions and their enthusiasm and energy. A tip of my hat to their teachers – I couldn’t do it.
October 13, 2024 in Business Planning, Civil Liabilities, Estate Planning, Income Tax | Permalink | Comments (0)
Sunday, October 6, 2024
Contracts, Estate Planning and Wetlands
Overview
Digital contracts are becoming more common for farmers and ranchers. That means there are some unique legal issues that might arise. The first part of today’s article takes a brief look at what those might be.
An estate planning tool in light of the uncertainty of whether the Trump tax cuts (Tax Cuts and Jobs Act (TCJA)) is a spousal lifetime access trust (SLAT). I provide a very brief explanation of what a SLAT is.
A new court decision from a federal court in Idaho provides insight as to how the Sackett test concerning the definition of a wetland under the Clean Water Act is to be applied. The case involved an Idaho farming operation. I survey the court’s decision.
Digital contracts, SLATs and wetlands – the topics of today’s blog
Digital Contract Basics
There are certain core elements to every contract – offer, acceptance and consideration. And, in general, there must be a meeting of the minds as to the essence of the contract. A question is how those elements are satisfied in the context of digital contracts. For starters, any offer should include definite terms. Vague terms will be interpreted according to the parties’ past course of dealing, if any, or be construed against the drafter, or be filled in based on law and precedent. Make sure you know what you are signing, whether paper or digital
In addition, an acceptance must mirror the offer. Any change in the terms means “no deal” until the original offeror accepts the new terms. So, be careful with a digital contract where you “click to accept” the contract’s terms. Make sure you know what you’re accepting.
Another requirement is consideration – an amount of payment. But with a digital contract what about a free trial use period? For example, could you sue a free online service provider when the product doesn’t work as promised? Doubtful because of no consideration.
And make sure to read a digital contract – it’s easy for the offer, acceptance and consideration to get buried in the fine print. A “meeting of the minds” is essential.
Spousal Lifetime Access Trusts
Future tax policy is uncertain right now and a big concern for some farmers and ranchers is what the federal estate tax exemption will be after 2025. If the exemption level drops, one strategy that might be effective to lessen a future estate tax burden is a spousal lifetime access trust, or SLAT.
A SLAT is an irrevocable trust designed to provide income to a beneficiary spouse while removing the trust’s assets from the grantor spouse’s taxable estate. As an irrevocable trust, it can’t be modified or revoked, and the assets can’t be returned to the donor spouse. The trustee must ensure that the trust assets are used according to the trust’s terms, and that the beneficiary spouse gets the income from the trust for life.
When the beneficiary spouse dies, the remaining trust assets pass to designated beneficiaries free of estate tax.
The technique could work well now while the estate tax exemption is high - allowing a significant amount of asset value to be transferred to the trust and offset by the exclusion. The value would also not be included in the beneficiary spouse’s estate.
If a SLAT can be funded with assets that will appreciate, the tax benefits can be maximized. One downside, however, is that the ultimate beneficiaries won’t get a step-up in basis at the time of the beneficiary spouse’s death.
Waters of the United States
The U.S. Supreme’s Court’s decision in the Sackett case in May of 2023 changed the way a “wetland” is defined for purposes of the federal government’s jurisdiction under the Clean Water Act (CWA). The most recent lower court decision involving the new definition as applied to a farmer involves a case out of Idaho.
In United States v. Ace Black Ranches, LLP, No. 1:24-cv-00113- DCN, 2024 U.S. Dist. LEXIS 156797 (D. Idaho Aug. 29, 2024), the Environmental Protection Agency (EPA) claimed that the defendant discharged “pollutants” into a navigable water of the United States (a river that passes through the defendant’s ranch) and associated wetlands without a Clean Water Act discharge permit. The EPA and the U.S. Army Corps of Engineers (COE) notified the defendant that it was going to start investigating potential CWA violations. The defendant withdrew its initial consent to the investigation and filed a complaint and motion for preliminary injunction. The case was dismissed. The EPA then obtained an administrative warrant and inspected the ranch in 2021 and 2023. The EPA then sued, claiming that the ranch had violated the CWA by illegally discharging pollutants by constructing multiple road crossings in the Bruneau River (a navigable water) and associated wetlands which impeded the flow of water and polluted the river. The EPA also claimed that the defendant “disturbed the riverbed” by mining sand and gravel from the river, and that the defendant’s construction of a center pivot irrigation system cleared and leveled “nearly all of the Ranch’s wetlands.” The EPA sought a permanent injunction that would bar the ranch from further discharges and would require the ranch to restore the impacted parts of the river.
The ranch moved for dismissal for failure to state a claim. The court granted the defendant’s motion and dismissed the case. The court determined that the EPA failed to sufficiently specify in its complaint that the wetlands at issue had a continuous surface connection with the Bruneau River to be considered indistinguishable from it (the requirement needed to satisfy the “adjacency test” established in Sackett v. Environmental Protection Agency, 598 U.S. 651 (2023)). It was not enough for the EPA to assert that it could clear up any confusion during discovery. The court noted that the EPA had to put forth sufficient allegations at the pleading stage to entitle it to discovery. As such, the EPA failed to state a claim upon which relief could be granted. However, the court gave the EPA an opportunity to amend its complaint within 30 days of the court’s order.
‘Til next time…
October 6, 2024 in Contracts, Environmental Law, Estate Planning | Permalink | Comments (0)
Wednesday, August 28, 2024
More Legal and Tax Issues Involving Farmers and Ranchers
Overview
With today’s article I look at more legal and tax issues that farmers and ranchers need to know about. Being aware of legal and tax issues is a means of overall risk management for the operation.
More discussion of legal and tax issues – it’s the topic of today’s post.
Getting Sued in Another State – The Personal Jurisdiction Issue
Walters v. Lima Elevator Co., 84 N.E.3d 1218 (Ind. Ct. App. 2017)
If you engage in a business transaction involving your farm or ranch in another state and a lawsuit is filed based on that transaction, does that state’s legal system have jurisdiction over you? In 1945, the U.S. Supreme Court said that a party (particularly a corporation or a business) could be sued in a state if the party had “minimum contacts” with that state. International Shoe Company v. State of Washington, 326 U.S. 310 (1945). Over time, many courts have wrestled with the meaning of “minimum contacts,” but it basically comes down to whether the party is deriving the benefit of doing business with that particular state or is sufficiently using the resources of that state. That’s oversimplifying the application of the Court’s reasoning, but I think you get the point.
In terms of applying the “minimum contacts” theory to farm businesses, a recent case provides a good illustration. In the case, a Michigan farmer ordered seed from an Indiana elevator about 20 miles away. It was the third time he had done this. He bought the seed on credit, and when it was ready he went to the elevator to pick it up. When he didn’t pay for the seed, the elevator sued him in the local court in Indiana. He sought to dismiss the case on the basis that the Indiana court didn’t have jurisdiction over him. He claimed that he lacked sufficient minimum contacts with Indiana to be sued there. The court disagreed. The Michigan farmer had “purposely availed” himself of the privilege of conducting business in Indiana. Because of that, the court reasoned, he could have reasonably anticipated being subject to the Indiana judicial system if he didn’t pay his bill. His due process rights were also not violated – his farm was less than 20 miles away from the Indiana elevator.
If you intentionally conduct business in a state and are sued as a result of your contacts and actions with that state, that state’s courts will likely have personal jurisdiction over you.
Social Security Planning for Farmers
Introduction
Part of retirement planning for a farmer includes Social Security benefits. Relatedly, if you are nearing retirement age you might be asking yourself when you should start drawing Social Security benefits. The answer is, “it depends.” But there are a few principles to keep in mind.
The first point to keep in mind is that maximum Social Security benefits can be received if you don’t withdraw benefits until you reach full retirement age – that’s presently between ages 66 and 67. Additional benefits can be achieved for each year of postponement until you reach age 70. Another point is that some Social Security benefits are reduced once certain income thresholds are reached. For 2024, if you haven’t reached full retirement age and earn more than $22,320, benefits get reduced $1 for every $2 above the limit. During the year in which you reach full retirement age, the earnings limit is $59,520 with a $1 dollar reduction for every $3 dollars over the limit. Once you hit full retirement age, the limit on earning drops off.
In-kind wages count toward the earnings limitation test, but employer-provided health insurance benefits don’t. Also, federal farm program payments are not earnings for years other than the first year you apply for Social Security benefits.
So, when should you start drawing benefits? It depends on your particular situation and your retirement plan. The Social Security Administration has some useful online calculators that can help. Check out ssa.gov.
Common Estate Planning Mistakes of Farmers
What are some common mistakes that farmers and ranchers make when it comes to estate planning?
Consider the following:
- Not ensuring title ownership of property complies with your overall estate planning goals and objectives. This includes the proper use of jointly held property, as well as IRAs and other documents that have beneficiary designations.
- Not knowing what the language in a deed means for purposes of passage of the property at death.
- Leaving everything outright to a surviving spouse when the family wealth is potentially subject to federal estate tax.
- Thinking that “fair” means “equal.” If you have both “on-farm” and “off-farm” heirs, the control of the family business should pass to the “on-farm” heirs, and the “off-farms” heirs should get an income interest that is roughly balanced in value to that of the “on-farm” heirs’ control interest. Leaving the farm to all the kids equally is rarely a good idea in that situation.
- Letting tax issues drive the process.
- Not preserving records and key documents in a secure place where the people that will need to find them know where they are.
- And not routinely reviewing your plan. Life events may have changed your goals or objectives.
I could list more, but these are some big ones. Try to avoid these mistakes with your estate plan.
When is a Partnership Formed?
Farmers and ranchers often do business informally. That informality can raise a question of whether the business arrangement has created a partnership. If that is determined to be the case, numerous legal issues might be created.
A big potential issue is that of unlimited liability. Partners are jointly and severally liable for the debts of the partnership that arise out of partnership business. Also, a partnership files its taxes differently than do individuals, and assets that are deemed to be partnership assets could pass differently upon the death of someone deemed to be a partner.
So how do you know if your informal arrangement is a partnership? From a tax standpoint, if you’re splitting net income from the activity rather than gross, IRS could claim the activity is a partnership. While simply jointly owning assets is not enough, by itself, to constitute a partnership, if you refer to you and your co-worker as “partners” or create a partnership bank account or fill out FSA documents as a “partnership,” a court could conclude the activity is a partnership. Most crop-share or livestock share leases are not partnerships, but you must be careful. It’s best to execute a written lease and clearly state that no partnership is intended if you don’t want questions to come up.
The IRS missed asserting that an informal partnership arrangement had been created by a mother and her daughter in a Tax Court case last year involving an Oklahoma ranch, and also lost on a hobby loss argument. Carson v. Comr., 2024 U.S. Tax Ct. LEXIS 1624 (U.S. Tax Ct. May 18, 2023). Don't count on IRS missing the same arguments in your situation.
Conclusion
There will be more issues to discuss next time.
August 28, 2024 in Business Planning, Contracts, Estate Planning, Income Tax | Permalink | Comments (0)
Thursday, August 8, 2024
More Legal Scenarios Involving Farmers and Ranchers
Overview
As I have noted many times before. There are many ways in which the law intersects with the daily lives of farmers and ranchers. Today’s article addresses several of those areas. Just a little thinking out loud on a random basis.
Self-defense; Good Samaritan laws; preparing for the exit; and cleaning out fencerows – some random topics addressed in today’s post.
Self-Defense
A common question in agricultural settings is how far you can go in defending your personal property from those that would cause damage or steal.
Agricultural property is often exposed to those who might want to steal, damage or destroy. Where’s the line drawn in far you can go to protect it? In general, to protect property from vandalism and theft, you have a right to use force that is reasonably necessary under the circumstances. But you can’t use force beyond what could reasonably be believed necessary under the circumstances, and you can’t use such force as is likely to lead to great bodily injury or death.
A famous Iowa case from the early 1970s points out that you can’t use force that could physically harm or kill another person in defending your personal property if your life isn’t likewise threatened. For instance, be careful using guard dogs to ward off trespassers. The general rule with respect to guard dogs is that you can’t use any more force through an animal than you could personally. So, if a guard dog injures or kills an intruder, it is the same as if you had done it. Likewise, liability for a dog's dangerous propensities cannot be avoided by posting a sign notifying trespassers of a dog's presence.
You can take steps to protect your property. Just don’t use any force that is more than what is necessary for the situation.
Relatedly, what can you do within the bounds of the law to defend yourself from an animal such as a dog or a bull or other farm animal that isn’t yours? In recent years, some states have enacted “stand your ground” provisions that allow you to use whatever force you think is necessary to protect yourself from an equivalent threat, up to and including lethal force. You don’t have a duty to get away before using force. But you can’t just fire away at will. Your use of deadly force must be justified – and that you’ll have to prove. You don’t get a presumption that you could use deadly force.
In rural settings, the issue often comes up with dogs and livestock that don’t belong to you. If the animal threatens you with great bodily harm or death, then you can take the animal’s life. But you’ll have to establish through video or eyewitness testimony that your action was justified. You’ll likely be charged with animal cruelty or damage to property and then you must establish that you acted properly based on the circumstances. Remember whether you acted properly is based on whether you had a reasonable fear for your life. A jury will determine that question if the matter ends up in court.
So, only take an animal’s life when it’s the last resort, and make sure you have evidence to back up your action.
Good Samaritan Laws
You’re not legally required to render aid to another person who is in peril. But does the law provide any protection if you try to help?
The law used to discourage people from helping others in peril. One extreme example was the Genovese case in Queens, New York in 1964. Many people watched from their homes as Kitty Genovese was attacked in the early morning hours on her return to her apartment from work. No one did anything until it was too late. They later said that they feared liability for getting involved. This event helped spur the enactment in all states of “Good Samaritan” laws.
A Good Samaritan law specifies that if you help a person in peril without expectation of compensation, you can only be held liable for injuries resulting from recklessness or willful intent to injure. These state laws also provide slightly different treatment for emergency medical technicians and hospital staff.
Even though the law doesn’t require you to help someone else in peril, if you do you won’t be liable for any injuries resulting from your attempt to help unless your assistance is reckless, or you intentionally injure the person. Kitty’s situation was horrible, but it did result in a good change in the governing legal rules. And, in agricultural settings, the rule can also apply in situations where aid is rendered to livestock in peril.
Preparing for the Exit
When it comes to estate planning, we tend to think of wills and trusts and powers of attorney. But there are other things you can do before those documents are drafted that will make creating those documents easier and smooth the transition upon death.
When you work on your estate plan, don’t forget to organize and document other information for those that will need it. A good idea is to put in a binder a list of your retirement plan information, and copies of health and life insurance policies. Burial plot location and funeral instructions. Also, provide your email, computer and phone passwords as well as bank account information and data about your debts and bills. Also, put in that binder copies of your driver’s license, birth certificate, social security card, and marriage license. Also include documents related to real estate, a list of your assets, land that you own, stored crops, livestock and marketing contracts. Also include copies of crop insurance policies and USDA program contracts and all your key business relationships.
Make sure the right person knows where to find the binder and make sure they have access to it.
Having this information collected will be helpful for any additional steps in the estate planning process. It will also likely allow more efficient use of an attorney’s time in drafting the necessary documents for your estate plan.
Issues when Cleaning Out a Fencerow
Cleaning up fencerows seems to be an ongoing project. But the cleanup process can generate legal issues that you might not have thought about.
When you’re cleaning out a fence row legal issues can arise that you might not have thought about. For example, what should you do if there’s a tree in the fence line? In that situation, each adjacent owner has an ownership interest in the tree. It’s considered to be jointly owned and you could be liable for damages if you cut it down and your neighbor objects. But, if only the branches or roots of a tree extend past the property line and onto an adjoining neighbor’s property, the branches and roots don’t give the neighbor an ownership interest in the tree. In that situation, you can trim the branches that hang over onto your property. That’s an important point, for example, if you are dealing with a thorn tree that can puncture tires.
Always make sure to trim branches, bushes and vines on a property line with care. Keep the neighbor’s rights in mind when doing the cleanup work. Maintaining good communication is aways beneficial when property line work is involved. Also, if a neighbor’s tree falls onto your property, it’s your responsibility to clean up the mess – but you can keep the resulting firewood. The converse is also true. And it’s not a trespass to be on your neighbor’s side of the fence when doing fence maintenance, such as cleaning out a fence row.
Conclusion
There will be more issues to discuss next time.
August 8, 2024 in Business Planning, Civil Liabilities, Criminal Liabilities, Estate Planning, Real Property | Permalink | Comments (0)
Sunday, July 21, 2024
More Legal and Planning Issues to Ponder
Overview
There’s always something to think about or plan for when it comes to ag law and tax. Just educating yourself about law and tax in terms of being able to identify the issues that might arise can be very helpful to your farming business if you then find legal and tax counsel to assist you with your plan or take steps to minimize your legal exposure.
More things legal and tax to ponder – it’s the topic of today’s post.
Sweat Equity – Don’t Count on It
Farming arrangements tend to be informal. That can include reliance upon “sweat equity” as a transition plan. The next generation builds up the business by investing money and time with the belief of ownership and control in the future. All goes well…until it doesn’t. The next generation may believe that their reward for “sweat equity” that is based on trust and commitment will be eventual ownership and control of the family farming operation. But, this informality can be a risky approach. The antidote to this risk is to formalize and document relationships and expectations and write out a solid plan for the future. Also, maintaining clear and open communication and dealing in actual dollars is also important. Sweat equity can’t be invested and it can’t be saved.
If you want the business to continue into the next generation, make sure to structure the business with a solid operating agreement so that the farming heir is protected from losing the business due to issues with siblings. If siblings are to be bought out, think through how the payments would be made.
While sweat equity built up by working hard for future rights is commendable, it can lead to serious family fights and disappointment. The last thing the next generation wants is to have invested substantial time and money in the family farm to end up not ever getting ownership and control.
It’s money well spent to put a succession plan in place. What’s your family farm legacy worth?
Farmers and Estimated Tax
If you’re a farmer, you can make one estimated tax payment each year on January 15. If you don’t do that, you can elect to file and pay 100 percent of your income tax liability by March 1 each year. This all means that qualification as a “farmer” is critical. To be a farmer for estimated tax purposes, at least two-thirds of your gross income must be from farming. Some items of income don’t qualify as farm income such as cash rent. But gains from selling livestock do, and starting with 2023 returns, gains from selling or trading farm equipment also count as farm income.
So if you have too much cash rent, you might not be a “farmer” for estimated tax purposes. But, if you qualified in 2023, you’ll automatically qualify in 2024. If you didn’t qualify last year, then make sure you don’t have too much non-farm income so that you’ll qualify this year.
If you don’t meet the definition of a farmer and you don’t make any estimated tax payments, you’ll get hit with a penalty. Also, as a non-farmer, you’ll have to pay in the lesser of 100 percent of your 2023 tax or 90 percent of 2024 tax.
If you think that this might apply to you, make sure to review it with your tax advisor to see what your options are. You might have time this year to restructure lease arrangements or sell livestock or equipment so that you have enough farm income to count as a farmer.
Negligent Entrustment
If you have a farm employee, what’s the extent of your liability exposure, and what steps should you take to minimize those potential legal problems? In a Texas case last year, a young man was killed while riding an ATV driven by the teenage son of a farming operation’s employee. The accident occurred off the farm’s premises during a fishing excursion. The farm owner was sued for wrongful death based on negligent entrustment. Both the trial court and the appellate court determined that there was no negligent entrustment because there wasn’t a special relationship between the ATV driver and the farm. He wasn’t an employee and the accident occurred while the ATV was being used for personal rather than business purposes. The courts also pointed out that the farm owner didn’t know or have reason to know that the employee’s son was an unlicensed driver or didn’t know how to handle an ATV.
As a farm owner, make sure to carefully train employees on usage of farm equipment, machinery and vehicles. A written guide for usage of these items in an employee handbook might be a good idea. Address issues such as off-farm use and use by family members. Also, make sure your liability insurance is adequate by getting a thorough review of what the policy does and does not cover. Those steps could help minimize your liability exposure.
The case is Mitschke v. Borromeo, No. 07-20-00283-CV, 2023 Tex. App. LEXIS 5117 (Tex. Ct. App. Jul. 12, 2023).
Current Deduction vs. Capitalization
You can claim a tax deduction for amounts spent for repairs on your farm. But an expense that improves property cannot be currently deducted. So, where’s the line drawn between the two?
The rules as to what is a currently deductible “repair” and what must be capitalized, added to basis and depreciated over time have never provided a bright line. The basic issue is distinguishing between deductible ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, and amounts spent to restore property. Amounts paid for incidental repairs are currently deductible. But amounts paid for new property or for permanent improvements or betterments that increase the value of any property, as well as amounts spent to restore property should be capitalized and added to basis.
Expenses for materials and supplies are fully deductible if the items purchased will be used in the farming business over the next 12 months – that includes replacement tractor tires. There is a safe harbor rule that can be used, but any amount beyond the safe harbor that is paid to improve existing property should be capitalized. The rules are detailed and tricky.
So, the next time you overhaul that tractor engine or replace disc blades or work on your pivot irrigation equipment, make sure you know the tax rules that apply beforehand so you can get the best tax result for your farming business.
Conclusion
Just some thoughts today to get you thinking about what can improve the bottom line of your farming operation.
July 21, 2024 in Civil Liabilities, Estate Planning, Income Tax | Permalink | Comments (0)
Sunday, June 23, 2024
Of Fences; Agritourism; Liquidity; Solar Panels & Blight; and Trees and Motorists
Overview
With today’s post I focus on additional common issues that farmers, ranchers and rural landowners frequently face.
Fence Disputes
One of the more common questions that I get involves disputes concerning fences. Fences are often critical in agriculture, so how can a dispute over fencing get resolved within the bounds of the law? A good place to start is by checking the land records to see if prior owners had recorded a fence agreement. If they did, the agreement would bind you and your neighbor. If there is no recorded fence agreement, you could execute a new one and have it recorded with the County Register of Deeds. Once it’s recorded it will bind all future owners.
If a boundary is in dispute because of conflicting surveys, any boundaries and markers set by the first survey control in a conflict with a subsequent survey. This is true even if there were errors in the original survey.
When a boundary dispute involves a disagreement between surveys, consider how the use of the land has been affected by the original survey’s location of the boundary. If the fence was erected along the old but erroneous survey line, and you and your neighbor have actively farmed to the fence line, the fence should not be moved. If the fence does not follow either the original survey or the later survey, the true boundary line may need to be designated.
As a last resort, if the issue is building or maintaining a fence, the “fence viewers” can be called to come out and make a view and a determination of responsibility. Each state has its own procedure for requesting a fence view and resolving fence building and maintenance disputes. Do you know the rules in your state?
Agritourism
Most states have agritourism laws that are designed to provide enhanced liability protection for injuries to participants or spectators associated with the inherent risks of a covered activity. Agritourism is generally defined broadly to include such things as corn mazes, hayrides, tours, roadside stands and other similar activities. Posting warning signs might also be required to receive the protection of the statute, as might the registering of the property with the state.
On the liability issue, a landowner is generally protected except for “wanton or willful” negligence. Also, having participants sign liability release forms may be required. State law might also provide tax credits and might protect the property’s ag tax classification.
Engaging in an agritourism activity on your farm can be a good way to generate additional income, but make sure you know the details of your state’s law. Also, your comprehensive farm liability policy probably won’t cover any claim arising from an agritourism activity. That’s because it’s likely to be defined as a non-farm business pursuit of the insured that falls within an exception to coverage.
Farms and Ranches – The Liquidity Problem
Concerns about the possibility of a reduced federal estate tax exemption are big in agriculture. If a drop in the exemption would impact the farming or ranching business, is there a plan in place to pay the resulting tax? It’s a real problem because ag estates are typically illiquid – farmers are often “asset rich, but cash poor.”
Liquidity refers to how easy it is to convert an asset into cash. Farmers and ranchers often have assets worth a substantial amount in terms of market value but may lack sufficient cash to meet current needs. What is at the heart of the liquidity problem? Farming and ranching often involves a substantial investment in capital assets. There typically isn’t a pile of liquid funds or assets that can be easily converted into cash. This can create problems upon death particularly if the goal is to keep the farm or ranch in the family for subsequent generations and there are both on-farm and off-farm heirs. This is a big problem for some.
While many estates don’t have an estate tax problem under current law, they could if the exemption drops. For instance, a current gross estate of about $14 million or twice that for a couple would not incur any federal estate tax, but if the exemption drops to about half of those levels starting in 2026 as will happen if Congress doesn’t act, the tax bill could be substantial. If there aren’t liquid funds to pay the tax, then the money will have to be borrowed or assets sold. That’s not a good result, but there are planning steps that can be taken to correct the potential problem. Yes, estate and business planning will cost, but solid plans for most people can be established for a fairly economical price – especially when you consider that the cost if for the protection and furtherance of your family’s farming/ranching legacy.
Solar Panels and Zoning
Many local zoning rules leave the door wide open to the potential for farmland to be converted into usage for solar panels – with no extra step required to go from agricultural to solar. Some of this is occurring on prime farmland. But leasing farmland for the placement of solar panels can destroy the land’s potential to return to farming. That’s because often fine sand is spread on the farmland where the panels will be placed to kill off plant growth under the panels. This doesn’t happen in every situation, but where it does, it destroys the possibility of growing anything in that field again without incurring significant remediation costs. And solar energy agreements may only require remedial work at the end of the contract – which could be 50 years or so into the future.
One study has forecast that 83 percent of solar energy development will be on farm and ranchland unless current government policies are changed. About half of that amount is projected to be on the nation’s most productive soil.
Local zoning and planning commissions are at the forefront of the issue. Rezoning or permitting should be necessary to convert farmland to solar fields – solar power generation is an industrial use. Traditionally a change in zoning classification involves a public process. That should be the case in this instance too.
Liability to Motorists
Here’s one I don’t get every day, although there are cases from time-to-time on this, and there was a somewhat related Kansas case a few years ago on the issue of a landowner’s duty (if any) to trim trees and brush near roadways. The question is whether you are responsible if a tree on your farm falls onto an adjacent road and causes injury?
The issue came up in a recent Texas case. There a windstorm uprooted a large oak tree on a farm, and it fell across a road. A driver hit the tree and sued for her injuries. She claimed the farmer failed to inspect the farm premises to ensure that objects on the farm were not a hazard to motorists. The farmer pointed out that there was no evidence that she had received any notice regarding problems with the tree and produced an affidavit from an arborist that the tree was healthy and would have required tremendous wind to blow it down.
The court ruled for the farmer – there is no duty to parties injured off premises because the landowner is not in possession and control of those areas. In addition, the court said that a landowner doesn’t owe a duty to make an adjoining road safe or to warn travelers of potential danger. There can be exceptions in special situations, but none of those applied in the case. For example, this case involved a farm in a rural area and there was no evidence that the farmer knew or should have known of the danger posed by the tree, and any potential danger wasn’t evident by looking at the tree.
And…motorists have a duty to drive according to the conditions – that includes being able to spot a large oak tree blocking both lanes of a road in time to avoid hitting it.
The case is Bell v. Cain, No. 06-23-00060-CV, 2024 Tex. App. LEXIS 1993 (Tex, Ct. App. Mar. 21, 2024).
June 23, 2024 in Civil Liabilities, Estate Planning, Real Property | Permalink | Comments (0)
Sunday, June 16, 2024
Rural Practice Digest - Substack
Overview
I have started a new Substack that contains the “Rural Practice Digest.” You can access it at mceowenaglawandtax.substack.com. While I will post other content from time-to-time that is available without a paid subscription, the Digest is for paid subscribers. The inaugural edition is 22 pages in length and covers a wide array of legal and tax topics of importance to agricultural producers, agribusinesses, rural landowners and those that represent them.
Contents
Volume 1, Edition 1 sets the style for future editions - a lead article and then a series of annotations of court opinions, IRS developments and administrative agency regulatory decisions. The lead article for Volume 1 concerns losses related to cooperatives. The USDA is projecting that farm income will be down significantly this year. That means losses will be incurred by some and some of those will involve losses associated with interests in cooperatives. The treatment of losses on interests in cooperatives is unique and that’s what I focus on in the article.
The remaining 19-pages of the Digest focus on various other aspect of the law that impacts farmers and ranchers. Here’s an overview of the annotation topics that you will find in Issue 1:
- Chapter 12 Bankruptcy
- Partnership Election – BBA
- Valuation Rules and Options
- S Corporation Losses
- Nuisance
- Fair Credit Reporting Act
- Irrigation Return Flow Exemption and the CWA
- What is a WOTUS?
- EPA Regulation Threatens AI
- Trustee Liability for Taxes
- Farm Bill
- Tax Reimbursement Clauses in IDGTs
- QTIP Marital Trusts and Gift Tax
- FBAR Penalties
- Conservation Easements
- Hobby Losses
- Sustainable Aviation Fuel
- IRS Procedures and Announcements
- Timeliness of Tax Court Petition
- BBA Election
- SCOTUS Opinion on Fees to Develop Property
- Quiet Title Act
- Animal I.D.
- “Ag Gag” Update
- What is a “Misleading” Financing Statement
- Recent State Court Opinions
- Upcoming Seminars
Substack Contents
In addition to the Rural Practice Digest, I plan on adding video content, practitioner forms and other content designed to aid those representing agricultural clients in legal and tax matters, and others simply interested in keeping up on what’s happening in the world of agricultural law and taxation.
Conclusion
Thank you in advance for your subscription. I trust that you will find the Digest to be an aid to your practice. Your comments are welcome. mceowenaglawandtax.substack.com
June 16, 2024 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Monday, May 6, 2024
Musings in Agricultural Law and Taxation – of Conservation Easements; IDGTs and Takings
Overview
The ag law and tax world continues to go without rest. It’s amazing how frequently the law intersects with agriculture and rural landowners. It really is “where the action is” in the law. From the U.S. Supreme Court all the way to local jurisdictions, the current developments just keep on rolling.
More recent developments in ag law and tax – it’s the topic of today’s post.
An Easement is Not Worth More than the Underlying Property
Oconee Landing Property, LLC, et al. v. Comr., T.C. Memo. 2024-25
In the latest round of the continuing saga involving donated conservation easement tax fraud, the Tax Court uncovered another abusive tax shelter. IRS guidelines make it clear that a conservation easement’s value is the value of the forfeited development rights based on the land’s highest and best use. To qualify as a highest and best use, a use must satisfy four criteria: (1) the land must be able to accommodate the size and shape of the ideal improvement; (2) a property use must be either currently allowable or most probably allowable under applicable laws and regulations; (3) a property must be able to generate sufficient income to support the use for which it was designed; and (4) the selected use must yield the highest value among the possible uses.
Note: A tract’s highest and best use is merely a factor in determining fair market value. It doesn’t override the standard IRS valuation approach – that being the price at which a willing buyer and a willing seller would arrive at. See, e.g., Treas. Reg. §1.170A-1(c)(2). See also Boltar LLC v. Comr., 136 T.C. 326 (2011).
In this case, the taxpayer donated 355 acres of undeveloped land to a land trust. The 355-acre tract was part of a larger tract that was a nationally recognized golf resort with associated developments. When the larger tract wouldn’t sell, the taxpayer became interested in the possibility of granting a conservation easement on the 355 acres. Ultimately, the taxpayer valued the 355 acres at about $60,000 per acre and claimed a charitable deduction for the entire amount - $20.67 million. The IRS disallowed the deduction due to lack of donative intent – the entire scheme involved a pre-determined agreement to secure inflated appraisals so that investors would be able to deduct more than their respective investments.
Note: The amount of the deduction that can be claimed is subject to a limitation based on a percentage of the taxpayer’s contribution base. I.R.C. §170(b)(1)(H). However, if the donor is a “qualified farmer or rancher” and the donated property is used in agricultural or livestock production, the deduction may be up to 100 percent of the donor’s contribution base. I.R.C. §170(b)(1)(E)(iv). For corporate farms and ranches, see I.R.C. §170(b)(2)(B) and for the definition of a “qualified farmer or rancher” see I.R.C. §170(b)(1)(E)(v) and Rutkoske v. Comr., 149 T.C. 133 (2017).
While the Tax Court determined that the donated easement had value, it agreed with the IRS that the value of the tract was approximately $5 million. However, the lack of a qualified appraisal as the regulations require be attached to the return wiped out any associated deduction. Simply setting a target value for the appraiser to hit coupled with the taxpayer’s knowledge that the value was overstated is not a qualified appraisal.
Note: Form 8283, Section B, as an appraisal summary must be fully completed and attached to the return for noncash donations greater than $5,000.
In addition, the Tax Court pointed out that the 355-acre tract had been transferred to a developer (a partnership) who then donated the easement. That meant that the donation was of ordinary income property which limited any deduction to the basis in the property. Because there was no evidence offered as to the basis of the property, the deduction was zero. I.R.C. §170(e)(1)(A).
For good measure, the Tax Court tacked on a gross overstatement penalty of 40 percent. In determining the penalty, the Tax Court agreed with the IRS position that the highest and best use of the tract was as a “speculative hold for mixed-use development” and the easement was worth less than $5 million. The Tax Court also tacked on a 20 percent penalty on the portion of the underpayment that wasn’t associated with the erroneous valuation.
Note: The rules associated with donated conservation easements are technical and must be precisely complied with. While large tax savings can be achieved by donating a permanent conservation easement (especially for farmers and ranchers), carefully following all of the rules is critical. Predetermining a valuation is a big “no-no.”
IRS Changes Position on Gift Tax Treatment of IDGT Tax Reimbursement Clauses
C.C.A. 202352018 (Nov. 28, 2023)
An Intentionally Defective Grantor Trust, or IDGT, is a tool used in estate planning to keep assets out of the grantor’s estate at death, while the grantor is responsible for paying income tax on the trust’s earnings. Those tax payments are not gifts by the grantor to the beneficiaries. If that tax burden proves to be too much it has been possible to give an independent trustee discretion to distribute funds from the trust to the grantor for making those tax payments. The IRS said in 2016 that also wouldn’t trigger any gift or income tax consequences for the grantor. Priv. Ltr. Rul. 201647001 (Aug. 8, 2016). But now IRS says that a reimbursement clause in an IDGT does trigger gift tax when the trustee distributes trust funds to the grantor. IRS now deems such a clause to result in a change in the beneficial interests in the trust rather than constituting merely being administrative in nature.
Note: While the IRS did not address the issue, it would seem that if state law authorizes the trustee to reimburse the grantor, as long as the trust doesn’t prohibit reimbursement, no gift tax should be triggered.
“Takings” Cases at the U.S. Supreme Court
Devillier v. Texas, 144 S. Ct. 938 (2024)
Sheetz v. El Dorado County, 144 S. Ct. 893 (2024)
Devillier – Is the Fifth Amendment “self-executing”? The family involved in Devillier has farmed the same land for a century. There was no problem with flooding until the State renovated a highway and changed the surface water drainage. In essence, the renovation turned the highway into a dam and when tropical storms occurred, the water no longer drained into the Gulf of Mexico. Instead, the farm was left flooded for days, destroying crops and killing cattle. The family sued the State of Texas to get paid for the Taking.
Note: Constitutional rights don’t usually come with a built-in cause of action that allows for private enforcement in courts – in other words, “self-executing.” They’re generally invoked defensively under some other source of law or offensively under an independent cause of action.
The family claimed that the Takings Clause is an exception based on its express language – “nor shall private property be taken for public use, without just compensation.” The case was removed to federal court and the family won at the trial court. However, the appellate court dismissed the case on the basis that the Congress hadn’t passed a law saying a private citizen could sue the state for a constitutional taking. In other words, the federal appellate court determined that the Fifth Amendment’s Takings Clause isn’t “self-executing.”
The U.S. Supreme Court agreed to hear the case with the question being what the procedural vehicle is that a property owner uses to vindicate their right to compensation against a state. The U.S. Supreme Court unanimously reversed the lower court, although it did not hold that the Fifth Amendment is “self-executing.” Texas does provide an inverse condemnation cause of action under state law to recover lost value by a Taking. The Supreme Court noted that Texas had assured the Court that it would not oppose the complaint being amended so that the case could be pursued in federal court based on Texas state law.
Sheetz - traffic impact mitigation fee and government extortion. Sheetz claimed that a local ordinance requiring all similarly situated developers pay a traffic impact mitigation fee posed the same threat of government extortion as those struck down in Nollan v. California Coastal Commission, 483 U.S. 825 (1987), Dolan v. City of Tigard, 512 U.S. 374 (1995), and Koontz v. St. Johns River Water Management District, 570 U.S. 595 (2013). Those cases, taken together, hold that if the government requires a landowner to give up property in exchange for a land-use permit, the government must show that the condition is closely related and roughly proportional to the effects of the proposed land use.
In this case, Sheetz claimed that test meant that the county had to make a case-by-case determination that the $24,000 fee was necessary to offset the impact of congestion attributable to his building project - a manufactured home on a lot that he owns in California. He paid the fee, but then filed suit to challenge its constitutionality under the Fifth Amendment. The U.S. Supreme Court unanimously ruled in his favor. The Court determined that nothing in the Takings Clause indicates that it doesn’t apply to fees imposed by state legislatures.
May 6, 2024 in Estate Planning, Income Tax, Regulatory Law | Permalink | Comments (0)
Tuesday, April 30, 2024
Summer Seminars – Branson and Jackson Hole
Registration for both of the national summer seminars that Paul Neiffer and I will be doing is now open. The Branson (College of the Ozarks) seminar is in-person only, but the Jackson Hole event is offered both in-person and online. For those attending the Jackson Hole seminar in-person, a room block is established at the Virginian Resort at a reduced rate.
The topics that we will cover are the same at both locations (although the material for Jackson Hole will be updated and current through mid-July).
Here’s a list of the topics we will be covering:
- Federal Tax Update
- Farm Bill Update
- Beneficial Ownership Information (BOI) Reporting
- Depreciation Planning
- Tax Planning Considering the Possible Sunset of TCJA
- How Famers Might Benefit from the Clean Fuel Production Tax Credit
- Conservation Easements
- Federal Estate and Gift Tax Update
- SECURE Act 2.0
- Split Interest Land Transactions
- Manager-Managed LLCs
- Types of Trusts
- Monetized Installment Sales
- Charitable Remainder Trusts or Cash Balance Plans
- Special Use Valuation
- Buy-Sell Agreements (planning in light of the Connelly decision)
Registration
For more information about the Branson event, and registration, click here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html
For more information about the Jackson Hole event, and registration, click here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html
April 30, 2024 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)
Monday, April 22, 2024
Branson Summer Seminar on Farm Income Tax and Estate/Business Planning
Overview
On June 12-13, I will be conducting a farm income tax and farm estate and business planning seminar at the Keeter Center on the campus of College of the Ozarks near Branson, MO. This is a live, in-person presentation only. No online option is available. My partner in presentation is Paul Neiffer. Paul and I have done these summer events for a number of years and are teaming up again this summer to provide you with high quality training on the tax issues you deal with for your farm and ranch clients.
Topics
Here’s a list of the topics that Paul and I will be digging into:
- Federal Tax Update
- Farm Bill Update
- Beneficial Ownership Information (BOI) Reporting
- Depreciation Planning
- Tax Planning Considering the Possible Sunset of TCJA
- How Famers Might Benefit from the Clean Fuel Production Tax Credit
- Conservation Easements
- Federal Estate and Gift Tax Update
- SECURE Act 2.0
- Split Interest Land Transactions
- Manager-Managed LLCs
- Types of Trusts
- Monetized Installment Sales
- Charitable Remainder Trusts or Cash Balance Plans
- Special Use Valuation
- Buy-Sell Agreements (planning in light of the Connelly decision)
Registration
The link for registration is below and can be found on my website – www.washburnlaw.edu/waltr and the seminar is sponsored by McEowen, P.L.C. You may mail a check with your registration or register and pay at the door. Early registration is eligible for a lower rate. Certification is pending with the National Association of State Boards of Accountancy (NASBA) to qualify for 16 hours of CPE credit and corresponding CLE credit (for attorneys).
Here is the specific link for the event: https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html
Jackson Hole
Paul and I will present the same (but updated) seminar in Jackson Hole, Wyoming, on August 5 and 6. That event will also be broadcasted live online.
We hope to see you there!
April 22, 2024 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)
Sunday, April 7, 2024
Family Settlement Agreement for Farm Family Not Done Properly
Overview
A family settlement agreement is one possible method of resolving conflicts among family members concerning assets and finances, among other issues. Done properly, a family settlement agreement can outline duties and responsibilities of family members and minimize or eliminate future family disputes. It is also a legally binding and enforceable contract. But, before a family settlement agreement is entered into, the family must carefully consider the purpose and scope of the agreement. The problems that need to be addressed should lead to provisions drafted into the agreement designed to resolve those problems.
A recent case from Iowa illustrates how not to go about executing a family settlement agreement – it’s the topic of today’s post.
Facts of the Case
In In re Estate of Schultz, No. 22-1671, 2024 Iowa App. LEXIS 217 (Iowa Ct. App. Mar. 6, 2024), the decedent and her husband were longtime farmers. He died in 2001 and the decedent died in 2019. They divided the farmland between them equally in value and executed mirror-image wills in 1998, that left the surviving spouse a life estate in the deceased spouse’s half of the farm property with the remainder interest passing equally to their four children upon the surviving spouse’s death.
Note: At the time the wills were prepared in 1998, the total value of the couple’s farmland was approximately $11 million. For deaths in 1998, the federal estate tax applicable exclusion was $625,000 with a top rate of 55 percent. Accordingly, the marital deduction wills with the credit shelter and life estate portions in each will was the proper approach from a federal estate tax minimization standpoint at the time.
The couple’s only son farmed with his father and on his own after his father’s death. In 2003, the son accompanied his mother to see her attorney. She changed her will to divide her farmland into specific farms and distributed them among her four children: four farms totaling 420 acres to the son; three farms totaling 151 acres to the three daughters to share equally; and one farm of 230 acres to be divided equally between all of the children along with her other property. The 2003 will named the son and one daughter as executors of the estate, but only the son was aware of the 2003 amended will. In addition, the decedent named the son and a different daughter as agents under a power of attorney. While the daughter named as agent under the power was not told of the designation, the son told another sister that she no longer needed to help their mother with her finances and bills. At about the same time, the decedent entered into a 16-year farm lease with the son with rent set at $70 per acre.
The sisters discovered the existence of the amended will in 2014 and all of the children and their mother met with an attorney to have the 1998 will restored. The attorney, after meeting with the mother privately, determined that she lacked testamentary capacity to change the 2003 will and suggested a family settlement agreement as an alternative. The mother and the four children entered into a family settlement agreement that divided all of the mother’s property equally among them upon her death. The decedent did not sign the agreement and two of the four siblings died before their mother (including the son). Upon the decedent’s death, a surviving daughter (as executor) sought to probate the decedent’s will. The attorney for the estate filed the family settlement agreement with the court the same day. After the 16-year lease expired, the executor also began renting 607 acres of farmland for $100 per acre for three years. She signed the lease as both tenant and landlord with her husband and son also signing as tenants.
Trial Court Decision
The probate (trial) court admitted the will and family settlement agreement and the daughter distributed the decedent’s estate according to the terms of the family settlement agreement. The trial court determined that the Family Settlement Agreement was valid and distributed the decedent’s estate in accordance with that agreement (25 percent to a surviving sister; 25 percent to the sister serving as executor; 12.5 percent each to two children of a predeceased sister; and 8.33 percent to the three children of the pre-deceased brother. The trial court also found that the decedent only changed her will in 2003 because of the son’s improper influence.
The children of the predeceased brother objected, claiming that the family settlement agreement was invalid, and that the daughter improperly accounted for estate assets and had engaged in self-dealing. The trial court determined that the executor had not engaged in self-dealing and directed the executor to either “amend” or “clarify” the accounting issue.
Appellate Court Has Different Views
On appeal, the appellate court reversed on the issue of the validity of the family settlement agreement. The appellate court found that the family settlement agreement was not valid. The parties’ interests had not yet vested because the mother was still living at the time and two of her children predeceased her, and their children were not party to the family settlement agreement – a requirement of state law. Iowa Code §633.273(1). The siblings’ expectancy interest passed to their children, but they hadn’t signed the family settlement agreement at the time it was admitted to probate. The appellate court remanded with directions for the trial court to hold further proceedings on the validity of the decedent’s 2003 will.
The appellate court also determined that the accounting issue was not properly before the court. However, the appellate court affirmed the trial court’s finding that the daughter that served as executor had not engaged in self-dealing. The rental amount was appropriate, and improvements made on the farmland were legitimate. The appellate court noted that state law requires court approval for self-dealing transactions (Iowa Code §633,155), but that the trial court retroactively approved the rental agreement and paying labor costs for the improvements.
Conclusion
There were various problems with this entire situation. The family was essentially trying to treat the family settlement agreement as a testamentary device. Without the mother’s signature and satisfaction of the formalities for a will, that won’t work. Also, state law was not followed in all respects to make the agreement valid. The accounting and self-dealing issues were the result of sloppiness by the executor and, perhaps, the attorney for the estate.
There’s a right way and a wrong way to do a family settlement agreement. This case grades over into the wrong way.
April 7, 2024 in Estate Planning | Permalink | Comments (0)
Friday, January 5, 2024
2023 in Review – Ag Law and Tax Developments (Part 2)
Overview
Today’s article is the second in a series discussing the top developments in agricultural law and taxation during 2023. As I work my way through the series, I will end up with the top ten developments from last year. But I am not there yet. There still some significant developments to discuss that didn’t make the top ten list.
Significant developments in ag law and tax during 2023, but not quite the top ten – it’s the topic of today’s post.
Scope of the Dealer Trust
In re McClain Feed Yard, Inc., et al., Nos., 23-20084; 23-20885; 23-20886 (Bankr. N.D. Tex. 2023)
The Packers and Stockyards Act of 1921 (PSA) (7 U.S.C. §§ 181 et seq.), applies to transactions in livestock or poultry in interstate commerce involving a covered a packer, dealer, market agency, swine contractor, or live poultry dealer. The PSA creates statutory trusts and requires bonds of market participants which may provide funds to reduce losses incurred by unpaid cash sellers of livestock or poultry. A similar provision applies for perishable commodities created by the Perishable Agricultural Commodity Act. 7 U.S.C. § 499e(c).
Historically, there have been numerous attempts to amend the PSA to create a “Dealer Trust” that would establish a statutory trust similar to the Packer Trust created by the PSA at 7 U.S.C. § 196. These efforts succeeded with legislation signed into law on December 27, 2020, that adds new Section 318 to the PSA. Codified at 7 U.S.C. § 217b.
The Dealer Trust’s purpose is to protect unpaid cash sellers of livestock from the bankruptcy of feeders, brokers and small processors. The new law puts unpaid cash sellers of livestock ahead of prior perfected security interest holders. It’s a provision like the trust that exists for unpaid cash sellers of grain to a covered grain buyer. The first case testing the scope of the Dealer Trust Act is winding its way through the courts.
A case involving the new Dealer Trust Act hit the courts in 2023. Over 100 livestock producers have $122 million in unpaid claims against three defunct cattle operations, and a lender says one of the feedyards sold about 78,000 cattle and didn’t pay on the loans. The problems stem from a $175 million Ponzi and check-kiting scheme that the debtors were engaged in.
One issue is what the trust contains for the unpaid livestock sellers. Is it all assets of the debtors? It could be – for feedyards and cattle operations, practically all the income is from cattle sales. So far, USDA has approved for payment only $2.69 million of claims for cash sellers of livestock, claiming that the balance is owed to non-cash sellers not covered by the law.
The law is new, so it’s not clear yet what is a trust asset for the benefit of the cash livestock sellers, and what assets, if any, are in the debtors’ bankruptcy estates. We should learn the answer to those questions in 2024.
Equity Theft
Tyler v. Hennepin County, 598 U.S. 631 (2023)
Equity that a homeowner has in their home/farm is the difference between the value of the home or farm and the remaining mortgage balance. It’s a primary source of wealth for many owners. Indeed, the largest asset value for a farm or ranch family is in the equity wrapped up in the land. In the non-farm sector, primary residences account for 26 percent of the average household’s assets. Certainly, the government has the constitutional power to tax property and seize property to pay delinquent taxes on that property. But is it constitutional for the government to retain the proceeds of the sale of forfeited property after the tax debt has been paid? That was a question presented to the U.S. Supreme Court in 2023.
In this case, Hennepin County. Minnesota followed the statutory forfeiture procedure, and the homeowner didn’t redeem her condominium within the allotted timeframe. The state ultimately sold the property and bagged the proceeds – including the homeowner’s equity in the property.
She sued, claiming that the county violated the Constitution’s Takings Clause (federal and state) by failing to remit the equity she had in her home. She also claimed that the county’s actions amounted to an unconstitutional excessive fine, violated her due process and constituted an unjust enrichment under state law. The trial court dismissed the case and the Eighth Circuit affirmed finding that she lacked any recognizable property interest in the surplus equity in her home. On further review, the U.S. Supreme Court unanimously reversed. The Court held that an unconstitutional taking had occurred.
All states have similar forfeiture procedures, but only about a dozen allow the state to keep any equity that the owner has built up over time. Now, those states will have to revise their statutory
forfeiture procedures.
Customer Loyalty Rewards
Hyatt Hotels Corporation & Subsidiaries v. Comr., T.C. Memo. 2023-122
Many companies, including agribusiness retailers, utilize customer loyalty programs as a means of attracting and keeping customers. Under the typical program, each time a customer or “member” buys a product or service, the customer earns “reward points.” The reward points accumulate and are computed as a percentage of the customer’s purchases. When accumulated points reach a designated threshold, they can then be used to buy an item from the retailer or can be used as a discount on a subsequent purchase (e.g., cents per gallon of off a fuel purchase). Some programs make be structured such that a reward card is given to the customer after purchases have reached the threshold amount. The reward card typically has no cash value and expires within a year of being issued. A “loyalty rewards” program is a cost to the retailer and a benefit to the customer, triggering tax issues for both.
In Hyatt, the petitioner established a “Gold Passport” rewards program in 1987 that provided its customers with reward points redeemable for free future stays at its hotels (the petitioner own about 25 percent of its branded hotels with the balance owned by third parties who license the petitioner’s IP and/or management services). Under the program, the petitioner required hotel owners to make payments into an operating fund (Fund) when a customer earned “points.” The petitioner was the custodian of the Fund and compensated a hotel owner out of the Fund when a guest redeemed reward points for free stays. The petitioner determined the rate of compensation. The petitioner invested portions of the Fund's unused balance in marketable securities which generated gains and interest. In 2011, the petitioner changed the compensation formula to increase the amount it could hold for investment. The petitioner also used the Fund to pay administrative and advertising expenses that it determined were related to the rewards program.
The points could not be redeemed for cash and were not transferrable. In addition, any particular member hotel could not get the payments to the Fund back except by providing free stays to members. The Fund allocated from 46-61 percent to reward point redemptions. Fund statements described the funds as belonging to the hotel owners that paid into the Fund. The petitioner’s Form 10-K filed with the SEC treated the Fund as a “variable interest entity” eligible for consolidated reporting. When the petitioner provided management services to member hotels, payments into the Fund were reported as “expenses.”
The petitioner did not report the Fund’s revenue into gross income with respect to the hotels it did not own and did not claim any deductions for expenses paid on the basis that petitioner was a mere trustee, agent or conduit for hotel owners rather than a true owner of the Fund. But, the petitioner did claim deductions for its share of program expenses associated with the 25 percent of hotels that it owned. The petitioner reported Fund assets and liabilities on a consolidated basis on Schedule L. The petitioner’s Form 1120 did not state that it was using the trading stamp method or include any statement concerning Treas. Reg. §1.451-4. The petitioner’s position was that third-party owners should make their own decision about tax treatment of the money they paid to the Fund.
The IRS audited and took the position that the petitioner was using an improper accounting method which triggered an I.R.C. §481 adjustment requiring the including in the petitioner’s income the cumulative amounts from 1987 (Fund revenue less expenditures). The IRS asserted an adjustment of $222.5 million and additional adjustments in 2010 and 2011. The petitioner disagreed and filed a Tax Court petition.
The Tax Court determined that the amounts the petitioner received related to the customer reward program (i.e., Fund revenue) were revenue includible in gross income because of the petitioner’s significant control over the Fund. That control indicated that the petitioner had retained a beneficial interest in the Fund, and the exception under the “trust fund” doctrine established in Seven-Up Co. v. Comr., 14 T.C. 965 (1950), acq., 1950-2 C.B. 4, did not apply.
Hyatt lays down a good “marker” for tax advisers with clients that offer loyalty reward programs to customers. Retail businesses that offer such programs will want to ensure that their program is structured in a manner that can fit within the trust fund doctrine’s exception for excluding program funds from gross income.
Basis of Assets Contained in an Intentionally Defective Grantor Trust (IDGT)
Rev. Rul. 2023-2, 2023-16 I.R.B. 658
An IDGT is an irrevocable trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death. Normally, an irrevocable trust is a tax entity distinct from the grantor and has its own income and deductions (net of distributions paid to beneficiaries) reported on its own income tax return. But there is language included in an IDGT that causes the income to be taxed to the grantor. So, a separate return need not be prepared for the trust, but you still get the trust assets excluded from the grantor’s estate at death. It also allows the grantor to move more asset value to the beneficiaries because the grantor is paying the tax.
Note: The term “intentionally defective grantor trust” refers to the language in the trust that cause the trust to be defective for income tax purposes (the trust grantor is treated as the owner of the trust for income tax purposes) but still be effective for estate tax purposes (the trust assets are not included in the grantor’s gross estate).
This structure allows the IDGT’s income and appreciation to accumulate inside the trust free of gift tax and free of generation-skipping transfer tax, and the trust property is not in the decedent’s estate at death. This will be an even bigger deal is the federal estate tax exemption is reduced in the future from its present level of $13.61 million. Another benefit of an IDGT is that it allows the value of assets in the trust to be “frozen.”
A question has been whether the assets in an IDGT receive a stepped-up basis (to fair market value) when the IDGT grantor dies. Over the years, the IRS has flip-flopped on the issue but in 2023 the IRS issued a Revenue Ruling taking the formal position that the trust assets do not get a stepped-up basis at death under I.R.C. §1014 because the trust assets, upon the grantor’s death, were not acquired or passed from a decedent as defined in I.R.C. §1014(b). So, the basis of the trust assets in the hands of the beneficiaries will be the same as the basis in the hands of the grantor.
Not getting a stepped-up basis at death for the assets in an IDGT is an important consideration for those with large estates looking for a mechanism to keep assets in the family over multiple generations at least tax cost. An irrevocable trust may still be appropriate for various reasons such as asset protection and overall estate tax planning. But, the IRS ruling does point out that it’s important to understand all of the potential consequences of various estate planning options.
January 5, 2024 in Estate Planning, Income Tax, Real Property, Regulatory Law | Permalink | Comments (0)
Tuesday, January 2, 2024
2023 in Review – Ag Law and Tax
Overview
As 2024 begins, it’s good to look back at the most important developments in agricultural law and tax from 2023. Looking at things in retrospect provides a reminder of the issues that were in the courts last year as well as the positions that the IRS was taking that could impact your farming/ranching operation. Over the next couple of weeks, I’ll be working my way through the biggest developments of last year, eventually ending up with what I view as the Top Ten developments in ag law and tax last year.
The start of the review of the most important ag law and tax developments of 2023 – it’s the topic of today’s post.
Labor Disputes in Agriculture
Glacier Northwest, Inc. v. International Brotherhood of Teamsters Local Union No. 174, 143 S. Ct. 1404 (2023)
In 2023, the U.S. Supreme Court ruled that an employer can sidestep federal administrative agency procedures of the National Labor Relations Board and go straight to court when striking workers damage the company’s property rather than merely cause economic harm. The case involved a concrete company that filed a lawsuit for damages against the labor union representing its drivers. The workers filled mixer trucks with concrete ready to pour knowing they were going to walk away. The company sued for damage to their property – something that’s not protected under federal labor law. The Union claimed that the matter had to go through federal administrative channels first.
The Court said the case was more like an ordinary tort lawsuit than a federal labor dispute, so the company could go straight to court. Walking away was inconsistent with accepting a perishable commodity.
There’s an important ag angle to the Court’s decision. Where there are labor disputes in agriculture, they are often timed to damage perishable food products such as fruit and vegetables. Based on the Court’s 8-1 opinion, merely timing a work stoppage during harvest might not be enough to be deemed economic damage, unless the Union has a contract. But striking after a sorting line has begun would seem to be enough.
Swampbuster
Foster v. United States Department of Agriculture, 68 F. 4th 372 (8th Cir. 2023)
Another 2023 development involved the application of the Swampbuster rules on a South Dakota farm. In 1936, the farmer’s father planted a tree belt to prevent erosion. The tree belt grew over the years and collects deep snow drifts in the winter. As the weather warms, the melting snow collects in a low spot in the middle of a field before soaking into the ground or evaporating. In 2011, the USDA called the puddle a wetland subject to the Swampbuster rules that couldn’t be farmed, and it refused to reconsider its determination even though it had a legal obligation to do so when the farmer presented new evidence countering the USDA’s position.
The farmer challenged the determination in court as well as the USDA’s unwillingness to reconsider but lost. This seems incorrect and what’s involved is statutory language on appeal rights under the Swampbuster program. The Constitution limits what the government can regulate, including water that doesn’t drain anywhere. In addition, the U.S. Supreme Court has said the government cannot force people to waive a constitutional right as a condition of getting federal benefits such as federal farm program payments.
We’ll have to wait and see whether the Supreme Court will hear the case.
Railbanking
Behrens v. United States, 59 F. 4th 1339 (Fed. Cir. 2023)
Abandoned rail lines that are converted to recreational trails have been controversial. There are issues with trespassers accessing adjacent farmland and fence maintenance and trash cleanup. But perhaps a bigger issue involves property rights when a line is abandoned. A federal court opinion in 2023 provided some guidance on that issue.
In 2023, a federal court clarified that a Fifth Amendment taking occurs in Rail-to-Trail cases when the trail is considered outside the scope of the original railway easement. That determination requires an interpretation of the deed to the railroad and state law. Under the Missouri statute involved in the case the court said the railroad grant only allowed the railroad to construct, maintain and accommodate the line. Once the easement was no longer used for railroad purposes, the easement ceased to exist. Trail use was not a railroad purpose. The removal of rail ties and tracks showed there would be no realistic railroad use of the easement and trail use was unrelated to the operation of a railway.
The government’s claim that the trail would be used to save the easement and that the railway might function in the future was rejected, and the court ruled that the grant was not designed to last longer than current or planned railroad operation. As a result, a taking had occurred.
CAFO Rules
Dakota Rural Action, et al. v. United States Department of Agriculture, No. 18-2852 (CKK), 2023 U.S. Dist. LEXIS 58678 (D. D.C. Apr. 4, 2023)
In 2023, USDA’s 2016 rule exempting medium-sized CAFOs from environmental review for FSA loans was invalidated. A medium-sized CAFO can house up to 700 dairy cows, 2,500 55-pound hogs or up to 125,000 chickens. The rule was challenged as being implemented improperly without considering the impact on the environment in general. The USDA claimed that it didn’t need to make any analysis because its proposed action would not individually or cumulatively have a significant effect on the human environment. So, the agency categorically exempted medium-sized CAFOs from environmental review.
But the court disagreed with the USDA and vacated the rule. The FSA conceded that it made no finding as to environmental impact. The court determined that to be fatal, along with providing no public notice that it was going to categorically exempt all loan actions to medium-sized CAFOs.
Don’t expect this issue to be over. In 2024, it’s likely that the agency will try again to exempt medium-sized CAFOs from environmental review for FSA loan purposes.
Charitable Remainder Annuity Trust Abuse
Gerhardt v. Comr., 160 T.C. No. 9 (2023)
In 2023, the U.S. Tax Court decided another case involving fraud with respect to a charitable remainder annuity trust. It can be a useful tax planning tool, particularly for the last harvest of a farmer that is retiring. But a group centered in Missouri caught the attention of the criminal side of IRS.
The fact of the case showed that farmers contributed farmland, harvested crops, a hog-finishing barn and hog equipment to Charitable Remainder Annuity Trusts. The basic idea of a CRAT is that once property is transferred to the trust the donor claims a charitable deduction for the amount contributed with the income from the CRAT’s annuity spread over several years at anticipated lower tax brackets. But contributing raised grain to a CRAT means you can’t claim a charitable deduction because you don’t have any income tax basis in the grain. In addition, there are ordering rules that govern the annuity stream coming back to the donor. Ordinary income is taxed first – which resulted from the contribution of the crops and depreciation recapture on the hog-finishing barn and equipment.
The farmers involved got into the CRATs by reading an ad in a farm magazine. The Department of Justice prosecuted the promoters that dished out the bad advice.
Get good tax advice if you consider using a CRAT. They can be a good tax planning tool but can create a mess if the rules aren’t followed.
Conclusion
This is the first pass at some of the biggest developments in ag law and tax during 2023. In my next post, I’ll continue the journey.
January 2, 2024 in Environmental Law, Estate Planning, Income Tax, Real Property, Regulatory Law | Permalink | Comments (0)
Monday, December 11, 2023
Probate Fees - How Much are They?
Overview
One of the reasons that people give for transferring property to a revocable trust during life is to avoid probate at death. That can be accomplished if all of the decedent’s property has been transferred to the trust before death. To make sure that occurs, the trust is often accompanied with a pour-over will. The property that hasn’t been retitled into the name of the trustee of the trust is “poured over” into the trust at death.
But just how much are probate fees? How are they determined? That’s the topic of today’s post.
Establishing Probate Fees
The avoidance of probate is often tied to the desire to avoid probate fees and maintain privacy. As for fees, how much can be anticipated? The answer depends. The more complex the estate, and/or the more issues that come up post-death, the estate can anticipate incurring more probate fees. The converse is also true. In some states, a flat percentage of the gross estate value can be charged as an attorney fee for the estate. That can range anywhere from about 1.5 percent to 6 percent or even higher.
Kansas probate fees. In Kansas, state law specifies that, “every fiduciary shall be allowed his or her necessary expenses incurred in the execution of his or her trust and shall have such compensation for services and those of his or her attorneys as shall be just and reasonable.” Kan. Stat. Ann. §59-1717. There is no statute in Kansas that allows for a percentage fee for handling a decedent’s estate. It’s not specifically disallowed if the percentage amount is backed up with itemized time sheets and is ultimately deemed reasonable by the probate court. In essence, then, probate fees are based on an hourly rate for the amount of hours reasonably spent working on the estate. In addition, an attorney’s fee for handling a decedent’s estate is also based on the eight factors of the Kansas Rules of Professional Conduct (KRPC). The probate court considers these eight factors when determining whether a fee is appropriate.
The eight factors are:
- The time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly;
- The likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer;
- The fee customarily charged in the locality for similar legal services;
- The amount involved and the results obtained;
- The time limitations imposed by the client or by the circumstances;
- The nature and length of the professional relationship with the client;
- The experience, reputation, and ability of the lawyer or lawyers performing the services; and
- Whether the fee is fixed or contingent. KRPC 1.5(a)
Kansas case. A recent Kansas county district court decision involved the application of the factors. In In re Estate of Appleby, No. CQ-2023-CV-000008 (Chautauqua Co. Dist. Ct., Nov. 9, 2023), from 2014 until death in 2021, the decedent had been the subject of a conservatorship. The person that would become the executor of the decedent’s estate was the conservator. The attorney that represented the executor for the decedent’s eventual estate, represented the conservator during the conservatorship. The annual billing statements submitted to the conservator for the legal work in the conservatorship were itemized and detailed. The itemized billing statements listed each date services were performed; a description of the services performed on each date; the amount of time worked on each date; the amount charged for the services performed on each date; the total amount of time worked during the billing period; and the total amount charged for work performed during the billing period. The conservator reviewed the statements, the court approved them and the conservator paid.
However, for estate administration work, the attorney did not provide the executor with a written representation agreement and did not communicate the basis or rate of the fee he intended to charge the estate. The executor believed the attorney would bill his time hourly, just as he had done for the previous seven years in the conservatorship matter.
The decedent died on July 6, 2021, with a gross estate value of $4,570,521.11. However, the attorney only first informed the executor on May 2, 2022, that a fee of three percent of the estate’s gross value would be charged. The executor informed the attorney that the fee should be based on an hourly rate. The attorney replied as follows:
“I feel comfortable asking for a fee based upon 3%. If you want to oppose it, that's fine. Please remember that our… service to her predates your appointment as her conservator. [We]…did quite a bit of "off the books" work for [the decedent] during her lifetime, … and… it would all even out when we handled the estate. Honestly, that's a common approach taken by attorneys ·when they know they'll be handling an estate at a later date. So, I don't know what I can say. I respect your views and your being upfront with me, but I know what the common practice has been and what we've always done.”
Ultimately, on May 30, 2023, the attorney generated a billing statement. The billing statement included descriptions of the work performed between the date of the decedent’s death and May 2023, but the descriptions were not tied to specific dates and did not include the amount of time spent performing any task on any date. The May 30 billing statement concludes with the application of a 3% fee to the $4,570,521.11 value of the estate assets for a total fee of $137,115.63. The local magistrate judge awarded the fee on June 5, 2023, and the executor appealed.
On appeal, the attorney estimated that he spent between 420 and 560 hours on the estate at a rate of $240 per hour. Only specific tasks, based on the review of the emails, amounted to 174-242 hours. The court then applied the eight factors of Rule 1.5(a) of the KRPC to the facts of the case. The court noted that the attorney didn’t keep time records, even though being on notice that the executor wanted to know the amount of time that was being billed. No time records kept. There was also no engagement letter that had been entered into with the client. The work on the estate, the court noted, did not involve difficult issues and a paralegal performed much of the work. The fact that the attorney had billed on a percentage basis for 40 years was severely mitigated by subsequent caselaw specifying that, “"fees which are not supported by meticulous, contemporaneous time records that show the specific tasks being billed should not be allowed." See, e.g., In re Estate of Trembley, 220 P.3d 1114 (Kan. Ct. App. 2009). The court also noted that the attorney had a previous 7-year relationship with executor as conservator and billed hourly for the work on the conservatorship.
Ultimately, the court approved what it deemed to be a reasonable fee of fee of $58,080 (down from the $137,115.63 requested). In percentage terms, the approved fee worked out to be slightly less than 1.3 percent of the estate value.
In reaching its decision, the court noted that approving attorney fees for work on an estate is a fact-based determination. The fees must be supported by contemporaneous time records. If they aren’t, an “award of…fees based on a percentage of an estate is not reasonable, regardless of the local custom.”
Note: The court also pointed out that the attorney involved “serves on the Kansas Board of Discipline for Attorneys.”
Conclusion
The fear of large and outrageous attorney fees for handling estates in Kansas is largely not justified. The courts operate as an effective “brake” on attorneys trying to charge unjustified fees – at least that’s been the case in Kansas since 2009. But, that may not be true in other states. So, for those wanting to avoid probate fees, a revocable trust (or some other type of trust) might be an appropriate estate planning tool. But, it’s important to understand just how attorney fees in probate are established. One wonders how many estates in Kansas have been unjustly overbilled since 2009 by the attorney involved in the case. All it took was one well-informed executor to get the right result.
December 11, 2023 in Estate Planning | Permalink | Comments (0)
Saturday, December 9, 2023
The Importance of Proper Asset Titling
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 included in the decedent’s gross estate at death and receives a fair-market basis at death.
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 nonmarital 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.
For marital joint tenancies, upon the death of the first spouse, one-half of the date-of-death value of the jointly held property is included in the first-spouse’s estate. However, the full value of the jointly held property is included in the first spouse’s estate (and receives a date-of-death income tax basis in the hands of the surviving spouse) if the marital joint tenancy was established before 1977 and the spouse that bought the property died after 1981 (Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992)).
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 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 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. Further review was denied.
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.
December 9, 2023 in Estate Planning, Income Tax | Permalink | Comments (0)
Friday, December 1, 2023
Funding a Buy-Sell Agreement with Corporate Owned Life Insurance – Will Corporate Value Be Enhanced?
Overview
In part one of this series (published back on July 3), I discussed buy-sell agreements in general and noted how beneficial they can be in the intergenerational transfer of a farm or ranch where keeping the business in the family is the key goal. There I covered buy-sell agreements in general, the various types of agreements and common triggering events.
With today’s article I dive deeper into other issues associated with buy-sell agreements -valuation rules and funding approaches. A recent court opinion points out the importance of following the valuation procedures set forth in the buy-sell agreement.
Part two of a two-part series on buy-sell agreements – it’s the topic of today’s post.
Valuation
While very few farming and ranching operations (and small businesses in general) are subject to the federal estate tax because of the current level of the exemption, some are. For those that are, in addition to providing a market for closely held shares at a determinable price, the buy-sell agreement can serve as a mechanism for establishing the value of the interest for estate tax purposes – or otherwise establish value of the decedent’s interest at death.
General rule. In general, the value of a closely held business (or other property) is determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the FMV of the property, or any restriction on the right to sell or use the property. I.R.C. §2703(a).
Exception – statutory requirements. A buy-sell agreement can establish the value of a deceased owner’s interest if six basic requirements are satisfied. Three of the requirements are statutory and three have been judicially created. The statutory requirements are found at I.R.C. §2703(b).
The statutory requirements specify that the buy-sell agreement must:
- Be a bona fide business arrangement; I.R.C. §2703(b)(1)
- Not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; I.R.C. §2703(b)(2) and
- Contain terms that are comparable to other arrangements entered into by persons in arms’ length transactions. I.R.C. §2703(b)(3)
A buy-sell agreement must satisfy each of the three statutory requirements if family members own 50 percent or more of the property subject to the restriction. An agreement is deemed to satisfy all three of the statutory requirements if more than 50 percent of the value of the property subject to the restriction is owned directly or indirectly by individuals who are not members of the transferor’s family. The interests owned by the nonfamily members must be subject to the same restrictions as the property owned by the transferor. Treas. Reg. §25.2703-1(b)(3).
Exception – caselaw requirements. Judicial opinions have created three additional requirements that a buy-sell agreement must satisfy to be effective to establish the value of a decedent’s interest. See, e.g., Estate of True v. Comr., 390 F.3d 1210 (10th Cir. 2004); St. Louis County Bank v. United States, 674 F.2d 1207 (8th Cir. 1982). Based on these cases, the agreement must also: contain a purchase price that is fixed and determinable under the agreement; be legally binding during life and after death; and have been entered into for a bona fide business reason and not be a substitute for a testamentary disposition for full and adequate consideration. To establish the purchase price with certainty an appropriate valuation method must be established. An independent party valuation will not only satisfy the requirements of I.R.C. §2703 but also provide an estimate of the potential funding obligation and the liquidity expectations of the seller/estate. See Rev Rul. 59-60 as amplified by Rev. Rul. 83-120,1983-2 CB 170.
The courts have indicated that preserving a business with family control for purposes of continuity and management can serve as a bona fide business arrangement. See St. Louis County Bank v. United States, 674 F.2d 1207 (8th Cir. 1982); Estate of Lauder v. Comr., T.C. Memo. 1992-736; Estate of Gloeckner v. Comr., 152 F.3d 208 (2nd Cir. 1998). This includes planning for the future liquidity needs of the decedent’s estate. Estate of Amlie v. Comr., T.C. Memo. 2006-76. But an entity that consists only of marketable securities is not a bona fide business arrangement. Holman v. Comr., 601 F.3d 763 (8th Cir. 2010). The long-established position of the IRS is that, “It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts to determine whether the agreement represents a bona fide business arrangement or a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth.” Rev.Rul 59-60, 1959-1 CB 137. See also Estate of True v. Comr., T.C. Memo 2001-167, aff’d., 390 F.3d 1210 (2004); Estate of Blount v. Comr., T.C. Memo. 2004-116.
Note: The business reasons for executing the buy-sell agreement should be documented.
The buy-sell agreement must not simply be a device to reduce estate tax value. This requires more than expressing a desire to maintain family control of the business. See, e.g., Estate of True v. Comr., 390 F.3d 1210 (10th Cir. 2004); Estate of Lauder v. Comr., T.C. Memo. 1992-736. In addition, a buy-sell agreement must have terms that are comparable to other buy-sell agreements that are entered into at arms-length. This requirement is satisfied if the agreement is one that unrelated parties in the same line of business could have reached in an arms’ length transaction. Treas. Reg. §25.2703-1(b)(4). This fair bargain standard is typically based on expert opinion testimony.
Funding Approaches
To be operational, the parties to the agreement must have funds available to buy the stock at the time the agreement is triggered. It is possible to use accumulated earnings of the business to fund a redemption. But such a strategy may not be treated as a “reasonable need of the business” with the result that the business (if it is a C corporation) could be subject to the accumulated earnings tax. I.R.C. §531. However, corporate accumulations used to pay off a note given a stockholder for a redemption is a reasonable need of the business, as a debt retirement cost. But see Smoot Sand & Gravel Corp. v. Comr., 274 F.2d 495 (4th Cir. 1960), cert. denied, 362 U.S. 976 (1960).
The use of life insurance. Typically, life insurance is purchased for each business owner to cover the total purchase price (or at least the down payment). However, the premiums on such policies are not deductible (see I.R.C. §264) and can create a substantial ongoing expense.
Corporate-owned. One approach is for the corporation to buy a life insurance policy on the life of each stockholder, with the corporation as the policy owner, premium payor, and beneficiary of these policies. The corporation would then use the life insurance to finance the purchase if, at the end of the first option period, the corporation buys the deceased stockholder’s interest. Or the corporation could lend the insurance proceeds to the stockholders if, at the end of the corporate option period, it is decided that the surviving stockholders should be the buyers (or to the extent stock remained to be purchased after the corporation’s option expires). Investment payments would be deductible to the stockholders and income to the corporation.
Shareholder-owned. An alternative approach is for each shareholder to buy, pay for, own, and be the beneficiary of a life insurance policy for each of the other shareholders. The surviving shareholders would then receive the proceeds when one shareholder dies, and, if a cross-purchase is indicated and appropriate, use the proceeds as the necessary funds to carry out the buy-sell agreement. The surviving shareholders could also lend the proceeds to the corporation if a redemption agreement is utilized, to enable the corporation to buy additional shares, or the surviving shareholders could make capital contributions which would have the effect of increasing each shareholder’s stock basis.
Note: The cash value of a permanent life insurance policy may be withdrawn by loan or surrender of the policy, but the value may be a very small percentage of the death benefit, inadequate to finance the buy-out. Disability insurance may be used to finance a purchase occasioned by an owner’s disability, but it can be quite expensive, and cannot be applied toward the purchase of an interest of an owner who is retiring or used to prevent the sale of an interest in the business to a buyer outside the family unit.
Other Approaches
A combination of the above approaches could also be used for funding the wait-and-see buy-sell agreement. For example, the corporation could own cash value life insurance and the owners could own term insurance. Also, the parties could have a split-dollar arrangement whereby the corporation pays for the cash value portion of the premiums and the shareholders own the policy and pay for the term portion of the premiums, with the proceeds split between them.
Potential Problem of Life-Insurance Funding
One potential problem of a corporation being the beneficiary of a life insurance policy designed to fund the buy-out of a deceased shareholder is that the IRS could argue that the policy proceeds are included in the corporate value. In Estate of Blount v. Comr., T.C. Memo. 2004-116, the issue was whether the insurance proceeds contractually deduction to the redemption of corporate shares being valued be treated as corporate property for valuation purposes. The decedent owned 83 percent of the stock in a corporation at death. There was a life insurance policy owned by the company that provided some $3.1 million to pay off the mandated buyout of the shares under a buy-sell agreement providing for a fixed value of the decedent shares. The buy-sell agreement value was held not to be controlling for estate tax purposes, mainly because the deceased owned 83 percent of the stock and could have changed the agreement at any time. Furthermore, the court determined that the buy-sell agreement was not similar to those involved in arm’s length transactions.
The 11th circuit reversed on the basis that the redemption obligation of the buy-sell agreement was a liability that offset the value of the death benefits used to fund the redemption. Estate of Blount v. Comr., 428 F.3d 1338 (11th Cir. 2005). Thus, even if the death benefits were included in the corporate value, there was a corresponding offsetting liability that would be accounted for by a “reasonably competent business person interested in acquiring the company.” Id.
Note: In a decision preceding the Tax Court’s decision in Blount, the Ninth Circuit court deducted the insurance proceeds from the value of the organization when they were offset by an obligation to pay those proceeds to the estate in a stock buyout. Cartwright v. Comr., 183 F.3d 1034 (9th Cir. 1999).
The issue in Blount and Cartwright resurfaced in Connelly v. United States, No. 4:19-cv-01410-SRC, 2021 U.S. Dist. LEXIS 179745 (E.D. Mo. Sept. 21, 2021). In Connelly, two brothers were the only shareholders of a closely-held family roofing and siding materials business. They entered into a stock purchase agreement that required the company to buy back shares of the first brother to die. The company then purchased about $3.5 million in life insurance coverage to ensure it had enough cash to redeem the stock. The brother holding the majority of the company’s shares (77.18 percent) died on October 1, 2013. The company received $3.5 million in insurance proceeds. The surviving brother chose not to buy his shares, so the company used a portion of the proceeds to buy the deceased brother’s shares from his estate for $3 million pursuant to a Sale and Purchase Agreement. Under the agreement the estate received $3 million, and the decedent’s son received a three-year option to buy company stock from the surviving brother. If the surviving brother sold the company within 10 years, the brother and decedent’s son would split evenly any gains from the sale.
The estate valued the decedent’s stock at $3 million and included that amount in the taxable estate. Upon audit the IRS asserted that the fair market value of the decedent’s corporate stock should have factored-in the $3 million in life-insurance proceeds used to redeem the shares which, in turn, resulted in a higher value of the decedent’s stock than was reported. The IRS assessed over $1 million in additional estate tax. The estate paid the deficiency and filed a refund claim in federal district court.
The district court noted that a stock-purchase agreement is respected when determining the fair market value of stock for estate tax purposes upon satisfying the requirements of I.R.C. §2703(b) (as noted above), and the additional judicially created requirements (also noted above). The IRS expert claimed that the insurance proceeds should be included in the company’s value as a non-operating asset, and that allowing the redemption obligation to offset the insurance proceeds undervalued the company’s equity and the decedent’s equity interest in the company, and would create a windfall for a potential buyer that a willing seller would not accept. The IRS expert concluded that the fair market value of the company was $6.86 million rather than $3.86 million. The IRS also claimed that the stock purchase agreement failed to control the value of the company. The estate claimed that the company sold the decedent’s shares at fair market value and that the shares had been properly valued. Thus, according to the estate, the $3 million in life insurance proceeds were properly excluded from the decedent’s estate based on the appellate opinion in Blount. The estate claimed that the stock purchase agreement provided a sufficient basis for the court to accept the estate’s valuation as the proper estate-tax value of the decedent’s shares. On that point, the IRS claimed that the stock purchase agreement was not a bona fide business arrangement and, as such, didn’t control the value of the decedent’s stock. The IRS position was that the stated estate planning objectives of the stock purchase of continued family ownership of the company were insufficient to make it a bona fide business arrangement, particularly because the brothers did not follow it by disregarding the agreement’s pricing mechanisms.
The district court did not rule on the bona fide business arrangement issue because it determined that the estate had failed to show that the stock purchase agreement was not a device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration. The process that the surviving brother and the estate used in selecting the redemption price bolstered the court’s conclusion that the stock purchase agreement was a testamentary device. They also did not obtain an outside appraisal or professional advice on setting the redemption price, thereby disregarding the appraisal requirement set forth in the agreement. The district court also noted that the agreement didn’t provide for a minority interest discount for the surviving brother’s shares or a lack of control premium for the decedent’s shares with the result that the decedent’s shares were undervalued. This also, according to the district court, demonstrated that the stock purchase agreement was a testamentary device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration and was not comparable to similar agreements negotiated at arms’ length.
On the issue of whether the life insurance proceeds should be included in corporate value, the court rejected the appellate court’s approach in Blount, finding it to be analytically flawed. The court concluded that the appellate court in Blount had misread Treas. Reg. §20.2031-2(f)(2), and that the regulation specifically requires consideration to be given to non-operating assets including life insurance proceeds, “to the extent such nonoperating assets have not been taken into account in the determination of net worth.” The district court concluded that the text of the regulation does not indicate that the presence of an offsetting liability means that the life insurance proceeds have already been “taken into account in the determination of a company’s net worth.” The district court concluded that, “by its plain terms, the regulation means that the proceeds should be considered in the same manner as any other nonoperating asset in the calculation of the fair market value of a company’s stock…. And…a redemption obligation is not the same as an ordinary corporate liability.” There is a difference, the court noted, between a redemption obligation that simply buys shares of stock, and one that also compensates for a shareholder’s past work. One that only buys stock is not an ordinary corporate liability – it doesn’t change the value of the corporation as a whole before the shares are redeemed. It involves a change in the ownership structure with a shareholder essentially “cashing out.” The court noted that the parties had stipulated that the decedent’s shares were worth $3.1 million, aside from the life insurance proceeds. The insurance proceeds were not offset by the company’s redemption obligation and, accordingly, the company’s fair market value and the decedent’s shares included all of the insurance proceeds, and the IRS position was upheld.
On appeal the U.S Court of Appeals for the Eighth Circuit affirmed. Connelly v. United States, 70 F.4th 412 (8th Cir. 2023). The appellate court held that the stock purchase agreement requiring the redemption of a deceased shareholder’s shares did not affect the value of the shares for estate tax purposes under I.R.C. §2703 because it did not provide for a fixed price or a formula for arriving at one. Instead, the agreement merely laid out two mechanisms by which the brothers might agree on a price - mutual agreement or appraisal. As for the appraisal approach, there was nothing in the agreement that fixed or prescribed a formula or measure for determining the price that the appraisers would reach. Thus, neither mechanism constituted a fixed or determinable price for valuation purposes. The appellate court determined that the $3 million that the corporation actually paid for the deceased brothers shares constituted an amount determined after death that was derived by an agreement between the brothers and not by any formula in the buy-sell agreement.
As for the value of the corporation (and, hence, the deceased brother’s interest in the corporation), the appellate court determined that the life insurance proceeds were an asset that increased the shareholders’ equity and that an obligation to redeem shares is not a liability in the ordinary business sense. Thus, the proper valuation of the corporation in accordance with I.R.C. §§2042 and 2031 must include the life insurance proceeds without treating the obligation to redeem shares as an offsetting liability. The court reasoned that in order for a willing buyer at the time of the brother’s death to own the stock outright, a willing buyer would account for control the life insurance proceeds and therefore would pay up to $6.86 million for the corporation, quote taking into account end quote the life insurance proceeds and then either extinguishing the agreement or redeeming the shares. Conversely, the appellate court determined that a hypothetical willing seller of the corporation would not find acceptable a price of $3.86 million with the knowledge that the company would be receiving $3 million in life insurance proceeds.
To illustrate its rationale, the appellate court explained explain that if it valued the corporation without accounting for the life insurance proceeds intended for redemption, then upon the brother’s death each share was worth $7,720 before redemption. After redemption, the deceased brother’s interest is extinguished, with the surviving brother having full control of the corporation’s $3.86 million value. The appellate court noted that this would essentially quadruple the value of the surviving brother’s shares, but that treating the life insurance as an offsetting liability would leave the stock value undisturbed (which was the estate’s position). The economic reality of the situation, the appellate court concluded, was that the life insurance proceeds was an asset that increased shareholders’ equity. The buy-sell agreement thus had nothing to do with being a corporate liability.
Note: A separate insurance LLC could be used to fund a buy-sell agreement in light of Connelly. The insurance LLC would collect the life insurance proceeds on the deceased owner. The LLC’s value would not be increased by the death benefit because it is allocated to the other owners in accordance with the buy-sell agreement due to special allocations in a LLC taxed as a partnership. See I.R.C. §704. A formal appraisal would likely only be required if there is real estate or some other difficult to value asset that the LLC owns. This does add a layer of complexity, but if there are more than two owners the additional complexity may be worth it.
Arguably, there is now a split on this issue between the 8th Circuit on one hand, and the 9th and 11th Circuits on the other (keep in mind the brothers in Connelly didn’t follow the buy-sell agreement). Indeed, a petition for certiorari was filed with the U.S. Supreme Court on August 15, 2023. Will the Supreme Court agree to hear Connelly? Not very likely at all.
Conclusion
A buy-sell agreement can be a very important part of a succession plan for a family farming/ranching business (or any small, family-owned business for that matter). However, it’s critical that the agreement be drafted properly and followed by the business owners.
December 1, 2023 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)
Saturday, November 25, 2023
More on Gift Giving
Overview
Earlier this month I wrote about one aspect of the tax rules surrounding making gifts. In that discussion I pointed out one way in which the IRS determines that a gift has been made – out of a “detached and disinterested generosity.” In other words, there is no quid pro quo. There’s nothing expected in return. But there are even more rules surrounding gifting. Today, I take a look at some of those additional rules in the context of how they came up in some recent cases and IRS rulings.
More on gift giving – it’s the topic of today’s post.
Disclosure and Statute of Limitations
A federal gift tax return (Form 709) must be filed when gifts to one person in a year total more than $17,000 this year. That amount goes to $18,000 for gifts made in 2024. That threshold is known as the “present interest annual exclusion” and it covers outright gifts up to that ceiling. Any excess amount gifted to a person in a calendar year then use up the donor’s unified credit that is available to offset taxable gifts during life or federal estate tax at death. So, while gifts over the threshold may not be taxable because of the credit, they still must be reported on Form 709. That’s an important point because filing Form 709 will toll the statute of limitations. Otherwise, the statute is never tolled, and the IRS can come back years later and assert that gift tax (and penalties) is due.
In Schlapfer v. Comr., T.C. Memo. 2023-65, the petitioner owned a life insurance policy that was issued in 2006. It was funded by his solely owned corporation. He assigned ownership of the policy to his mother, aunt and uncle in 2007. In 2012, he got involved with the IRS Offshore Voluntary Disclosure Program (OVDP) because IRS thought he had undisclosed offshore assets that he hadn’t disclosed that triggered a tax reporting obligation. As part of the disclosure packet that he submitted to the IRS in 2013, he included a 2006 Form 709 with an attached protective election describing a gift of just over $6 million of corporate stock but asserting that it wasn’t taxable because it was a gift of intangible personal property from a non-domiciled foreign citizen. In 2016, he signed Form 872 for his 2006 Form 709, agreeing to extend the time to assess tax until November 30, 2017.
Note: The present interest annual exclusion was only $1 million for years 2006 and 2007.
In August of 2016, the IRS issued the petitioner a report for his gift tax return. The IRS concluded in the report that there was no taxable gift in 2006, but that he had made a taxable gift of the insurance policy in 2007 (the year in which he relinquished dominion and control) for which he didn’t file a gift tax return and now owed over $4.5 million of gift tax, plus penalties of approximately $4.3 million. The IRS didn’t buy his claim that he was a non-domiciled foreign citizen, noting that he had lived in the U.S. since 1979, possessed a green card, and actually became a citizen in 2008. The IRS claimed that the 2007 wasn’t adequately disclosed and that the statute of limitations on assessment never began to run.
The petitioner withdrew from the OVDP, and the IRS prepared a substitute gift tax return for 2007, followed with the provision in late 2019 of a statutory notice of deficiency formally asserting the $4.4 million in gift tax deficiency and $4.3 million in penalties. In turn, he filed a Tax Court petition claiming that the three-year statute of limitations (running from the time the gift tax return is filed) to assess gift tax had expired because he had filed a gift tax return with a protective election.
The Tax Court agreed with the petitioner, noting that it was immaterial when the gifts were completed. This was because the Tax Court determined that he had made adequate disclosure of incomplete gifts upon the filing of his 2006 return. That was enough, the Tax Court reasoned, to trigger the three-year period of limitations (see Treas. Reg. § 301.6501(c)-1(f)(5)) because he had adequately disclosed the gifts on his 2006 gift tax return by providing the IRS with enough information by virtue of the return and accompanying documents. Taken in total it was enough to satisfy the adequate disclosure requirement, resulting in substantial compliance. This was true even though the petitioner had not strictly satisfied the requirements of Treas. Reg. § 301.6501(c)-1(f)(2). Thus, the period of limitations to assess the gift tax had expired before the deficiency notice was issued.
Charitable Giving - Substantiation
If you are claiming a deduction for a charitable gift, you must substantiate the gift. In Albrecht v. Commissioner, T.C. Memo. 2022-53, the petitioner donated approximately 120 pieces of jewelry to a museum in 2014. The museum was a qualified charity. The museum executed a “Deed of Gift” which specified, in part, that “all rights, titles, and interests” in the jewelry were transferred from the donor to the donee upon donation unless otherwise stated in the Gift Agreement. The petitioner claimed a charitable deduction for the donation on her 2014 return and supported the claimed deduction by submitting the “Deed of Gift” documentation.
The IRS denied the deduction on the basis that the “Deed of Gift” documentation did not meet the substantiation requirements of I.R.C. §170(f)(8)(B) that require a description of the donated item(s); whether the donee provided any form of consideration in exchange for the donation; and a good faith estimate of the value of the donation. The IRS pointed out that the “Deed of Gift” documentation from the museum did not state whether the museum provided any goods or services in return for the donation. In addition, the terms of the “Deed of Gift” documentation with the museum referred to a superseding agreement, “the Gift Agreement,” which left open the question of whether the donor retained some title or rights to the donation, and also indicated that the petitioner’s documentation did not include the entire agreement with the done.
The Tax Court agreed with the IRS and held that the petitioner did not comply with the substantiation requirements of I.R.C. §170(f)(8)(B) and denied the charitable deduction.
Estate Transfers
The decedent in Estate of Spizzirri v. Comr., T.C. Memo. 2023-25, had four children from the first of his four marriages and had three stepchildren as the result of his fourth marriage. Before his fourth marriage, the decedent and his next wife-to-be entered into a prenuptial agreement, which was modified several times during their marriage. Among other provisions, the prenuptial agreement, as modified, provided that the decedent’s will would include payments to the surviving spouse and a bequest of $1 million to each of the stepchildren.
Although the decedent’s fourth marriage was never dissolved, he and his wife were estranged for several years before his death as a result of his various relationships with other women that resulted in two illegitimate children. The decedent made large payments to a number of these women as well as to various other family members, but he never reported them as gifts or issued a Form 1099-MISC to the recipients. The decedent’s will had been executed before his fourth marriage and did not contain the provisions he agreed to in the prenuptial agreement regarding payments to his surviving spouse and her children. The will generally provided that the decedent’s estate would go to his children from his first marriage. There were three codicils to this will, all of which specified the rights of his two bastard sons and one that provided for the payment of the mortgage on, and transfer of his interest in, a condominium he had purchased with one of his courtesans.
During probate, the decedent’s surviving spouse filed claims seeking enforcement of the prenuptial agreement, which were ultimately settled. The surviving spouse’s children also filed claims seeking to enforce the prenuptial agreement regarding the $1 million bequest to each of them. The estate ultimately paid these bequests and sent the Forms 1099-MISC reporting these payments. After the claims were settled, the estate filed an estate tax return. Among other reported items, the return reported no adjusted taxable gifts, even though the decedent had made payments to various persons in excess of the gift tax annual exclusion. The return also reported the payments to the surviving spouse’s children as claims against the estate that reduced the decedent’s taxable estate. Additionally, the estate claimed as administrative expenses the cost of repairs to property of the estate.
The IRS issued a notice of deficiency that increased adjusted taxable gifts from zero to nearly $200,000, disallowed the deductions for the payments to the surviving spouse’s children, and disallowed administrative expenses for repairs to one of the estate’s properties. The Tax Court determined that the estate had failed to meet its burden of proof that the transfers were not gifts. The estate argued that the transfers were payments for care and companionship services during the last years of the decedent’s life. The court noted that the decedent made the transfers by checks that contained no indication that they were meant as compensation. In addition, the decedent failed to issue any Forms 1099 or W-2 related to these payments, nor did he report them on his personal income tax returns. The Tax Court also noted that witness testimony failed to establish that the transfers were anything other than gifts. The Tax Court also noted that the payments to the surviving spouse’s children would only provide a deduction for the estate if they were bonafide and contracted for “adequate and full consideration in money or money’s worth” and not be predicated solely on the fact that the claim is enforceable under state law. Based on these requirements, the Tax Court determined that the claims were not bonafide but were of a donative character, finding that payments to the surviving spouse’s children did not stem from an agreement for the performance of services — they were essentially bequests not contracted for adequate and full consideration in money or money’s worth.
Regarding the administrative expenses for repairs to the house, the Tax Court noted that Treas. Reg. §20.2053-3(a) limits deductible administrative expenses to those that are actually and necessarily incurred in the administration of the decedent’s estate. The Tax Court noted that the appraisal report for the house, on which the house’s claimed FMV was based, stated that the decks on the house that were repaired “may need to be replaced” and that the estate did not provide any corroboration that their replacement was necessary for a sale or to maintain the FMV claimed on its return. Thus, the court determined that the costs paid for the repairs were not deductible expenditures necessary for the house’s preservation and care but rather were nondeductible expenditures for improvements to it.
Conclusion
The rules on gifting can be complex. If you are thinking about making substantial gifts and/or doing so in a complicated fashion, make sure to get good professional advice beforehand.
November 25, 2023 in Estate Planning | Permalink | Comments (0)
Monday, November 20, 2023
Ethics and 2024 Summer Seminars!
Tax Ethics
On December 15, I'll be conducting a 2-hour tax ethics program. It will be online-only attendance. If you are in need of a couple of hours of ethics, this will be a good opportunity to meet the ethics requirement. I'll be covering various ethical scenarios that tax professionals encounter. The session will be a practical, hands-on application of the rules, including Circular 230. If you have attended or are registered to attend a KSU Tax Institute, you get a break on the registration fee.
For more information you can click here: https://www.washburnlaw.edu/employers/cle/taxethics.html
Also, you may register here: https://form.jotform.com/232963813182156
Summer Seminars
On June 12 and 13, Paul Neiffer and I will be holding a farm tax and farm estate/business planning conference at the Keeter Center on the campus of the College of the Ozarks, just a bit south of Branson, MO. This conference is in-person only. On August 5 and 6, we will be doing another conference in Jackson Hole, WY, at the Virginian Resort. Hold the dates and be watching for more information. This conference will be both in-person and online. Registration will open for the seminars in January. There is a room block established at the Virginian.
Hope to see you online at the ethics seminar and at one of the summer conferences.
November 20, 2023 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)
Saturday, November 11, 2023
Feeling Detached and Disinterested? – Then Gift Giving Is for You!
Overview
Soon the Christmas season will be upon us. With that comes the joy of gift giving. But not according to the IRS. If you gift assets, either as part of an estate plan or for purposes of setting up another person in business or for other reasons, you must be “detached and disinterested.” That sounds as if it saps the joy right out of gift giving. Thanks, IRS!
But, what does “detached and disinterested” mean? When is a transfer of funds really a gift? Why does it matter? It matters because the recipient of a gift doesn’t have to report the value of the gifted amount into income. If the amount transferred is not really a gift, then it’s income to the recipient and the value of the gifted property is still in the estate of the person making the gift. When large amounts are involved, the distinction is of utmost importance.
When is a transfer of funds a gift? It’s the topic of today’s post.
Definition of a “Gift”
Under the Internal Revenue Code (“Code”), gross income is income from whatever source derived unless otherwise excluded. I.R.C. §61(a). However, gross income does not include the value of property that is acquired by gift. I.R.C. §102(a). In Comr. v. Duberstein, 363 U.S. 278 (1960), the U.S. Supreme Court defined a gift under I.R.C. §102 as a transfer that proceeds from a “detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses.” As a result, the Supreme Court concluded that the most important consideration in determining whether a gift has been made is the donor’s intent. That’s a broader inquiry than simply looking at how the donor characterizes a particular transaction. A court will examine objectively whether a gift occurs based on the facts and if those facts support a donor that intended a transfer based on affection, etc. Detached and disinterested generosity is the key. If the transfer was made out of a moral duty or some sort of expectation on the recipient’s part, it is not a gift under I.R.C. §102 because it did not arise out of a detached and disinterred generosity. Similarly, when the recipient has rendered services to a donor, a payment for services is not a gift even if the transferor had no legal obligation to pay the remuneration for the services.
Apart from the Court’s analysis in Duberstein, a particular transaction may amount to a “common law” gift. A common law gift requires only a voluntary transfer without consideration. If the donor had no legal obligation to make the payment, the transfer is a gift under the common law standard. That’s an easier standard to satisfy than the Code definition set forth in Duberstein.
Example – Tax Court Decision
In Kroner v. Comr., T.C. Memo. 2020-73 illustrates how the courts examine whether a particular transfer constitutes a gift and the consequences of misreporting the transaction(s) for tax purposes. The petitioner was the CEO of a business that bought and sold structured settlement payments and lottery winnings. The company would buy structured payments from lottery winners and resell the payments to investors. The petitioner had historically worked in the discounted cashflow industry and, as a result, met a Mr. Haring, a wealthy British citizen, sometime in the 1990s. Their business relationship lasted until 2007.
In 2003 and 2004, the petitioner was interested in protecting his assets and an attorney recommended the use of an “offshore” trust to hold the petitioner’s assets. An offshore trust is often associated with tax scams, but I reserve that discussion for another post in the future. In any event, the petitioner established the “Kroner Family Trust” in a small island in the Caribbean. The petitioner was the beneficiary of the trust along with his son. In 2007, the petitioner established another trust in the Bahamas to hold business assets. From 2005-2007, the petitioner received wire transfers from Mr. Haring totaling $24,775,000. Some of the transferred funds went directly to the petitioner, but others went to the trust in the Caribbean Island and still others went to the petitioner’s business. The lawyer that set up the offshore trusts “advised” the petitioner that the transfers were gifts that the petitioner didn’t have to report as taxable income. The attorney’s legal “analysis” which led him to this conclusion was a conversation he had with the petitioner and a note that he drafted for Mr. Haring stating that the transfers were gifts. The attorney also advised the petitioner of the requirements to file Form 3520 every year that he received a transfer from Mr. Haring to report the gifts from a foreign person. A CPA prepared the Form 3520 for the necessary years. The petitioner never reported any of the transfers from Mr. Haring as taxable income.
The petitioner was audited for tax years 2005-2007. The IRS took the position that the transfers were not gifts, should have been reported as taxable income, and assessed accuracy-related penalties on top of the tax deficiency.
The Tax Court agreed that the transfers should have been included in the petitioner’s taxable income. They were not gifts. The Tax Court noted that Mr. Haring’s intention was the most critical factor in determining the status of the transfers. The petitioner bore the burden to establish Mr. Haring’s intent by a preponderance of the evidence. However, Mr. Haring never appeared at trial and didn’t provide testimony. Instead, the petitioner tried to establish the gift nature of the transfers by his own testimony. The petitioner and Mr. Haring had operated some business interests together in the 1990s, and the petitioner acted as a nominee for Mr. Haring for certain of Mr. Haring financial interests. He even formed a trust in Liechtenstein for Mr. Haring in 2000. Mr. Haring also provided a loan for the petitioner’s credit counseling business in 2000. That loan was paid off in 2007. Mr. Haring also held about a 70 percent equity interest in the petitioner’s cashflow industry business in exchange for providing funding and loan guarantees. He later liquidated his interest for $255 million.
The petitioner last saw Mr. Haring in 2002 and testified at trial that he didn’t know where he lived and that he didn’t know his telephone number. He did, however, receive a telephone call from Mr. Haring in 2005 that lasted no more than three minutes. The petitioner claimed that Mr. Haring told him during the call that Mr. Haring had a “surprise” for the petitioner. The petitioner later met with Mr. Haring’s associate and they set up the ability to receive wire transfers from Mr. Haring into the petitioner’s bank account. That’s when the attorney drafted a note to the petitioner from Mr. Haring stating that the transfers would be gifts.
The Tax Court didn’t buy the petitioner’s story, finding that neither the petitioner nor the attorney were credible witnesses. The Tax Court stated that the petitioner’s testimony was self-serving and that the attorney’s testimony was “simply not credible.” There was no supporting documentary evidence. In addition, the attorney represented both Mr. Haring and the petitioner. The Tax Court also noted that the attorney was “evasive in his answers and in his selective invocation of the attorney-client privilege with regard to the legal advice provided to Mr. Haring about the transfers.” The Tax Court also doubted the authenticity and credibility of the 2005 note allegedly from Mr. Haring but drafted by the attorney regarding his desire to gift funds to the petitioner. Thus, the note carried little weight in determining whether the transfers were gifts.
The Tax Court also determined that the petitioner failed to prove that the transfers were made with disinterested generosity. The record was simply devoid of any credible evidence to prove that Mr. Haring transferred the funds to the petitioner with detached and disinterested generosity. The Tax Court noted that timing of some of the transfers with liquidity events of the petitioner’s business of which Mr. Haring was an investor. That raised a question as to whether Mr. Haring was acting as the petitioner’s nominee.
The Tax Court determined that the petitioner need not pay the 20 percent accuracy-related penalty because the IRS failed to satisfy its burden of production under I.R.C. §6751(b).
Conclusion
The Kroner case is a textbook lesson on what constitutes a gift – detached and disinterested generosity. The burden of establishing that a transfer is a nontaxable gift is on the party asserting that the transfer amounted to a gift. The case is also a lesson into the messes that sloppiness and questionable lawyering can get a client into. When the amount of the gift (or gifts) is as large as that involved in the Kroner case, attention to detail is a must. The income tax consequences from being wrong are enormous.
For gifts you make this Christmas season, remember that the resulting tax consequences to you are likely to be better if you remain “detached and disinterested.”
November 11, 2023 in Estate Planning | Permalink | Comments (0)
Wednesday, November 1, 2023
Split-Interest Land Acquisitions – Is it For You? (Part 2)
Overview
Yesterday’s article looked at what a split-interest transaction is, how it works, and when it can be useful as part of an estate plan. In particular, the focus of Part 1 was on removing after tax income from a family farming corporation and how it can work when farmland is purchased.
Today’s article looks at the relative advantages and disadvantages of the split-interest transaction, and what the rules are when property that is acquired in a split-interest transaction is sold.
Part 2 of split-interest transactions – it’s the topic of today’s post.
Advantages and Disadvantages
Advantages. Because land is not depreciable, the most efficient form of acquisition is to use earnings exposed to a low tax rate. A closely-held C corporation is a relatively efficient entity for creating after-tax dollars with the current tax rate at a flat 21 percent. Even though C corporation after-tax dollars are used for the acquisition of most of the cost of land, the split-interest technique avoids the long-term negative aspect of having the farmland trapped inside the C corporation, and thus avoids the risk of double taxation of land appreciation.
Even though corporate dollars are used to acquire the asset, the individual succeeds to full tax basis in the asset (reduced by any tax depreciation allowable to the corporation on the depreciable portion of the property). The remainderman acquires basis in the real estate even though no economic outlay has occurred by that individual.
Disadvantages. The individual who buys the remainder interest must do so entirely from other sources of after-tax earnings. The land produces no income to the remainderman during the period that the land is available for use by the corporation under the specified term certain. Also, if the land is purchased on a contract or installment payment arrangement, each party must provide its contribution, either to the down payment or the contract.
Note. The party with the cash for the down payment may provide any portion or all of such down payment, with an adjustment for that party’s contribution to the contract. The contract may provide for interest only payments by one party, until the other party’s contribution toward the purchase has been fully paid.
Example. Sow’s Ear, Inc. has been retaining equity of approximately $40,000 per year ($50,000 taxable income minus state and federal taxes) for a number of years. Chuck, the corporate president would like to purchase additional land with the funds that the corporation has accumulated. Chuck wants the corporation to buy the land with those available funds. However, having the corporation purchase the land would trap up that land inside the corporation and potentially expose it to the double tax upon liquidation as well as eliminating capital gain rates if the corporation would have to sell the land.
An alternative solution would be a split interest purchase. Assume that the land could be purchased for $1 million, with $450,000 down and a contract at 5 percent for the balance, payable $52,988.26 annually for 15 years. Chuck would like to farm for another 20 years via the corporation. Assume that the monthly IRS purchased interest rate for a 20-year split-interest purchase requires the term interest holder to pay 58 percent of the total purchase price or $580,000. Sow’s Ear, Inc. may pay $200,000 of the down payment. It’s share of the remaining balance due is $380,000. Chuck, as the remainder holder, is responsible for $420,000. The balance due for the down payment may be made by either party. If Sow’s Ear, Inc. borrows to satisfy the remaining down payment of $250,000, it will assume $130,000 of the note payable for the balance due ($580,000 less $200,000 cash less $250,000 remaining down payment). Chuck will assume the remaining balance due of $420,000.
Each party must pay interest that economically accrues on its share of the seller-financed debt, otherwise the below-market rate loan rules apply, which tie in with OID requirements. The parties may determine the share of principal to be paid by each, as long as a total of $52,988.26 annually is paid to satisfy the requirements of the seller-financed note. Because Chuck, as the remainderman, has no cash flow coming from the property for the next 20 years, he will have to obtain funds from sources other than rents from the property to fund his payments. The deductibility of interest expense will be subject to the passive activity rules of I.R.C. §469. The interest expense is a passive activity deduction, even though no rent is currently received by Chuck. If Chuck has no passive income from other activities, the interest expense will create a passive loss carryover, to be available to offset net rental income after the term interest held by the corporation expires.
Observation. The split-interest technique is essentially limited to C corporations, because if two related individuals are involved the person acquiring the term interest is treated as having made a gift of the value of the term right to the purchaser of the reminder right.
Observation. In times of low interest rates (i.e., low AFR factors that determine the percentage to be paid by each party), the corporate share will be smaller than occurs in periods when interest rates are higher.
Sale of Split-Interest Property
If a sale occurs during the split ownership of the property, the sale proceeds must be allocated between the corporate term holder and the individual remainderman based on the IRS interest rate and the remaining term certain periods as of the date of the sale. After allocating the sale proceeds to each party, gain or loss is recognized by each party (the corporate term holder and the individual remainderman) by comparing the sale proceeds to the adjusted tax basis of the property. The adjusted tax basis needs to reflect the nondeductible amortization adjustment occurring annually and the shift of this basis to the remainderman in accordance with I.R.C. §167(e)(3).
Example. Assume that RipTiller, Inc. and Dave Jr. (from the prior example) purchased another farm seven years ago for $200,000, with the corporation acquiring a 32-year term certain. Assume that using interest rates in effect at that time, Dave Jr. was required to pay $25,000 and the corporation paid $175,000 toward the farm purchase price. The corporate basis was further allocated as $20,000 attributable to depreciable tiling and $155,000 attributable to the land cost. By the current year, the corporation would have depreciated about $9,000 of the $20,000 of tiling, leaving an adjusted basis of approximately $11,000. The land basis of $155,000 would also have been reduced annually under straight-line amortization over the 32-year term certain. Assume that about $4,800 per year of amortization occurred over the seven-year holding period of the corporation, resulting in a total reduction to the corporate basis of $33,600. The amortization would be treated as land basis reductions to the corporation, and as land basis increases to Dave Jr. Accordingly, at the time of the sale of the farm, the adjusted tax basis to each party is as follows:
Corporate Basis
Land Tiling Total
Basis at Purchase $155,000 $20,000 $175,000
Deductible Depreciation ($9,000) ($9,000)
Statutory Amortization ($33,600) ($33,600)
Adjusted Basis $121,400 $11,000 $132,400
Dave Jr.’s Basis:
At Purchase $25,000
Statutory Increase for Amortization $33,600
Total Adjusted Tax Basis $58,600
If the farm is sold for $250,000, the term certain percentage and remainder percentage must be calculated for a term certain with 25 years remaining. Assume that the current IRS mid-term annual AFR is 6.0 percent. According to the IRS term certain table for 6.0 percent, the 25-year income right is to be allocated 76,7001 percent and the remainderman is to be allocated 23.2999 percent. Accordingly, about $192,000 of the sale proceeds are allocable to the corporation and the remaining $58,000 is allocable to the individual. The corporation would compare its $192,000 of approximate proceeds to its adjusted tax basis in the land and tiling of approximately $132,000. In this example RipTiller, Inc. would report $60,000 of gain. Dave Jr. would report a small capital loss ($58,000 allocated sale price vs. $58,600 adjusted tax basis).
Observation. Interest rates at the time of purchase compared to interest rates at the time of sale can have a major influence on the allocations under the split-interest rules. In the example, if interest rates rise from the time of purchase to the time of sale, Dave Jr. would have a lower percentage of the sale price allocable to his remainder interest, and could incur a significant capital loss that was not immediately deductible.
Split-Interest Purchases with Unrelated Parties
The IRS has addressed the tax effects of split-interest purchases where the term holder and the remainder holder were unrelated. In two Private Letter Rulings (200852013 (Sept. 24, 2008) and 200901008 (Oct. 1, 2008)) that appear to address the same set of facts, two unrelated buyers acquired several parcels of commercial real estate that included both depreciable buildings and land. The first buyer acquired a 50-year term interest in the property, and the second buyer acquired a remainder interest in that same property. The IRS determined that the buyer of the term interest was entitled to depreciate the commercial real estate (which the buyer of the term interest intended to use in its active conduct of renting commercial and residential property) ratably over the 50-year period of the term certain. The portion of the taxpayer’s basis allocable to the buildings was held to be depreciable under the normal I.R.C. §168 MACRS recovery periods. In addition, the IRS determined that the holding period for the buyer of the remainder interest began at the time of the purchase.
Observation. A term certain remainder purchase arrangement of farmland (that is used in the taxpayer’s trade or business) where the two parties are unrelated could result in a term certain amortizable interest in the land. This is the case, according to the IRS, even though the farmland is not depreciable. But see the Lomas case referenced in Part 1). Examples of unrelated parties under I.R.C. §267 for these rules would include cousins and in-laws, such as a father-in-law, brother-in-law, or sister-in-law.
Estate Tax Implications
For transactions that are between unrelated parties (as defined in I.R.C. §267), several federal estate tax advantages can be achieved. If the “split” property is fairly valued (by a qualified appraiser), there is no gift upon creation of the split interest if IRS tables are used to value each party’s contribution. Also, because the life estate interest ends upon the death of the life estate holder, there is no taxable transfer by that person that would trigger estate tax. There is no inclusion in the life estate holder’s estate (and no interest subject to probate). The property becomes fully vested in the remainder holder upon the life estate holder’s death. As a result, there is no basis “step-up” to fair market value at the time of the life estate holder’s death in the hands of the remainder holder. The basis of the property in the hands of the remainder holder is the cost of the remainder interest (the amount paid for the remainder interest).
Conclusion
Is a split-interest transaction for you? The answer, of course, is that it “depends.” For transactions involving individuals, the tax advantages (income tax as well as estate tax) are lost if the parties to the transaction are related. Also, it’s important to make sure to the remainder holder provides consideration for the acquisition of the remainder interest (and not simply the life estate holder providing the financing to the holder of the remainder interest). If that doesn’t happen, the IRS will likely claim that the life estate holder made a gift of a future interest that is subject to gift tax and can’t be offset by the present interest annual exclusion (currently $17,000 per year per donee).
Still uncertain is whether, for example, a split-interest purchase between unrelated parties (such as between a farm tenant that is looking to farm additional land and an investment firm). The IRS letter rulings seem to address this issue in a commercial context. Another issue in some states is that the strategy won’t work in some states if the investor is a corporation, limited liability company or trust that is disqualified from owning and/or operating agricultural land by statute.
For split-interest transactions involving a C corporation, if done correctly, the technique can be beneficial from a tax standpoint.
November 1, 2023 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)