Agricultural Law and Taxation Blog

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

Overview

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

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

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

Valuation 

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

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

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

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

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

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

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

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

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

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

Funding Approaches

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

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

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

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

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

Other Approaches

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

Potential Problem of Life-Insurance Funding

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

Overview

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

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

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

Background - LLCs and Self-Employment Tax

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Soroban Capital Partners LP

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

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

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

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

Conclusion

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

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

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

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

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

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

Current Issues in Ag Law and Taxation

Overview

Today’s article addresses several current and recurring issues in the fields of law and taxation that are of importance to farmers and ranchers. 

Right to Repair

Agribusinesses can exert power over farmers through limits on technology use and access, as well as by other agreements that producers sign to utilize services and products.  A big issue is whether the ownership of the technology associated with farm equipment and machinery limits a farmer’s right to repair. 

When a farmer buys new machinery, the manufacturer may view the transaction more as a technology lease than as a machine sale. At issue is the ownership of the software and technology in the farm machinery.  The dramatic increase in computerization of equipment means that all types of data are sent to the cloud by a transmitter.  As a result, the manufacturer will claim that only an authorized dealer can make repairs. 

This is the crux of the “right to repair” argument.  John Deere has said it will provide timely electronic access to farmers and independent repair shops of the manuals, software and tools necessary to operate, maintain, repair or upgrade equipment.  But access won’t be free, and the agreement is off if a party to the deal introduces right to repair legislation in a state legislature.   Other manufacturers have struck similar deals.

At least 11 states have introduced legislation on the issue recently. Colorado’s right to repair law, “The Consumer Right to Repair Agriculture Equipment Act,” (HB 23-1011) goes into effect at the start of 2024. 

Good Husbandry Provisions in Ag Leases

According to the USDA, about 40 percent of all farmland is leased.  A requirement of good husbandry is a part of all ag leases, either through language in the lease or implicitly where a court will require the tenant to farm in accordance with generally accepted farming practices.  See, e.g., Bostic v. Stanley, 608 S.W.3d 907 (Ark. Ct. App. 2020).  It’s tied to the common law duty of “waste” – the tenant can’t mismanage the land resulting in substantial injury.  Examples include removing topsoil, demolishing buildings or fences, cutting timber or destroying cover crops.  It can also include improper tillage practices and failing to control weeds or insects.  There’s no specific legal definition, so the interpretation of good husbandry’s meaning is left up to the courts unless the lease has a specific clause. 

In one case, a breach of the duty of good husbandry was found where the tenant started harvesting wheat too late.  A breach was also found in another case where the tenant removed manure at the end of the lease.  But a breach won’t likely be found if weather prevents completion of harvest and other farms in the area have been similarly affected. 

If you’re concerned about your tenant’s farming practices, consider putting a clause in a written lease detailing the farming practices that you deem appropriate and those that you don’t. 

WOTUS Update

The legal challenges and disputes continue related to the regulatory definition of “waters of the United States” or WOTUS.  The disputes concern the EPA and Corp of Engineers regulation published on September 8 purportedly conforming the regulatory definition of “waters of the United States” to the Supreme Court’s ruling in a case last May.  https://www.federalregister.gov/documents/2023/09/08/2023-18929/revised-definition-of-waters-of-the-united-states-conforming  The disputes have implications for many farmers and ranchers.  Twenty-six states have sued claiming that the EPA and the Corps of Engineers violated the law when it modified its existing rule to supposedly comply with the Court’s ruling.  The states claim that the agencies didn’t provide enough analysis or explanation of the scope of federal jurisdiction in response to the Court’s decision.  They also claim the federal agencies are undermining state control over land management and failed to define terms such as “relatively permanent” and “continuous connection.” 

In addition, Texas and Idaho claim that the modified rule oversteps state sovereignty and asserts federal authority over non-navigable waters. Some industry and ag groups have joined this lawsuit. 

As the Supreme Court ruled, only relatively permanent waters that are directly connected to larger navigable water bodies are “waters of the U.S.”  It’s up to the federal agencies to write a rule that provides the parameters of that definition.  Expect the legal battles to continue.

Considerations When Buying Farmland

Whether to buy farmland is perhaps the biggest decision you’ll have to make with respect to your farming operation as well as your legacy.  But there are lots of things to consider before signing on the dotted line.  Of course, price is a primary consideration in most transactions, but there are factors that can influence the land’s value that aren’t necessarily reflected in the sale price. 

The following is a list of some of those factors:

• Make sure to account for any improvements that will be needed to buildings, fences and drainage tile.
• Also check the watershed and potential drainage or irrigation issues.
• Is the land in a drainage district?
• Is there potential for an endangered species habitat designation?
• Is there an old dump site on the property?
• Are there any government contracts such as the CRP or easements on the property?
• Is the land leased to a tenant? If so, has the tenancy been terminated?  Simply buying the land will not terminate an existing lease. 
• Is there a subsurface tenant?

Checking available public records and asking questions of the current owner and neighbors is a good thing to do.  Also, physically inspect the property, and get the seller to sign a thorough disclosure document.

Perhaps most importantly, don’t let your emotions drive the decision.

Exclusion of Meals and Lodging from Income

The value of meals and lodging furnished on the business premises for the employer’s convenience and as a condition of employment is not taxable income to the employee and is deductible by the employer if the meals and lodging is provided in-kind.  It also isn’t wages for FICA and FUTA purposes.

This is a C corporation benefit.  A C corporation provides the broadest fringe benefits of any entity structure.  One of those is the ability to provide tax-free meals and lodging to employees.  The meals and lodging must be furnished on the business premises, be provided for the employer’s convenience and as a condition of employment.  Remoteness of the farm or ranch is a factor, but not a determining one.  See, e.g., Caratan v. Comr., 442 F.2d 606 (9th Cir. 1971).  Whether you have a good business reason to have employees on the premises at all times is.  A key to success on that issue is documenting the need and requirement in employment agreements or corporate resolutions.

If done right, it can be a nice tax-free fringe benefit for employees and a deduction for the corporation.

Hobby Losses

For a business expense to be deductible, it generally must be “ordinary and necessary” and incurred in a business that is conducted with a profit intent.  If not, the activity is deemed to be a hobby and associated losses are “hobby losses.” The impact of the tax law on hobby losses is currently harsh. 

Over the years, many cases involving ag activities have been the focus of the IRS.  If the activity is deemed to be a hobby, any losses are miscellaneous itemized deductions which are currently disallowed. See, e.g., Gregory v. Comr., 69 F.4th 762 (11th Cir. 2023), aff’g., T.C. Memo. 2021-115.  But all the income from the activity must be reported into gross income. 

The IRS and the courts analyze nine factors for determining whether there is a profit intent.  Those factors are the manner in which the activity is conducted; the taxpayer’s expertise or that of adviser(s); the time and effort put in; whether there’s an expectation that the assets will appreciate in value; the taxpayer’s success in carrying on similar activities; the taxpayer’s history of income or loss; whether there’s ever been a profit; and two socioeconomic factors.

None of the factors is conclusive by itself.  It’s how they stack up in a given situation.  What is for sure, though, is that the tax rule is harsh if your activity is deemed to be a hobby.

An S Corporation is a Separate Entity from Yourself

A key principle of tax law is that you can’t deduct expenses that you pay on behalf of someone else.  That rule extends to corporations and their shareholders.  The rule was applied in a recent Tax Court case, Vorreyer, et al. v. Comr., T.C. Memo. 2022-97, involving a farming business operating as an S corporation. 

You can’t deduct an expense of your corporation as your own - even if the corporation is a pass-through entity such as an S corporation.  While there’s a limited exception, it didn’t apply in the recent case where the taxpayers operated a farm individually and through several related entities including an S corporation.  They paid the corporation’s property taxes and utility expenses and deducted the amounts on their personal returns. 

But the Tax Court said that the business expenses of the S corporation could not be disregarded at the corporate level.  The S corporation’s income must be matched at the corporate level against the S corporation’s expenses that were incurred to produce that income before the net income or loss amount can flow through to the shareholders. 

The result was that the deductions on the shareholders’ personal returns were disallowed.  Although S corporate income or loss would eventually flow through to them, a corporation is a separate taxable entity.

The lesson is clear – make sure to respect an entity structure.  You can’t claim a personal deduction for a corporate expense.

FBAR Penalties

In recent years some American farmers have started farming operations in foreign countries, particularly in South America.  Doing so could trigger a provision in the Bank Secrecy Act and if the provision is violated, the penalties can be harsh.  Under the rule, persons with a bank account in a foreign country containing $10,000 or more must report the account to the IRS by the annual tax filing deadline. 

In a recent case involving a dual citizen of the U.S. and Romania, the IRS asserted penalties of almost $3 million.  He didn’t know about the requirement and didn’t report his foreign accounts for several years.  He disputed the penalty amount, claiming that it should be reduced to $50,000 based on his failure to file one form annually for five years that disclosed all of his foreign accounts.  The Government claimed the penalty was on a per account basis.  He won the argument at the trial court but lost on appeal.  At the Supreme Court he won – the penalty is on a per-form basis. Bittner v. United States, 598 U.S. 85 (2023).

For farmers with farming operations outside the U.S. it’s likely that a foreign bank account exists.  If so, it’s imperative that Form FinCen 114 is filed annually that reports those accounts to the IRS. 

Conclusion

I’ll ramble on more next time.  And…I’m starting to compile my list of the biggest ag law and tax developments of 2023.  What do you think were the most important ones?

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.

Odds and Ends in Ag Law and Tax

Overview

The world of ag law and tax never stops revolving.  That’s probably not always a good thing for farmers and ranchers.  I suspect many involved in agriculture would appreciate less involvement of law and tax in their lives and their business operations.  But it’s the reality which means that it’s important to stay on top of the developments and issues that impact the business bottom line.

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

Scope of Dealer Trust Act at Issue

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.

In 2021, a Dealer Trust became part of the Packers and Stockyards Act 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 similar to 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 is in the courts.  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.   

What if the Trump Tax Cuts Aren’t Extended? 

A recent report from economists from Harvard, Princeton, the University of Chicago and the U.S. Treasury have produced a recent report that the Trump tax cuts, particularly the corporate tax reform provisions, created a large surge in business investment, economic growth, higher wagers for workers and little impact on government revenue.  The report can be found here:  https://conference.nber.org/conf_papers/f191672.pdf

The Trump tax cuts (known as the Tax Cuts and Jobs Act (TCJA)) permanently reduced the corporate tax rate from 35 percent to 21 percent and allowed for immediate expensing for shorter-term capital investments (although the provision is currently 80 percent for 2023 and is phasing down).  The economists noted in their report that, “the dynamic labor and corporate tax revenue feedback in the first 10 years is less than 2 percent of baseline corporate revenue, as investment growth causes both higher labor tax revenues from wage growth and offsetting corporate revenue declines from more depreciation deductions.”  In other words, the economists are saying that when companies reinvest and grow and become more efficient, employee salaries increase, and more taxes get paid.  The result is no net loss to the Treasury over a 10-year period.  The report noted that in 2017, the year before the Trump tax cuts took effect, revenue to the federal government was $3.3 trillion.  In fiscal year 2021 the Treasury took in $4 trillion and $4.9 trillion in fiscal year 2022.  But it dropped to $4.44 trillion in fiscal year 2023 due to the slowing economy burdened by inflationary economic policies. 

Many individual provisions of the TCJA are set to expire at the end of 2025.  For many, this could have a significant impact starting in 2026. Do you have a plan in place if the tax law changes dramatically at that time?  If Congress allows the TCJA to expire, how might it impact you?  For starters, tax rates will increase, and those currently in the 12 percent federal bracket will see a 25 percent increase in their tax rate.  Currently, the 12 percent bracket for married persons filing jointly applies to taxable incomes from $22,000-$89,450.  So, for instance, a married couple with $75,000 of taxable income would see their tax bill raise from $8,560 to approximately $10,350. 

In addition, the standard deduction will be reduced (essentially cut in one-half), but personal exemptions will be restored.  Also, the child tax credit will be reduced from $2,000 per qualifying child to $1,000, refundability will be reduced and the credit will be eliminated entirely for some families.  For homeowners, the current limit on the mortgage interest deduction will be removed.

The 2017 law removed the penalty for not getting government health insurance, but that will be restored starting in 2026, as will the deduction for state and local taxes.  In addition, the lower limit on charitable deductions will be reinstated.  For businesses that aren’t corporations, the 20 percent deduction on business income will go away.   

The estate tax exemption will be essentially cut in half, (from about $14 million in 2025 to about $7 million in 2026).  For larger estates, making gifts now might make some sense. 

It might be time to start thinking about the changes that could occur starting in 2026 and putting a good plan in place to handle what could happen.  If you operate a farming or ranching business, think of higher taxes as an additional cost that needs to be managed.

You're Responsible for Filing Your Tax Return

Lee v. United States, No. 22-10793, 2023 U.S. App. LEXIS 28228 (11th Cir. Oct. 24, 2023)

The plaintiff’s CPA failed to file the plaintiff’s tax return for three consecutive years, 2014-2016. Ultimately, the plaintiff filed his returns in December of 2018.    In 2019, the IRS assessed the plaintiff with over $70,000 in penalties for violating I.R.C. §6651(a) of the Internal Revenue Code and barred the plaintiff from applying his 2014 overpayment to taxes owed for 2015 and 2016, because as being beyond the statute of limitations in I.R.C. §6511(b).  The CPA informed the IRS that his tax preparation software couldn’t prepare the plaintiff’s returns because of their complexity but didn’t tell the plaintiff of the problem. 

The plaintiff learned about the problem when an IRS agent showed up at his office.  The CPA had failed to update the plaintiff’s address with the IRS.  The plaintiff sued the tax software company and the CPA for negligence and the suit settled in 2020.  The plaintiff sued for a refund of taxes, claiming that his failure to file was due to reasonable cause.  He also sought a refund of penalties.  The trial court ruled for the government based on United States v Boyle, 469 U.S. 241 (1985), where the U.S. Supreme Court applied a bright-line rule that “reliance on an agent,” without more, does not amount to “reasonable cause” for failure to file a tax return on time.  The question in this case was whether the rule in Boyle applies to e-filed returns. 

The appellate court noted that the plaintiff signed Form 8879, authorization to e-file, on time but the CPA failed to electronically transmit the taxpayer's return. In a case of first impression on the issue, the appellate court affirmed.  Here the Circuit Court sided with the IRS and held that the rule applies to e-filed returns and denied the taxpayer's reasonable cause for failure to file argument.  The appellate court determined that for the e-filing was the same as paper filing for the purpose of responsibility for filing the return and that Form 8879 did not make e-filing fundamentally different from paper filing.  The appellate court noted that the plaintiff had not experienced a disability or illness that affected his ability to exercise ordinary care and prudence.  He also did not ask the CPA to provide a copy to him for any of the years in question of the acceptance notice from the software company that his returns had been successfully electronically filed. 

Interest Paid on Late Child Support Is Includible in Payee’s Gross Income 

Rodgers v. Comr., T.C. Memo. 2023-56

The petitioner and her ex-spouse were involved in litigation concerning the termination of the ex-spouse’s child support obligation.  He was found to be arrears in his child support obligation to the extent of $18,000.  That amount was later amended to $16,044.37, which included $10,682.48 of interest.  The arrearage was paid, and the petitioner was issued a 1099-INT showing $7,824 of interest income for 2015.  The plaintiff did not include the interest amount in her income for 2015 and the IRS issued her a deficiency notice.  She took the position that the amount was nontaxable child support. 

The Tax Court noted that under Alabama law the amount for arrearages was specifically designated as interest. As such, the Tax Court upheld the position of the IRS that the amount was taxable interest to the plaintiff.  The Court found the amount to be taxable interest. 

Appraisal Necessary for Non-Cash Donations

Bass v. Comr., T.C. Memo. 2023-41 

 In 2017, the petitioner donated clothing and non-clothing items to the Goodwill and Salvation Army.  He made 173 separate trips to Goodwill and Salvation Army to avoid (at least in his mind) having the items appraised.  For each trip a worker provided him with a donation acknowledgement receipt which he filled out, listing the items donated and their market values.  The Goodwill receipts indicated the donated items were worth $18,837 and the Salvation Army items would worth $11,779.  He attached two Forms 8283 to his tax return but did not obtain a written appraisal, claiming that he didn’t need one because he did not donate any single item worth over $5,000.  Indeed, no single item exceeded $250. 

The Tax Court disagreed, holding that all of the non-cash items had to be aggregated for purposes of whether an appraisal is required.  The Tax Court affirmed the position of the IRS that the petitioner’s charitable deduction should be denied. 

Mortgage Interest Deduction Disallowed

Shilgevorkyan v. Comr., T.C. Memo. 2023-12

In this case, the petitioner claimed a mortgage interest deduction for 2012 associated with a home that his brother purchased for $1,525,000 in 2005.  The purchased was financed with a bank loan.  The brother and his wife were listed as the borrowers on the loan.  The brother (and wife) and another brother also took out a $1,200,000 construction loan.  Both loans were secured by the home.  The construction loan was used to build a separate guest house on the property.  In 2010, one brother executed a quit claim deed in favor of the petitioner with respect to the property. 

During 2012, the petitioner didn’t make any loan payments and was not issued a Form 1098 for the year.  While the petitioner lived in the guest house for part of 2012, he did not list the property as being his place of residence or address.  On his 2012 return, the petitioner claimed a $66,354 deduction for one-half of the total mortgage interest paid for the year as reported on Form 1098 that was issued to his brother and his brother’s wife. 

The IRS disallowed the deduction and the Tax Court agreed.  The petitioner failed to prove that the debt on the property was his obligation, did not show ownership (legal or equitable) in the property, and the quitclaim deed did not convey title to him under state law.  The Tax Court also determined that the petitioner failed to establish that the residence was his “qualified residence.” 

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

Overview

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

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

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

Advantages and Disadvantages

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

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

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

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

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

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

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

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

 

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

Sale of Split-Interest Property

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

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

Corporate Basis

                                                                                   Land               Tiling               Total

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

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

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

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

Dave Jr.’s Basis:

            At Purchase                                                     $25,000

            Statutory Increase for Amortization          $33,600

            Total Adjusted Tax Basis                               $58,600

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

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

Split-Interest Purchases with Unrelated Parties

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

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

Estate Tax Implications

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

Conclusion

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

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

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

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

In General

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

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

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

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

Split-Interest Transactions

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

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

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

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

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

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

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

A couple of points can be made about this conclusion:

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

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

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

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

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

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

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

Conclusion

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

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

Introduction

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

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

New Corporate Reporting Requirements

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Withdrawing an ERC Claim

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

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

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

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

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

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

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

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

Written Farm Lease Expires by its Terms; No Holdover Tenancy

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

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

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

Ag Law and Tax Topics – Miscellaneous Topics

I haven’t been able to write for the blog recently given my heavy travel and speaking schedule, and other duties that I have.  But that doesn’t mean that all has been quiet on the ag law and tax front.  It hasn’t.  Today I write about several items that I have been addressing recently as I criss-cross the country talking ag law and tax.

What if TCJA Isn’t Extended?

Tax legislation that went into effect in 2018 is set to expire at the end of 2025.  For many, this could have a significant impact starting in 2026. Do you have a plan in place if the tax law changes dramatically at that time? 

If Congress allows the 2017 tax law to expire, how might it impact you?  For starters, tax rates will increase, and those currently in the 12 percent federal bracket will see a 25 percent increase in their tax rate.  Currently, the 12 percent bracket for married persons filing joints applies to taxable incomes from $22,000-$89,450.  So, for instance, a married couple with $75,000 of taxable income would see their tax bill raise from $8,560 to approximately $10,350. 

In addition, the standard deduction will be reduced (essentially cut in one-half), but personal exemptions will be restored.  Also, the child tax credit will be reduced from $2,000 per qualifying child to $1,000, refundability will be reduced and the credit will be eliminated entirely for some families.  For homeowners, the current limit on the mortgage interest deduction will be removed.

The 2017 law removed the penalty for not getting government health insurance, but that will be restored starting in 2026, as will the deduction for state and local taxes.  In addition, the lower limit on charitable deductions will be reinstated.  For businesses that aren’t corporations, the 20 percent deduction on business income will go away.   

The estate tax exemption will be essentially cut in half, (from about $14 million in 2025 to about $7 million in 2026).  For larger estates, making gifts now might make some sense. 

It might be time to start thinking about the changes that could occur starting in 2026 and putting a good plan in place to handle what could happen.  If you operate a business, think of higher taxes as an additional cost that needs to be managed.

Buying Farmland with a Growing Crop

Buying farmland with a growing crop presents unique tax issues.  It has to do with allocating the purchase price and the timing of deductions. 

When you buy farmland with a growing crop on it the tax Code requires that you allocate the purchase price between crops and land based on their relative fair market values.  You can’t deduct the cost of the portion of the land purchase allocated to the growing crop.  While the IRS has not been clear on the issue, the costs should be capitalized into the crop and deducted when the income from the crop is reported or fed to livestock, which may be in a year other than the year in which the crop is sold.

If you buy summer fallow ground, you can’t deduct or separately capitalize for later deduction the value of costs incurred before the purchase.  Additional costs incurred before harvest such as for hauling are deductible if you’re on the cash method.

One approach to consider that could lead to a better tax result might be to lease the land before the purchase.  That way you incur the planting costs and can deduct them rather than the landlord that will sell the farmland to you. 

If your considering buying farmland with a growing crop talk with your farm tax advisor so you get the best tax result possible for your particular situation.

What is Livestock?

The definition of “livestock” can come up in various settings.  For example, sometimes the tax Code says that bees are livestock for one purpose but are not for other purposes.  The issue of what is livestock can also arise in ag lending situations, ag contracts as well as zoning law and ordinances. 

What is “livestock”? The definition of “livestock” for purposes of determining whether an asset is used in a farming business includes “cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals.”  It does not include “poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, and reptiles.” While that definition normally does not include bees and other insects as livestock, the IRS has ruled that honeybees destroyed due to nearby pesticide use qualify for involuntary conversion treatment. 

When pledging livestock as collateral for an ag loan, it should be clear whether unborn young count as “livestock” subject to the security agreement.  From a contract standpoint, semen is not livestock unless defined as such. 

For zoning laws and ordinances, clarity is the key.  Is a potbellied pig “livestock” or a pet”?  Will an ordinance that bans livestock prohibit the keeping of bees in hives?  It probably won’t unless it specifically defines bees as “livestock.” 

Partition of Farmland

If your estate plan is to simply “let the children figure it out,” it’s likely instead that a judge will.  Indeed, one of those situations where a judge gets involved is when the parents have left farmland in co-equal ownership to multiple children after the last of the parents to die.  That often leads to a partition and sale with the proceeds being split among the children. 

Partition and sale of land is a legal remedy available if the co-owners cannot agree on whether to buy out one or more of them or sell the property and split the proceeds.  It’s often the result of a poorly planned estate where the surviving parent leaves the land equally to all of the children and not all of them want to farm or they simply can’t get along.  Because they each own an undivided interest in the entire property, they each have the right of partition to parcel out their interest.  But that rarely is the result because they aren’t able to establish that the tract can be split exactly equally between them in terms of soil type and slope, productivity, timber, road access, water and the like.  So, a court will order the entire property sold and the sale proceeds split equally.  That result can devastate an estate plan where the intent was to keep the farm in the family for future generations.

A little bit of estate planning can produce a much better result.

Crop Insurance Proposal

For many farmers, crop insurance is a key element of an effective risk management strategy. Private companies sell and service the policies, but taxpayers subsidize the premiums.  That means the public policy of crop insurance is a component of Farm Bill discussions.  There’s a current reform proposal on the table. 

A crop insurance reform proposal has been introduced in the U.S. House.  Its purpose is to help smaller farming operations get additional crop insurance coverage.  But its means for doing so is to eliminate premium subsidies for large farmers without providing additional coverage for smaller producers. 

The bill caps annual premium subsidies at $125,000 per farmer and eliminates them for farmers with more than $250,000 in adjusted gross income.  The bill also reduces the subsidies to crop insurance companies which is projected to reduce their profit from 14 percent to about 9 percent. 

In addition, the bill eliminates subsidies for Harvest Price Option and requires the USDA to disclose who gets subsidies and the amount.  It also restricts crop insurance to active farmers.

The bill represents a dramatic change to the crop insurance program.  There’s not really anything in the bill to help smaller farming operations, and if the bill passes all farmers would see an increase in crop insurance premiums. 

Veterinarian’s Lien

A lien gives the lienholder an enforceable right against certain property that can be used to pay a debt or obligations of the property's owner. Most states have laws that give particular persons a lien by statute in specific circumstances. These statutory liens generally have priority over prior perfected security interests.

The rationale behind statutory liens is that certain parties who have contributed inputs or services to another should have a first claim for payment.  But you have to be able to prove entitlement to the lien.

In a recent case, a veterinarian treated a rancher’s cattle.  The rancher didn’t pay the vet bill and while the bill remained outstanding, the vet came into possession of cattle that the rancher was grazing for another party.  The vet cared for the cattle for over two months and then filed a lien for his services.  Ultimately the cattle were sold at a Sheriff’s sale and the rancher’s lender claimed it had a prior lien on the proceeds.  Normally, the veterinarian’s lien would beat out the lender’s lien, but the court concluded that the veterinarian couldn’t establish who actually delivered the cattle to him or that the rancher requested his services. 

The court said the vet didn’t meet his burden of proof to establish that the lien was valid. While liens have position, their validity still must be established.

Digital Assets and Estate Planning

One often overlooked aspect of estate planning involves cataloguing where the decedent’s important documents are located and who has access to them.  The access issue is particularly important when it comes to the decedent’s digital assets such as accounts involving email, banks, credit cards and social media. 

Who has access to a decedent’s digital assets and information?  Certainly, the estate’s fiduciary should have access, but it’s the type of access that is the key.  The type of access, such as the ability to read the substance of electronic communications, should be clearly specified in the account owner’s will or trust.  If access to digital assets and information is to be granted to a third party before death, the type and extent of access should be set forth in a power of attorney. 

But, even with proper planning, it is likely that a service provider will require that the fiduciary obtain a court order before the release of any digital information or the granting of access. 

Digital assets are a very common piece of a decedent’s estate.  Make sure you have taken the needed steps to allow the proper people to have access post-death.  Doing so can save time and expense during the estate administration process.

There are also tax consequences of exchanging digital assets after death.

Conclusion

These are just a few items of things that have been on my mind recently.  I am sure more will surface soon.

KSU Tax Institutes – Kansas and Online

Overview

Dating back into the 1940’s, the Department of Agricultural Economics at Kansas State University has provided educational tax seminars for tax preparers.  I have been privileged to be a part of them since 1993.  These are outstanding seminars for all who prepare tax returns – CPAs; accountants; enrolled agents; attorneys; and all others that prepare tax returns professionally or for their own business, including farming operations.  With respect to farm returns, the last time survey data was compiled, it revealed that over 90 percent of all farm returns in Kansas were prepared by persons that attended a Kansas Tax Institute.  That’s impressive!

Dates and Locations

This year the institute will be held at six in-person locations across the state.  In addition, there will be two online institutes.  Each institute is a two-day conference.  Here are the dates and locations for each institute:

Online 1 – November 1 and 2

Garden City – November 6 and 7

Hays – November 8 and 9

Lawrence – November 20 and 21

Salina – November 27 and 28

Wichita – December 7 and 8

Pittsburg – December 13 and 14

Online 2 – December 18 and 19

Ethics

There will be a 2-hour ethics session for tax preparers on December 15.  This will be online only (as of this time). 

Speakers

Along with myself, this year’s speakers include Paul Neiffer (formerly of CliftonLarsonAllen); Prof. Ed Morse (Creighton Law School); and Cathy Murphy (formerly of IRS and now owner of Kingdom CPA Service, LLC in the St. Louis area).  Also, the Kansas Department of Revenue, represented by Carl York and Roger Basinger will make a presentation at each location.

Itinerary

The itinerary for each school as well as who is teaching each topic is as follows:

Online 1; Garden City; Hays; and Online 2

Day 1 [Roger McEowen; Paul Neiffer; and Carl York/Roger Basinger]

New Developments (Part 1)

• Employee Retention Credit
• Energy Credits; Corporate taxes; and healthcare and payroll tax provisions
• Form 1099-K issues

Ag Issues (Part 1)

• Deducting residual soil fertility
• Charitable remainder trusts
• Tax issues with easement payments
• Ag-related rulings and cases
  • Excise tax
  • Hobby losses
  • Lodging and meals
  • Conservation easements

Small Business Issues

• Planning and pitfalls of pass-through entity tax
• Corporate transparency act
• Form 7203
• Appendix – questions to consider in electing the PTE tax

 

Capitalization vs. Repair Review

• Fundamental concepts
• Capitalization vs. repair decisions
• Changing an accounting method
• Dispositions under the tangible property regulations

Select topics for Partnership Operations

• Partnership agreement
• Capital accounting
• Guaranteed payments
• Allocations
• Effect of I.R.C. §§734(b) and 743(b) adjustments
• Debt-financed acquisitions and distributions
• Partnerships and S.E. tax

Depreciation

• Applicability
• Computing basis
• Listed property limitations
• R.C. §179
• Bonus depreciation
• Depreciation system and method
• Recovery period for remaining basis
• Proper convention
• Change in business use
• Correcting errors

Retirement Plan Issues for Individuals

• Inherited retirement plans
• Secure Act 2.0
• Roth IRA update

Kansas Department of Revenue

• 2023 Legislative Changes
  • Discussion of various bills passed in the 2023 Legislative Session
• Updates to 2022 Legislation Session
  • Discussion could include updates to SALT Parity, Aerospace and Aviation Tax Credit,

and Homestead Senior and Disabled Veteran Claim (SVR)

• Changes impacting tax filings for 2023 and 2024
  • Personal Exemption for Disabled Veterans
  • Corporate Income Tax Reduction
  • Sales Tax Delivery Charges
  • Sales Tax Filing Frequency Changes
  • Research and Development Tax Credit

Rulings and Cases (Part 1)

Day 2 – [Roger McEowen and Cathy Murphy]

New Developments (Part 2)

• Changes to R&E and R&D Credit
• Retirement plan distributions
• Estate tax “clawback” and DSUEA ordering rules
• Digital asset taxation
• Expiring provisions

Ag Issues (Part 2)

• Buy-sell agreements
• Form 1041 for farm estates and trusts
• Tax treatment of R&E and R&D expenses
• Ag-related rulings and cases
  • Farming-related deductions
  • Entity tax issues
  • Real estate tax issues
  • Shareholder compensation

Individual Taxpayer Issues

• Estimated tax payments
• College cost planning
• Settling a taxpayer’s estate

Written Information Security Plans and Protecting Client Data

• Legislative mandates
• Creating a WISP
• WISP template
• Risk assessment
• Data attacks
• Involvement of outside IT services firms
• Discussion scenarios

IRS Update

• New Forms and instructions
• New 1099 filing procedures 
• Correspondence audits and secure messaging
• Timely mailed/ received dates for returns
• Statute of Limitations
• Offers in compromise

Independent Contractors

• Determining worker classification
• Tax home issues
• Gross income issues
• Treatment of equipment
• Travel expenses
• Meals and entertainment expenses
• Other expense issues
• SE tax
• State income tax issues

Ruling and Cases (Part 2)

Lawrence; Salina; Wichita; Pittsburg

Day 1 [Ed Morse and Carl York/Roger Basinger]

New Developments

• Employee Retention Credit
• Energy Credits; Corporate taxes; and healthcare and payroll tax provisions
• Form 1099-K issues
• Changes to R&E and R&D Credit
• Retirement plan distributions
• Estate tax “clawback” and DSUEA ordering rules
• Digital asset taxation
• Expiring provisions

Small Business Issues

• Planning and pitfalls of pass-through entity tax
• Corporate transparency act
• Form 7203
• Appendix – questions to consider in electing the PTE tax

 

Capitalization vs. Repair Review

• Fundamental concepts
• Capitalization vs. repair decisions
• Changing an accounting method
• Dispositions under the tangible property regulations

Select topics for Partnership Operations

• Partnership agreement
• Capital accounting
• Guaranteed payments
• Allocations
• Effect of I.R.C. §§734(b) and 743(b) adjustments
• Debt-financed acquisitions and distributions
• Partnerships and S.E. tax

Depreciation

• Applicability
• Computing basis
• Listed property limitations
• R.C. §179
• Bonus depreciation
• Depreciation system and method
• Recovery period for remaining basis
• Proper convention
• Change in business use
• Correcting errors

Retirement Plan Issues for Individuals

• Inherited retirement plans
• Secure Act 2.0
• Roth IRA update

Kansas Department of Revenue

• 2023 Legislative Changes
  • Discussion of various bills passed in the 2023 Legislative Session
• Updates to 2022 Legislation Session
  • Discussion could include updates to SALT Parity, Aerospace and Aviation Tax Credit,

and Homestead Senior and Disabled Veteran Claim (SVR)

• Changes impacting tax filings for 2023 and 2024
  • Personal Exemption for Disabled Veterans
  • Corporate Income Tax Reduction
  • Sales Tax Delivery Charges
  • Sales Tax Filing Frequency Changes
  • Research and Development Tax Credit

Rulings and Cases (Part 1)

 

Day 2 [Roger McEowen and Cathy Murphy]

IRS Topics [Supplemental Material]

Ag Issues

• Deducting residual soil fertility
• Charitable remainder trusts
• Tax issues with easement payments
• Ag-related rulings and cases
  • Excise tax
  • Hobby losses
  • Lodging and meals
  • Conservation easements
  • Farming-related deductions
  • Entity tax issues
  • Real estate tax issues
  • Shareholder compensation
• Buy-sell agreements
• Form 1041 for farm estates and trusts
• Tax treatment of R&E and R&D expenses
• Ag-related rulings and cases

Individual Taxpayer Issues

• Estimated tax payments
• College cost planning
• Settling a taxpayer’s estate

Written Information Security Plans and Protecting Client Data

• Legislative mandates
• Creating a WISP
• WISP template
• Risk assessment
• Data attacks
• Involvement of outside IT services firms
• Discussion scenarios

IRS Update

• New Forms and instructions
• New 1099 filing procedures 
• Correspondence audits and secure messaging
• Timely mailed/ received dates for returns
• Statute of Limitations
• Offers in compromise

Independent Contractors

• Determining worker classification
• Tax home issues
• Gross income issues
• Treatment of equipment
• Travel expenses
• Meals and entertainment expenses
• Other expense issues
• SE tax
• State income tax issues

 

Rulings and Cases (Part Two)

 

Registration Link

Here’s the link to find registration information about the Institutes:   https://agmanager.info/events/kansas-income-tax-institute

Conclusion

I hope to see you at one of the tax institutes.  If you can’t participate in-person, perhaps you can join online.  The institutes are top-notch instruction to get you fully prepared for the upcoming tax season.  You won’t find a better deal around for CPE/CLE on tax matters. 

Extended Livestock Replacement Period Applies in Areas of Extended Drought – IRS Updated Drought Areas

Overview

Each year, by the end of September, the IRS provides guidance on the extension of the replacement period under I.R.C. §1033(e)(2)(B) for livestock sold on account of drought, flood or other weather-related condition.  The extended replacement period allows taxpayers additional time to replace the involuntarily converted livestock with like-kind replacement animals without triggering gain on the sale.  Significant parts of the country in 2023 have experienced severe drought with many cattle being sold as a result.  That makes the tax rules surrounding distress sales of livestock critical to understand.

The IRS recently issued its 2023 guidance on the issue on the extended replacement period for drought (and other weather-related) sales of livestock.

Background

With Notice 2023-67, 2023-179, I.R.B., the IRS issued its annual Notice specifying those areas that are eligible for an extension of the replacement period for livestock that farmers and ranchers must sell because of severe weather conditions (drought, flood or other weather-related conditions).  For livestock owners in the listed areas that were anticipating that their replacement period would expire at the end of 2024 now have at least until the end of 2024 to replace the involuntarily converted livestock.

Involuntary Conversion Rules

In general.  I.R.C. §1033(e) provides that a taxpayer does not recognize gain when property is involuntarily converted and replaced with property that is similar or related in service or use.  Under I.R.C. §1033(e)(1), the sale or exchange of livestock that a taxpayer holds for draft, dairy or breeding purposes in an amount exceeding the number of livestock that the taxpayer would normally sell under the taxpayer’s usual business practice, is treated as a non-taxable involuntary conversion if the sale of the livestock is solely on account of drought, flood or other weather-related conditions. The weather-related conditions must result in the area being designated as eligible for assistance by the federal government. 

Note:   For purposes of this rule, poultry does not count as “livestock.”  Likewise, livestock raised for other purposes, such as slaughter or sport, are also not eligible for this relief.

The replacement period.  The livestock must be replaced with "like-kind" livestock. I.R.C. §1033(a)(1). Normally, the replacement period is four years from the close of the first tax year in which any part of the gain from the conversion is realized. I.R.C. §1033(e)(2)(A).  But the Treasury Secretary has discretion to extend the replacement period on a regional basis for “such additional time as the Secretary deems appropriate” (apparently without limit) if the weather-related conditions that resulted in the federal designation continue for more than three years.  I.R.C. §1033(e)(2)(B). If the IRS doesn’t extend the four-year replacement period, a taxpayer can request such an extension.  I.R.C. §1033(a)(2)(B)(ii). 

Note:  It is not clear when the three-year period begins.  It may begin on the date the area is designated as being eligible for assistance by the federal government or when the weather-related conditions begin.  IRS clarification is needed.

Note:  Any extension of the replacement period on a regional basis also extends the period in which a cash basis farmer may elect to defer gain for a year on the sale of excess livestock sold on account of weather-related conditions under I.R.C. §451(g). 

If the involuntary conversion of livestock is on account of drought and the taxpayer’s replacement period is determined under I.R.C. §1033(e)(2)(A), the extended replacement period under I.R.C. §1033(e)(2)(B) and Notice 2006-82, 2006-2 C.B. 529 is until the end of the taxpayer’s first taxable year after the first drought-free year for the applicable region.  That is defined as the first 12-month period that ends on August 31 in or after the last of the taxpayer’s four-year replacement period and does not include any weekly period for which exceptional, extreme or severe drought is reported for any location in the applicable region.  The “applicable region” is the county (and all contiguous counties) that experienced the drought conditions on account of which the livestock was sold or exchanged

Note:   If an area is designated as not having a drought-free year, the extended replacement period applies.

Thus, for a taxpayer who qualified for a four-year replacement period for livestock sold or exchanged on account of drought and whose replacement period is scheduled to expire at the end of 2022 (or, for a fiscal-year taxpayer, at the end of the first tax year that includes August 31, 2022), the replacement period extends until the end of the taxpayer’s first taxable year ending after a drought-free year for the applicable region.  In other words, eligible farmers and ranchers with a drought replacement period presently scheduled to expire on December 31, 2022, will now, in most instances, have until the end of their next tax year to replace the sold livestock (e.g., Dec. 31, 2023). 

Determining Eligible Locations

One way to determine if a taxpayer is in an area that has experienced exceptional, extreme or severe drought is to refer to the U.S. Drought Monitor maps that are produced on a weekly basis by the National Drought Mitigation Center  The U.S. Drought Monitor maps are archived at  https://droughtmonitor.unl.edu/Maps/MapArchive.aspx

Another way, of course, is to wait for the IRS to publish its list of counties, which it is required to issue by the end of September each year.

In accordance with the 2023 IRS Notice on the matter, the following is a list of the counties (and other areas) for which the 12-month period ending August 31, 2024, is not a drought-free year:

Alabama

Counties of Baldwin, Coffee, Colbert, Conecuh, Covington, Dale, Escambia, Geneva, Henry, Houston, Jackson, Lauderdale, Lawrence, Limestone, Madison, Marshall, Mobile, Monroe, Morgan, and Washington.

Arizona

Counties of Apache, Cochise, Coconino, Graham, Greenlee, La Paz, Mohave, Navajo, Pima, Santa Cruz, Yavapai, and Yuma.

Arkansas

Counties of Arkansas, Ashley, Baxter, Benton, Boone, Bradley, Calhoun, Carroll, Chicot, Clark, Clay, Cleburne, Cleveland, Columbia, Conway, Craighead, Crawford, Crittenden, Cross, Dallas, Desha, Drew, Faulkner, Franklin, Fulton, Garland, Grant, Greene, Hempstead, Hot Spring, Howard, Independence, Izard, Jackson, Jefferson, Johnson, Lafayette, Lawrence, Lee, Lincoln, Little River, Logan, Lonoke, Madison, Marion, Mississippi, Monroe, Montgomery, Nevada, Newton, Ouachita, Perry, Phillips, Pike, Poinsett, Polk, Pope, Prairie, Pulaski, Randolph, Saint Francis, Saline, Scott, Searcy, Sebastian, Sevier, Sharp, Stone, Union, Van Buren, Washington, White, Woodruff, and Yell.

California

Counties of Alameda, Alpine, Amador, Butte, Calaveras, Colusa, Contra Costa, Del Norte, El Dorado, Fresno, Glenn, Humboldt, Imperial, Inyo, Kern, Kings, Lake, Lassen, Los Angeles, Madera, Marin, Mariposa, Mendocino, Merced, Modoc, Mono, Monterey, Napa, Nevada, Orange, Placer, Plumas, Riverside, Sacramento, San Benito, San Bernardino, San Diego, San Francisco, San Joaquin, San Luis Obispo, San Mateo, Santa Barbara, Santa Clara, Santa Cruz, Shasta, Sierra, Siskiyou, Solano, Sonoma, Stanislaus, Sutter, Tehama, Trinity, Tulare, Tuolumne, Ventura, Yolo, and Yuba.

Colorado

Counties of Adams, Alamosa, Arapahoe, Baca, Bent, Cheyenne, Conejos, Costilla, Crowley, Custer, Delta, Denver, Dolores, Elbert, El Paso, Fremont, Garfield, Huerfano, Jackson, Kiowa, Kit Carson, La Plata, Larimer, Las Animas, Lincoln, Logan, Mesa, Moffat, Montezuma, Montrose, Morgan, Otero, Phillips, Prowers, Pueblo, Rio Blanco, Rio Grande, Routt, San Miguel, Sedgwick, Teller, Washington, Weld, and Yuma.

Connecticut

Counties of Fairfield, Hartford, Litchfield, Middlesex, New Haven, New London, Tolland, and Windham. Delaware County of Sussex. District of Columbia District of Columbia.

Florida

Counties of Alachua, Baker, Bay, Bradford, Brevard, Broward, Calhoun, Charlotte, Citrus, Collier, Columbia, DeSoto, Dixie, Escambia, Flagler, Franklin, Gadsden, Gilchrist, Glades, Gulf, Hamilton, Hardee, Hendry, Hernando, Highlands, Hillsborough, Holmes, Indian River, Jackson, Jefferson, Lafayette, Lake, Lee, Leon, Levy, Liberty, Madison, Manatee, Marion, Martin, Miami-Dade, Monroe, Okaloosa, Okeechobee, Orange, Osceola, Palm Beach, Pasco, Pinellas, Polk, Putnam, Saint Lucie, Santa Rosa, Sarasota, Seminole, Sumter, Suwannee, Taylor, Union, Volusia, Wakulla, Walton, and Washington.

Georgia

Counties of Baker, Baldwin, Banks, Barrow, Berrien, Bibb, Bleckley, Brooks, Butts, Cherokee, Clarke, Clayton, Clinch, Cobb, Colquitt, Cook, Crawford, Dawson, Decatur, DeKalb, Douglas, Early, Echols, Elbert, Fannin, Forsyth, Franklin, Fulton, Gilmer, Grady, Greene, Gwinnett, Habersham, Hall, Hancock, Hart, Henry, Houston, Jackson, Jasper, Jones, Lamar, Lanier, Laurens, Lincoln, Lowndes, Lumpkin, McDuffie, Madison, Miller, Mitchell, Monroe, Morgan, Murray, Newton, Oconee, Oglethorpe, Peach, Pickens, Pike, Pulaski, Putnam, Rabun, Rockdale, Seminole, Stephens, Taliaferro, Taylor, Thomas, Towns, Twiggs, Union, Upson, Walton, Warren, Washington, White, Wilkes, and Wilkinson.

Hawaii

Counties of Hawaii, Honolulu, Kalawao, Kauai, and Maui.

Idaho

Counties of Adams, Bannock, Bear Lake, Benewah, Blaine, Bonner, Bonneville, Boundary, Butte, Camas, Caribou, Cassia, Clearwater, Custer, Franklin, Fremont, Gooding, Idaho, Kootenai, Latah, Lemhi, Lewis, Lincoln, Minidoka, Nez Perce, Oneida, Owyhee, Power, Shoshone, Teton, Twin Falls, Valley, and Washington.

Illinois

Counties of Adams, Alexander, Bond, Boone, Brown, Bureau, Carroll, Cass, Champaign, Christian, Clark, Clay, Clinton, Coles, Cook, Crawford, Cumberland, DeKalb, De Witt, Douglas, DuPage, Edgar, Effingham, Fayette, Ford, Franklin, Fulton, Gallatin, Grundy, Hamilton, Hancock, Hardin, Henderson, Henry, Iroquois, Jackson, Jasper, Jefferson, Jo Daviess, Johnson, Kane, Kankakee, Kendall, Knox, Lake, La Salle, Lee, Livingston, Logan, McDonough, McHenry, McLean, Macon, Madison, Marion, Marshall, Mason, Massac, Menard, Mercer, Monroe, Morgan, Moultrie, Ogle, Peoria, Perry, Piatt, Pike, Pope, Pulaski, Putnam, Randolph, Rock Island, Saint Clair, Saline, Sangamon, Schuyler, Scott, Shelby, Stark, Stephenson, Tazewell, Union, Vermilion, Warren, Washington, Whiteside, Will, Williamson, Winnebago, and Woodford.

Indiana

Counties of Benton, Boone, Carroll, Cass, Clay, Clinton, DeKalb, Elkhart, Fayette, Fountain, Fulton, Hamilton, Hancock, Harrison, Hendricks, Henry, Howard, Jasper, Johnson, LaGrange, Lake, LaPorte, Madison, Marion, Miami, Montgomery, Morgan, Newton, Noble, Owen, Parke, Perry, Porter, Pulaski, Putnam, Randolph, Shelby, Starke, Steuben, Sullivan, Tippecanoe, Tipton, Union, Vermillion, Vigo, Warren, Wayne, and White.

Iowa

Counties of Adair, Adams, Allamakee, Appanoose, Audubon, Benton, Black Hawk, Bremer, Buchanan, Buena Vista, Butler, Calhoun, Carroll, Cass, Cedar, Cerro Gordo, Cherokee, Chickasaw, Clarke, Clay, Clayton, Clinton, Crawford, Dallas, Davis, Decatur, Delaware, Des Moines, Dickinson, Dubuque, Emmet, Fayette, Floyd, Franklin, Fremont, Greene, Grundy, Guthrie, Hamilton, Hancock, Hardin, Harrison, Henry, Howard, Humboldt, Ida, Iowa, Jackson, Jasper, Jefferson, Johnson, Jones, Keokuk, Kossuth, Lee, Linn, Louisa, Lucas, Lyon, Madison, Mahaska, Marion, Marshall, Mills, Mitchell, Monona, Monroe, Montgomery, Muscatine, O'Brien, Osceola, Page, Palo Alto, Plymouth, Pocahontas, Polk, Pottawattamie, Poweshiek, Ringgold, Sac, Scott, Shelby, Sioux, Story, Tama, Taylor, Union, Van Buren, Wapello, Warren, Washington, Wayne, Webster, Winnebago, Winneshiek, Woodbury, Worth, and Wright.

Kansas

Counties of Allen, Anderson, Atchison, Barber, Barton, Bourbon, Brown, Butler, Chase, Chautauqua, Cherokee, Cheyenne, Clark, Cloud, Coffey, Comanche, Cowley, Crawford, Decatur, Dickinson, Doniphan, Douglas, Edwards, Elk, Ellis, Ellsworth, Finney, Ford, Franklin, Geary, Gove, Graham, Grant, Gray, Greeley, Greenwood, Hamilton, Harper, Harvey, Haskell, Hodgeman, Jackson, Jefferson, Jewell, Johnson, Kearny, Kingman, Kiowa, Labette, Lane, Leavenworth, Lincoln, Linn, Logan, Lyon, McPherson, Marion, Marshall, Meade, Miami, Mitchell, Montgomery, Morris, Morton, Nemaha, Neosho, Ness, Norton, Osage, Osborne, Ottawa, Pawnee, Phillips, Pratt, Rawlins, Reno, Republic, Rice, Riley, Rooks, Rush, Russell, Saline, Scott, Sedgwick, Seward, Shawnee, Sheridan, Sherman, Smith, Stafford, Stanton, Stevens, Sumner, Thomas, Trego, Wabaunsee, Wallace, Washington, Wichita, Wilson, Woodson, and Wyandotte.

Kentucky

Counties of Adair, Allen, Anderson, Ballard, Barren, Bath, Boone, Bourbon, Boyd, Boyle, Bracken, Breckinridge, Bullitt, Butler, Caldwell, Calloway, Carlisle, Carroll, Carter, Casey, Christian, Clark, Crittenden, Daviess, Edmonson, Elliott, Estill, Fayette, Fleming, Franklin, Fulton, Gallatin, Garrard, Grant, Graves, Grayson, Green, Greenup, Hancock, Hardin, Harrison, Hart, Henry, Hickman, Hopkins, Jefferson, Jessamine, Kenton, Larue, Lawrence, Lee, Lewis, Lincoln, Livingston, Logan, Lyon, McCracken, McLean, Madison, Marion, Marshall, Mason, Meade, Menifee, Mercer, Metcalfe, Montgomery, Morgan, Muhlenberg, Nelson, Nicholas, Ohio, Oldham, Owen, Pendleton, Powell, Robertson, Rockcastle, Rowan, Scott, Shelby, Simpson, Spencer, Taylor, Todd, Trigg, Trimble, Union, Warren, Washington, Webster, Wolfe, and Woodford. Louisiana Parishes of Acadia, Allen, Ascension, Assumption, Avoyelles, Beauregard, Bienville, Bossier, Caddo, Calcasieu, Caldwell, Cameron, Catahoula, Concordia, De Soto, East Baton Rouge, East Carroll, East Feliciana, Evangeline, Franklin, Grant, Iberia, Iberville, Jackson, Jefferson, Jefferson Davis, Lafayette, Lafourche, La Salle, Livingston, Madison, Morehouse, Natchitoches, Orleans, Ouachita, Plaquemines, Pointe Coupee, Rapides, Red River, Richland, Sabine, Saint Bernard, Saint Charles, Saint Helena, Saint James, Saint John the Baptist, Saint Landry, Saint Martin, Saint Mary, Saint Tammany, Tangipahoa, Tensas, Terrebonne, Vermilion, Vernon, Washington, Webster, West Baton Rouge, West Carroll, West Feliciana, and Winn.

Maine

Counties of Androscoggin, Cumberland, Knox, Lincoln, Sagadahoc, Waldo, and York.

Maryland

City of Baltimore.

Counties of Anne Arundel, Baltimore, Carroll, Frederick, Harford, Howard, Montgomery, and Prince George's.

Massachusetts

Counties of Barnstable, Berkshire, Bristol, Dukes, Essex, Franklin, Hampden, Hampshire, Middlesex, Norfolk, Plymouth, Suffolk, and Worcester. Michigan County of Allegan, Barry, Branch, Cass, Clinton, Eaton, Genesee, Gogebic, Gratiot, Hillsdale, Ingham, Ionia, Jackson, Kent, Lake, Lapeer, Lenawee, Livingston, Macomb, Manistee, Mason, Missaukee, Monroe, Montcalm, Oakland, Ontonagon, Osceola, Saint Clair, Saint Joseph, Sanilac, Shiawassee, Washtenaw, Wayne, and Wexford.

Minnesota

Counties of Aitkin, Anoka, Becker, Beltrami, Benton, Big Stone, Blue Earth, Brown, Carlton, Carver, Cass, Chippewa, Chisago, Clay, Clearwater, Cottonwood, Crow Wing, Dakota, Dodge, Faribault, Fillmore, Freeborn, Goodhue, Grant, Hennepin, Houston, Hubbard, Isanti, Itasca, Jackson, Kanabec, Kandiyohi, Kittson, Koochiching, Lac qui Parle, Lake, Lake of the Woods, Le Sueur, Lincoln, Lyon, McLeod, Marshall, Martin, Meeker, Mille Lacs, Morrison, Mower, Murray, Nicollet, Nobles, Norman, Olmsted, Otter Tail, Pine, Pipestone, Pope, Ramsey, Redwood, Renville, Rice, Rock, Roseau, Saint Louis, Scott, Sherburne, Sibley, Stearns, Steele, Stevens, Swift, Todd, Traverse, Wabasha, Wadena, Waseca, Washington, Watonwan, Wilkin, Winona, Wright, and Yellow Medicine.

Mississippi

Counties of Adams, Amite, Bolivar, Claiborne, Coahoma, Copiah, Covington, DeSoto, Forrest, Franklin, George, Greene, Hancock, Harrison, Hinds, Holmes, Humphreys, Issaquena, Jackson, Jefferson, Jefferson Davis, Lafayette, Lamar, Lawrence, Leflore, Lincoln, Madison, Marion, Marshall, Panola, Pearl River, Perry, Pike, Pontotoc, Quitman, Rankin, Sharkey, Simpson, Smith, Stone, Sunflower, Tate, Tunica, Union, Walthall, Warren, Washington, Wilkinson, and Yazoo.

Missouri

Counties of Adair, Andrew, Atchison, Audrain, Barry, Barton, Bates, Benton, Bollinger, Boone, Buchanan, Butler, Caldwell, Callaway, Camden, Cape Girardeau, Carroll, Carter, Cass, Cedar, Chariton, Christian, Clark, Clay, Clinton, Cole, Cooper, Crawford, Dade, Dallas, Daviess, DeKalb, Dent, Douglas, Dunklin, Franklin, Gasconade, Greene, Grundy, Harrison, Henry, Hickory, Holt, Howard, Howell, Iron, Jackson, Jasper, Jefferson, Johnson, Knox, Laclede, Lafayette, Lawrence, Lewis, Lincoln, Linn, Livingston, McDonald, Macon, Madison, Maries, Marion, Mercer, Miller, Mississippi, Moniteau, Monroe, Montgomery, Morgan, New Madrid, Newton, Oregon, Osage, Ozark, Pemiscot, Perry, Pettis, Phelps, Pike, Platte, Polk, Pulaski, Putnam, Ralls, Randolph, Ray, Reynolds, Ripley, Saint Charles, Saint Clair, Sainte Genevieve, Saint Francois, Saint Louis, Saline, Schuyler, Scotland, Scott, Shannon, Shelby, Stoddard, Stone, Sullivan, Taney, Vernon, Warren, Washington, Wayne, Webster, and Wright.

Montana

Counties of Beaverhead, Blaine, Broadwater, Cascade, Chouteau, Custer, Daniels, Dawson, Deer Lodge, Fallon, Fergus, Flathead, Gallatin, Garfield, Glacier, Granite, Hill, Jefferson, Judith Basin, Lake, Lewis and Clark, Liberty, Lincoln, McCone, Madison, Meagher, Mineral, Missoula, Petroleum, Phillips, Pondera, Powell, Prairie, Ravalli, Richland, Roosevelt, Sanders, Sheridan, Silver Bow, Teton, Toole, Valley, Wheatland, and Wibaux.

Nebraska

Counties of Adams, Antelope, Arthur, Banner, Blaine, Boone, Box Butte, Boyd, Brown, Buffalo, Burt, Butler, Cass, Cedar, Chase, Cherry, Cheyenne, Clay, Colfax, Cuming, Custer, Dakota, Dawes, Dawson, Deuel, Dixon, Dodge, Douglas, Dundy, Fillmore, Franklin, Frontier, Furnas, Gage, Garden, Garfield, Gosper, Grant, Greeley, Hall, Hamilton, Harlan, Hayes, Hitchcock, Holt, Hooker, Howard, Jefferson, Johnson, Kearney, Keith, Keya Paha, Kimball, Knox, Lancaster, Lincoln, Logan, Loup, McPherson, Madison, Merrick, Morrill, Nance, Nemaha, Nuckolls, Otoe, Pawnee, Perkins, Phelps, Pierce, Platte, Polk, Red Willow, Richardson, Rock, Saline, Sarpy, Saunders, Scotts Bluff, Seward, Sheridan, Sherman, Sioux, Stanton, Thayer, Thomas, Thurston, Valley, Washington, Wayne, Webster, Wheeler, and York.

Nevada

City of Carson City.

Counties of Churchill, Clark, Douglas, Elko, Esmeralda, Eureka, Humboldt, Lander, Lincoln, Lyon, Mineral, Nye, Pershing, Storey, Washoe, and White Pine.

New Hampshire

Counties of Cheshire, Hillsborough, Merrimack, Rockingham, and Strafford.

New Jersey

Counties of Atlantic, Bergen, Cape May, Cumberland, Essex, Hudson, Hunterdon, Mercer, Middlesex, Monmouth, Morris, Passaic, Salem, Somerset, Sussex, and Union.

New Mexico

Counties of Bernalillo, Catron, Chaves, Cibola, Colfax, Curry, DeBaca, Dona Ana, Eddy, Grant, Guadalupe, Harding, Hidalgo, Lea, Lincoln, Los Alamos, Luna, McKinley, Mora, Otero, Quay, Rio Arriba, Roosevelt, Sandoval, San Juan, San Miguel, Santa Fe, Sierra, Socorro, Taos, Torrance, Union, and Valencia.

New York

Counties of Bronx, Columbia, Dutchess, Kings, Nassau, New York, Orange, Putnam, Queens, Richmond, Rockland, Suffolk, Ulster, and Westchester.

North Carolina

Counties of Cherokee, Clay, Graham, Jackson, Macon, Swain, and Transylvania.

North Dakota

Counties of Barnes, Benson, Billings, Bottineau, Bowman, Burke, Burleigh, Cass, Cavalier, Dickey, Divide, Dunn, Eddy, Emmons, Foster, Golden Valley, Griggs, Hettinger, Kidder, LaMoure, Logan, McHenry, McIntosh, McKenzie, McLean, Mountrail, Nelson, Pembina, Pierce, Ramsey, Ransom, Renville, Richland, Rolette, Sargent, Sheridan, Sioux, Slope, Stark, Steele, Stutsman, Towner, Traill, Walsh, Ward, Wells, and Williams.

Ohio

Counties of Adams, Brown, Clermont, Darke, Preble, Scioto, and Williams.

Oklahoma

Counties of Adair, Alfalfa, Atoka, Beaver, Beckham, Blaine, Bryan, Caddo, Canadian, Carter, Cherokee, Choctaw, Cimarron, Cleveland, Coal, Comanche, Cotton, Craig, Creek, Custer, Delaware, Dewey, Ellis, Garfield, Garvin, Grady, Grant, Greer, Harmon, Harper, Haskell, Hughes, Jackson, Jefferson, Johnston, Kay, Kingfisher, Kiowa, Latimer, Le Flore, Lincoln, Logan, Love, McClain, McCurtain, McIntosh, Major, Marshall, Mayes, Murray, Muskogee, Noble, Nowata, Okfuskee, Oklahoma, Okmulgee, Osage, Ottawa, Pawnee, Payne, Pittsburg, Pontotoc, Pottawatomie, Pushmataha, Roger Mills, Rogers, Seminole, Sequoyah, Stephens, Texas, Tillman, Tulsa, Wagoner, Washington, Washita, Woods, and Woodward.

Oregon

Counties of Baker, Benton, Clackamas, Clatsop, Crook, Deschutes, Douglas, Gilliam, Grant, Harney, Hood River, Jackson, Jefferson, Josephine, Klamath, Lake, Lane, Lincoln, Linn, Malheur, Marion, Morrow, Multnomah, Polk, Sherman, Tillamook, Umatilla, Union, Wallowa, Wasco, Wheeler, and Yamhill. Pennsylvania Counties of Lancaster and York.

Rhode Island

Counties of Bristol, Kent, Newport, Providence, and Washington.

South Carolina Counties of Abbeville, Anderson, Greenville, Laurens, McCormick, Oconee, Pickens, and Spartanburg.

South Dakota

Counties of Aurora, Beadle, Bennett, Bon Homme, Brookings, Brown, Brule, Buffalo, Campbell, Charles Mix, Clark, Clay, Codington, Corson, Custer, Davison, Day, Deuel, Dewey, Douglas, Edmunds, Fall River, Faulk, Grant, Gregory, Haakon, Hand, Hanson, Hutchinson, Jackson, Jerauld, Kingsbury, Lake, Lawrence, Lincoln, Lyman, McCook, McPherson, Marshall, Meade, Mellette, Miner, Minnehaha, Moody, Oglala Lakota, Pennington, Roberts, Sanborn, Spink, Stanley, Todd, Tripp, Turner, Union, Walworth, Yankton, and Ziebach.

Tennessee

Counties of Bedford, Benton, Bledsoe, Blount, Bradley, Cannon, Carroll, Chester, Coffee, Davidson, Decatur, DeKalb, Dyer, Franklin, Gibson, Giles, Grundy, Hamilton, Hardin, Henderson, Henry, Hickman, Houston, Humphreys, Lake, Lauderdale, Lawrence, Lewis, Lincoln, Loudon, McMinn, McNairy, Madison, Marion, Marshall, Meigs, Monroe, Montgomery, Moore, Obion, Perry, Polk, Rhea, Roane, Rutherford, Sequatchie, Shelby, Stewart, Sumner, Tipton, Van Buren, Warren, Wayne, Weakley, White, Williamson, and Wilson.

Texas

Counties of Anderson, Andrews, Angelina, Aransas, Archer, Armstrong, Atascosa, Austin, Bailey, Bandera, Bastrop, Baylor, Bee, Bell, Bexar, Blanco, Borden, Bosque, Bowie, Brazoria, Brazos, Brewster, Briscoe, Brooks, Brown, Burleson, Burnet, Caldwell, Calhoun, Callahan, Cameron, Carson, Castro, Chambers, Cherokee, Childress, Clay, Cochran, Coke, Coleman, Collin, Collingsworth, Colorado, Comal, Comanche, Concho, Cooke, Coryell, Cottle, Crane, Crockett, Crosby, Culberson, Dallam, Dallas, Dawson, Deaf Smith, Delta, Denton, DeWitt, Dickens, Dimmit, Donley, Duval, Eastland, Ector, Edwards, Ellis, El Paso, Erath, Falls, Fannin, Fayette, Fisher, Floyd, Foard, Fort Bend, Freestone, Frio, Gaines, Galveston, Garza, Gillespie, Glasscock, Goliad, Gonzales, Gray, Grayson, Gregg, Grimes, Guadalupe, Hale, Hall, Hamilton, Hansford, Hardeman, Hardin, Harris, Harrison, Hartley, Haskell, Hays, Hemphill, Henderson, Hidalgo, Hill, Hockley, Hood, Hopkins, Houston, Howard, Hudspeth, Hunt, Hutchinson, Irion, Jack, Jackson, Jasper, Jeff Davis, Jefferson, Jim Hogg, Jim Wells, Johnson, Jones, Karnes, Kaufman, Kendall, Kenedy, Kent, Kerr, Kimble, King, Kinney, Kleberg, Knox, Lamar, Lamb, Lampasas, La Salle, Lavaca, Lee, Leon, Liberty, Limestone, Lipscomb, Live Oak, Llano, Loving, Lubbock, Lynn, McCulloch, McLennan, McMullen, Madison, Marion, Martin, Mason, Matagorda, Maverick, Medina, Menard, Midland, Milam, Mills, Mitchell, Montague, Montgomery, Moore, Motley, Nacogdoches, Navarro, Newton, Nolan, Nueces, Ochiltree, Oldham, Orange, Palo Pinto, Panola, Parker, Parmer, Pecos, Polk, Potter, Presidio, Randall, Reagan, Real, Red River, Reeves, Refugio, Roberts, Robertson, Rockwall, Runnels, Rusk, Sabine, San Augustine, San Jacinto, San Patricio, San Saba, Schleicher, Scurry, Shackelford, Shelby, Sherman, Smith, Somervell, Starr, Stephens, Sterling, Stonewall, Sutton, Swisher, Tarrant, Taylor, Terrell, Terry, Throckmorton, Tom Green, Travis, Trinity, Tyler, Upton, Uvalde, Val Verde, Van Zandt, Victoria, Walker, Waller, Ward, Washington, Webb, Wharton, Wheeler, Wichita, Wilbarger, Willacy, Williamson, Wilson, Winkler, Wise, Yoakum, Young, Zapata, and Zavala.

Utah

Counties of Beaver, Box Elder, Cache, Carbon, Daggett, Davis, Duchesne, Emery, Garfield, Grand, Iron, Juab, Kane, Millard, Morgan, Piute, Rich, Salt Lake, San Juan, Sanpete, Sevier, Summit, Tooele, Uintah, Utah, Wasatch, Washington, Wayne, and Weber.

Vermont

County of Windham.

Virginia City of Falls Church.

Counties of Accomack, Clarke, Fairfax, Fauquier, Frederick, Loudoun, Northampton, Rappahannock, Shenandoah, and Warren.

Washington

Counties of Asotin, Benton, Chelan, Clallam, Columbia, Cowlitz, Franklin, Garfield, Grays Harbor, Jefferson, King, Kitsap, Kittitas, Lewis, Mason, Okanogan, Pacific, Pend Oreille, Pierce, San Juan, Skagit, Skamania, Snohomish, Stevens, Thurston, Wahkiakum, Walla Walla, Whatcom, Whitman, and Yakima. West Virginia County of Jefferson.

Wisconsin

Counties of Adams, Ashland, Barron, Bayfield, Brown, Buffalo, Burnett, Calumet, Chippewa, Clark, Columbia, Crawford, Dane, Dodge, Douglas, Dunn, Fond du Lac, Forest, Grant, Green, Green Lake, Iowa, Iron, Jackson, Jefferson, Juneau, Kenosha, La Crosse, Lafayette, Langlade, Lincoln, Manitowoc, Marathon, Marquette, Milwaukee, Monroe, Oneida, Outagamie, Ozaukee, Pepin, Pierce, Polk, Portage, Price, Racine, Richland, Rock, Rusk, Saint Croix, Sauk, Sawyer, Sheboygan, Taylor, Vernon, Vilas, Walworth, Washburn, Washington, Waukesha, Waupaca, Waushara, Winnebago, and Wood.

Wyoming

Counties of Albany, Campbell, Carbon, Converse, Fremont, Goshen, Laramie, Lincoln, Niobrara, Park, Platte, Sublette, Sweetwater, Teton, Uinta, and Weston.

Federated States of Micronesia

State of Kapingamarangi.

Republic of the Marshall Islands

Atoll of Wotje.

Commonwealth of Puerto Rico

Municipalities of Aibonito, Arecibo, Barranquitas, Camuy, Cayey, Cidra, Coamo, Guayama, Hatillo, Isabela, Lares, Orocovis, Quebradillas, Salinas, San Sebastian, Utuado, and Villalba.

United States Virgin Islands

Islands of Saint Croix, Saint John, and Saint Thomas.

Of Accounting Methods, Farmland Leases and Farm Program Benefits

Overview

An accounting method is the manner in which a taxpayer reports income and deducts business-related expenses.  Under the cash method, income is reported in the year it is received, and expenses are deducted in the year they are paid.  I.R.C. §461(a).  Conversely, taxpayers on the accrual method keep a closing and opening inventory and take into account income when it is earned (when it accrues) rather than when sold, and expenses when incurred rather than when paid.  For accrual basis taxpayers, income is reported when it shows up in the closing inventory.  Accrual basis taxpayers may have a more even income stream, but there are some very significant tax negatives associated with accrual accounting such as its relative complexity as compared with cash accounting. 

Note:  Farm taxpayers that utilize cash accounting taxpayers practically always hold inventory that has not been reported as income.   At death, the potential gain is eliminated as property takes on a new basis at death equal to fair market value (except for items categorized as “income in respect of decedent”).  Consequently, it is usually advantageous for a farmer or rancher to use the cash method of accounting. 

Farming businesses, in general, can use the cash method of accounting, and most do.  A taxpayer generally may adopt any permissible method. Treas. Reg. Sec. 1.446-1(e)(1). 

But, certain rules apply when a taxpayer changes from one method of accounting to another.  Those rules came up in a case involving an Arkansas farming corporation involving the corporation’s tax treatment of income and deductions associated with its leasing of farmland.

Change in accounting method rules – it’s the topic of today’s post.

Computation of Taxable Income

A taxpayer computes taxable income “under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.”  I.R.C. §446(a).  By definition, an accounting method consists of both the overall plan of accounting for gross income or deductions and the treatment of any material item used in that overall plan.  Treas. Reg. Sec. 1.446-1(e)(2)(ii).  Once an accounting method has been adopted, the general rule is that it cannot be changed without IRS consent.  I.R.C. §446(e).  A change in the treatment of an asset from non-depreciable or nonamortizable to depreciable or amortizable, or vice versa, is a change in the taxpayer’s method of accounting.  Treas. Reg. §1.446-1(e)(2)(ii)(d)(2).  In addition, such a change in treatment results in an adjustment under I.R.C. §481to prevent the duplication or omission of income or deductions and to reflect the cumulative difference between the old and new methods.  Treas. Reg. §446-1(e)(2)(ii)(d)(5)(ii). 

Note:  A change in the method of accounting does not include a change in treatment resulting from a change in the underlying facts.  Treas. Reg. §1.446-1(e)(2)(ii)(b). 

Accounting Methods and Farming

Many farmers participate in the federal government’s farm programs and receive farm program payments.  The amount of payments a farm is eligible to receive is tied to the farm “base acres.” In other words, base acres is farmland that establishes a “base” for the right to receive farm subsidies for the production of certain commodities.  Base acres are a farm’s crop specific acreage of wheat, feed grains, rice, oilseeds, pulse crops, or peanuts that are eligible to be used for Farm Service Agency (FSA) program purposes.  Base acres do not necessarily align with current plantings.  For instance, upland cotton base acres on the farm are renamed “generic” base acres.   

Note:  A farmer’s base acreage is reduced by the portion of cropland placed in the Conservation Reserve Program (CRP) but is increased by CRP base acreage leaving the CRP.

Government allotments or quotas.  Historically, farmers have been required to participate in acreage allotments.  An acreage allotment is a particular farm’s share, based on its historic production, of the national acreage needed to produce sufficient supplies of a particular crop.  In essence, an allotment represents the federal government’s attempt to micro-manage production of certain types of crops.  These allotments have been held to not be depreciable due to a lack of a determinable useful life.  For example, in Wenzel v. Comr., T.C. Memo. 1991-166, the Tax Court addressed the peanut base acreage allotment as part of the federal farm programs was depreciable.  The Tax Court noted that while the program had been controversial for some time, it continued to be reauthorized by subsequent farm bills.  Thus, the Tax Court determined that the peanut program was a stable program that would continue unless the Congress took action to terminate it.  Because the actions of Congress were completely unpredictable, the Tax Court held that the peanut program base acreage allotment was indeterminant and the associated cost to the taxpayer was not depreciable. 

Later, in C.C.A. 200429001 (Jul. 16, 2004), the IRS noted that three additional Farm Bills had become law since the Tax Court’s ruling in Wenzel and the peanut program continued.  That lead the IRS to conclude that the duration of the peanut program could not be determined with reasonable certainty or accuracy.  Consequently, the IRS determined, the peanut base acreage allotment did not have a determinable useful life and could not be depreciated.   But a transferable right to receive a premium price for a fixed quantity of milk in accordance with a regional milk marketing order has been held to be amortizable (e.g., the cost could be spread over the useful life – 15 years) when it has a statutory expiration date and is not expected to be renewed.  For example, in Van de Steeg v. Comr., 60 T.C. 17 (1973), aff’d., 510 F2d 961 (9th Cir. 1975), the taxpayers were dairy farmers who marketed their milk production subject to a Federal Milk Marketing Order.  On several occasions they purchased an intangible asset (referred to as a "class I milk base") which they used in their dairy business. They claimed depreciation for the milk base and IRS disallowed the deduction on the basis that the asset had an indeterminable useful life – it depended on the will of the Congress whether to extend the program.  The Tax Court (affirmed by the Ninth Circuit) held that the program that created the class I milk base always contained an express termination date and the existence of two extensions did not change the fact that a termination date always existed, even though the date had changed. 

Note:  While the IRS disagrees with the Van de Steeg opinion, it did announce that it would follow it.  Rev. Rul. 75-466, 1975-2 C.B. 74.

Changing Tax Treatment of “Base” Acres

Conmac Investments, Inc. v. Comr., T.C. Memo. 2023-40

In this case, the petitioner was a corporation that owned and leased farmland to tenant farmers under oral leases.  The petitioner did not personally farm any of the land, but was a mere investor.  The petitioner's line of business involved  the retail sale of new and used automobiles.  The farmland contained “base acres” –such as wheat, corn, soybeans, cotton, rice, etc., from the USDA.  The farm program payments (paid pursuant to the 2008 and 2014 Farm Bills) were paid to the tenants.  Under the oral leases, the tenants received all of the payments attributable to the base acres and the annual rent payment was generally 25 percent of the gross income from the farmland, with “gross income from the farmland” including any farm subsidy payments received on account of the base acres. 

Before 2009, the petitioner did not claim any deductions for amortization or depreciation of the base acres.  But, starting in 2009, the petitioner began claiming an amortization or depreciation deduction for base acres acquired and placed in service in 2004 through 2013 (i.e., asserting an ownership interest in an intangible asset).  Changing the treatment of an asset from non-depreciable to depreciable or non-amortizable to amortizable (or vice-versa) is a change of accounting that results in an I.R.C. §481 adjustment.

Note:  Why the petitioner decided to claim deductions against, essentially, cash rent, is not known.  It was the tenants that were assuming the risk of production under the leases, not the petitioner.  In essence, the petitioners started claiming deductions against guaranteed rental income without assuming any of the risk of the expenses under the leases. 

However, the petitioner did not attach Form 3115 (application for change in accounting method) to its Form 1120 (corporate tax return) or otherwise seek IRS consent to change its accounting method.  The petitioner also did not file amended returns with an explanatory statement for all open years reclassifying the base acres as amortizable under I.R.C. §197.  The petitioner also did not adopt the same accounting treatment for all bases acres that it owned. 

The IRS determined that the petitioner had adopted an impermissible method of accounting and asserted deficiencies of approximately $116,000 for 2013 and $114,000 for 2014, and that an I.R.C. §481 adjustment of $141,614 for 2009-2012 was required.  The petitioner claimed that it had not changed its accounting method because of a change in underlying facts impacting its business.  In addition, the petitioner claimed that even if there weren’t a change in the underlying facts that supported an accounting method change, the lack of IRS consent didn’t matter because the relevant tax years had closed.  The petitioner also claimed that an I.R.C. §481 adjustment wasn’t necessary because it should have been made for the “year of change” (e.g., 2009) and that IRS could no longer require the adjustment because 2009 was a closed tax year.

The Tax Court (opinion by Judge Paris) agreed with the IRS noting that the petitioner had changed an accounting method in violation of I.R.C. §446(e) which requires IRS consent for such a change, and that an I.R.C. §481 adjustment was proper.  The facts did not involve the application of an existing accounting method to a change in business practices.  Indeed, there was no change in business practices - the petitioner continued to serve as landlord to the tenant farmers and didn’t change the terms of the leases.  Instead, the only economic consequence was the tax benefit that the petitioner received on account of the change – there was no change in existing legal or economic relationships. In addition, the petitioner continued to treat base acres acquired and placed in service in other years as nonamortizable or non-depreciable.  The Tax Court determined that the petitioner has simply made a business decision in 2009 to start claiming amortization deductions on farmland what it had acquired and placed in service beginning in 2004.  The corporation, the Tax Court pointed out, failed to identify the facts that had changed that caused it to change its tax treatment of the rented farmland.

Note:  Judge Paris brought up on her own the case of Comr. v. Brookshire Bros. Holding, Inc., 320 F.3d 507 (5th Cir. 2003), aff’g., T.C. Memo. 2001-150.  In that case, the appellate court, affirming the Tax Court, held that an IRS challenge to a method change for which consent was not given must be for the year of the improper change, and that failure to obtain prior consent did not serve as a basis to challenge the change for a closed year.  Judge Paris distinguished Brookshire on the basis that the corporation in the present case did not file amended returns with an explanatory statement for all open years reclassifying the base acres. In addition, based on the corporation’s inconsistent treatment of the base acres depending on the year the farmland was placed in service, the Tax Court determined that finding an unauthorized change in accounting would promote consistency and wouldn’t offend basic fairness.

The Tax Court also sustained the I.R.C. §481 adjustment.  The Tax Court rejected the petitioner’s argument that the I.R.C. §481 adjustment was barred by the statute of limitations after finding that the “year of the change” was the oldest open tax year.  The Tax Court explained that the only limitation on an I.R.C. §481(a) adjustment is that no pre-1954 adjustments may be made.  So long as a change in an accounting method has occurred, the IRS may adjust a taxpayer’s income in an open year to reflect amounts attributable to years for which the applicable statute of limitations has expired (i.e., time-barred years).  Huffman v. Comr., 518 F.3d 357 (6th Cir. 2008), aff’g., 126 T.C. 322 (2006). 

Conclusion

The bottom line in Conmac was that the petitioner’s failure to get IRS permission under I.R.C. §446(e) prevented the corporation from implementing an accounting method change with respect to the base acres rented to tenants for tax years 2009-2014.  As a result, the petitioner had tax deficiencies to pay and had to include in income for 2013 a positive I.R.C. §481 adjustment for I.R.C. §197 amortization deductions claimed for the base acres for 2009-2012. 

Not understanding the tax nuances of agricultural leases and the tax treatment of ag-related intangibles, as well as the procedures for changing accounting methods ending up costing the petitioner a large sum in tax deficiencies (about $100,000) an I.R.C. §481 adjustment of about $141,000 plus attorney fees. 

Developments in Ag Law and Ag Tax

Overview

In recent weeks, a number of important and interesting developments have occurred in the realm of agricultural law and taxation.  The subjects include various tax issues; oil and gas; state taxation issues; IRS information; and farm program payments.

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

Revised Form I-9

Form I-9 is an important document for ag employers hiring workers.  It verifies the identity and employment authorization of farm employees and protects the employer from penalties associated with improper hires.  A new version of the Form became available on August 1 and it’s this version that must be used starting November 1.   

All U.S. employers must ensure proper completion of Form I-9 for each individual hired, and whether the employment involves citizens or noncitizens. While agriculture is often treated differently under the law in many situations, that’s not the case when it comes to Form I-9.  There is no exception based on size of the farming operation or for family owned farming businesses.

The Form applies to employment situations.  It doesn’t apply when a farmer hires custom work or work to be done as an independent contractor.

A revised version of Form I-9 became available on August 1.  The Form has been condensed in some instances and it clarifies the difference between “noncitizen national” and “noncitizen authorized to work.”  Also, the revised Form can be filled out on tablets and mobile devices, and a checkbox has been added for employers to indicate when they have remotely examined Form I-9 documents.  Certain other revisions have been made and the Instructions for the Form have also been updated. 

Both employees and employers must complete the Form within three days of the hire.  Employers must retain the Form and make it available for inspection. 

You can access the new version here:  https://www.uscis.gov/sites/default/files/document/forms/i-9.pdf  The government’s summary of the revised Form is here:  https://www.uscis.gov/sites/default/files/document/fact-sheets/FormI9SummaryofChangesFactSheet.pdf

Florida Foreign Ownership Law in Effect – Injunction Denied

Ownership of U.S. land, specifically agricultural lands, by foreign persons or entities has been an issue that traces to the origins of the United States. Today, approximately fourteen states specifically forbid or limit nonresident aliens, foreign businesses and corporations, and foreign governments from acquiring or owning an interest in agricultural land within their state. Although these states have instituted restrictions, each state has taken its own approach. In other words, a uniform approach to restricting foreign ownership has not been established because state laws vary widely.

Currently, the following states restrict (in one fashion or another) foreign ownership of agricultural land.  about one-half of the states restrict agricultural land acquisition by aliens.  AL, AR, FL, HI, ID, IN, IA, KS, KY, LA, MN, MS, MO, MT, NE, ND, OH, OK, PA, SC, SD, TN, UT, VA, WI,   

The states with the most restrictive laws are IA, KY, MN, MO, NE, ND, OK, SD and WI.  The other 16 states have minor restrictions on foreign ownership of agricultural land. 

Recently, the issue of restricting foreign investment in and/or ownership of agricultural land has been raised in Alabama, Arizona, Arkansas, California, Florida, Indiana, Iowa, Mississippi, Missouri, Montana, North Dakota, Oklahoma, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, Washington, and Wyoming. Each of these states have proposed, or planned to propose, legislation restricting foreign ownership and/or investment in agricultural land to varying degrees.  Several high-profile events have spurred this renewed interest including a Chinese-owned company acquiring over 130,000 acres near an Air Force base in Texas and a 300-acre purchase by another Chinese company near a different Air Force base in North Dakota.  Also, the slow “fly-over” of a Chinese spy balloon from Alaska to South Carolina, mysterious damages to many food processing facilities, pipelines and rail transportation have contributed to the growing interest in national security and restrictions on ownership of U.S. farm and ranchland by known adversaries.

The Florida provision limits landownership rights of certain noncitizens that are domiciled either in China or other countries that are a “foreign country of concern.”  Fla. Stat. §§692.201-.204.   The countries considered as a FCOC under the law include China; Russia; Iran; North Korea; Cuba; Venezuela’s Nicolás Maduro regime; and Syria. Four Chinese citizens living in Florida, along with a real estate brokerage firm, claimed that the law violated their equal protection rights because it restricts their ability to purchase real property due to their race. They also claimed that the law violated the Due Process Clause and the Supremacy Clause of the Constitution and the Fair Housing Act (FHA). Under the law, Chinese investors that are not U.S. citizens that hold or acquire and interest in real property in Florida on or after July 1, 2023, must report their interests to the state or be potentially fined $1,000 per day the report is late.  Chinese acquisitions after July 1, 2023, are subject to forfeiture to the state with such acquisitions constituting a third-degree felony.  The seller commits a first-degree misdemeanor for knowingly violating the law.

The plaintiffs sought an injunction against the implementation of the law before it went into effect on July 1, 2023.  However, the law went into effect on July 1, with the litigation pending.

On August 17, the court denied the plaintiffs’ motion for an injunction.   Shen v. Simpson, No. 4:23-cv-208-AW-HAF, 2023 U.S. Dist. LEXIS 152425 (N.D. Fla. Aug. 17, 2023).  The court determined that the Florida provision classified persons by alienage (status of an alien) rather than by race because it barred landownership by persons who are not lawful, permanent residents and who are domiciled in a “country of concern” while exempting noncitizens domiciled in countries that were not “countries of concern.”  Thus, the restriction was not race-based (it applied equally to anyone domiciled in China, for example, regardless of race) and was not subject to strict scrutiny analysis which would have required the State of Florida to prove that the law advanced a compelling state interest narrowly tailored to achieve that compelling interest.  Strict scrutiny, the court noted only applies to laws affecting lawful permanent aliens, and the Florida provision exempts nonresidents who are lawfully permitted to reside in the U.S.  Thus, the law was to be reviewed under the “rational basis” test.  See, e.g., Terrace v. Thompson, 263 U.S. 197 (1923).

The court held that the State of Florida did have a rational basis for enacting the ownership restrictions – public safety and to “insulate [the state’s] food supply and…make sure that foreign influences…will not pose a threat to it.”  This satisfied the rational basis test for purposes of the plaintiffs’ equal protection challenge and the FHA challenge (because the law didn’t discriminate based on race) and also meant that the court would not enjoin the law because the plaintiffs’ challenge on this basis was unlikely to succeed. 

The Florida law, the court concluded, also defined “critical military infrastructure” and “military installation” in detail which gave the plaintiffs sufficient notice that they couldn’t own ag land or acquire an interest in ag land within 10 miles of a military installation or “critical infrastructure facility,” or within five miles of a “military installation” by an individual Chinese investor.  Thus, the court determined that the plaintiffs’ due process claim would fail. 

The plaintiffs also made a Supremacy Clause challenge claiming that federal law trumped the Florida law because the Florida law conflicted with the manner in which land purchases were regulated at the federal level.  They claimed that federal law established a procedure to review certain foreign investments and acquisitions for purposes of determining a threat to national security.  The court disagreed, noting the “history of state regulation” of alien ownership” and that the Congress would have preempted state foreign ownership laws conflicted with the federal review procedure. 

USDA Payments Nontaxable?

Partisan legislation has been introduced into the U.S. House (no bill number yet) that would make numerous farm program benefits nontaxable.  Identical legislation was introduced into the Senate in late 2022.  The law, known as The Family Farmer and Rancher Tax Fairness Act of 2023, would make payments to “distressed” borrowers tax-free, as well as certain payments to “underserved” farmers in high poverty areas and payments to farmers that have allegedly been discriminated against by the USDA. Specifically, the payments covered by the bill are defined as any payment described in section 1066(e) of the American Rescue Plan Act of 2021 (as amended by section 22007 of Public Law 117–169) or section 22006 of Public Law 117–169.  It should be noted that none of the USDA program payments that the bill makes nontaxable are associated with the virus.  While the bill could end up being included in the Farm Bill (which will likely not be passed this year).  However, the bill makes little tax or economic sense (it would create perverse economic incentives) and will likely face stiff opposition. 

Conclusion

These are just a few recent developments in the world of ag law and tax.  More will be forthcoming in another post.

Ag Law and Tax Ramblings

Overview

The subject matter of agricultural law and taxation is very dynamic.  Farmers, ranchers and agribusiness ventures can find themselves involved in legal and tax issues in many ways.  Let’s take a look at a few of those issues.

Random thoughts and developments in ag law and tax – it’s the topic of today’s post.

Crop Insurance Deferral

Farmers facing drought this year will likely collect crop insurance.  The tax law allows crop insurance proceeds to be deferred if the farmer has a business practice of deferring crop sales.  But there’s a limitation on the amount that can be deferred.  The amount that you can defer is limited to the portion related to crop damage.  The portion associated with price is not deferrable.  Crop damage is based on yield loss times the crop’s base price before you plant the crop.  If the price at harvest equals or is greater than the base price, all of your crop insurance proceeds are related to yield and will be fully deferable. 

However, if harvest price is lower than the base price, the portion of the crop insurance proceeds related to the drop in price is based solely on the price drop.  That means that at least some of the crop insurance proceeds won’t be deferable. 

Note:  I have a formula in my treatise, Principles of Agricultural Law, with examples of the computation.  Note that the formula is not official IRS policy, but the IRS in Pub. 225 does recognize the principal of the formula.

The good news is that you won’t have to calculate the numbers.  Your crop insurance provider usually reports the amount of price and yield loss when the proceeds are sent out.

This year, it’s looking likely that most crop insurance proceeds will be a result of a price drop and not a price increase at harvest.  So don’t be surprised if you won’t be able to defer all of your crop insurance proceeds.  Keep that in mind as you start to think about tax planning coming into the last quarter of 2023.

Tax Legislation

The Tax Cuts and Jobs Act (TCJA) enacted in late 2017 contains numerous provisions that will expire at the end of 2025.  Farmer and ranchers and tax preparers are beginning to raise questions with me about how I see the tax landscape shaping up come 2026.  For starters, I think it’s unlikely that the Congress will act on major tax policy until it has too.  That would mean that we won’t see tax legislation until late in 2025.  However, the Congress has a habit of passing Omnibus spending legislation late in the year and tax provisions could be thrown in that bill this coming December.  If that happens, what might be addressed later this year?  I see one possibility being that of bonus depreciation being reinstated to 100 percent, perhaps on a retroactive basis.  It’s currently 80 percent and is phasing down.  Also, I have heard rumblings about making the qualified business income deduction (20 percent for sole proprietorships and pass-through income) permanent.  There might also be another attempt to increase the Child Tax Credit.

As for what might happen in 2025, it will depend on the politics at that time and general economic conditions.  One thing is for sure, the higher interest rate on the debt (caused by bad economic policies) is causing the government to spend much more on debt service and will make tax reform to help the economy more difficult.

Trains and Crossings

An issue for all motorists, but one of particular interest to motorists using rural roadways is the length of time that a train can block a crossing. 

Many states have statutes that specify the maximum length of time that a train can block a public road.  The state laws vary, but a general rule of thumb is that a blockage cannot exist for more than 20 minutes.  There are numerous exceptions concerning such things as emergencies and when the blockage is a result of something beyond the railroad’s control.  When state law doesn’t address the issue, there may be restrictions at the local level.

An interesting question involves the extent to which state laws on road blockages are valid.  Railroads are subject to an interesting mix of federal and state law.  Does federal law preempt state law on this issue?  It can if state law only applies to railroad companies rather than the public at large and has more than just a remote or incidental effect on railway transportation.  That’s because the Surface Transportation Board has exclusive jurisdiction to regulate railways. 

This all means that state law must be carefully tailored to apply broadly to roadway obstructions generally, and not have anything more than a slight impact on railway transportation.  If those requirements are not satisfied, federal law may control.

What’s a Tractor?

A recent case (Brownell v. Brownell, No. SCSC024547 (Dist. Ct. Fayette Co, IA (Aug. 16, 2023)) involved a father suing his son over the sale of a tractor.  The father bought a tractor to use in his farming operation.  It was equipped with a cab, three-point hitch, draw bar and PTO shaft – all of which were detachable.  During his high school years, the son used the tractor in tractor pulls, which required the removal of the detachable parts.  Dad continued to pay for the fuel for the tractor and kept it insured.  Mom and Dad then divorced and as part of the divorce Dad discussed selling the tractor to their son.  No formal written sale contract was entered into, but Dad told his attorney that he had agreed to sell the tractor to his son for $10,000 with no weights or other items, noting that a bank had a lien on all farm equipment. 

The son paid $10,000 to his parents and when he took delivery of the tractor, he also took the draw bar, three-point hitch and PTO shaft.  The legal question was whether the attachments counted as the “tractor” entitling the son to them.  While the attachments were extraneous to the oral contract, the court said the son reasonably believed that they came with the tractor and were a part of it.

It’s always a good idea to get contracts in writing – even seemingly simples ones, and even ones between family members.  It’s hard for me to fathom a father suing his son, but I have seen it happen numerous times.

Also, this case reminds me of a Kansas case about 25 years ago involving a new combine that caught fire during its first usage when the engine malfunctioned.  While the insurance company made the farmer whole, the company claimed in court that it only insured the shell of the combine and not the component parts (i.e., the engine) so the engine manufacturer should be on the hook for the loss.  The court disagreed.  A “combine” meant all of the component parts of the combine.  That’s what a reasonable insured would think with respect to a self-propelled combine. 

Renting Out Part of the Home

If you rent out part of your home, be careful in how you account for the income.  You will need to do an allocation for the expenses and the basis of the portion of the home rented out.  For instance, in Lin v. Comr., T.C. Memo. 2023-37, a married couple rented out a basement apartment in their home to a friend.  They charged $300/month (the Tax Court ignored the issues that the rent might have been below fair rental value) and deducted expenses associated with the rental on their Schedule E.  They also claim depreciation but in doing so used their basis in the entire house.  The Tax Court determined that the expenses should have been allocated to the space rented and that some of the expenses didn’t pertain to the rented portion of the home.  For example, expenses incurred to renovate the bathroom were incurred after the tenant moved out and there was no evidence provided that they had ever rented the space before or would do so in the future.  On the depreciation issue, the Tax Court held that the rental income was only offset by the basis in the rented space and that the couple didn’t supply any square footage numbers on which to allocate depreciation (or the other expenses) attributable to the rented portion of the home.  The IRS did allow some expense deductions, and the Tax Court allowed those. 

Stolen Money Taxable - Disallowed Theft Loss Rule Stings Scammed Couple

Overview

Casualty and theft losses are important because of the exposure of farm property to the elements as well as exposure to those who might steal.  Casualty and theft losses are deductible regardless of whether the property is used in the trade or business, held for the production of income or held for personal purposes although the rules differ slightly on how the loss is calculated.  But a rule change that took effector for tax years beginning after 2017 and before 2026 has changed the landscape for deducting casualty and theft losses.  In a recent case a couple discovered how unfortunate that disallowance rule can be for a theft loss based on an egregious set of facts. 

Extent of Deduction

For property held for nonbusiness use, the first $100 of casualty or theft loss attributable to each item is not deductible.  The deduction is also limited to the excess of aggregate losses over 10 percent of adjusted gross income.  Since 1983, nonbusiness losses have been deductible only to the extent total nonbusiness casualty and theft losses exceed 10 percent of the taxpayer's adjusted gross income.  However, each casualty or theft loss of nonbusiness property continues to be deductible only to the extent the loss exceeds $100.  These personal casualty gains and losses (from non-business property) are netted against each other.  If the losses exceed the gains, all gains and losses are ordinary.  Losses to the extent of gains are allowed in full.  Losses in excess of gains are subject to the 10 percent adjusted gross income floor.  All personal casualty losses are subject to the $100 floor before netting.  If the personal gains for any taxable year exceed the personal casualty losses for the year, all gains and losses are treated as capital gains and losses.

TCJA Limitation

The Tax Cuts and Jobs Act (TCJA), for tax years 2018-2025, disallows an itemized deduction for personal casualty and theft losses, except for casualty losses attributable to a federally declared disaster.  I.R.C. §165(h)(5).  The loss is normally deductible in the year the casualty is incurred, but an election can be made to deduct such a loss in the tax year preceding the year in which the disaster occurred. I.R.C. §165(i).       

“Casualty” Defined

A casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature.  The issue in a particular case comes down to drawing a line.  In this instance, the line is between what is a casualty and what is ordinary wear and tear.  If, for example, a farmer or rancher failed to screw the drain plug into a crankcase and loses all of the oil, or failed to put any oil in the crankcase after draining it and starts down the road, is that a casualty loss or is that ordinary wear and tear when the engine is ruined? 

In the farm and ranch setting, there are numerous cases involving the improper use of herbicides, flood, frost and freezing, insect damage, drought, fire and wind, all of which are examples of casualty where damage was caused.  If the taxpayer can successfully demonstrate that such losses were sudden, unexpected and unusual, the losses will be deductible.  To be deductible, the loss must not be caused as the result of willful negligence.  See, e.g., Rohrs v. Comr., T.C. Sum. Op. 2009-199.  Losses because of disease or termite damage, for example, are generally not eligible for casualty loss treatment because the loss is progressive rather than sudden. For example, Dutch Elm disease has been repeatedly rejected as a cause of a casualty loss along with most other tree diseases as well.

“Theft” Defined

Theft, on the other hand, is the criminal misappropriation of property.  Theft includes larceny, robbery and embezzlement.  In one case, an individual purchased a farm, under a sale contract which specified that the well on the premises was a “good producing water well.”  Shortly after the buyer obtained possession of the premises, the well went dry.  The buyer argued in court that he had suffered a theft loss because the seller misrepresented the well.  The court rejected the buyer's argument, ruling that no theft had occurred.  The court ruled that there may have been fraud or misrepresentation but not theft giving rise to a deduction.  It is usually quite difficult for an event to be considered a theft unless there has been a criminal taking of property as determined by state law.  However, one court has allowed a theft loss deduction for investors who were defrauded in a real estate investment scheme.

Timing of theft loss deduction

Theft losses are only deductible in the year of discovery rather than the year that the theft occurred.  This fact has proved to be one of the major stumbling blocks in the ability to deduct for losses attributable to theft.  Many times, people wait around thinking they will find the item that has come up missing, or that it will be returned, only to discover too late that the property was stolen and is not now deductible. Casualty losses, alternatively, are deductible only in the year the damage occurred.

Calculating the Deduction

The amount of the itemized deduction for both casualty and theft losses is the lesser of (1) the difference between the fair market value before the casualty or theft and the fair market value afterwards and (2) the amount of the adjusted income tax basis for purposes of determining loss. See, e.g., McClune v. Comr., T.C. Memo. 2005-47.  Obviously, with theft, the item is gone, so the fair market value afterward is zero.  Thus, the deductible theft loss is equivalent to the fair market value of the item immediately preceding the time of the theft.  However, the deduction can never exceed the basis in the item.  Hence, the loss attributable to theft or casualty is the lesser of the difference of the fair market value before and after or the basis in the item.  In effect, the measure of the loss is the economic loss suffered limited by the basis.

Example:

Assume a rancher has five Hereford cows and one Hereford bull under a tree one June morning when lightning strikes and kills them all.  The cows were raised and have a basis of $0.00 and a fair market value of $4,500.  The bull, which was purchased for $5,000, had a fair market value of $6,000 at the time of death. The casualty, if all of the animals are struck dead on the spot, is calculated as follows: The difference in the fair market value before and after the loss is $10,500 ($10,500 - $0.00).  However, the total basis in all of the animals is only $5,000 - the basis of the bull.  Since the deductible loss can never exceed the basis, the amount of the deduction is limited to $5,000. 

A similar principle applies for crops lost immediately before harvesting due to a catastrophic event.   If the taxpayer deducted the cost of raising the crop, the income tax basis in the crop is zero and the deductible loss is zero.  The part that has been through the tax mill once cannot be run through a second time.  Thus, returning to the example, only the bull would have a basis.  In addition, any loss must be reduced by any insurance recovery.  Thus, returning to the example, if we assume that $4,500 of insurance was collected, the deductible loss would be limited to $500.

Recent Case

The harshness of the TCJA limitation on deducting a theft loss was recently borne out in Gomas v. United States, No. 8:22-cv-1271-TPB-TGW, 2023 U.S. Dist. LEXIS 122729 (M.D. Fla. Jul. 17, 2023).  In the case, a couple was scammed out of almost $2 million by their daughter/stepdaughter (“Anderson”).  The couple retired in 2016 and turned their pet food business over to Anderson.  About a year later, Anderson caused them to believe that former employees had misused the business’ credit card processing account to scam customers, and that they should hire legal counsel to protect their rights.  There was some support for Anderson’s claim, at least in the couple’s mind, because there had been a problem with a former employee who was fired in 2014.  Anderson suggested an attorney they could hire, and they sent her about $140,000 to retain him.  But that was a ruse.  The attorney didn’t exist.  Anderson always acted as the go-between and even set up a fake email address posing as the attorney along with forging various legal and business documents.  Via her scheme, Anderson got the couple to send her more money on the claim that the funds would settle their legal troubles.  Eventually friends of the couple (who Anderson had also stolen from) tried to reach the “attorney” and in the process uncovered Anderson’s scheme.  The couple was informed of the fraud in 2019 and the police opened an investigation at that time.  Anderson was arrested, pleaded guilty and was sentenced in late 2022. 

While the scheme was being perpetrated, the couple withdrew funds from their retirement accounts.  During 2017, they withdrew over $1.1 million from an IRA, giving about $700,000 of that amount to Anderson in over 100 transactions.  The couple was over age 59 and ½ so there was no 10 percent penalty for early withdrawal, but their 2017 return included $1,174,020 in pension and IRA distributions and a tax liability of $410,841, which they paid.  In early 2020, they filed an amended 2017 return seeking a refund based on claiming a deduction of the $1,174,020 they received from their IRA and pension accounts based on the theft.  The IRS disallowed the deduction in full, and the IRS appeals office upheld the IRS determination.  The couple then filed suit seeking a refund of the tax paid.  The IRS moved for summary judgment.

The court, agreeing with the IRS, granted its summary judgment motion.  The court noted that the couple received the distributions from the retirement accounts.  Anderson only received the funds by later transfer from the couple.  Anderson had not forged their signatures, which would have led to a different tax outcome. Accordingly, the couple was the “payee” of the account funds within the meaning of I.R.C. §408(d)(1).  Anderson’s later theft did not change the couple’s status as the taxable distribute of the funds.  Thus, the funds were properly taxable in 2017 and because the theft wasn’t discovered until 2019, a theft loss deduction was not available that year due to the TCJA provision.

The couple tried another tact.  They claimed that the funds were deductible in 2017 as an ordinary and necessary business expense because Anderson led them to believe that the funds were being used to pay for legal services tied to legal matters associated with the business they used to own and operate.  But the court rejected this argument because the couple had already retired from the business before 2017.  The expenses were not associated with any business-related activity of the couple.  In any event, the expenses, the court noted, would have been nondeductible personal expenses and they never reported the payments as such on any tax return as they were incurred.

Conclusion

Certainly, the Congress did not contemplate the TCJA provision curtailing a theft loss deduction as playing out the way that it did in Gomas.  Indeed, the court indicated that the fact that the couple had to pay tax on the stolen funds was unjust.  But that was the result of the applicable law for the tax years at issue and the “kinder, gentler IRS” was unwilling to exercise discretion and excuse payment of taxes on the stolen funds. 

Coeur d’ Alene, Idaho, Conference – Twin Track

Overview

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

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

Idaho Conference

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

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

Tax Track (Day 1)

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

Tax Track (Day 2)

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

Ag Law Track (Day 1)

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

Ag Law Track (Day 2)

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

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

Speakers

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

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

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

The speakers for the ag law track are as follows:

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

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

Who Should Attend

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

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

Sponsorship

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

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

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

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

Sunday Afternoon Random Thoughts on Ag Law and Tax

Overview

I am in the midst of a 10-day traveling and speaking “tour” and have a moment to share a few thoughts of what has been rolling around in my mind (besides what I have been teaching recently).  Some of these thoughts are triggered by questions that I receive, others by cases that I read, yet still others simply from conversations that I have had with other recently.  Those thoughts include liability for guests on the farm; the usefulness of Health Savings Accounts; pre-paid farm expenses and death; putting a plan in place to address long-term health care costs; and custom agreements for direct beef sales from the farm.

Random thoughts in ag law and tax – it’s the topic of today’s blog article.

Direct Beef Sales and Custom Agreements

It seems that the interest in buying beef products directly from cattle producers is on the rise. But direct sales/purchases may trigger some different rules.  In general, if a person wants to buy beef directly from a cattle producer the law treats the transaction differently depending on whether the live animal is sold to the buyer or whether processed beef is sold.  The matter turns on whether the animal owner is the end consumer.  If the cattle producer sells processed beef to the buyer, the processing of the animal must occur in an inspected facility and the producer would also be subject licensing, labeling and insurance requirements.  But if the producer sells the live animal to the buyer then the producer can also do the processing and sell any remaining beef not initially purchased to another buyer.    

This means that a contract should clearly state that the live animal is being sold and in what percentage.  If a specific animal is sold, the animal should be identified.  Also, the calculation of the price should be detailed and how payment is to be made.  Any processing fees should be set forth and the agreement should be clear that the meat can’t be resold or donated.  In addition, it is important to make sure to clearly state when the animal is the buyer’s property.  The key point is that the owner of the animal and the consumer of the beef must be the same. 

The bottom line is to have a good custom harvest agreement to be able to use the custom exempt processing option. 

Handling Long-Term Care Costs

Planning for long-term care costs should be an element of a complete estate plan for many farm and ranch families.  Having a plan can help minimize the risk that the farm assets or land would have to be sold to come up with the funds to pay a long-term care bill.  What are some steps you can take to put a plan in place that will protect the farm assets from being sold to pay a long-term health care bill? 

A ballpark range of the monthly cost of long-term care is $7,000-9,000 in many parts of the country.  If you are planning on covering that expense with Medicaid benefits keep in mind that you can only have very little income and assets to be eligible. 

A good place to start is to estimate your current monthly income sources.  What do you have in rents, royalties, Social Security benefits, investment income, and other income?  You will only need to plug the shortfall between the monthly care cost and your then current monthly income sources.  That difference might be able to be made up with long-term care insurance.  Those policies can differ substantially, so do your homework and examine the terms and conditions closely.    

If a policy can be obtained to cover at least the deficiency that income doesn’t cover, all of the farm assets will be protected. Many insurance agents and financial advisors can provide estimates for policies and help you determine the type of policy that might be best for you. 

When should you be thinking about putting a plan together?  Certainly, before a major medical problem occurs.  If you are in relatively good health, policy premiums will be less.  Certainly, before age 70 would be an excellent time to employ a plan.

Planning to protect assets from depletion paying for long-term health care costs is beset with a complex maize of federal and state rules.  Make sure you get good guidance. 

Pre-Paid Farm Expenses and Death

Many cash-basis farmers pre-pay next-year’s input expenses in the current year and deduct the expense against current year income.  The IRS has specific rules for pre-paying and deducting.  Another issue with pre-paid inputs is what happens if a farmer claims the deduction and then dies before using the inputs that were purchased? 

To be able currently deduct farm inputs that will be used in the next year, three requirements must be met.  The items must be purchased under a binding contract for the purchase of specific goods of a minimum quantity; the pre-purchase must have a business purpose or not be entered into solely for tax avoidance purposes; and the transaction must not materially distort income. 

If the rules are satisfied but the farmer dies before using the inputs that were purchased, what happens?  In Estate of Backemeyer v. Comr., 147 T.C. 526 (2016), a farmer pre-purchased about $235,000 worth of inputs associated with the planting of next year’s crop.  The deduction was taken on the return for the year of purchase, but the farmer died before using the inputs.  The inputs passed to his widow who used them to put the crop in the ground.  She deducted the inputs again on the return for that year.  The IRS objected, but the court said that’s the way the tax rules work.  The value of the inputs was included in his estate, and she could claim a deduction against their cost basis – the fair market value at the time of his death.

Liability for Guests on the Farm

What’s your liability for guests on the farm?  The answer is, “it depends.”  Facts of each situation are paramount, and the outcome of each potential liability event will turn on those facts. For example, in Jones v. Wright, 677 S.W.3d 444 (Tex. Ct. App. 2023), a family who came to the plaintiffs’ property to look at a display of Christmas lights sued the landowner for the death of their child who was killed by a motorist while crossing the road after leaving the premises. 

When they left the property, their minor child was struck and killed by a vehicle while crossing the road to get to the family’s vehicle. The family sued the landowners for wrongful death and negligence claiming that they were owed a duty of care as invitees that was breached by the landowners’ failure to make the premises safe or warn of a dangerous condition.

The court disagreed based on several key factors.  The landowners didn’t charge a fee for viewing the lights; the vehicle that struck the child was being driven at night without lights; there hadn’t been any similar prior accidents on the road; the landowners used loudspeakers to tell visitors not to park on the opposite side of the road; and the accident occurred on property the landowners didn’t own.  Based on those facts, the court said the landowners didn’t breach any duty that was owed to the family.  The child’s death was not a foreseeable risk. 

But slightly different facts could have led to a different outcome.

Health Savings Accounts

One of the best-kept secrets of funding medical costs is a Health Savings Account (HSA).  Surveys indicate that a self-employed farmer pays about $12,000-$15,000 annually for health insurance.  To make matters worse, the policies often come with high deductibles and limited coverage.  An HSA can provide current and future income tax benefits while simultaneously allowing the self-funding of future medical costs. 

An issue for many is that it’s unlikely that medical expenses are deductible for failure to meet the threshold for itemizing deductions.  That threshold is only likely to be met in a year when substantial medical costs are incurred.  An HSA is an option without the deduction restrictions, but it does need to be paired with a high deductible insurance policy.

With an HSA, contributions are deductible up to $7,750 this year for a family, earnings grow tax-free, and distributions to pay for qualified medical expenses are also not taxed. Qualified expenses include Medicare premiums, or any other qualified medical expenses incurred before retirement.  If you’re a farmer that files a Schedule F, an HSA is the simplest and most cost-effective way to receive a deduction for medical costs. 

But you can’t contribute to an HSA once you are enrolled in Medicare. So, it might be a good idea to fully fund an HSA but not take any distributions until retirement.  One downside with an HSA is that if it is inherited, the recipient has one year to cash it in.  If there aren’t any qualified expenses to be reimbursed, income tax will result.

Conclusion

Just some random thoughts this Sunday afternoon.  For you father’s reading this, I trust you have had a very pleasant Father’s Day.  Now it’s time to get some rest for an early morning flight to Georgia.

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

Overview

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

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

Idaho Conference

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

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

Tax Track (Day 1)

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

Tax Track (Day 2)

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

Ag Law Track (Day 1)

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

Ag Law Track (Day 2)

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

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

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

Miscellaneous Agricultural Law Topics

Proper Tax Reporting of 4-H/FFA Projects

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

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

The Importance of Checking Beneficiary Designations

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

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

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

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

Liability Release Forms – Do They Work?

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

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

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

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

Equity Theft

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

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

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

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

The Climate, The Congress and Farmers

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

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

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

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

Secure Act 2.0 Errors

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

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

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

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

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

Implications of SCOTUS Union Decision on Farming Businesses

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

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

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

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

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

Digital Grain Contracts

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

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

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

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

Tax Potpourri – Hobby Losses; Employer-Provided Housing; Tax Computation for Fuel Blenders; and Conservation Easement Deeds

Overview

Recently, the U.S. Tax Court has issued opinions involving several areas that also can involve farmers and ranchers.  With today’s post I highlight some of those recent cases and provide some context for how the issues might apply to agricultural producers and/or agribusinesses. 

Recent Tax Court cases (and a Rev. Rul.) of interest – it’s the topic of today’s post.

IRS Focuses on Wrong Issues – Loses Hobby Loss Argument

Carson v. Comr., No. 23086-21S (U.S. Tax Ct. Mar. 22, 2023)

The Oklahoma ranch at issue was originally owned by the petitioner’s grandmother and then inherited by petitioner’s mother.  In 2009, as part of a family succession plan, the petitioner’s mother transferred the ranch to a revocable trust.  Under the trust’s terms, if the mother died and was predeceased by the petitioner’s stepfather, the ranch would pass equally to the petitioner and her brother.  If the petitioner’s stepfather were alive at the time of the mother’s death, the ranch would remain in trust for his life and then distribute equally to the petitioner and her brother upon the stepfather’s death.  The petitioner and her mother executed two separate agreements in 2013 and 2016 whereby the petitioner agreed to contribute financially to the ranch and that the petitioner and her mother would jointly agree about the amount, if any, of cash distributions from ranch earnings would be made to the petitioner.  From 2014 to 2019, the petitioner paid the ranch expenses, but the mother reported on her return the income from cattle sales.  The petitioner did not receive any cash distributions from ranching activities and as a result did not report ranch income.  The petitioner’s children participated in rodeos, and the income from the rodeo activities were reported on the petitioner’s Schedule F under “livestock activities.”  For 2017, the petitioner’s Schedule F reported gross income of $2,741 and deductions of $128,990 from the ranching activity.  For 2018, the petitioner’s Schedule F reported gross income of $8,063, including $1.867 of compensation for labor services performed by the children for local ranches and $6,196 for the children’s rodeo competition winnings.  Expense deductions claimed on Schedule F were $133,929.  From 2014-2019, the petitioner reported cumulative losses of $502,742 on Schedule F which far exceeded the cumulative Schedule F gross income and largely offset the ordinary income of the petitioner and her husband (primarily wage income).  IRS audited and determined that the Schedule F activity was rodeo and not ranching, ignoring the fact that the Schedule F expenses were predominantly from the ranching activity.  As a result, the IRS determined that the rodeo activity was not engaged in with the requisite profit motive and disallowed all Schedule F deductions for 2017 and 2018.  The Tax Court determined that the IRS had focused improperly on the rodeo activity rather than the ranching activity, noting that the petitioner had credibly testified that the Schedule F activities primarily related to the ranch and not to rodeos.  As such, the losses related to the ranching activity and not the rodeo activity, and the IRS failed to challenge the profit motive of the ranching activity.  The Tax Court refused to allow the IRS to refocus its challenge to the Schedule F deductions on the ranching activity, holding that the IRS had waived its right to do so.  Thus, the activity reported on Schedule F for 2017 and 2018 was deemed to be engaged in for profit. 

Note:  It's puzzling why the IRS didn't question the arrangement between the petitioner and her mother.  It's equally puzzling why the IRS focused solely on the Schedule F income resulting from the children’s rodeo activity.  The arrangement between the petitioner and her mother was more akin to that of a partnership, and the fact that the ranch was in a revocable trust meant that the mother could revoke the trust at any time.  That fact could have easily led IRS to claim that there really wasn’t a trade or business activity being conducted between the petitioner and her mother.  Indeed, the expenses the petitioner paid were really the trust’s expenses meaning that it was the trust that was conducting the trade or business activity.  It's also puzzling why the IRS did not focus on the fact that the arrangement was designed to prevent the petitioner from recognizing any income.  But the IRS mistakenly claimed that the primary purpose of the business was to fund the rodeo activities of the children.  There was no attempt to find and examine relevant information concerning the ranching activity.

Value of Employer-Provided Housing Not Excludible from Income

Smith v. Comr., T.C. Memo. 2023-6

The petitioner was an Air Force veteran and engineer who accepted an offer of employment with a defense contractor to work as an engineer in Australia.  He was given options for housing - 1) a furnished house for which he would have to report the fair rental value on his return; or 2) a payment to compensate him for the cost or owning or renting housing.  He accepted company-provided housing approximately 11 miles from his work location.  After eight years of living in the company-provided housing, the company ceased providing housing and he had to find housing on his own.  For 2016 and 2017, the petitioner reported the value of the housing provided to him on his return, but then filed amended returns that claimed an offsetting deduction for “employee benefit programs.”  On his 2018 return he reported the value of the housing but also claimed a deduction for “employee benefit programs.”  The IRS disallowed the deductions.  The Tax Court noted that certain conditions must be satisfied to exclude the value of employer-provided lodging from income under I.R.C. §119 – the lodging must be furnished for the convenience of the employer; furnished on the business premises; and the employee must be “required to accept the lodging as a condition of employment.  The Tax Court determined that the lodging was not furnished on the business premises.  The petitioner’s occasional business activities at the home were not sufficient to establish that the housing was integral to the employer’s business activities and the housing was not necessary for the performance of his duties. 

Note:  There are numerous cases involving farms and ranches on the issue of employer-provided meals and lodging with the focus being on the definition of the “business premises” and “for the convenience of the employer.” 

Excise Tax Expense Rather Than Gross Excise Tax Liability Used in Computing COGS for Fuel Blender 

Growmark, Inc. v. Comr., 160 T.C. No. 11 (2023) 

The petitioner, an agricultural supply cooperative that also blends fuel (including ethanol and biodiesel), serves the supply needs of its member-patrons that are primarily independent farmers.  The petitioner incurred an I.R.C. §4801 fuel excise tax liability when it removed a taxable fuel that it owned as a position holder (holding inventory in a fuel distribution facility) from a rack at a distribution facility.  The I.R.C. §4801 tax was also incurred with respect to the gallons of ethanol and biodiesel when it removed and sold the ethanol or biodiesel as part of an alcohol fuel mixture or biodiesel mixture.  During the tax years at issue, the excise tax reflected the petitioner’s fuel mixtures for sale to third parties for use as a fuel.  The ethanol that the petitioner produced and then blended with taxable fuel was eligible for either the alcohol fuel mixture excise tax credit of I.R.C. §6426(a)(1) and (b) or the alcohol mixture income tax credit under I.R.C. §40(a)(1).  However, the petitioner only claimed the alcohol fuel and biodiesel mixture excise tax credits under I.R.C. §6426 for all of the alcohol fuel and biodiesel mixtures it produced and sold during 2009 and 2010.  The petitioner filed Form 720 (Quarterly Excise Tax Credit Tax Return) for each of the quarters beginning or ending within its tax years 2009-2010 and claimed the credit on the Forms.  As noted above, as a fuel blender the petitioner could reduce its taxable income from fuel mixture sales by subtracting its cost-of-goods-sold (COGS), including certain federal excise taxes.  For each year in issue, the petitioner filed Form 1120-C (cooperative tax return) on which it included in its cost-of-goods-sold (COGS) its actual excise tax expense (excise tax liability less the amount of tax credits allowed under I.R.C. §6426).  That caused the petitioner’s COGS to be lower and its taxable income higher than it would have been had its excise tax liability not been reduced by the tax credits it received.  The petitioner later claimed that it could claim its gross excise tax liability unreduced by the tax credits it received as part of its COGS.  The IRS disagreed.  Thus, the issue was whether the petitioner had to reduce deductions based on fuel tax liability or include the refundable fuel tax credits in income.  IRS had previously taken the position that when there is no actual excise tax liability, a purely refundable fuel tax credit does not reduce any deduction for fuel or create any addition to income. C.C.A. 201342010 (Aug. 29, 2013).  When there is actual fuel tax liability, the IRS position is that the credits must first offset this liability and reduce the deduction for tax expense (or COGS) or be included in income.  See Notice 2015-65, 2015-35, IRB 235; C.C.A. 201406001 (Jan. 13, 2014).  The IRS has also won several court cases on the issue.  See Sunoco, Inc. v. United States, 908 F.3d 710 (Fed. Cir. 2018), cert. den., 140 S. Ct. 46 (2019); Delek US Holdings, Inc. v. United States, 32 F.4th 495 (6th Cir. 2022); Exxon Mobil Corporation v. United States, 43 F. 4th 424 (5th Cir. 2022).  The Tax Court agreed with the IRS, noting that the legislative history and the statutory construction supporting the conclusion that the tax credits must first be used to offset tax liability – actual excise expense rather than gross excise tax liability must be used to calculate COGS.

Note:  The facts of the case did not allow the Tax Court to address the situation where the entity generating the fuel tax credit is separate from the activity generating the excise tax liability.  Potentially, it could be possible to achieve the result the petitioner sought by structuring the taxpayer’s business differently. 

Safe Harbor Language Provided for Conservation Easement Deeds

Notice 2023-30, 2023-17 IRB 766

Under Section 605(d)(1) of the SECURE 2.0 Act, which was enacted as part of the Consolidated Appropriations Act, 2023, P.L. 117-328, the IRS was required to provide safe harbor language for extinguishment and boundary line adjustment clauses in conservation easement deeds by April 28, 2023.  IRS issued this Notice on April 24, 2023, providing the safe harbor language and triggering a 90-day period for a donor to amend an easement deed to substitute the safe harbor language for the corresponding language in the original deed.  Thus, under Section 605(d)(2) of the Secure Act 2.0, donors are allowed, but not required, to amend their deeds to include this language. Donors wanting to make the change must do so by July 24, 2023.  Any amendment will be treated as effective as of the date of the recording of the original easement deed.  IRS points out in the Notice that an amendment cannot be made for any easement deed relating to any contribution that was part of a reportable transaction or was a transaction that was not treated as a qualified conservation contribution by reason of I.R.C. §170(h(7); a transaction for which a charitable deduction contribution had been disallowed by the IRS and the donor was contesting the disallowance in federal court before the amended deed was recorded; or a transaction for which a claimed charitable deduction for the contribution resulted in an underpayment and a penalty under I.R.C. §6662 or §6663 had been finally determined. 

Deductibility of Personal Interest and the Home Mortgage Exception

Overview

The rules for the deductibility of interest can be a bit tricky.  Also, to properly account for interest, the definition of interest is critical.  In addition, there apparently is some confusion that has arisen concerning the proper classification of lender fees for tax purposes.

Today’s article takes a look at the deductibility of one of the classifications of interest – personal interest.  A subsequent article will take a look at the tax deductibility of investment interest and business interest. 

The tax treatment of personal interest and the exception for mortgage interest - it’s the topic of today’s post.

Background

Presently, there exist different rules for the three types of interest:  personal interest, investment interest and business interest.  For farmers and ranchers, the bulk of farm interest should be deductible as business interest.  That makes the classification of interest the end of the inquiry critical to determining the proper tax treatment. 

Personal Interest and the Exception for Mortgage Interest. 

Personal interest is not deductible unless the debt is secured by a mortgage on the principal residence, which is referred to a qualified residence interest. I.R.C. §§163(h)(2)(D); (h)(3).  Generally, qualified residence interest is any interest paid on a loan secured by the taxpayer’s main home and one other residence. See, e.g., Boehme v. Comr., T.C. Memo. 2003-81 (where loan was acquisition debt, but repayment was secured by taxpayer’s right to receive future lottery payments rather than the residence, loan interest was not qualified residence interest).  If the other residence is rented out, the taxpayer or a member of the taxpayer’s family must use the second home for more than the greater of two weeks or 10 percent of the number of days when the residence is rented for a fair rent to persons other than family members.  The loan may be a mortgage to buy the home, or a second mortgage.  The exception to the rule of nondeducibility of personal interest applies to “qualified residence interest.” That is defined as interest associated with the taxpayer's principal residence on the first $750,000 ($375,000 if married filing separately) of indebtedness.  These limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer’s main home and second home.  The deduction is on a per taxpayer basis to unmarried co-owners of a qualified residence.  See, e.g., Voss v. Comr., 796 F.3d 1051 (9th Cir. 2015).  

Note:  A higher limitation applies ($1 million ($500,000 if married filing separately)) if the mortgage interest is attributable to indebtedness incurred before December 16, 2017.  Through 2022 this threshold also included mortgages taken out before October 13, 1987.

If the residence contains a business office for which a home office deduction is claimed, an allocation must be made between the part of the home that is the qualified home and the part that is not.  The business portion of the home mortgage interest allowed as a deduction is included in the business use of the home deduction that is reported on Schedule C (Form 1040), line 30, or Schedule F (Form 1040), line 32.  For taxpayers that itemize deductions on Schedule A, the personal part of the deductible mortgage interest is reported on Schedule A, line 8a or 8b and the business portion is reported on Schedule C (or F). 

Mortgage interest is not deductible unless the taxpayer files either Form 1040 or 1040-SR and itemizes deductions on Schedule A.  Also, the mortgage must be secured debt on a qualified home in which the taxpayer’s has an ownership interest.  The mortgage must provide that the home satisfies the debt in the event of default.  The mortgage must be recorded, and both the taxpayer and the lender must intend that the loan be repaid.  A “wraparound mortgage” is secondary financing and is not secured debt unless it is recorded or otherwise perfected under state law. 

Note.   For tax years 2018 through 2025, an interest deduction is no longer available for home equity indebtedness unless the indebtedness is used to buy, build or substantially improve the taxpayer’s personal residence that secures the loan.  The total loan balance (first mortgage and home equity loan is subject to the $750,000 (mfj) limitation.  IR 2018-32, Feb. 21, 2018.

An election can be made to treat secured mortgage debt as not secured by the home.  The election may only be revoked with IRS consent.  The election might make sense in situations where the debt would be fully deductible as business debt regardless of whether it qualifies as home mortgage interest and would allow a greater interest deduction on another debt that would give rise to a deduction for home mortgage interest. 

Unique Situations

Divorce.  Questions concerning the deductibility of qualified residence interest can arise in unique situations. For example, if a divorce decree or separation agreement requires the taxpayer to make all of the mortgage payments on a jointly owned home with an ex-spouse, the taxpayer and the ex-spouse may each treat one-half of the interest payments as qualified residence interest if the home is a qualified residence.  IRS Pub. No. 504 (2022), p. 14.

Retirement plan.  If a loan from a qualified retirement plan is characterized as a distribution and is a bona fide loan, the interest may satisfy the definition of qualified residence interest. F.S.A. 200047022 (Aug. 22, 2000). 

Trust or estate.  Simply transferring title of a qualified residence to a trust does not disqualify the grantor’s continued payment of interest on the indebtedness as deductible qualified residence interest. See, e.g., Investment Research Associates Limited & Subsidiaries v. Comr., T.C. Memo. 1999-407.  After the grantor dies, if the estate or a trust pays interest on a mortgage attributable to a residence that the estate or trust holds, the interest is treated as qualified residence interest if the residence is a qualified residence of a beneficiary having a present or residuary interest in the estate or trust.  I.R.C. §163(h)(4)(D). 

Mortgage interest refunds.  The IRS ruled in Rev. Rul. 92-91, 1992-2 CB 49, that an interest overcharge due to the lender’s miscalculation of an adjustable-rate mortgage that the cash basis borrower paid was deductible in the year paid as qualified residence interest even though it was reimbursed in a later tax year. 

Conclusion

A subsequent article will take a look at investment interest and business interest.  Included in the discussion will be the issue of whether loan extension fees meet the definition of deductible business interest.  That’s an issue that arisen recently with respect to some farm loans.