Thursday, October 31, 2019
An interesting question was posed to me at a recent tax seminar. The question was whether director fees are subject to self-employment tax. That question comes up because sometimes farmers, ranchers and others receive income for serving as a director of a farming or ranching business, an agricultural cooperative, an ag lender or other organization.
Whether a director fee is subject to self-employment tax turns on whether the fee constitutes employee wages. Making that determination turns on the facts and circumstances of the particular situation.
Director fees and self-employment tax – it’s the topic of today’s post.
Self-Employment Tax Basics
A self-employed individual is one who has net earnings from self-employment as defined by I.R.C. §1402(a). “Net earnings from self-employment” means gross income derived from a trade or business that the taxpayer conducts (less associated deductions). Id. But, a “trade or business” for self-employment tax purposes does not include “the performance of services by an individual as an employee.” I.R.C. §1402(c)(2).
A corporate director, under the right set of facts, is not a corporate employee. Treas. Reg. §31.3121(d)-1(b) specifies that, “Generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation. A director of a corporation in his capacity as such is not an employee of the corporation.”
On the self-employment tax issue, the IRS ruled in 1972, that director fees are self-employment income subject to self-employment tax. Rev. Rul. 72-86, 1972-1 CB 273. That is certainly the case if a “director” performs no services for the corporation. But, what if some services are provided? When does a “director” cross the line and grade over into “employee” status with payments received constituting wages? If the fees constitute “wages” they aren’t subject to self-employment tax and there could be other implications.
The Blodgett case
In Blodgett v. Comr., T.C. Memo. 2012-298, the petitioner served on a local bank board. The board operated independently and represented members of the community that owned the bank. The board supervised bank management but did not participate in daily bank operations. The bank provided liability coverage, life and disability insurance and retirement benefits, but not health insurance to the board members. The petitioner was also vested in the bank’s retirement plan for board members. He put in less than five hours a week on board member business and did not hold himself out as a contractor and did not claim any tax deductions for business expenses because the bank paid all expenses. The bank issued him a Form 1099-MISC, Miscellaneous Income, reporting "nonemployee compensation" of $26,750 for his services. He reported the amount on line 21 of his return as “other income” not subject to self-employment tax. The IRS disagreed, asserting that the income was attributable to work the petitioner performed as an independent contractor and that self-employment tax was owed.
The Tax Court agreed with the IRS and analyzed the facts based on a seven-factor test. Those factors, set forth in Weber v. Comr., 103 T.C. 378 (1994), are: (1) extent of control maintained by the bank; (2) responsibility for providing work facilities; (3) the opportunity for the trustee to receive a profit or loss; (4) the ability of the bank to fire the trustee; (5) the trustee duties as part of the bank’s regular business activities; (6) the permanency of the bank-trustee relationship; and (7) the intent of the bank-trustee relationship.
Here's how the factors shook out in Blodgett:
Factors favoring employee status:
- The bank provided the trustees with meeting rooms, office supplies, and other items necessary to fulfill their duties.
- The trustees were paid for attending board meetings and did not have additional opportunities for profit or loss.
- The petitioner had been reelected to his position for more than 10 consecutive three-year terms, but bank management was appointed for one-year terms.
Factors favoring nonemployee status:
- The board of trustees operated independently from the bank’s management and were not subject to any meaningful control by the bank.
- Only corporate members could terminate the trustees, and then only on a limited basis including by a vote of the members.
- The trustees’ duties were primarily related to oversight with no involvement in daily bank operations.
- Evidence showed that the bank had no intent to create and employer-employee relationship with the trustees and issued Forms 1099-Misc. instead of Forms W-2 to all of the trustees.
The court didn’t simply stack up the factors and see whether a majority of them favored employee or nonemployee status. Instead, the court placed the most weight on how much control the bank exercised over the trustees and determined that the trustees were not employees and that self-employment tax was owed.
The Burbach Case
In Burbach v. Comr., T.C. Memo. 2019-17, the petitioner was an engineer whose LLC business involved working with towns to determine the need for a public pool. If it was determined that a pool had merit, the petitioner would plan and market the pool and organize fundraising for the construction of the pool. Ultimately, he changed his business form from an LLC to two corporations – one to hold the operating assets of the business and another corporation to hold real estate. With help from his tax advisor, the petitioner established a self-employed pension plan. He funded the plan by taking “director fees” out of the operating entity which he then deposited into his personal checking account with subsequent transfers to his pension account. He reported the director fees on Schedule C and claimed an offsetting deduction for the contributions to his self-employed retirement plan.
The facts got tangled with respect to late-filed corporate returns and ultimately it was determined that the pension plan needed to be an employer-sponsored plan run through the operating entity because it had employees and also because all the compensation on which plan contributions were based was W-2 compensation that the corporation paid to the petitioner as an employee. The plan was corrected retroactively with the operating entity as the plan sponsor including all eligible employees in the plan and including the amounts the petitioner received as director fees for plan purposes.
The parties settled on the plan qualification issues, but the IRS claimed that the director fees the petitioner received were wages as remuneration for employee services. As wages, the IRS argued, the petitioner couldn’t claim I.R.C. §404 pension plan deductions because he had no self-employment income.
The Tax Court agreed with the IRS for the following reasons:
- The petitioner was the operating entity’s sole shareholder and was involved hands-on in the company’s daily affairs.
- While the petitioner was the operating entity’s only director, there was no evidence that he provided any director services. Instead, the services provided involved daily decisions concerning engineering, project management and marketing.
- The petitioner had represented to the IRS when he and the operating entity applied for a compliance statement for the pension plan that he was providing services that were essentially employee services.
Consequently, the petitioner had no earnings from self-employment and I.R.C. §404(a)(8) barred him from claiming any deductions for contributions he had made to his Keogh-type pension plan for the tax years at issue. Instead, he was an “employee” within the meaning of I.R.C. §401(c)(1) and the operating entity was his “employer” under I.R.C. §401(c)(4) by virtue of I.R.C. §404(a)(8).
Note that the outcome in Burbach was different that the typical outcome with respect to directors’ fees. While it’s a facts and circumstances determination, most often those facts indicate that directors’ fees are self-employment income. Had that been the case in Burbach, the petitioner, as a corporate director, could have established a Keogh plan based on those fees. See, e.g., I.R.C. §3121(d)(1); Treas. Reg. §31.3121(d)-1(b). However, the petitioner provided more than minor services and was classified as an employee whose director fees were classified as wages.
It’s not uncommon in rural areas for farmers, ranchers and others to serve on various corporate boards for which compensation is received. It’s important to properly report the director fee income on the return. That will turn on the classification of the relationship of the taxpayer to the entity involved. Facts and circumstances of each situation are critical. If the taxpayer is deemed to be an independent contractor with self-employment income, perhaps there are associated costs that can be deducted to help offset the income and self-employment tax. Likewise, it may be possible to establish a pension plan. But the facts must support the classification desired.
Tuesday, October 29, 2019
One of the new taxes created under Obamacare is a 3.8 percent tax on passive sources of income of certain individuals. It’s called the “net investment income tax” and it took effect in January of 2013. Its purpose was to raise about half of the revenue needed for Obamacare. It’s a complex tax that can surprise an unsuspecting taxpayer – particularly one that has a one-time increase in investment income (such as stock). But it can also apply to other sources of “passive” income, such as income that is triggered upon the sale of farmland.
But are farmland sales always subject to the additional 3.8 percent NIIT? Are there situations were the sale won’t be subject to the NIIT? These questions are the topic of today’s post.
The NIIT is 3.8% of the lesser of (1) net investment income (NII); or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). I.R.C. §1411. The threshold amount is not indexed for inflation. For this purpose, MAGI is defined in Treas. Reg. §1.1411-2(c)(2). For an estate or trust, the NIIT is 3.8% of the lesser of (1) undistributed NII; or (2) the excess of AGI (as defined in I.R.C. §67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins ($12,750 for 2019). I.R.C. §1411(a)(2).
What is NII? For purposes of the NIIT, net investment income (NII) is gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the NII tax doesn't apply. I.R.C. §1411(c)(1)(A)(i). If the taxpayer either owns or is engaged in a trade or business directly or indirectly through a disregarded entity, the determination of character of income for NIIT purposes is made at the individual level. Treas. Reg. §1.1411-4(b)(1). If the income, gain or loss traces to an investment of working capital, it is subject to the NIIT. I.R.C. §1411(c)(3). Also, the NIIT applies to business income if the trade or business at issue is a passive activity. I.R.C. §1411(c)(2)(A). But, if income is subject to self-employment tax, it’s not NII subject to the NIIT. I.R.C. §1411(c)(6).
Sale of Farmland and the NIIT
Capital gain income can trigger the application of the NIIT. However, if the capital gain is attributable to the sale of a capital asset that is used in a trade or business in which the taxpayer materially participates, the NIIT does not apply. For purposes of the NIIT, material participation is determined in accordance with the passive loss rules of I.R.C. §469.
If an active farmer sells a tract of land from their farming operation, the capital gain recognized on the sale is not subject to the NIIT. However, whether the NIIT applies to the sale of farmland by a retired farmer or a surviving spouse is not so easy to determine. There are two approaches to determining whether the NIIT applies to such sales – the I.R.C. §469(f)(3) approach and the I.R.C. §469 approach
I.R.C. §469(h)(3) approach. I.R.C. §469(h)(3) provides that “a taxpayer shall be treated as materially participating in any farming activity for a taxable year if paragraph (4) or (5) of I.R.C. §2032A(b) would cause the requirements of I.R.C. §2032A(b)(1)(C)(ii) to be met with respect to real property used in such activity if such taxpayer had died during the taxable year.” The requirements of I.R.C. §2032A(b)(1)(C)(ii) are met if the decedent or a member of the decedent’s family materially participated in the farming activity five or more years during the eight years preceding the decedent’s death. In applying the five-out-of-eight-year rule, the taxpayer may disregard periods in which the decedent was retired or disabled. I.R.C. §2032A(b)(4). If the five-out-of-eight year rule is met with regard to a deceased taxpayer, it is deemed to be met with regard to the taxpayer’s surviving spouse, provided that the surviving spouse actively manages the farming activity when the spouse is not retired or disabled. I.R.C. §2032A(b)(5).
To summarize, a retired farmer is considered to be materially participating in a farming activity if the retired farmer is continually receiving social security benefits or is disabled; and materially participated in the farming activity for at least five of the last eight years immediately preceding the earlier of death, disability, or retirement (defined as receipt of social security benefits).
The five-out-of-eight-year test, once satisfied by a farmer, is deemed to be satisfied by the farmer’s surviving spouse if the surviving spouse is receiving social security. Until the time at which the surviving spouse begins to receive social security benefits, the surviving spouse must only actively participate in the farming operation to meet the material participation test.
“Normal” I.R.C. §469 approach. A counter argument is that I.R.C. §469(h)(3) concerns the recharacterization of a “farming activity,” but not the recharacterization of a rental activity. Thus, if a retired farmer is no longer farming but is engaged in a rental activity, §469(h)(3) does not apply and the normal material participation tests under §469 apply.
What are the material participation tests of I.R.C. §469? As set forth in Treas. Reg. §1.469-5T, they are as follows:
(1) The individual participates in the activity for more than 500 hours during such year;
(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
The above tests don’t apply to a limited partner in a limited partnership, and only one of the tests is likely to have any potential application in the context of a retired farmer to determine whether the taxpayer materially participated in the farming activity – the test of material participation for any five years during the ten years preceding the sale of the farmland.
Clearly, the “normal” approach would cause more transactions to be subject to NIIT. It’s also the approach that the IRS uses, and it is likely the correct approach.
Sale of land held in trust. When farmland that has been held in trust is sold, the IRS position is that only the trustee of the trust can satisfy the material participation tests of §469. This is an important point because of the significant amount of farmland that is held in trust, particularly after the death of the first spouse, and for other estate and business planning reasons. However, the IRS position has been rejected by the one federal district court that has ruled on the issue. Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003). The IRS did not appeal the court’s opinion, but continued to assert in in litigation in other areas of the country. In a case from Michigan in 2014, the U.S. Tax Court in a full tax court opinion, rejected the IRS’s position. Frank Aragona Trust v. Comm’r, 142 T.C. 165 (2014). The Tax Court held that the conduct of the trustees acting in the capacity of trustees counts toward the material participation test as well as the conduct of the trustees as employees. The Tax Court also implied that the conduct of non-trustee employees would count toward the material participation test. The court’s opinion makes it less likely that the NIIT will apply upon trust sales of farmland where an actual farming business is being conducted.
Obamacare brought with it numerous additional taxes. One of those, the NIIT, applies to passive income of taxpayer’s with income above a certain threshold. The NIIT can easily be triggered upon sale of particular assets that have been held for investment or other purposes, including farmland. Some planning may be required to avoid its impact.
Wednesday, October 23, 2019
In 1972, comedian George Carlin listed in a monologue the “Seven Words You Can Never Say on Television.” He then proceeded to use all seven words multiple times. The use of those words constitutes a violation of Federal Communications Commission standards and triggers a penalty. In the tax world, there are also “dirty” words, and they are used to describe something that happens in tax that triggers a bad tax result for the taxpayer. “Recapture” is one of those words. It means that a tax benefit previously received must be given up – paid back. That “pay back” is often at ordinary income tax rates rather than the (often) more favorable capital gain rates.
Recapture in the context of depletion deductions previously claimed that is associated with oil and gas interests – it’s the topic of today’s post.
Recapture – What Is It?
At its core, recapture is the Code’s procedure for triggering income on a gain a taxpayer realizes upon the disposition of an asset that had previously provided a tax benefit, such as through depreciation. Because depreciation can be deducted from ordinary income to reflect the wear-and-tear on an asset (an exhaustion factor) used in the taxpayer’s trade or business or for the production of income where the asset has a determinable useful life of more than one year, gain on the disposal of the asset (up to the taxpayer’s recomputed basis in the asset (see, e.g. I.R.C. §1016 and/or I.R.C. §1245(a)(2)(A)) must be reported as ordinary income. It is not reported as capital gain in accordance with I.R.C. §1231. Depreciation recapture attributable to tangible personal property is governed by I.R.C. §1245. The provision governing recapture associated with real property is I.R.C. §1250. For I.R.C. §1250 recapture purposes, the IRS refers to it as “additional depreciation” in IRS Pub. 544. In I.R.S. Pub. 544, the IRS describes it as the portion of accumulated depreciation that exceeds straight line depreciation. It is taxed at ordinary income rates to the extent of gain realized at a maximum of 37 percent (presently). The portion corresponding to straight-line depreciation is “unrecaptured §1250 gain” and is taxed at a maximum rate of 25 percent. Any remaining gain is long-term capital gain if the taxpayer had held the property for over a year, and is taxed at a maximum capital gain rate of 20 percent.
Depletion Deduction Recapture
There’s another recapture section of the Code – I.R.C. §1254. It’s titled, “Gain from disposition of interest in oil, gas, geothermal, and other mineral properties.” While gain on the sale or exchange of natural resources is generally capital gain in nature via I.R.C. §1221 or I.R.C. §1222 or via the netting process of I.R.C. §1231, I.R.C. §1254 taxes as ordinary income the recapture of depletion deductions previously claimed when an oil or gas interest is disposed of in a taxable transaction. Under I.R.C. §1254, the amount recaptured as ordinary income is the lesser of (1) the sum of the deductions for depletion under I.R.C. §611 that reduced the property’s adjusted basis, and the intangible drilling and development costs currently deducted under I.R.C. §263; or (2) the gain obtained by deducting the adjusted basis of the property from the amount realized. I.R.C. §§1254(a)(1)(A),(B).
Because I.R.C. §1254 applies to depletion that reduces adjusted basis, it applies to both percentage and cost depletion – to the extent either depletion approach reduced the adjusted basis of the subject property. Thus, gain in excess of depletion previously allowed is taxed as ordinary income. It also applies separately to each property of the taxpayer, if the taxpayer has more than a single property. I.R.C. §614 defines “property” for this purpose. Also, if the taxpayer only disposes of a portion of a property that is subject to I.R.C. §1254 depreciation recapture, rules governing partial dispositions can apply. See I.R.C. §1254(a)(2); Treas. Reg. §1.1254-1(c).
Consider the following example:
Suzy, in 2011, acquired a working interest in an oil and gas deposit. Her original basis in the interest was $100,000. During Suzy’s period of ownership, she was allowed (and claimed) $75,000 of depletion deductions. Thus, her adjusted basis in the working interest is $25,000 in accordance with I.R.C. §1016(a)(2). Suzy did not expense any intangible drilling and development costs. Suzy later sells her working interest in the deposit in 2019 for $125,000 - its fair market value at the time of sale. Suzy has realized gain of $125,000 less her adjusted basis of $25,000, or $100,000. Applying I.R.C. §1254(a)(1), Suzy has recapture of the previously claimed depletion deductions of the lesser of $75,000 or $100,000. Thus, $75,000 of the $100,000 gain is treated as ordinary income. The remaining $25,000 gain is taxed as long-term capital gain in accordance with I.R.C. §1231.
Other Rules on Recapture
As noted above, recapture is potentially triggered when the taxpayer’s interest is disposed of in a taxable transaction. In other words, there must be a “disposition” of the asset before recapture is possible. Some transactions do not constitute a “disposition” for purposes of recapture under I.R.C. §1254. These include mortgaging the property (Treas. Reg. §1.1254-1(b)(3)(ii)(A)); any abandonment (unless the taxpayer recognizes income on the foreclosure of a nonrecourse debt) (Treas. Reg. §1.1254-1(b)(3)(ii)(B)); leasing or subleasing the property (Treas. Reg. §1.1254-1(b)(3)(ii)(C)); the termination or election of S corporation status (Treas. Reg. §1.1254-1(b)(3)(ii)(D)); including the property in a pooling or unitization arrangement (Treas. Reg. §1.1254-1(b)(3)(ii)(E)); the expiration or reversion of an operating mineral interest in whole or in part by the terms of the agreement (Treas. Reg. §1254-1(b)(3)(ii)(F)); or any conversion of an overriding royalty interest that at the grantor’s option (or at the option of a successor in interest) converts to an operating mineral interest after a certain amount of production. Treas. Reg. §1.1254-1(b)(3)(ii)(G). Also, when taxpayers exchange their interests in oil and gas partnerships for stock of a newly organized corporation, they don’t have any gain or loss except to the extent that their share of partnership liabilities exceed their basis. In this situation, there is no recapture of intangible drilling costs. Priv. Ltr. Rul. 8107099 (Nov. 21, 1980).
If the disposition of the oil or gas (or geothermal) property is by gift, recapture is not triggered. Treas. Reg. §1.1254-2(a)(1). But if the transaction is a part gift/part sale transaction (typically utilized in estate planning situations and other transactions involving family members) recapture can apply to any gain that the transaction triggers. Treas. Reg. §1.1254-2(a)(2). The charitable deduction associated with a gift to a charitable organization of a working or operating interest in an oil or gas property must be reduced by the amount of any intangible drilling and development costs attributable to the donated interest that the donor previously deducted under I.R.C. §1254. I.R.C. §170(e)(1)(A).
As usual, a transfer on account of death does not trigger recapture. Treas. Reg. §1.1254-2(b). Also, if the disposition occurs as part of a like-kind exchange under I.R.C. §1031, the depreciation recapture taxed as ordinary income is limited to the “boot” (gain attributable to “unlike” property) involved in the exchange. Treas. Reg. §1.1254-2(c). On this last point, it appears to be implicit in the regulation that an interest in an oil and gas property constitutes real estate for purposes of I.R.C. §1031. That’s an important point now that personal property is not eligible for tax-deferred treatment under I.R.C. §1031.
When a partnership disposes of an interest in oil and gas (or other natural resources), the amount treated as ordinary income is determined at the partner level. Each partner recognizes as ordinary income the lesser of the partner’s I.R.C. §1254 costs with respect to the property disposed of, or the partner’s share of the amount (if any) by which the amount realized upon the sale, exchange, or involuntary conversion, or the fair market value of the property upon any other disposition, exceeds the adjusted basis of the property. Treas. Reg. §1.1254-5(b)(1).
Oil and gas taxation is a bit unique in many respects. Depletion, while conceptually the same as depreciation, is nuanced. The rules on recapture of the depletion deduction generally follow the rules for depreciation recapture. That means if the rules are triggered, the result is not going to be a good one for the taxpayer. Remember, “recapture” is one of the “dirty” words in tax. Avoid it if you can.
Monday, October 21, 2019
Last week’s post on cost depletion generated an interesting question from a reader concerning whether a bonus payment that a landowner receives upon signing an oil and gas lease agreement entitles the landowner to a cost depletion deduction on the payment. That’s an important question. The increased production of oil and gas on privately owned property in recent years means that an increasing number of landowners are receiving payments from oil and gas companies, including bonus payments.
The taxation of bonus payments associated with oil and gas leases – that’s the topic of today’s post.
Character of the gain. The lessee typically pays a lump-sum cash bonus during the initial lease term (pre-drilling) for the rights to acquire an economic interest in the minerals. This is the basic consideration that the lessee pays to the lessor (landowner) when the lease is executed. The lessor reports the bonus payment on Schedule E, Supplemental Income and Loss. It constitutes net investment income (NII) that is potentially subject to the additional 3.8 percent NII tax (NIIT) of I.R.C. §1411. A bonus payment is generally categorized as ordinary income and not capital gain because it is not tied to production. See, e.g., Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 588 Fed. Appx. 199 (3d Cir. 2014).
A bonus payment may be paid annually for a fixed number of years regardless of production. If the lessee cannot avoid the payments by terminating the lease, the payments are termed a lease bonus payable in installments. These payments are also consideration for granting a lease. They are an advance payment for oil, and each installment is typically larger than a normal delay rental. A cash-basis lessee must capitalize such payments, and the fair market value (FMV) of the contract in the year the lease is executed is ordinary income to the lessor if the right to the income is transferable. Rev. Rul. 68-606, 1968-2 CB 42. However, if the bonus payments are made under a contract that is nontransferable and nonnegotiable, a cash-basis lessor can defer recognizing the payments until they are received. See, e.g., Kleberg v. Comm’r, 43 BTA 277 (1941), non. acq. 1952-1 CB 5.
Cost depletion? Can a lessor claim cost depletion on a bonus payment? This question came up in a Tax Court case in 2013. In Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 558 Fed. Appx. 199 (3d Cir. 2014), the taxpayer owned a tract of land in Pennsylvania and entered into an oil and gas agreement with an oil and gas company. The lease called for the taxpayer to receive a lease bonus payment upfront for entering into the lease agreement. The taxpayer was also entitled to a royalty payment of 16 percent of the net profits of oil and gas extracted from the leased premises. The bonus payment was not tied to extraction or production in any fashion. It was purely an upfront payment made to induce the taxpayer to execute the lease agreement. The taxpayer reported the bonus payment as long-term capital gain rather than ordinary income on the assertion that the transaction amounted to a sale of oil and gas. On audit, the IRS disagreed, recharacterized the bonus payment as ordinary income and slapped a 20 percent accuracy-related penalty on top.
The Tax Court agreed with the IRS, citing the classic U.S. Supreme Court case of Burnet v. Hamel, 287 U.S. 103 (1932). On the sale/lease issue, the Tax Court taxpayer retained an economic interest in the oil and gas deposits that were the subject matter of the lease. That was true, the Tax Court reasoned because under the lease the taxpayer was entitled to royalty payments computed as a percentage of net profits of oil and gas that were extracted from the property. That meant that the taxpayer possessed an economic interest in the in-place minerals. See, e.g., Kittle v. Comr., 21 T.C. 79 (1953). Had the transaction been a sale, the Tax Court reasoned, there would have been an exchange of a set quantity of oil and gas for a particular price.
The taxpayer also claimed that the bonus income was subject to percentage depletion. Percentage depletion is a cost recovery method that provides a tax deduction for most natural resources. Percentage depletion assigns a set percentage of depletion to the gross income derived from extracting fossil fuels, minerals, or other nonrenewable resources. For oil and gas, the allowable statutory percentage depletion deduction is the lesser of net income or 15% of gross income. If net income is less than 15% of gross income, the deduction is limited to 100% of net income. I.R.C. §613(b)(2). The Tax Court disagreed with the taxpayer’s claim that percentage depletion applied. I.R.C. §613A(d) bars percentage depletion from applying to lease bonus payments. The payment must be tied to production for percentage depletion to apply. See Treas. Reg. §1.613A-3(j).
But the Tax Court did indicate that the taxpayer’s bonus payment could be eligible for cost depletion. The Tax Court noted that cost depletion, in accordance with Treas. Reg. §1.612-3(a)(1), is tied to the taxpayer’s basis for depletion. The amount of the deduction is dependent upon depletion basis, future expected royalties and the amount of the upfront bonus payment. The taxpayer needed to establish all of these amounts to claim a deduction for cost depletion. The taxpayer failed to do so. The Tax Court also upheld the accuracy-related penalty.
The Dudek case makes it clear that the taxpayer must establish a basis in the minerals subject to an oil and gas lease agreement to be able to claim cost depletion. That can be tricky when land is acquired that has an oil and gas deposit and purchase transaction combines both the land and the deposit together. It is the position of the IRS that minerals do not have a separate cost basis unless the seller’s cost stipulated such an amount; or was the result of an estate tax valuation that contained the separate valuations; or the seller’s cost basis can be properly allocated in accordance with existing evidence at the time of the acquisition. I.R.M. 126.96.36.199.1.2 (Dec. 3, 2013). While the IRS has indicated that a taxpayer might be able to establish a separate value for the minerals based on the evidence, it clearly is the taxpayer’s burden to prove the basis allocated to the oil and gas (or other mineral) deposit. See, e.g., Rev. Rul. 69-539, 1969-2 CB 141; Collums v. United States, 480 F. Supp. 864 (D. Wyo. 1979). That allocation might even be 100 percent of the taxpayer’s basis in the lease if a zero estimate of future royalties is reasonable (such as in a wildcat area). See, e.g., Collums v. United States, 480 F. Supp. 864 (D. Wyo. 1979); but see Tech. Adv. Memo. 8532011 (May 7, 1985).
Cost depletion can be confusing. The Dudek opinion reiterates the long-standing ordinary income treatment of bonus payments associated with oil and gas leases. It also points out that cost depletion can apply to the payments. But work must be done to be able to claim cost depletion, and that burden is on the taxpayer.
Thursday, October 17, 2019
When financial and economic conditions sour, one of the issues that can come up concerns the ability to collect on debts. Ag retail businesses are experiencing tougher credit relations with farm clients due to difficult times in some sectors of production agriculture. Thus, a debt can turn into a “bad debt.” That has tax consequences. An income tax deduction is allowed for debts which become worthless within the taxable year.
What does it take to be able to deduct a bad debt? Is there a tax difference between a business bad debt and a non-business bad debt?
Distinguishing between business and non-business bad debts. That’s the topic of today’s blog post.
Elements Necessary For Deductibility
Debtor-creditor relationship. For a bad debt to be deductible, there must be a debtor-creditor relationship involving a legal, valid, and enforceable obligation to pay a fixed or determinable sum of money. See, e.g., Meier v. Comm’r, T.C. Memo. 2003-94; Treas. Reg. §1.166-1(c). In addition, the taxpayer must be able to show that it was the intent of the parties at the time the transaction was entered into to create that debtor-creditor relationship. The requisite intent is established by showing that when the relationship was formed, the taxpayer had an actual expectation of repayment and intended to enforce the debt if necessary. Thus, a deductible bad debt can derive from a loan made in the context of protecting the taxpayer’s investment if the purpose of making the loan was for business and their was intent to collect on the loan if necessary.
While a formal loan agreement helps establish this intent, the lack of one will not absolutely bar the finding of a bona fide debt. Conversely, the existence of paperwork documenting the transaction (such as a note) does not always mean that the transaction constitutes a bona fide debt stemming from a debtor-creditor relationship.
Related party? The fact that the debtor and creditor are related parties does not preclude a bad debt deduction. The key is whether the loan that is now worthless was made for legitimate business purposes and arises from a debtor-creditor relationship and meets the other requirements as noted above. However, the IRS tends to look more closely to debts involving related parties than those involving non-related parties.
Classification of Bad Debts
For individuals and entities taxed as individuals, bad debts may be business bad debts or nonbusiness bad debts. Corporations have only business bad debts. Business bad debts are deducted directly from gross income while a nonbusiness bad debt of a non-corporate taxpayer is reported as a short-term capital loss when it becomes totally worthless.
So what is the distinction between a business bad debt and a nonbusiness bad debt? A business bad debt relates to operating a trade or business and is mainly the result of credit sales to customers or loans to suppliers, clients, employers or distributors. The loan transaction must have a relationship to the taxpayer’s trade or business. Treas. Reg. §1.166-5(b). According to the U.S. Supreme Court, the relationship of the loan transaction to the taxpayer’s trade or business is dependent upon whether the taxpayer’s “dominant motivation” for the loan was related to the taxpayer’s business. United States v. Generes, 405 U.S. 93 (1972). In Generes, the Court concluded that the taxpayer's status as an employee was a business interest, but the taxpayer’s status as a shareholder was a nonbusiness interest. But, this does not appear to be a blanket rule for every situation. While the Court indicated that a business bad debt can arise from a loan transaction entered into to protect an employment status, source of income, a business relationship or to protect a business reputation, the Court also seemed to indicate that a shareholder can still experience a business bad debt if the loan transaction has a business purpose and otherwise meets the requirements of a business bad debt. The facts are critical.
A taxpayer that is in the trade or business of lending money generally treats uncollectable loans as business bad debts. See, e.g., Henderson, 375 F.2d 36 (5th Cir. 1967); Serot v. Comr., T.C. Memo. 1994-532; aff’d. without pub. op., 74 F.3d 1227 (3d Cir. 1995); Owens v. Comr., T.C. Memo. 2017-157. The cases cited also provide good guidance on how much loan activity is necessary for a taxpayer to be treated as being in the trade or business of lending money.
Claiming the Deduction
A bad debt deduction may be claimed only if there is an actual loss of money or the taxpayer has reported the amount as income. A business bad debt may be totally worthless (no collection potential) or partially worthless. I.R.C. §166(a)(1)-(2). In any event, the allowed deduction for a bad debt does not include any amount that was deducted in a prior year at a time that the debt was only partially worthless. Treas. Reg. §1.166-3(b).
A bad debt is deductible when worthlessness can be established. A nonbusiness bad debt must be wholly worthless in the year for which the deduction is claimed. Cooper v. Comr., T.C. Memo 2015-191; Treas. Reg. §1.165-5(a)(2). But, the actual tax year of worthlessness can sometimes be difficult to determine. If the IRS, on audit, views worthlessness to have occurred in a year before the bad debt deduction was actually claimed, the applicable statute of limitation for seeking a refund or credit for a bad debt is seven years (rather than the normal three years). I.R.C. §6511(d).
But, a bad debt can’t be claimed if the taxpayer doesn’t have any records or activity to establish that the money transferred created an enforceable loan entered into for profit. That can be a key point with many farming operations and loans between family members. See, e.g., Vaughters v. Comr., T.C. Memo. 1988-276. It’s critical to properly document the arrangement.
Careful tax planning can help maximize the tax benefit of a bad debt deduction and minimize the economic pain. Today’s post covered the basics of bad debts, perhaps a future post can dig a little further.
Monday, October 7, 2019
2013 marked the beginning of major law changes impacting estate planning. Those changes were continued and, in some instances, enhanced by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017. In particular, the “applicable exclusion amount” was enhanced such that (for deaths in 2019) the associated credit offsets the first $11.4 million in taxable estate value (or taxable gifts). Consequently, the vast majority of estates are not impacted by the federal estate tax. The “stepped-up” basis rule was also retained. I.R.C. §1014. Under that rule, property included in the estate at death gets an income tax basis in the hands of the heirs equal to the property’s fair market value (known as “stepped-up” basis). Much estate planning now emphasis techniques to cause property inclusion in a decedent’s estate at death to get the basis increase.
What are the planning steps to achieve a basis increase? What about community property? These are the issues addressed in today’s post.
Basis “Step-Up” Considerations – First Things First
As noted above, under present law, the vast majority of estates do not face federal estate tax at death. Thus, obtaining a basis increase for assets included in the gross estate is typically viewed as more important. Consequently, an initial estate planning step often involves a comparison of the potential transfer tax costs with the income tax savings that would arise from a “step-up” in basis. Unfortunately, this is not a precise science because the applicable exclusion adjusts be for inflation or deflation and could change dramatically depending on the whim of politicians.
It’s also important to note that a basis increase is of no tax help to the owner of the property that dies. The only way to capture the income tax benefits of the stepped-up basis adjustment is for the recipients of those assets to dispose of them in a taxable transaction. The degree of the benefit is tied to the asset. Farm and ranch land may never be sold or may only be sold in the very distant future. A basis adjustment at death is also beneficial if the asset involved is depreciable or subject to depletion. An additional consideration is whether the asset involved is an interest in a pass-through entity such as a partnership or an S corporation.
Exceptions To “Stepped-Up” Basis
There are exceptions to the general rule of date- of-death basis. For example, if the estate executor elects alternate valuation under I.R.C. §2032, basis is established as of the alternate valuation date (typically six months after death). Also, if the estate executor elects special use valuation under I.R.C. §2032A, the lower agricultural use value of the elected property as reported on the federal estate tax return establishes the basis in the hands of the heirs. For deaths in 2019, the maximum statutory value reduction for elected land is $1,160,000.
In addition, for land subject to a qualified conservation easement that is excluded from the gross estate under I.R.C. §2031(c), a “carryover” basis applies to the property. Also not receiving a basis increase at death is property that constitutes income in respect of a decedent (such as unrecognized interest on U.S. savings bonds, accounts receivable for cash basis taxpayers, qualified retirement plan assets, and IRAs, among other things). There’s also a special basis rule that involves appreciated property that was gifted to the decedent within one year of death, where the decedent transferred the property back to the original donor of such property (or the spouse of the donor). The donor receiving the property back will take as a basis the basis that the decedent had in the property immediately before the date of death. I.R.C. §1014(e). The property basis won’t step-up to fair market value at the date of the decedent’s death.
Community Property Considerations
The advantage of community property. On the basis step-up issue, estates of persons living in community property states have an advantage over estates of persons domiciled in separate (common law) property states. Under community property law, all assets acquired during marriage by either spouse, except gifts, inheritances, and assets acquired with separate property, are considered to be owned equally by the spouses in undivided interests. The title of an asset is not definitive in terms of ownership in community property states like it is in common law states. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.
The ownership portion of the couple’s community property that is attributable to the surviving spouse by virtue of I.R.C. §1014(b)(6) gets a new basis when the first spouse dies if at least one-half of the community property is included in the decedent’s estate for federal estate tax purposes. This became the rule for deaths after 1947. Restated differently, there is a basis adjustment of both the decedent’s and surviving spouse’s one-half of community property at death if at least one-half of the community property was included in the decedent’s gross estate under the federal estate tax rules – which would normally be the result. The federal tax law considers the surviving spouse’s share to have come from the decedent. The result is a 100 percent step-up in the basis of the property. Conversely, in a common law property state, property that one spouse owns outright at death along with only 50 percent of jointly owned property is included in the estate of the first spouse to die (and receives a basis adjustment) unless the rule of Gallenstein v. Comr., 975 F.2d 286 (6th Cir. 1992) applies to provide a 100 percent basis step-up for property acquired before 1977.
Community property spousal trusts. Three common law property states, Alaska, South Dakota and Tennessee, authorize the creation of “community property trusts” for married couples that establish via the trust an elective community property system. See, Alaska Stat. Ann. §34.77.100; Tenn. Code Ann. Ch. 35-17-101 – 35-17-108; S.D. Cod. Laws. Ch. 55-17-1 – 55-17-14. In these states, married couples can classify property as community property by transferring the property to a qualifying trust.
Under the Alaska provision (enacted in 1998), at least one trustee must be an individual who resides in Alaska or a trust company or bank with its principal place of business in Alaska. The trust is irrevocable unless it provides for amendment or revocation. Certain disclosures must be made for the trust to be valid, and the trust must contain specific language declaring that the property contained in the trust is to be community property. Resident married couples can also execute an agreement to create community property for property that is not held in trust.
The Tennessee provision was enacted in 2010 and allows married couples to convert their property to community property by means of a “Community Property Trust.” Again, the idea of the trust is to achieve a 100 percent basis step-up for all of the trust property at the death of the first spouse. Comparable to the Alaska provision, at least one trustee must be an individual that resides in Tennessee or a company that is authorized to act as a fiduciary in Tennessee.
Under the South Dakota law (enacted in 2016), property contained in “South Dakota Spousal Trust” is considered to be community property even if one spouse contributed more than 50 percent of the property to the trust. At least one trustee must be a South Dakota resident, which could be one of the spouses. S.D. Cod. Laws §§55-17-1; 55-3-41. The trust must state that the trust property is intended to be community property and must specify that South Dakota law applies. S.D. Cod. Laws §55-17-3. Both spouses must sign the trust. S.D. Cod. Laws §55-17-1. Nonresidents can also utilize such a trust if a trustee is a qualified person that resides in South Dakota. In addition, significant disclosures are required between the spouses and both must consent and execute the trust. S.D. Cod. Laws §§55-17-11; 55-17-12. The trust can be either revocable or irrevocable if the trust language allows for amendment or revocation. S.D. Cod. Laws. §55-17-4.
Transfer of farmland. Can farmland that is owned in joint-tenancy, tenancy-by-the-entirety, or co-tenancy in a common law property state be transferred to a Community Property Trust created under the laws of these states and be treated as community property in order to achieve a full stepped-up basis at the death of the first spouse? Normally the law of “situs” (e.g. the location of where land is located) governs the legal status of the land transferred to a trust that is administered in another state. Neither the Alaska, South Dakota, nor Tennessee laws clearly address the legal nature of farmland that is transferred to such a trust from a common law property state, and there appears to be no caselaw or IRS rulings that address the question. Thus, a preferable planning approach might be to transfer the out-of-state farmland to an entity such as a limited liability company or family limited partnership followed by a transfer of the interests in the entity to the trust. Perhaps doing so would avoid questions concerning the property law and income tax basis issues associated with the out-of-state farmland.
The UDCPRDA. Presently, sixteen states (Alaska; Arkansas; Colorado; Connecticut; Florida; Hawaii; Kentucky; Michigan; Minnesota; Montana; New York; North Carolina; Oregon; Utah; Virginia and Wyoming) have enacted the Uniform Disposition of Community Property Rights at Death Act (“UDCPRDA”). The UDCPRDA specifies how property that was acquired while the spouses resided in a community property state passes at death if the spouses then reside in a common law property state. The UDCPRDA preserves the community property nature of the property, unless the couple has taken some action to sever community property rights. It does so by specifying that upon the death of the first spouse, one-half of the community property is considered the property of the surviving spouse and the other half is considered to belong to the deceased spouse. This should achieve a full basis step-up due to the unlimited marital deduction of I.R.C. §2056, however there aren’t any cases or IRS rulings on the impact of the UDCPRDA on basis step-up under I.R.C. §1014(b)(6).
The disparate treatment of community and common law property under I.R.C. §1014 has incentivized estate planners to come up with techniques designed to achieve a basis “step up” for the surviving spouse’s common law property at the death of the first spouse.
One way to achieve the basis increase is to give each spouse a power of appointment over the other spouse’s property which causes, on the death of the first spouse, the deceased’s spouse’s property to be included in the decedent’s estate by virtue of I.R.C. §2033 (if owned outright) and I.R.C.§2038 if owned in a revocable trust. The surviving spouse’s property would also be included in the decedent’s estate by virtue of I.R.C. §2041. The power held by the first spouse to die terminates upon the first spouse’s death and would be deemed to have passed at that time to the surviving spouse.
Another technique involves the use of a joint exempt step-up trust (JEST). In essence, both spouses contribute their property to the JEST that holds the assets as a common fund for the benefit of both spouses. Either spouse may terminate the trust while both are living, with the result that the trustee distributes half of the assets back to each spouse. If there is no termination, the joint trust becomes irrevocable upon the first spouse’s death. Upon the first spouse’s death, all assets are included in that spouse’s estate. Upon the first spouse’s death, assets equal in value to the first spouse’s unused exclusion will be used to fund a bypass trust for the benefit of the surviving spouse and descendants. These assets will receive a stepped-up basis and will not be included in the surviving spouse’s estate. Any asset in excess of the funding of the bypass trust will go into an electing qualified terminable interest property (QTIP) trust under I.R.C. §2056(b)(7). If the first spouse’s share of the trust is less than the available exclusion, then the surviving spouse’s share will be used to fund a bypass credit shelter trust. These assets will avoid estate taxation at the surviving spouse’s death.
The JEST technique comes with caution. Because the surviving spouse (the donor) could revoke the joint revocable living trust at any time, the surviving spouse arguably has dominion and control over the trust assets during the year before and up to the time of the decedent spouse’s death. That could mean that I.R.C. §1014(e) applies to disallow a basis increase in the surviving spouse’s one-half interest in the trust due to retained control over the trust assets within a year of death. See, Priv. Ltr. Ruls. 9308002 (Nov. 16, 1992) and 200101021 (Oct. 2, 2000).
For the vast majority of people, avoiding federal estate tax at death is not a concern. Some states, however, do tax transfers at death and the exemption in those states is often much lower than the federal exemption. But, achieving an income tax basis at death is of primary importance to many people. Community property has an advantage on this point, and other planning steps might be available to receive a full basis step-up at death. In any event, estate and income tax basis planning is a complex process for many people, especially those with farms and ranches and other small businesses that are trying to make a successful transition to the next generation. Competent legal and tax counsel is a must.
Wednesday, October 2, 2019
Court cases are many in which the IRS has asserted that the taxpayer is engaged in an activity without an intent to make a profit. If the IRS prevails in its claim that the taxpayer’s activity is a hobby, deductions for losses from the activity are severely limited. The tax result is even harsher as a result of the Tax Cuts and Jobs Act (TCJA).
What does it take to be conducting an activity with a profit intent? How did the TCJA change the impact of the “hobby loss” rules? These are the topics of today’s blog post.
Tax Code Rules
What is a “hobby”? A “hobby” under the Code is defined in terms of what it is not. I.R.C. §183. A hobby activity is essentially defined as any activity that a taxpayer conducts other than those for which deductions are allowed for expenses incurred in carrying on a trade or business or producing income. I.R.C. §§162; 212. The determination of whether any particular activity is a hobby activity or not is based on the facts and circumstances of each situation. It’s a highly subjective determination. But the Code provides a safe harbor. I.R.C. §183(d). Under the safe harbor, an activity that doesn’t involve horse racing, breeding or showing must show a profit for three of the last five years, ending with the tax year in question. It’s two out of the last seven years for horse-related activities. If the safe harbor is satisfied (either for horse activities or other activities, a presumption arises that the activity is not a hobby. The safe harbor applies only for the third (or second) profitable year and all subsequent years within a five-year (or seven-year) safe-harbor period that begins with the first profitable year. Treas. Reg. §1.183-1(c).
The burden of proof. Satisfaction of the safe harbor shifts the burden to prove that the activity is a hobby (i.e., lacks a profit motive) to the IRS. But the IRS can rebut the for-profit presumption even if the safe harbor is satisfied – although it doesn’t tend to do so without extenuating circumstances.
What about losses in early years? As noted above, the safe harbor applies only after a taxpayer incurs a third profitable year within the five-year testing period. That means that only loss years arising after that time (and within the five-year period) are protected. Losses incurred in the first several years are not protected under the safe harbor. It makes no difference whether the activity turns a profit in later years.
Postponing the safe harbor. It is possible to postpone the application of the safe harbor until the close of the fourth tax year (or sixth (for horse activities) after the tax year the activity begins. I.R.C. §183(e). This is accomplished by making an election via Form 5213 to allow losses incurred during the five-year period to be reported on Schedule C. Thus, if the activity shows a profit for three or more of the five years, the activity is presumed to not be a hobby for the full five-year period. The downside risk of the election occurs if the taxpayer fails to show a profit for at least three of the five years. If that happens, a major tax deficiency could occur for all of the years involved. Thus, filing Form 5213 should not be made without thoughtful consideration. For example, while the election provides more time to establish that an activity is conducted with a profit intent, it will also put the IRS on notice that an activity may be conducted without a profit intent. It also extends the statute of limitations for a tax deficiency (and refund claims) associated with the activity. See, e.g., Wadlow v. Comr., 112 T.C. 247 (1999).
Showing a Profit Intent – Some Recent Cases
While the IRS is presently not aggressively auditing many returns involving farm-related activities, the hobby loss area involving ag activities is one of them. So, what does it take to establish the necessary profit intent? Some recent court decisions provide guidance.
Cattle ranching activity deemed to be a hobby. In Williams v. Comr., T.C. Memo. 2018-48, the petitioner grew up on the family ranch in the Texas panhandle. He then went on to have a career as a chiropractor. He also operated a publishing and research business and a gun shop. He sold his chiropractic practice and bought an 1,100-acre ranch in south-central Texas. He ran a feeder-stocker cattle operation on the ranch, employing two ranch workers to tend to the cattle. The petitioner also hired a bookkeeper to manage his various business activities and a CPA to do the tax work for his businesses. He put approximately six to eight hours a week into the cattle ranching activity, and also spent time in his other business ventures. He modified his cattle operation after encountering problems that were detrimental to the viability of the business. The petitioner’s publishing business showed an average profit of approximately $300,000 each year; the gun shop was approximately a break-even business; and the cattle business averaged Schedule F losses of about $100,000 annually over a 15-year period, never showing a profit in any year (although losses declined on average over time).
The IRS examined years 2011 and 2012 and disallowed the loss from the ranching activity on the basis that the petitioner did not engage in the activity with a profit intent. The Tax Court analyzed each of the nine factors under Treas. Reg. §1.183-2. Of the nine factors contained therein, only one favored the petitioner - he did not derive any personal pleasure from the cattle ranching activity. The Tax Court determined that the petitioner did not operate the ranch in a businesslike manner; had no formal education in animal husbandry; did not view the hours spent in the activity by the employees as attributable to the petitioner; did not have a reasonable expectation of appreciation of the value of the ranch’s assets (but the Tax Court ignored the building improvements and fences that were built); had no history of running comparable businesses profitably; and had substantial income from other sources that the losses from the ranching activity offset.
Horse activity was a hobby. In Sapoznik v. Comr., T.C. Memo. 2019-77, the petitioners bought a horse in 2011 and participated in horse shows in 2014 and 2015. The horse was top-ten in its class nationally, and the petitioners hoped to be able to sell the horse for more than its purchase price. However, the lost more than $100,000 and sold the horse for what they paid for it. The petitioners deducted the $100,000 loss and the IRS rejected the deduction and assessed a penalty exceeding $6,000. The Tax Court agreed with the IRS that the activity was a hobby. The Tax Court noted that the petitioners had not conducted the activity in a businesslike manner. They also had no written business plan and didn’t keep accurate books and records. They also made no changes in how they conducted the activity to reduce expenses or generate additional income, and they did not attempt to educate themselves on how to conduct the activity. They also did not rely on the activity as a major source of their income, and never came close to making a profit.
Profit was “too gone for too long.” In Donoghue, et ux. v. Comr., T.C. Memo. 2019-71, the petitioners, sustained losses in their horse breeding/racing activity for almost 30 years without ever showing a profit. The husband was a computer programmer and his wife a retired paralegal and business executive. The wife had been a life-long horse enthusiast. They operated the activity via a partnership as a “virtual farm.” The IRS denied the loss deductions from the activity and the Tax Court agreed on the basis that the petitioners couldn’t satisfy the requirements of the regulations under I.R.C. §183. The Tax Court noted that the evidence clearly established that the petitioners didn’t operate the activity in a businesslike manner. They didn’t breed, race or sell any of their horses during the years at issue. While they had separate bank accounts and some records, the records were incomplete or inaccurate. While the petitioners had written business plans, the plans projected net losses and remained essentially unchanged from the original plans 30 years earlier. Also, their long string of unbroken losses was used to offset non-farm income, and the petitioners derived substantial personal pleasure from the activity. They left the “grueling aspects” of the activity to others that they paid, and there was no evidence that they sought expert advice concerning how to make a profit at the activity. Instead, they sought only general advice.
Golf course activity conducted for profit. In one recent non-ag case, WP Realty, LLP v. Comr., T.C. Memo. 2019-120, a profit intent was found to be present. The petitioner, a limited partnership, owned and operated a golf course. The limited partner and sole shareholder of the general partner was a real estate developer and developer of golf courses who created a nonprofit corporation to which he planned to donate the golf course at issue. The IRS approval of nonprofit status was conditioned on the corporation focusing only on charitable activities and distributing funds to a medical center. As a result, the golf course gave access to the corporation and members. The corporation paid rent and members paid fees for golf rounds. The golf course was managed by an experienced manager. The manager kept complete books and records and maintained budgets for the course and facilities. Between 2001 and 2015, the golf course sustained losses which flowed through the petitioner to the limited partner. The golf course reported a net profit in 2016.
The IRS denied the loss deductions on the basis that the golf course was not engaged in its activity for profit. The Tax Court disagreed based on the nine factors of Treas. Reg. §1.183-2(b), a predominance of which favored the petitioner. The golf course was operated in a businesslike manner with complete and accurate books and records, and the records were used to determine when capital improvements should be made. Steps were also taken to make the golf course more profitable. In addition, the managers had extensive experience in the golf industry and in managing golf clubs. The Tax Court also noted that the limited partner had successfully developed two other golf clubs and did not derive substantial tax benefits from the passed-through losses. While a long history of losses was present, that factor was not enough to negate the petitioner’s actual and honest intent to make a profit.
The TCJA suspends miscellaneous itemized deductions for years 2018-2025. Thus, deductions for expenses from an activity that is determined to be a hobby are not allowed in any amount for that timeframe. I.R.C. §67(g). But all of the income from the activity must be recognized in adjusted gross income. That’s painful, and it points out the importance of establishing the requisite profit intent.
Hobby activities involving agricultural activities (especially those involving horses) have been on the IRS radar for quite some time. That’s not expected to change. It’s also an issue that some states are rather aggressive in policing. See, e.g., Howard v. Department of Revenue, No. TC-MD 160377R, 2018 Ore. Tax LEXIS 35 (Ore. Tax Ct. Mar. 16, 2018); Feola v. Oregon Department of Revenue, No. TC-MD 160081N, 2018 Ore. Tax. LEXIS 48 (Ore. Tax. Ct. Mar. 27, 2018). It’s also not an issue that the U.S. Supreme Court is likely to review if the taxpayer receives an unfavorable opinion at the U.S. Circuit Court of Appeals level. See, e.g., Hylton v. Comr., T.C. Memo. 2016-234, aff’d., No. 17-1776, 2018 U.S. App. LEXIS 35001 (4th Cir. 2018), cert. den., No. 18-789, 2019 U.S. LEXIS 966 (U.S. Sup. Ct. Feb. 19, 2019).
Friday, September 27, 2019
In Tuesday’s Part One of a two-part series on family limited partnerships (FLPs), I looked at where an FLP might fit as part of a business or succession plan for a farm or ranch operation. Today, in Part Two, I examine the relative advantages and disadvantages of the FLP form.
The pros and cons of the FLP – that’s the topic of today’s blog post.
Advantages of an FLP
Income taxation. An FLP is generally taxed like a general partnership. There is no corporate-level tax and taxes are not imposed on assets passing from the FLP to the partners (unlike an S corporation). Thus, the FLP is not recognized as a taxpayer, and the income of the FLP passes through to the partners based on their ownership interest. The partners report the FLP income on their individual income tax returns and must pay any tax owed. Income is allocated to each partner to the extent of the partner’s share attributable to their capital (or pro rata share).
This tax feature of the FLP can be an attractive vehicle if a transfer of interests to family members in a lower tax bracket is desired. Transfers of FLP interests can also be made to minor children if they are competent to manage their own property and participate in FLP activities. But, such transfers are typically made in trust on behalf of the minor. Also, unearned income of children under age 18 (and in certain cases up to age 23) may be subject to the “kiddie tax” and thus be taxable at the parents’ income tax rate.
Avoidance of transfer taxes. Another advantage of an FLP is that it can help avoid transfer taxes - estate tax, gift tax and generation skipping transfer tax. Transfer tax avoidance is accomplished in three ways: 1) by the removal of future asset appreciation; 2) the utilization of the present interest annual exclusion for gift tax purposes; and 3) the use of valuation discounts for both gift and estate tax purposes. Of course, the federal estate and gift tax is not much concern for very many at the present time with the applicable exclusion amount set at $11.4 million for deaths in and gifts made in 2019. But, the present high level of the exclusion is presently set to expire after 2025. Depending on politics, it could be reduced before 2025.
Transfer of assets yet maintenance of control. Another advantage of an FLP is that it allows the senior generation of the family to distribute assets currently while simultaneously maintaining control over those assets by being the general partner with as little as a 1% interest in the FLP. This can allow the general partner to control cash flow, income distribution, asset investment and all other management decisions.
But, a word of caution is in order. I.R.C. §2036(a)(1) provides that a decedent’s gross estate includes the value of property previously transferred by the decedent if the decedent retained the possession or enjoyment of, or the right to the income from, the transferred property. I.R.C. §2036(a)(2) includes in the gross estate property previously transferred by the decedent if the decedent retained the right, either alone or in conjunction with any person, to designate the persons who are to possess or enjoy the transferred property or its income. Thus, pursuant to §2036(a)(2), the IRS may claim that because a general partner controls partnership distributions, a transferred partnership interest should be taxed in the general partner’s estate.
In the typical FLP scenario, the parents establish the FLP with themselves as the general partners and gift the limited partnership interests to their children. In this situation, if the general partners have the discretionary right to determine the amount and timing of the distributions of cash or other assets, rather than the distributions being mandatory under the terms of the partnership agreement, the IRS could argue that the general partners (who have transferred interests to the limited partners) have retained the right to designate the persons who will enjoy the income from the transferred property. An exception exists for transfers made pursuant to a bona fide sale for adequate and full consideration.
Consolidation of family assets. An FLP also keeps the family business in the family, with the limited partner interests restricted by the terms of the partnership agreement. Such restrictions typically include the inability of the limited partner to transfer an FLP interest unless the other partners are first given the opportunity to purchase (or refuse) the interest. This virtually guarantees that non-family members will not own any of the business interests. These agreements (buy-sell agreements and rights of first refusal) must constitute a bona fide arrangement, not be a device to transfer property to family members for less than full and adequate consideration, and have arm’s length terms. An agreement structured in this manner will produce discounts from fair market value for transferred interests that are subject to the agreement.
Provision for non-business heirs. The FLP can also provide for children not in the family business and allow for an even distribution of the estate among all family members, farm and non-farm. The limited partner interest of a non-farm heir can allow that heir to derive an economic benefit from the income distributions made from time to time without being involved in the day-to-day operation of the business.
Asset protection. The FLP can also serve as an asset protection device. This is particularly the case for the limited partners. A limited partner has no ownership over the assets contributed to the FLP, thus the creditor’s ability to attach those assets is severely limited. In general, a court order (called a “charging order”) would be required to reach a limited partner interest, and even if the order is granted, the creditor only receives the right to FLP income to pay the partner’s debt until the debt is paid off. The creditor still does not reach the FLP assets. The limited partnership agreement and state law are crucial with respect to charging orders. Also, a charging order could put a creditor in a difficult position because tax is owed on a partner’s share of entity profits even if they are not distributed. Thus, a creditor could get pinned with a tax liability, but no income flowing from the partnership to pay the obligation. However, a general partner does not receive the same creditor protection unless the general partner interest is structured as a corporation.
Establishing a corporation as the general partner should be approached with care. It cannot be established as merely a sham to avoid liability. If it is, IRS and/or the courts could ignore it and pierce the corporate veil. To avoid this from happening, the corporation must be kept separate from the FLP. Funds and/or assets must not be commingled between the FLP and the corporation, and all formalities must be observed to maintain the corporate status such as keeping records and minutes, holding directors and shareholders’ meetings and filing annual reports.
- The FLP can also provide flexibility because the FLP agreement can be amended by vote in accordance with the FLP agreement.
- Consolidation of assets. The assets of both the general and limited partners are consolidated in the FLP. That can provide for simplification in the management of the family business assets which could lead to cost savings. In addition, the management of the assets and related investments can be managed by professional, if desired.
- Minimization or elimination of probate. Assets may be transferred to the FLP and the ownership interests may be transferred to others, with only the FLP interest owned at death being subject to probate. Upon death, the FLP continues to operate under the terms of the FLP agreement, ensuring continuity of the business without any disruption caused by death of an owner. Relatedly, an FLP will also typically avoid the need for an ancillary probate (probate in the non-domiciliary state) at the FLP interest owner’s death. Most states treat FLP interests as personal property even if the FLP owns real estate. To the extent probate is avoided, privacy is maintained.
- Partnership accounting rules. The rules surrounding partnership accounting, while complicated, are relatively flexible.
- Ease of gifting. The FLP structure does provide a mechanism that can make it easier for periodic gifting to facilitate estate and tax planning goals.
Disadvantages of an FLP
While there are distinct advantages to using an FLP in the estate and business succession planning context, those advantages should be weighed against potential drawbacks. The disadvantages of using an FLP can include the following:
- An FLP is a complex form of business organization that requires competent legal and tax consultation to establish and maintain. Thus, the cost of formation could be relatively higher than other forms of doing business.
- Unlimited liability of the general partners. However, slightly over one-half of states have enacted legislation allowing the formation of a limited liability limited partnership (LLLP), which is typically accomplished by converting an existing limited partnership to an LLLP. In an LLLP, any general partner has limited liability for the debts and obligations of the limited partnership that arise while the LLLP election is in place. In addition, some states (such as California) that do not have a statute authorizing on LLLP will recognize LLLPs formed under the laws of another state. Also, while Illinois does not authorize LLLPs by statute, it does allow the formation of an LLLP under the Revised Uniform Limited Partnership Act.
- Ineligibility of FLP members for many of the tax-free fringe benefits that employees are eligible for.
- The gifts of FLP interests must be carefully planned to not trigger unexpected estate, gift or GSTT liability.
- Establishing and FLP can be costly in terms of the legal work necessary to draft the FLP agreement, changing title to assets, appraiser fees, state and local filing fees, and tax accounting fees.
- There could be additional complications in community property states. In community property states, guaranteed payments (compensation income) from an FLP are treated as community property. However, FLP income distributed at the discretion of the general partner(s) is classified as separate property.
The FLP can be a useful business organizational form for the farm or ranch business. Careful considerations of the pros and cons of the entity choice in accordance with individual goals and objectives is essential.
Monday, September 23, 2019
Receiving income tax basis for a contribution of debt to an S corporation is an important issue. Tax basis allows a shareholder to determine the tax effect of transactions with the corporation. It’s a measure of the shareholder’s investment in the corporation and is adjusted upward by the shareholder’s share of corporate income and downward by the portion of the corporation’s losses (and nondeductible expenses) allocated to the shareholder. Similarly, any expenses that the shareholder transfers to the corporation will increase basis and expenses the shareholder receives from the corporation will decrease basis.
But, what if the shareholder loans money to the corporation? Will that increase the shareholder’s stock basis? The answer is that “it depends.”
Shareholder loans and stock basis – it’s the topic of today’s blog post.
Debt Basis Rules
A fundamental principle is that debt basis has no impact on the determination of gain or loss on the sale of stock. It also doesn’t impact the taxability of an S corporation’s distributions. Two fundamental principles apply: 1) debt basis has only one purpose – to “soak up” losses that are allocated to a shareholder; and 2) a shareholder in an S corporation gets basis only for those debts made directly from the shareholder to the S corporation. That means for a shareholder to get debt basis, the shareholder must make the loan directly to the S corporation rather than through a related party (entity) that the shareholder owns. There must be an “economic outlay” that (as the courts have stated) makes the shareholder “poorer in a material sense.” See, e.g., I.R.C. §1366(d)(1)(B).
Regulations and Cases
In 2014, the Treasury adopted regulations on the matter. The regulations, known as the “bona fide debt” provisions appeared to replace the “actual economic outlay” test set forth by the judicial decisions on the matter. Under the regulations, the debt must satisfy two requirements: 1) the debt must run directly from the shareholder to the S corporation; and 2) the debt must be bona fide as determined under general federal tax principles based on the facts and circumstances. Treas. Reg. §1.1366-2(a)(2).
In Oren v. Comr., 357 F.3d 854 (8th Cir. 2004), a case decided by the U.S. Court of Appeals for the Eighth Circuit in 2004 (a decade before the 2014 regulations) the court held that a taxpayer lacked enough stock basis to deduct losses passed through to him from his S corporations. He had created loans between himself and his commonly owned S corporations. The transactions were designed to create stock basis so that he could deduct corporate losses. The taxpayer’s S corporation loaned $4 million to the taxpayer. He then loaned the funds to another S corporation in which he was also an owner. The second S corporation then loaned the funds back to the first S corporation. All of the transactions were executed on the same day with notes specifying that the interest was due 375 days after demand. Annual interest was set at 7 percent. The taxpayer claimed that he could use the debt basis created in the second S corporation to deduct the passthrough losses on his individual return. The IRS disagreed and the court agreed with the IRS – he wasn’t poorer in any material sense after the loans were made and he had no economic outlay. The only thing that happened was that there were offsetting bookkeeping entries. There were also other problems with the way the entire transaction was handled.
In Meruelo v. Comr., No. 18-11909, 2019 U.S. App. LEXIS 13305 (11th Cir. May 6, 2019), a case involving a tax year after the 2014 regulations became effective, the taxpayer was a shareholder in an S corporation that bought a condominium complex in a bankruptcy sale. To fund its operations, the S corporation accepted funds from numerous related entities. Ultimately, lenders foreclosed on the complex, triggering a large loss which flowed through to the taxpayer. The taxpayer deducted the loss, claiming that the amounts that the related entities advanced created stock basis (debt basis) allowing the deduction. The IRS disallowed the deduction and the Tax Court agreed.
The appellate court affirmed on the grounds that the advances were not back-to-back loans, either in form or in substance. In addition, the related entities were not “incorporated pocketbooks” of the taxpayer. There was no economic outlay by the taxpayer that would constitute basis. There was no contemporaneous documentation supporting the notion that the loans between the taxpayer and the related entities were back-to-back loans (e.g., amounts loaned to a shareholder who then loans the funds to the taxpayer), and an accountant’s year-end reclassification of the transfers was not persuasive. While the taxpayer owned many of the related entities, they acted as business entities that both disbursed and distributed funds for the S corporation’s business expenses. The appellate court noted the lack of caselaw supporting the notion that a group of non-wholly owned entities that both receive and disburse funds can be an incorporated pocketbook. To generate basis, the appellate court noted, a loan must run directly between an S corporation and the shareholder.
Some had thought that the 2014 regulations had materially changed the way that debt basis transactions would be looked at in the S corporation context. Indeed, the preamble to the regulations did lead to the conclusion that the IRS was moving away from the “economic outlay” test to a “bona fide indebtedness” test (except in the context of shareholder guarantees). See also Treas. Reg. §1.1366-2(a)(2). That lead some to believe that debt basis could be created without an economic outlay. Meruelo establishes that such a belief may not be true.
The lesson of Meruelo (and prior cases) is clear. Debt basis won’t result with a loan from a related party, and it won’t result from simply a paper transaction entered into near the end of the tax year. Don’t cut corners. Pay the money yourself or borrow it from a third party (such as a bank) and then loan the funds directly to the S corporation. Also, make sure that the transaction is booked as a loan. Interest should be charged, and a maturity date established. Make a duck look like a duck.
Thursday, September 19, 2019
The Internal Revenue Code (Code) suspends the statutory timeframe for claiming a tax refund for the period of time that an individual is suffering a financial disability. I.R.C. §6511(h). It’s an important statutory provision that can provide relief in the event of unforeseen circumstances. But definitions matter and there is a key exception to the statutory time suspension.
The suspension of the timeframe for claiming a tax refund – it’s the topic of today’s post.
Under I.R.C. §6511 for all taxes for which a return must be filed, a claim or refund must be filed within: (1) three years of the time the return was filed, except, if the return was filed before it was due, then the claim must be filed within three years of the return's due date; (ii) two years from the time the tax was paid, if that period ends later; or, (iii) two years from the time the tax was paid, if no return's filed by a taxpayer required to file a return. I.R.C. §6511(b)(2).
However, those timeframes are suspended for the time period that an individual is “financially disabled.” An individual is “financially disabled” if the individual cannot manage his financial affairs by reason of his medically determinable physical or mental impairment, and the impairment can be expected to result in death, or has lasted, or can be expected to last, for a continuous period of not less than 12 months. I.R.C. §6511(h)(2)(A). Upon the individual’s death, the suspension period ends, and if a joint return is filed, each spouse’s financial disability must be separately determined. C.C.A. 200210015 (Nov. 26, 2001).
The statute has no application to corporations because it, by its terms, applies to an “individual.” That’s the case even for a solely owned corporation where the owner is financially disabled. See, e.g., Alternative Entertainment Enterprises, Inc. v. United States, 277 Fed. Appx. 590 (6th Cir. 2008). The statute also only applies to the limitation periods that are listed in the provision. That means, for example, that it won’t extend the limitations periods for other provisions of the Code such as for net operating losses or loss carrybacks (now only for farmers), etc. See, e.g., McAllister v. United States, 125 Fed. Cl. 167 (2016).
The statute also doesn’t apply to an estate. This point was made clear in a recent case. In Carter v. United States, No. 5:18-cv-01380-HNJ, 2019 U.S. Dist. LEXIS 134035 (N.D. Ala. Aug. 9, 2019) a decedent’s estate sought relief on the basis that the estate’s personal representative was financially disabled for a period of time entitling the estate to file a claim for refund after the time period set forth in I.R.C. §6511(a). The estate claimed that it should be treated as in individual for relief purposes. The estate sought a refund of federal estate tax tied to the value of bank stock that the decedent held at the time of death which made up 45 percent of the gross estate value. Unknown at the time of death was that a fraud had been committed against the bank which ultimately led to the bank being shut down and the stock rendered worthless. The personal representative was traumatized by the events, suffering emotional distress which rendered her unable to manage the estate which was substantiated by a physician who maintained that the representative’s disabilities triggered I.R.C. § 6511(h)’s equitable tolling provision so as to excuse the untimely filing of the refund claim.
The court disagreed with the estate’s position, holding that the term “individual” in I.R.C. §6511(h)(1) did not apply to an estate. The court pointed out that I.R.C. §7701(a)(1) defines a person as “an individual, a trust, estate, partnership, association, company or corporation.” The court reasoned that this made it clear that the Congress saw individuals and estates as distinct types of taxpayers, and the use of the term individual in I.R.C. §6511(h) limited the relief to natural persons. The court also noted that even if the estate’s claim weren’t time-barred, it would fail on its own merits because estate tax value is based on the value as of the date of death or the alternate valuation date of six months after death. Simply because the fact of the bank fraud arose post-death didn’t change the fact that it wasn’t known at the time of death and the stock was being actively traded at death, the measuring date for federal estate tax purposes.
In all situations, as you probably could guess, a taxpayer is not considered to be financially disabled unless the taxpayer can prove that the statutory requirements are met to the satisfaction of the government. I.R.C. §6511(h)(2)(A).
The courts have fleshed-out the edges on the statute. For example, in Brosi v. Comr., 120 T.C. 5 (2003), the petitioner claimed that the reason he didn’t file was because he was too busy providing care to his mother working for an airline. The Tax Court held he wasn’t entitled to relief because he didn’t personally suffer any physical or mental impairment. The same result occurred in Pleconis v. Internal Revenue Service, No. 09-5970 (SDW) (ES), 2011 U.S. Dist. LEXIS 88471 (D. N.J. 2011). In that case, the taxpayer failed to show that he was financially disabled from 2001-2007 because the evidence showed that even during the periods when he underwent surgeries, he was able to manage his finances, and his conditions had improved by January of 2006. In another case, a taxpayer that missed 60 days of work due to high blood sugar didn’t qualify as “financially disabled. Bhattacharyya v. Comr., 180 Fed. Appx. 763 (9th Cir. 2006).
Authorized “agent”? The statute clearly states that an individual cannot satisfy the statute to be treated as “financially disabled” when there is a spouse or an authorized agent that can handle the individual’s financial affairs for the individual, whether they choose to do so or not. I.R.C. §6511(h)(2)(B). See also, Pull v. Internal Revenue Service, No. 1:14-cv-02020-LJO-SAB, 2015 U.S. Dist. LEXIS 39562 (E.D. Cal. 2015); Plati v. United States, 99 Fed. Cl. 634 (2011). This is the case even when the power to act on the individual’s behalf exists under a durable power of attorney, but the agent has not acted and has agreed not to act on the individual’s behalf until the individual wants the agent to act or otherwise becomes “disabled.” See, e.g., Bova v. United States, 80 Fed. Cl. 449 (2008).
The issue of the presence of an authorized agent came up again in a recent case. In Stauffer v. Internal Revenue Service, No. 18-2105, 2019 U.S. App. LEXIS 27827 (1st Cir. Sept. 16, 2019), an individual who filed suit on behalf of his father’s estate claimed that the IRS had improperly denied his 2013 claim for his father’s 2006 tax refund as untimely. He claimed that the tax refund claim time limitation was suspended because of his father’s financial disability. The trial court dismissed the claim because the son held a durable power of attorney that authorized him to act on his father’s behalf with respect to his father’s financial matters. It made no difference whether he ever actually had acted on his father’s behalf. The mere fact that the durable power of attorney had been executed and was in effect was enough to bar the application of the statute. On appeal, the appellate court agreed.
Financial hardship brings its own set of complications to other areas of life. The Code provides some relief from the filing deadlines. But, the relief only applies to an “individual” and only if that individual is suffering from a financial disability. If someone else is authorized to act on the financial affairs of the individual, the individual cannot be financially disabled. These points should be kept in mind.
Wednesday, September 11, 2019
This month’s installment of court developments concerning agriculture in the courts covers recent developments involving the valuation of a timber enterprise; obtaining a tax refund for an estate due to a financial disability; the calculation of a casualty loss; and the growing of hemp.
Ag law and tax developments in the courts – it’s the topic of today’s post.
Estate Tax Valuation
At issue in Estate of Jones v. Comr., T.C. Memo. 2019-101 were the proper valuations, as of May 28, 2009, of limited partner units in a timber business and stock shares in a sawmill. The decedent died in 2014, having established the sawmill business in 1954 and expanding it substantially since then. The decedent bought about 25,000 acres of timber in 1989 and an additional 125,00 acres in 1992. Later in 1992, the decedent formed the limited partnership to invest in, acquire, hold and manage timberlands and real estate and incur debt. The decedent transferred the timberland, which was considered to be the sawmill’s inventory, to the limited partnership in exchange for an interest in the entity.
The decedent began doing some succession planning in 1996 with the intent of keeping the business in the family as a successful operation. That plan included making gifts of interests in the businesses to family members, including significant blocks of stock. Upon the decedent’s death, the IRS challenged the valuation for gift tax purposes of the 2009 transfers of limited partnership interests and interests of the S corporation that owned the sawmill. Transfer of the limited partnership units was also restricted via a buy-sell agreement that contained a right-of-first refusal. Thus, the determination of fair market value of the 2009 transfers had to account for lack of marketability, lack of control, lack of voting rights of an assignee and reasonably anticipated cash distributions allocable to the gifted interests.
The IRS valued the transfers utilizing a net asset value approach and the estate’s expert used a discounted cash flow approach for both the timberland and the mill. The Tax Court agreed with the valuation arrived at by the estate’s expert, a far lower amount than what the IRS had arrived at.
There are many underlying details concerning the valuation approaches that I am not discussing here. The major point is, however, that taking care to follow well-established valuation procedures and keeping good records is essential. The Tax Court will often adopt the approach that is most precise and is substantiated.
Refund Claims Due To Financial Disability
I.R.C. §6511(h) establishes a statute of limitations for filing a claim for refund due to financial disability. The provision provides “an individual is financially disabled if such individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment of the individual which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.” I.R.C. §6511(a)-(c) specifies that, “In the case of an individual, the running of the periods specified in subsections (a), (b), and (c) shall be suspended during any period of such individual’s life that such individual is financially disabled.” In Carter v. United States, No. 5:18-cv-01380-HNJ, 2019 U.S. Dist. LEXIS 134035 (N.D. Ala. Aug. 9, 2019) a decedent’s estate sought relief on the basis that the estate’s personal representative was financially disabled for a period of time entitling the estate to file a claim for refund after the time period set forth in I.R.C. §6511(a). The estate claimed that it should be treated as in individual for relief purposes. The estate sought a refund of federal estate tax tied to the value of bank stock that the decedent held at the time of death which made up 45 percent of the gross estate value. Unknown at the time of death was that a fraud had been committed against the bank which ultimately led to the bank being shut down and the stock rendered worthless. The personal representative was traumatized by the events, suffering emotional distress which rendered her unable to manage the estate which was substantiated by a physician who maintained that the representative’s disabilities triggered § 6511(h)’s equitable tolling provision so as to excuse the untimely filing of the refund claim.
The court disagreed with the estate’s position, holding that the term “individual” in I.R.C. §6511(h)(1) did not apply to an estate. The court pointed out that I.R.C. §7701(a)(1) defines a person as “an individual, a trust, estate, partnership, association, company or corporation.” The court reasoned that this made it clear that the Congress saw individuals and estates as distinct types of taxpayers, and the use of the term individual in IRC §6511(h) limited the relief to natural persons. The court also noted that even if the estate’s claim weren’t time-barred, it would fail on its own merits because estate tax value is based on the value as of the date of death or the alternate valuation date of six months after death. Simply because the fact of the bank fraud arose post-death didn’t change the fact that it wasn’t known at the time of death and the stock was being actively traded at death, the measuring date for federal estate tax purposes.
Calculating a Casualty Loss
While the casualty loss deduction rules have been modified for tax years beginning after 2017, the underlying manner in which a casualty loss is to be computed remains largely the same. Those rules involve documenting the value of the property before the casualty; determining the value after the casualty; income tax basis; and the amount of insurance proceeds received. It’s a big issue for agriculture particularly because of the exposure of agricultural property to weather. A recent Tax Court case illustrates how a casualty loss is computed.
In Taylor II v. Comr., T.C. Memo. 2019-102, the petitioner claimed a casualty loss on his 2008 return for damage from a hurricane. An insurance company paid over $2.3 million in claims, and the claimed deduction was $888,345. The petitioner reported a basis in the property of $6.5 million, insurance reimbursement of $2.3 million and a pre-casualty fair market value of $15,442,059 and a post-casualty fair market value of $12,250,000. The pre-casualty FMV was based on the 2009 listing price of the property reduced for time spent on the market. No testimony was provided as to post-casualty FMV.
The Tax Court (Judge Paris) noted that to compute a casualty loss deduction, the pre and post-FMV values of the impacted property must be computed and the property basis must be established. The Tax Court noted that decline in value can alternatively be established via the regulations under I.R.C. §165 if the taxpayer has repaired the property damage resulting from the casualty, the taxpayer may use the cost of repairs to prove the loss of value to the property from the casualty. In that instance, the taxpayer must show that (a) the repairs are necessary to restore the property to its condition immediately before the casualty, (b) the amount spent for such repairs is not excessive, (c) the repairs do not care for more than the damage suffered, and (d) the value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty. The Tax Court noted that the record did not establish that the valuations were based on competent appraisals, and didn’t indicate how the petitioner’s CPAs determined the pre or post-casualty FMV of the property, even though the pre-casualty FMV was consistent with the value reported to the insurance company. The Tax Court concluded that the appraisals were not reliable measures of the taxpayer's casualty loss and didn’t rely on them. In addition, the taxpayer received insurance payments that exceed the cost of repairs. That meant that a casualty loss deduction couldn’t be claimed based on the regulations. The Tax Court disallowed any casualty loss deduction.
Growing of Hemp
The 2018 Farm Bill allows for hemp (not marijuana) production and allows states and Indian tribes to opt for either primary regulatory authority, or USDA authority over any proposed hemp production. Under the primary authority option, a state may submit its own plan to the U.S. Secretary of Agriculture (Secretary). Once a plan is submitted, the Secretary has 60 days to approve or deny the plan. Under the “USDA option,” hemp can be produced under a plan established by the USDA, but the plan must still be submitted to and approved by the Secretary. The Farm Bill provides that the Secretary has explicit authority to set regulations and guidelines that relate to the implementation to both the primary regulatory authority option or the USDA option. On February 27, 2019, the USDA issued a notice that the agency had begun gathering information to promulgate rules and regulations related to the 2018 Farm Bill and the production of hemp in the United States.
In Flandreau Santee Sioux Tribe v. United States Department of Agriculture, No. 4:19-CV-04094-KES, 2019 U.S. Dist. LEXIS 95188 (D. S.D. Jun. 6, 2019), the plaintiff, an Indian tribe, submitted its own proposed hemp production plan in March of 2019. The Secretary issued a letter in stating that the plan would be approved or denied within 60 days after hemp production regulations were finalized – likely in the fall of 2019. On May 6, the plaintiffs submitted a letter to USDA requesting a waiver of regulatory requirements so that the plaintiff could plant hemp during the 2019 growing season. A meeting was held to discuss the waiver. Later that month the plaintiff sued for a temporary restraining order or preliminary injunction seeking to force the USDA to grant the hemp planting waiver.
A hearing on the temporary restraining order was held in June. After the hearing, the court denied the plaintiff’s motion. The court determined that the plaintiff’s motion was not yet ripe and that the plaintiff was not likely to ultimately succeed on the merits of its claim. The court noted that the Farm Bill gave the Secretary broad discretion with respect to hemp production. In addition, the 60-day window to approve or reject plans did not begin until the USDA finalized regulations. The court also noted that there was no monetary remedy built into the law because the USDA was not required to pay compensation for economic losses. The court also determined that the plaintiff’s potential economic losses did not outweigh the impact on the USDA if the injunction were to be granted. The court noted that the issuance of an injunction would force the USDA to act before it could carefully lay out the regulations on hemp production. Such haste in allowing production could have detrimental long-term effects.
There’s never a dull moment in ag law and tax.
Monday, September 9, 2019
When facing financial trouble and bankruptcy, don’t forget about the taxes. While Chapter 12 bankruptcy contains a provision allowing for the deprioritization of taxes, there is no comparable provision for other types of bankruptcies. But, for Chapter 7 and 11 filers, there is a possibility that taxes could be dischargeable in bankruptcy. That’s because under those bankruptcy code provisions, a new tax entity is created at the time of bankruptcy filing.
But, discharging taxes in bankruptcy is a tricky thing. It involves timing and, perhaps, not filing successive cases.
The discharge of tax liability in bankruptcy – it’s the topic of today’s post.
The Bankruptcy Estate as New Taxpayer
As noted, for Chapter 7 (liquidation bankruptcy) or Chapter 11 (non-farm reorganization bankruptcy), a new tax entity separate from the debtor is created when bankruptcy is filed. That’s not the case for individuals that file Chapter 12 (farm) bankruptcy, or Chapter 13 bankruptcy, and for partnerships and corporations under all bankruptcy chapters. In those situations, the debtor continues to be responsible for the income tax consequences of business operations and disposition of the debtor's property. Thus, payment of all the tax triggered in bankruptcy is the responsibility of the debtor. The only exception is that Chapter 12 filers can take advantage of a special rule that makes the taxes a non-priority claim. 11 U.S.C. §1232.
Categories of taxes. The creation of the bankruptcy estate as a new taxpayer, separate from the debtor, highlights the five categories of taxes in a Chapter 7 or Chapter 11 case.
- Category 1 taxes are taxes where the tax return was last timely due more than three years before filing. If an extension was filed, an individual’s return can last be timely filed on October 15th. In this case, the tax is dischargeable provided the bankruptcy is filed on or after October 16th three years after the year the tax return was filed. These taxes are dischargeable unless the debtor failed to file a return or filed a fraudulent return.
- Category 2 taxes are the taxes due within the last three years. These taxes are not dischargeable but are entitled to an eighth priority claim in the bankruptcy estate, ahead of the unsecured creditors.
- Category 3 taxes are the taxes for the portion of the year of bankruptcy filing up to the day before the day of bankruptcy filing. If the debtor's year is closed as of the date of filing, the taxes for the first year, while not dischargeable, are also entitled to an eighth priority claim in the bankruptcy estate. If the debtor's year is not closed, the entire amount of taxes for the year of filing are the debtor's responsibility.
- Category 4 taxes are the taxes triggered on or after the date of filing and are the responsibility of the bankruptcy estate. Taxes due are paid by the bankruptcy estate as an administrative expense. If the taxes exceed the available funds, the tax obligation remains against the bankruptcy estate but does not return to the debtor. Most bankruptcy trustees abandon assets if the taxes incurred will make the bankruptcy estate administratively insolvent.
- Category 5 taxes are for the portion of the year beginning with the date of bankruptcy filing (or for the entire year if the debtor's year is not closed) and are the responsibility of the debtor.
The election to close the debtor’s tax year. In general, the bankrupt debtor’s tax year does not change upon the filing of bankruptcy. But, debtors having non-exempt assets that will be administered by the bankruptcy trustee may elect to end the debtor’s tax year as of the day before the bankruptcy filing.
Making the election creates two short tax years for the debtor. The first short year ends the day before bankruptcy filing and the second year begins with the bankruptcy filing date and ends on the bankrupt’s normal year-end date. If the election is not made, the debtor remains individually liable for income taxes for the year of filing. But, if the election is made, the debtor’s income tax liability for the first short year is treated as a priority claim against the bankruptcy estate, and can be collected from the estate if there are sufficient assets to pay the bankruptcy estate’s claims through the eighth priority. If there are not sufficient assets to pay the income tax, the remaining tax liability is not dischargeable, and the tax can be collected from the debtor at a later time. The income tax the debtor owes for the years ending after the filing is paid by the debtor and not by the bankruptcy estate. Thus, closing the debtor’s tax year can be particularly advantageous if the debtor has substantial income in the period before the bankruptcy filing. Conversely, if a net operating loss, unused credits or excess deductions are projected for the first short year, a short year election should not be made in the interest of preserving the loss for application against the debtor’s income from the rest of the taxable year. Even if the debtor projects a net operating loss, has unused credits or anticipates excess deductions, the debtor may want to close the tax year as of the day before bankruptcy filing if the debtor will not likely be able to use the amounts, the items could be used by the bankruptcy estate as a carryback to earlier years of the debtor (or as a carryforward) and,
But, in any event, if the debtor does not act to end the tax year, none of the debtor’s income tax liability for the year of bankruptcy filing can be collected from the bankruptcy estate. Likewise, if the short year is not elected, the tax attributes (including the basis of the debtor’s property) pass to the bankruptcy estate as of the beginning of the debtor’s tax year. Therefore, for example, no depreciation may be claimed by the debtor for the period before bankruptcy filing. That could be a significant issue for many agricultural debtors.
Consider the following example:
Sam Tiller, a calendar year/cash method taxpayer, on January 26, 2019, bought and placed in service in his farming business, a new combine that cost $400,000. Sam is planning on writing off the entire cost of the new combine in 2019. However, assume that during 2019, Sam’s financial condition worsens severely due to a combination of market and weather conditions. As a result, Sam files Chapter 7 bankruptcy on September 5, 2019.
If Sam does not elect to close the tax year, the tax attributes (including the basis of his property) will pass to the bankruptcy estate as of the beginning of Sam’s tax year (January 1, 2019). Therefore, Sam would not be able to claim any of the depreciation for the period before he filed bankruptcy (January 1, 2016, through September 4, 2019).
The Timing Issue - Illustrative Cases
As you have probably already figured out, timing of the bankruptcy filing is critical to achieving the best possible tax result. Unfortunately, it’s often the case that tax considerations in bankruptcy are not sufficiently thought out and planned for to achieve optimal tax results. Unfortunately, this point is illustrated by a couple of recent cases.
Filing too soon. In Ashmore v. Comr., T.C. Memo. 2017-233, the petitioner claimed that his 2009 tax liability, the return for which was due on April 15, 2010, was discharged in bankruptcy. He filed Chapter 7 on April 8, 2013. That assertion challenged whether the collection action of the IRS was appropriate. As indicated above, the Tax Court noted that taxes are not dischargeable in a Chapter 7 bankruptcy if the return can last be timely filed within three years before the date the bankruptcy was filed. Because the petitioner filed bankruptcy a week too soon, the Tax Court held that his 2009 taxes were not dischargeable and could be collected. As a result, the IRS settlement officer did not abuse discretion in sustaining the IRS levy. In addition, the Tax Court, held that the IRS did not abuse the bankruptcy automatic stay provision that otherwise operates to bar creditor actions to collect on debts that arose before the bankruptcy petition was filed.
The Tax Court’s conclusion in Ashmore is not surprising. The three-year rule has long been a part of the bankruptcy code. Indeed, in In re Reine, 301 B.R. 556 (Bankr. W.D. Mo. 2003), the debtor filed the Chapter 7 bankruptcy petition more than three years after filing the tax return, but within three years of due date of return. The court held that the debtor’s tax debt was not dischargeable.
The peril of multiple filings. In Nachimson v. United States, No. 18-14479-SAH, 2019 Bankr. LEXIS 2696 (Bankr. W.D. Okla. Aug. 23, 2019), the debtor filed Chapter 7 on October 25, 2018 after not filing his tax returns for 2013 through 2016. Immediately after filing bankruptcy, the debtor filed an action claiming that his past due taxes were discharged under 11 U.S.C. §523(a)(1). After extension, the debtor’s 2013 return was due on October 15, 2014. His 2014 return was due April 15, 2015. The 2016 return was due on April 15, 2016. The 2016 return was due April 15, 2017. The debtor had previously filed bankruptcy in late 2014 (Chapter 13), but the case was dismissed on January 14, 2015 after lasting 80 days. He then filed a Chapter 11 case on November 5, 2015, but it was dismissed on April 13, 2016 after 160 days. After that dismissal, he filed another Chapter 11 case on October 20, 2016, but it was dismissed on December 30, 2016 after 71 days. He filed the present Chapter 7 case, as noted, on October 25, 2018. Thus, as of October 25, 2018, he had been in bankruptcy proceedings from October 15, 2014 through October 25, 2018 -311 days.
11 U.S.C. §523(a)(1)(A) provides, in general, that a discharge of debt in bankruptcy does not discharge an individual debtor from any income tax debt for the periods specified in 11 U.S.C. §507(a)(8). One of the periods contained in 11 U.S.C. §507(a)(8)(A)(i), is the three-year period before the bankruptcy petition is filed. Importantly, 11 U.S.C. §507(a)(8)(A)(ii)(II) specifies that an otherwise applicable time period specified in 11 U.S.C. §507(a)(8) is suspended for any time during which a governmental unit is barred under applicable non-bankruptcy law from collecting a tax as a result of the debtor’s request for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days; plus any time during which the stay of proceedings was in effect in a prior bankruptcy case or during which collection was precluded by the existence of one or more confirmed bankruptcy plans.
So, what does all this mean? It means that when a debtor files multiple, successive bankruptcy cases, the ordinary operation of the automatic stay 11 U.S.C. § 507(a)(8) and the three-year look-back rule is altered by 11 U.S.C. § 362(c)(3)(A) which specifies that if a debtor had a case pending within the preceding one-year period that was dismissed, then the automatic stay with respect to any action taken with respect to a debt or property securing that debt terminates with respect to the debtor on the 30th day after the filing of the later case.
Here, the debtor sought to have his 2013 and 2014 tax liabilities discharged in the present bankruptcy case under 11 U.S.C. §523(a)(1)(A) on the basis that the filing dates for those returns were outside the three-year look-back period. He wanted a rather straightforward application of the three-year rule. However, the IRS took the position that the three-year “look-back” period was extended due to the debtor's bankruptcy filings. The court agreed with the IRS, noting that the three-year look-back period began on October 25, 2015. But the court determined that the real issue was whether the look-back period extended back 401 (311 plus 90) days, or only for the first 30 days following each bankruptcy filing as provided by 11 U.S.C. § 362(c)(3)(A).
The court noted that the Congress, in 2005, amended 11 U.S.C. §507(a)(8) to codify the U.S. Supreme Court decision of Young v. United States, 535 U.S. 43 (2002) where the Supreme Court concluded that the tolling provision of 11 U.S.C. § 507(a)(8) was not impacted by the automatic nature of 11 U.S.C. § 362(c)(3)(A). Instead, for purposes of the tolling provision, the stay of proceedings was in effect in each of debtor's three previous cases until each was dismissed. In addition, the Congress amended the statute to tack-on another 90 days to the extension. See, In re Kolve, 459 B.R. 376 (Bankr. W.D. Wisc. 2011). The look-back period automatically tolls upon the filing of a previous case. See, e.g., In re Clothier, 588 B.R. 28 (Bankr. W.D. Tenn. 2018). Thus, instead of suspending the look-back period, it extends it and allows the priority and nondischargeability of tax claims to reach further into the past. Thus, the court in the present case determined that the look-back period extended back three years plus 401 days. Since the debtor filed the bankruptcy petition in the present case on October 25, 2018, the three-year plus 401-day look-back period (80 + 160 + 71 +90) reached back to September 19, 2014. Because the debtor's 2013 and 2014 tax liabilities were due after that date (including the extension for the 2013 liability), neither was dischargeable in the current bankruptcy case.
Bankruptcy planning should necessarily account for taxes. The cases point out that timing of the filing of the bankruptcy petition is critical, and that successive filings can create tremendous complications. Competent legal and tax counsel is a must, in addition to competent bankruptcy counsel.
Tuesday, September 3, 2019
During this time of financial stress in parts of the agricultural sector, a technique designed to assist a financially troubled farmer has come into focus. When farmland is sold under an installment contract, it’s often done to aid the farmer-buyer as an alternative to more traditional debt financing. But what if the buyer gets into financial trouble and can’t make the payments on the installment obligation and the seller forgives some of the principal on the contract? Alternately, what if the principal is forgiven as a means to pass wealth to the buyer as a family member and next generation farmer? What are the tax consequences of principal forgiveness in that situation?
The Tax consequences of forgiving principal on an installment obligation – it’s the topic of today’s post.
The Deal Case
In 1958, the U.S. Tax Court decided Deal v. Comr., 29 T.C. 730 (1958). In the case, a mother bought a tract of land at auction and transferred it in trust to her three sons-in-law for the benefit of her daughters. Simultaneously, the daughters (plus another daughter) executed non-interest-bearing demand notes payable to their mother. The notes were purportedly payment for remainder interests in the land. The mother canceled the notes in portions over the next four years. For the tax year in question, the mother filed a federal gift tax return, but didn’t report the value of the cancelled notes on the basis that the notes that the daughters gave made the transaction a purchase rather than a gift. The IRS disagreed, and the Tax Court agreed with the IRS. The notes that the daughters executed, the Tax Court determined, were not really intended to be enforced and were not consideration for their mother’s transfers. Instead, the transaction constituted a plan with donative intent to forgive payments. That meant that the transfers were gifts to the daughters. Even though the amount of the gifts was under the present interest annual exclusion amount each year, they were gifts of future interests such that the exclusion did not apply and the full value of the gifts was taxable.
Subsequent Tax Court Decisions
In 1964, the Tax Court decided Haygood v. Comr., 42 T.C. 936 (1964). Here, the Tax Court upheld an arrangement where the parents transferred property to their children and took back vendor’s lien (conceptually the same as a contractor’s lien) notes which they then forgave as the notes became due. Each note was secured by a deed of trust or mortgage on the properties transferred. The Tax Court believed that helped the transaction look like a sale with the periodic forgiveness of the payments under the obligation then constituting gifts.
What did the Tax Court believe was different in Haygood as compared to Deal? In Deal, the Tax Court noted, the property was transferred to a trust and on the same day the daughters (instead of the trust) gave notes to the mother. In addition, the notes didn’t bear interest, and were unsecured. In Haygood, by contrast, the notes were secured, and the amount of the gift at the time of the initial transfer was reduced by the face value of the notes.
A decade later the Tax Court ruled likewise in Estate of Kelley v. Comr., 63 T.C. 321 (1974). This case involved the transfer of a remainder interest in property and the notes received (non-interest- bearing vendor’s lien notes) were secured by valid vendor’s liens and constituted valuable consideration in return for the transfer of the property. The value of the transferred interests were reported as taxable gifts to the extent the value exceed the face amount of the notes. The notes were forgiven as they became due. The IRS claimed that the notes lacked “economic substance” and were just a “façade for the principal purposes of tax avoidance.”
The Tax Court disagreed with the IRS position. The Tax Court noted that the vendor’s liens continued in effect as long as the balance was due on the notes. In addition, before forgiveness, the transferors could have demanded payment and could have foreclosed if there was a default. Also, the notes were subject to sale or assignment of any unpaid balance and the assignee could have enforced the liens. As a result, the transaction was upheld as a sale.
The IRS Formally Weighs In
In Rev. Rul. 77-299, 1977-2 C.B. 343, real property was transferred to grandchildren in exchange for non-interest-bearing notes that were secured by a mortgage. Each note was worth $3,000. The IRS determined that the transaction amounted to a taxable gift as of the date the transaction was entered into. The IRS also determined that a prearranged plan existed to forgive the payments annually. As a result, the forgiveness was not a gift of a present interest.
The IRS reiterated its position taken in Rev. Rul. 77-299 in Field Service Advice 1999-837. In the FSA, two estates of decedents held farm real estate. The executors agreed to a partition and I.R.C. §1031 exchange of the land. After the exchange, the heirs made up the difference in value of the property they received by executing non-interest-bearing promissory notes payable to one of the estates. The executors sought a court order approving annual gifts of property to the heirs. They received that order which also provided that the notes represented valid, enforceable debt. The notes were not paid, and gift tax returns were not filed. Tax returns didn’t report the annual cancellation of the notes. The IRS determined that a completed gift occurred at the time of the exchange and that each heir could claim a single present interest annual exclusion ($10,000 at the time). The IRS determined that the entire transaction was a prearranged plan to make a loan and have it forgiven – a sham transaction. See also Priv. Ltr. Rul. 200603002 (Oct. 24, 2005).
The IRS position makes it clear from a planning standpoint where the donor intends to forgive note payments that the loan transaction be structured carefully. Written loan documents with secured notes where the borrower has the ability to repay the notes and actually does make some payment on the notes would be a way to minimize “sham” treatment.
The Congress enacted the Installment Sales Revision Act of 1980 (Act). As a result of the Act, several points can be made:
- Cancelation of forgiveness of an installment obligation is treated as a disposition of the obligation (other than a sale or exchange). R.C. §453B(f)(1).
- A disposition or satisfaction of an installment obligation at other than face value results in recognized gain to the taxpayer with the amount to be included in income being the difference between the amount realized and the income tax basis of the obligation. R.C. §453B(a)(1)
- If the disposition takes the form of a “distribution, transmission, or disposition otherwise than by sale or exchange,” the amount included in income is the difference between the obligation and its income tax basis. R.C. §453B(a)(2).
- If related parties (in accordance with I.R.C. §267(b)) are involved, the fair market value of the obligation is considered to be not less than its full face value. R.C. §453B(f)(2).
Impact of death. The cancellation of the remaining installments at death produces taxable gain. See, e.g., Estate of Frane v. Comr., 98 T.C. 341 (1992), aff’d in part and rev’d in part, 998 F.2d 567 (8th Cir. 1993). In Frane, the Tax Court decided, based on IRC §453(B)(f), that the installment obligations of the decedent’s children were nullified where the decedent (transferor) died before two of the four could complete their payments. That meant that the deferred profit on the installment obligations had to be reflected on the decedent’s final tax return. But, if cancelation is a result of a provision in the decedent’s will, the canceled debt produces gain that is included in the estate’s gross income. See, e.g., Priv. Ltr. Rul. 9108027 (Nov. 26, 1990). In that instance, the obligor (the party under obligation to make payment) has no income to report.
If an installment obligation is transferred on account of death to someone other than the obligor, the transfer is not a disposition. Any unreported gain on the installment obligation is not treated as gross income to the decedent and no income is reported on the decedent's return due to the transfer. The party receiving the installment obligation as a result of the seller's death is taxed on the installment payments in the same manner as the seller would have been had the seller lived to receive the payments.
Upon the holder’s death, the installment obligation is income-in-respect-of-decedent. That means there is no basis adjustment at death. I.R.C. §691(a)(4) states as follows:
“In the case of an installment obligation reportable by the decedent on the installment method under section 453, if such obligation is acquired by the decedent’s estate from the decedent or by any person by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent—
an amount equal to the excess of the face amount of such obligation over the basis of the obligation in the hands of the decedent (determined under section 453B) shall, for the purpose of paragraph (1), be considered as an item of gross income in respect of the decedent; and
such obligation shall, for purposes of paragraphs (2) and (3), be considered a right to receive an item of gross income in respect of the decedent, but the amount includible in gross income under paragraph (2) shall be reduced by an amount equal to the basis of the obligation in the hands of the decedent (determined under section 453 B).”
But, disposition (sale) at death to the obligor is a taxable disposition. I.R.C. §§691(a)(4)-(5). Similarly, if the cancelation is triggered by the holder’s death, the cancellation is treated as a transfer by the decedent’s estate (or trust if the installment obligation is held by a trust). I.R.C. §691(a)(5)(A).
No disposition. Some transactions are not deemed to be a “disposition” for tax purposes. Before the Act became law, the IRS had determined that if the holder of the obligation simply reduces the selling price but does not cancel the balance that the obligor owes, it’s not a disposition. Priv. Ltr. Rul. 8739045 (Jun. 30, 1987). Similarly, the modification of an installment obligation by changing the payment terms (such as reducing the purchase price and interest rate, deferring or increasing the payment dates) isn’t a disposition of the installment obligation. The gross profit percentage must be recomputed and applied to subsequent payments. Also, where the original installment note was replaced, the substitution of a new promissory note without any other changes isn’t a disposition of the original note. See, e.g., Priv. Ltr. Ruls. 201144005 (Aug. 2, 2011) and 201248006 (Aug. 30, 2012).
There is also no disposition if the buyer under the installment obligation sells the property to a third party and the holder allows the third party to assume the original obligor’s obligation. That’s the case even if the third party pays a higher rate of interest than did the original obligor.
Debt forgiveness brings with it tax consequences. Installment obligations are often used to help the obligor avoid traditional financing situations, particularly in family settings. It’s also used as a succession planning tool. But, it’s important to understand the tax consequences for the situations that can arise.
Friday, August 30, 2019
The fall academic semester has begun at the law school and at K-State. That means that my campus teaching duties are done for the year, and now I am fully devoted to speaking at ag law and ag tax events across the country. Actually, I finished up the calendar year’s teaching in late July and have been on the road ever since in Lawrence, Kansas, Illinois, Colorado, Montana, South Dakota and Nebraska. So where does the ag law and tax road take me this fall? What opportunities are there for you this fall to gain additional CLE/CPE credits?
Fall ag law and ag tax seminars – it’s the topic of today’s post.
In the next couple of months, the trail starts with the Washburn Law School/Kansas State University Agribusiness Symposium. This year’s event will be held in Hutchinson, Kansas on September 13 in conjunction with the state fair. Sessions this year include discussions of the legal issues association with precision agriculture and technology; water rights and how to evaluate risks that might reduce value and usefulness; tax planning issues for farmers and ranchers in light of the Tax Cuts and Jobs Act; the details of what happening in the farm economy both from a macroeconomic sense and a microeconomic one; agricultural trade issues; farm bill issues; and ethics. You can learn more about the event and register here: https://www.kfb.org/Article/2019-Kansas-State-UniversityWashburn-University-School-of-Law-Agribusiness-Symposium. This event is also available online for those that aren’t able to travel to Hutchinson.
After the Symposium, I head to Lexington, Kentucky for the presentation of an ag tax seminar and then to Illinois for ag tax seminars in Rock Island and Champaign. You can lean more about the Illinois seminars and register here: https://taxschool.illinois.edu/merch/2019farm.html. For my Iowa friends, particularly those in eastern Iowa, the Rock Island school may be a convenient location for you.
When the calendar flips to October, I will be found in Fresno, California. On October 1 I will providing four hours of ag tax content at the California CPA Society’s “Farmers Tax and Accounting Conference.” The conference is also webcast. For more information, click here: http://conferences.calcpa.org/farmers-tax-accounting-conference/.
The following two weeks show me on the road in Kansas and Nebraska with CPA firm in-house CPE training events.
Late October – Mid-December
Beginning on October 29 are the Kansas State University Tax Institutes that I am a part of. Those begin in western Kansas and move east across the state, finishing in Pittsburg on Dec. 11 and 12. The Pittsburg event is also live simulcast over the web. On December 13, Prof. Lori McMillan (also of Washburn Law) and myself will conduct a 2-hour tax ethics session live in Topeka and over the web. You can learn more about the KSU tax institutes here: https://agmanager.info/events/kansas-income-tax-institute.
I will be conducting additional two-days tax seminars in November. On November 5-6, I will be in Sioux Falls, South Dakota and on November 7-8 I will be in Omaha, Nebraska. You can learn more about those events here: https://astaxp.com/seminars/. On November 20, I will be teaching the second day of a tax seminar in Fargo, North Dakota and then doing the same again in Bismarck on November 22. These are for the University of North Dakota. More information can be obtained about these events here: https://und.edu/conferences/nd-tax-institute/.
When the calendar turns to December, I will be in San Angelo, Texas doing an all-day ag tax seminar for the Texas Society of CPAs on December 3. The next day I will be kicking off the Iowa Bar Bloethe Tax School in Des Moines with a four-hour session on farm taxation. December 6 finds me in Omaha teaching farm tax at the Great Plains Federal Tax Institute. More information about the event can be found here: https://greatplainstax.org/. As mentioned above, the two-hour tax ethics seminar will be in Topeka, Kansas on December 13. That ethics session will also be webcast.
Other events may be added in over the coming weeks. When the calendar flips to 2020, I will be in Nashville, Tennessee; San Antonio, Texas; and Boise, Idaho just to name a few locations. Make sure to check my calendar that is posted on www.washburnlaw.edu/waltr. I update the calendar often.
I hope to see you at one or more of the events this fall!
Monday, August 26, 2019
For agricultural labor, only cash wages are subject to Social Security tax. Wages paid in-kind to agricultural labor are not subject to FICA tax, FUTA (Federal Unemployment Tax Act) tax, or income tax withholding, but they are subject to income tax. I.R.C. §§ 3121(a)(8), 3306(b)(11). In 1994, an IRS Task Force produced guidelines that set forth several factors as relevant in determining when a particular in-kind payment qualifies for the exemption. Those guidelines are still relevant in structuring in-kind wage payment arrangements.
Payment in the form of grain, soybeans, cotton or other commodities usually qualifies for the exemption. Payments in the form of livestock or livestock products cause problems but, with careful attention to the rules, should qualify for the special treatment for wages paid in-kind. Payments in a form equivalent to cash are ineligible for the in-kind wage treatment.
But, are commodity wages subject to Form W-2 reporting? They are if they are “wages.” But, are commodity wages really “wages” for W-2 reporting purposes? I got into this issue in an earlier post with respect to whether wages paid to children under age 18 are within the definition of “wages” for purposes of the 20 percent pass-through deduction of I.R.C. §199A here: https://lawprofessors.typepad.com/agriculturallaw/2018/08/the-qualified-business-income-deduction-and-w-2-wages.html.
Commodity wages and W-2 reporting: revisiting the definition of “wages” – it’s the topic of today’s post.
I.R.C. §6051(a)(3) requires the reporting of “wages” as that term is defined in I.R.C. §3401(a). I.R.C. §3401(a) defines “wages” as “all remuneration” including all remuneration paid in a medium other than cash. That’s an all-inclusive definition. However, I.R.C. §3401(a)(2) provides an exception to that broad definition. Ag labor that is defined in I.R.C. §3121(g) is not a “wage” if it meets the definition of a “wages” under I.R.C. §3121(a). I.R.C. §3121(a) specifies that the cash value of all remuneration paid in any medium other than cash is included in the definition of “wages,” except that the term does not include (among others) wages defined in I.R.C. §3121(a)(8). That’s a key exception - it excepts remuneration paid in any medium other than cash for agricultural labor (i.e., commodity wages).
“Wages” as defined by I.R.C. §3121(a)(8)(B) provides another exception from the definition of “wages” for W-2 reporting purposes. This exception applies if the amount paid to the employee is less than $150 AND the total expenditures for ag labor is less than $2,500 for the year. Stated another way (and how the statute actually reads), cash remuneration for ag labor is exempt unless the wage amount to the payee is at least $150 or the total expenditures for ag labor is at least $2,500. The farmer doesn’t need to report any W-2 if all employees are less than $150 and the total to all employees is less than $2,500. That’s because if the exemption of I.R.C. §3121(a)(8)(B) is triggered, all cash wages paid to ag employees satisfy the definition of “wages” that are excluded from the definition of wages for W-2 reporting purposes.
Why File Form W-2?
Even though Form W-2 need not be filed to report commodity wage payments, there are good reasons to complete the Form and file it. For example, W-2 filing is necessary to allow the taxpayer to e-file the tax return. But, even if the commodity wage is not reported on Form W-2, it is reported as other income on Form 1040 if not supported by Form W-2. E-filing would still be allowed.
In addition, Form W-2 filing helps the recipient determine the correct amount of wages to report on line 1. Also, without Form W-2, the recipient may not know the value of the commodity on the date of payment. Similarly, Form W-2 helps the recipient determine the correct income tax basis of the grain sold when calculating gain or loss on the subsequent sale of the commodity that is received in lieu of wages. In addition, if the recipient does not receive a Form W-2, it will be easy for the recipient of the commodity wages to forget to report the fair market value of the commodity wages on their tax return. Also, properly reporting the commodity wages on Schedule F could qualify the taxpayer for “farmer” status if the taxpayer doesn’t have enough gross farm income to satisfy the two-third’s test for estimated tax purposes.
Commodity Wages – A Caution
A further consideration when deciding whether to pay agricultural wages in-kind is that the payment of in-kind wages may threaten an agricultural employee's eligibility for disability benefits and may reduce or eliminate the employee's retirement benefits. Agricultural employees receiving wages in-kind do not build up retirement or disability credit under the Social Security system. For that reason, many employers agree to pay part of the wages in cash and part in-kind. The cash portion would be credited for purposes of the quarters of coverage needed for disability benefits and for purposes of retirement benefits.
Also, payments in-kind for agricultural labor are not considered wages for purposes of determining the amount of earnings in retirement.
Although reporting the income on Form W-2 might be helpful to the employee, the farmer paying the commodity wage does not have a duty to do so. Value is inherently subjective. A bushel of corn in a livestock farmer’s hands, at the farm, may be valued differently when viewed from the perspective of the employee, who is responsible for handling and later selling that commodity. It is not, therefore, the farmer’s responsibility to determine the value of the commodity transferred to the employee and report that value on Form W-2.
Clearly, the Code does not require Form W-2 reporting for commodity wage payments. This comports with the Code’s longtime exclusion of agriculture from the need to determine the value of commodities that are transferred. For example, Form 1099-Misc need not be issued for crop share rents and the landlord need not report the value of the rent received in income as a crop share until it is converted to cash (or used to satisfy a liability).
Thus, while Form W-2 reporting is not required for in-kind wage payments to agricultural labor as noted above, it might be a good idea to do so in particular circumstances.
Friday, August 23, 2019
Farmers have various sources of income. Of course, grain sales and livestock sales are common and the tax rules on the treatment of such sales are generally well understood. Farmers also have other miscellaneous sources of income from such things as the sale of timber and soil and natural resources. Another source of income for some farmers and ranchers is from breeding fees.
The proper tax reporting of income from breeding fees – it’s the topic of today’s post.
Sale or Lease?
Perhaps the starting point in determining the proper tax treatment of breeding fees from the perspective of both the buyer and the seller is to properly analyze the transaction that the parties have entered into. The key question is whether a breeding fee arrangement is a lease or a sale. This is not only important from a tax standpoint, but also from a financing and secured transaction standpoint. See, e.g., In re Joy, 169 B.R. 931 (Bankr. D. Neb 1994).
The courts and the IRS have, at least to a small extent, dealt with the proper tax treatment of breeding fees. A breeding or stud fee is classified as either a cost of raising or a cost of acquiring an animal, depending on which party bears the risk of loss that the breeding process may be unsuccessful. See, e.g., Jordan v. Comr., T.C. Memo. 2000-206. For example, in Duggar v. Comr., 71 T.C. 147 (1978), acq., 1979-1 C.B. 1, the petitioner entered into a “management agreement” with a cattle breeder. Under the agreement, the petitioner leased 40 brood cows and paid a fee for the artificial insemination of each brood cow as the initial step in developing a purebred herd. The agreement specified that the petitioner owned each calf at the time of birth, but did not have possession of any particular calf until after weaning – about a year after birth. The petitioner also paid a “calf maintenance” fee for each calf until the calf was weaned. After weaning and gaining possession of a calf, the petitioner could either sell the calf or pay an additional annual maintenance fee to the cattle breeder for the care of the heifers during the pre-breeding timeframe.
On his tax return, the petitioner deducted the cost of leasing the cows and maintenance fee associated with each calf for both the pre-weaning and pre-breeding stages. The IRS denied the deductions and the Tax Court agreed. The Tax Court concluded that the transaction between the petitioner and the cattle breeder was essentially the purchase of weaned calves. It couldn’t be properly characterized as the rental and care of breeding cows because the risk of loss with respect to any particular calf didn’t pass to the petitioner until after the calf was weaned. Thus, the costs that the petitioner incurred for the leasing of the cows and the maintenance of the calves before weaning had to be capitalized. However, the Tax Court did conclude that the expenses that the petitioner incurred to maintain the calves post-weaning were currently deductible.
Shortly after the Tax Court decided Duggar, the IRS issued a Revenue Ruling on the subject. The facts of the ruling are similar to those of Duggar. In Rev. Rul. 79-176, 1979-1 C.B. 123, a taxpayer on the cash method of accounting entered into a cattle breeding service agreement with another party. The agreement was specifically referred to as a lease. The agreement specified that the taxpayer “leased” cows from the herd owner. Under the agreement, any calf that was produced within a year of mating was to remain with its mother for a year after birth. When a calf was weaned the agreement termination and the calf was to be healthy and ready for breeding. Only after a calf was weaned did the taxpayer gain possession of the calf. Upon gaining possession, the taxpayer could sell the calf or place it in a herd management program.
Based on these facts, the IRS took the position that the arrangement amounted to a sales contract for the purchase of a live calf. Thus, the costs attributable to the cattle breeding, including the breeding fee and the initial cost of caring for the cow and calf until the calf was weaned, were non-deductible capital expenditures under I.R.C. §263. The calf could be depreciated over its useful life.
In contrast to the facts of Duggar and Rev. Rul. 79-176, if a taxpayer pays a breeding fee an animal bred that the taxpayer owns, the fee is deductible.
For a taxpayer that is on accrual accounting, breeding fees must be capitalized and allocated to the cost basis of the animal.
What About Embryo Transplanting?
An amount paid for embryo transplanting, including the cost of buying the embryo and costs associated with preparing the animal for transplantation and the transplant fees are deductible as “breeding fees.” Priv. Ltr. Rul. 8304020 (Oct. 22, 1982). But, if the taxpayer buys a pregnant cow the purchase price is to be allocated to the basis of the cow and resulting calf in accordance with the fair market value of the cow and the calf. In this situation, there is no current deduction for the purchase price of the cow or the portion of basis that is allocated to the calf.
What About the Owner of the Breeding Cattle?
Neither the Tax Court in Duggar, nor the IRS in Rev. Rul. 79-176 discussed the tax consequences to the owner of the breeding cattle. But, as noted above, both the Tax Court and the IRS treated that transactions involved as a sale. Because of that characterization, the owner of the breeding cattle should treat receipt of breeding fees as income from the sale of calves. If part of all of the fee is later refunded because the animal did not produce live offspring (or for any other reason) any breeding fees received should still be treated as income in the year received with a later deduction for the year that a refund is made.
Farmers and ranchers generate income in unique ways. Breeding fees arrangements are just one of those ways. Most likely, any such arrangement should be treated as a sale on the tax return. But, as noted, the correct answer is highly fact dependent.
Thursday, August 8, 2019
The Tax Cuts and Jobs Act of 2017 (TCJA) changed the landscape of tax-deferred exchanges under I.R.C. §1031. Personal property trades are no longer eligible for tax-deferred treatment. But, the rules governing tax-deferred exchanges of real estate didn’t change. That makes the definition of “real estate” of utmost importance. In prior posts I have addressed the issue of what constitutes like-kind “real estate” for I.R.C. §1031 purposes. See, e.g., https://lawprofessors.typepad.com/agriculturallaw/2018/10/what-is-like-kind-real-estate.html. But, what about an easement? Or, more specifically, what about a perpetual conservation easement? Do they qualify as “like-kind” to real estate such that the proceeds received from a donation/sale transaction can be used to acquire replacement real estate and the transaction be tax-deferred?
Conservation easements and the like-kind exchange rules – it’s the topic of today’s post
The Definition of “Real Estate”
Under the I.R.C. §1031 rules, “real estate” is defined very broadly. Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment purposes. The regulations define “like-kind” in terms of reference to the nature or character of the replacement property rather than its grade or quality. Treas. Reg. §1.1031(a)-1(b); see also C.C.M. 201238027
In addition, it doesn’t matter whether the real estate involved in a tax-deferred exchange is improved or unimproved. Treas. Reg. §1.1031(a)-1(b), (c). Thus, agricultural real estate may be traded for residential real estate. However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are “I.R.C. §1245 property.” For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in the exchange. Also, remember, post-2017, the value of personal property associated with the real estate that does not fit within the definition of “real estate” is no longer eligible for tax-deferral under I.R.C. §1031.
Easements. Defined broadly, an easement is a nonpossessory interest in another party’s land that entitles the holder of the easement the right to use the land subject to the easement in the manner that the easement specifies. Conservation easements involve development rights. There is support for the notion that development rights in land are like-kind to real estate. For instance, in Rev. Rul. 55-749, 1955-2 CB 295, the IRS determined that land was like-kind to perpetual water rights. The IRS also has taken the position that a leasehold interest in a producing oil lease that extended until the exhaustion of the oil deposit was like-kind to a fee interest in a ranch. Rev. Rul. 68-331, 1968-1 CB 352.
In addition, Rev. Rul. 59-121, 1959-1 CB 212, the IRS took the position that an easement sold was an interest in real property. Under the facts of the ruling, the taxpayer granted easements to an industrial company over his ranchland that he used for grazing livestock that were raised for sale. The easements granted were for an indefinite duration and he was paid for the easement grants. The easements provided for the construction of a dam across a creek located on the taxpayer's property in order to create a reservoir and impound water and as a depository for waste material produced as a byproduct of the company's industrial process. The easements specified that the taxpayer retained all rights to explore for and produce oil, gas, or other minerals on the land subject to the easements and he could use the land and buildings on it if he didn’t interfere with the easement rights granted. The IRS said that the funds the taxpayer received for the easement grants constituted proceeds from the sale of an interest in real property. Thus, the amount received could be applied to reduce the basis of the land subject to the easement, with any excess (recognized gain) being eligible for investment in like-kind real estate.
Later, in 1972, the IRS determined that a right-of-way easement was like-kind to real estate. Rev. Rul. 72-549, 1972-2 CB 352. In 1971, under threat of condemnation the taxpayer granted an electric power company an easement and right-of-way over part of the taxpayer’s property that he used in his trade or business. The amount received for the easement and right-of-way triggered gain to the taxpayer. The easement and right-of-way were permanent and exclusive, and the company obtained the right to construct, maintain, operate, and repair power transmission lines and electrical towers on the right-of-way. The taxpayer used the funds acquired from the easement and right-of-way grant to acquire other real estate that he would use in his trade or business. The IRS ruled that the acquired property qualified as like-kind replacement property under I.R.C. §1031.
More closely aligned with conservation easements, the U.S. Supreme Court held in 1958 that when a right or interest arises out of real estate and is for a term short of “perpetuity” (which also means a land lease of less than 30 years) and the interest is defined in terms of money, the right or interest is not like-kind to a fee simple interest in real estate. The case was the consolidation of five cases involving the conversion of future income from oil leases into present income in the form of real estate. Comr. v. P.G. Lake, Inc, et al., 356 U.S. 260 (1958). Also, in Priv. Ltr. Rul. 200901020 (Oct. 1, 2008), the IRS determined that development rights that a taxpayer transferred were like-kind to a fee interest in real estate; a real estate lease with at least 30 years remaining at the time of the exchange; and land use rights for hotel units.
On conservation and agricultural easements, the following IRS rulings are helpful guidance:
- Ltr. Rul. 9851039 (Sept. 15, 1998) – The taxpayers sought to convey a perpetual agricultural conservation easement on their farms to the state in exchange for property of like-kind. Under state law, an ag conservation easement constituted an interest in land and was deemed to be the same as covenants that ran with the land. In other words, the easement was deemed to be like-kind to a fee simple and the proceeds received from the easement grant could be reinvested in like-kind real estate under the I.R.C. §1031 rules.
- Ltr. Rul. 200201007 (Oct. 2, 2001) - The IRS concluded that a perpetual conservation easement on a ranch could be exchanged for a fee interest in other ranch property that was subject to a (negative) perpetual conservation easement. Again, one of the keys to the IRS conclusion was that under applicable state law, a perpetual conservation easement constituted an interest in real property.
- Ltr. Rul. 9232030 (May 12, 1992) – The IRS determined that the exchange of a perpetual agricultural conservation easement on a farm for a fee simple interest in other real property qualified as a tax-deferred exchange under I.R.C. §1031.
- Ltr. Rul. 9621012 (Feb. 16, 1996) – In this private ruling, a county sought to acquire a perpetual scenic conservation easement over a ranch to protect a coastline viewshed that the state wanted to protect in perpetuity. While the taxpayer retained the right to use the ranch for ranching and grazing purposes, the portion of the ranch subject to the easement could not be developed. The taxpayer was willing to make the conveyance, but only in return for property of like-kind that qualified for non-recognition treatment under I.R.C. §1031. The IRS determined that the exchange of the easement for a fee simple interest in timberland, farm land or ranch land qualified as an exchange of property that qualified for tax deferral under I.R.C. §1031.
- Ltr. Rul. 200649028 (Sept. 8, 2006) – This private ruling involved transferable rural land use credits under state law. The state was concerned about controlling development and developed a system whereby the owner of credits could develop property in a manner that otherwise wasn’t permissible without the credits (termed “stewardship credits”). Any use or transfer of the credits had to be publicly recorded as an easement that ran with the land in favor of the county, qualified state agency or state land trust. The credits were perpetual in nature, and state law specified that a “stewardship easement” was an interest in real property. The taxpayer involving in the private ruling sought to sell the credits to a buyer and use the proceeds of sale to buy replacement real estate via a qualified intermediary. The taxpayer would use the replacement property for productive use in the taxpayer’s trade or business or for investment purposes. The IRS determined that the transaction qualified for tax deferral under I.R.C. §1031.
- Ltr. Rul. 200805012 (Oct. 30, 2007) -Here, the IRS privately ruled that development rights were like kind, to a fee interest in property that a taxpayer relinquished in an exchange. The trade transaction was quite complex and was accomplished via a qualified intermediary
The IRS has been aggressive at auditing donated conservation easements accomplished via a syndicated partnership. These transactions involve either an individual or an entity buying undeveloped property and then transferring it to a partnership. Partnership interests are then sold to “investors.” After the land appreciates in value, the partnership donates a conservation easement on the land to a qualified land trust with the charitable deduction flowing to the investors. This strategy made it on the 2019 IRS list of the “Dirty Dozen” tax scams and the Congress is taking action to eliminate the technique. In the U.S. Senate, The “Charitable Conservation Easement Program Integrity Act of 2019” has been introduced to end syndicated partnership easement donations. It also contains provisions that are effective retroactively and bars deductions when the value of the associated property has appreciated in value more than 2.5 times the initial investment
The use of proceeds from a conservation easement donation in a transaction that will qualify as an I.R.C. §1031 exchange can be handled in a rather straightforward manner. In addition, separate exchanges can occur as to the easement and the residual interest in the real estate. Issues, if any present themselves, could occur with respect to the Natural Resource Conservation Service and its option and funding process. But those are separate matters from the deferred tax treatment of the transaction qualifying as an I.R.C. §1031 exchange.
Tuesday, August 6, 2019
In 2018, the U.S. Supreme Court, in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), handed South Dakota a narrow 5-4 win in its quest to collect taxes from online sales. The Court held that the Constitution’s Commerce Clause did not bar South Dakota from statutorily requiring remote sellers without a physical presence in the state to collect and remit sales tax on goods and services that are sold to buyers for delivery inside the state of South Dakota. In so doing, the Court distinguished and at least partially overruled 50 years of Court precedent on the issue.
But, did the Court open the floodgates for the states to tax every dollar of sales in a state from an out-of-state seller? That’s a hard case to make because the Court ruled specifically on a South Dakota statute that contained a de minimis sales requirement before state sales tax kicked-in. However, the Kansas Department of Revenue (KDOR) has now taken the position that any amount of sales by a remote seller (a seller without any physical presence in Kansas) to a Kansas buyer triggers the need of the remote seller to register with the state and pay Kansas sales tax.
The Kansas position concerning sales taxation of remote sellers and implications – the focus of today’s blog post.
Online Sales - Historical Precedent
The core constitutional issues concerning a state’s ability to impose sales (and/or use) tax on a seller with no physical presence in the state involve interstate commerce and due process. In 1967, the U.S. Supreme Court determined that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States” in holding that Illinois could not subject a mail order seller located in Missouri to use tax where the seller had no physical presence in Illinois. National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967). In holding the law unconstitutional, the Court reasoned that subjecting the seller’s interstate business to local “variations in rates of tax…and record-keeping requirements” would violate the purpose of the Commerce Clause “to ensure a national economy free from…unjustifiable local entanglements.”
Twenty-five years later, the Court reaffirmed the limitations of the Commerce Clause on state regulatory authority in Quill Corporation v. North Dakota, 504, U.S. 298 (1992). In Quill, the Court held that a mail order house with no physical presence in North Dakota was not subject to North Dakota use tax for “property purchased for storage, use, or consumption within the State.” The Court followed closely its holding in National Bellas Hess, Inc. because doing so “encourage[d] settled expectations and …foster[ed] investment by businesses and individuals.” As applied to internet sales, Quill (which predated the internet) does not exempt all internet sales from state sales taxes – just sales by sellers who don’t have a physical presence in a particular state. National retailers have a presence in many states.
More recently, in 2015, the Court examined a Colorado “tattletale” law that required out-of-state sellers with no physical presence in the state “to notify…customers of their use tax liability and to report” sales information back to Colorado. Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2013). The trial court enjoined enforcement of the law on Commerce Clause grounds. On appeal, the Tenth Circuit held that it couldn’t hear the challenge to the law because the Tax Injunction Act (28 U.S.C. §1341) divested it of jurisdiction and the matter belonged in state court and, ultimately, the U.S. Supreme Court. The Tenth Circuit remanded the case for dismissal of the Commerce Clause claims and dissolution of the permanent injunction. The U.S. Supreme Court reversed and remanded the decision of the Tenth Circuit on the jurisdiction issue and, on remand, the Tenth Circuit, invalidated the Colorado law on Commerce Clause grounds. Direct Marketing Association v. Brohl, 814 F.3d 1129 (10th Cir. 2016).
In the U.S. Supreme Court’s reversal and remand of the Tenth Circuit’s decision in Direct Marketing Association, Justice Kennedy wrote a concurring opinion that essentially invited the legal system to find an appropriate case that would allow the Court to reexamine the Quill and National Bellas Hess holdings. Hence, the South Dakota legislation.
South Dakota Legislation and Litigation
S.B. 106 was introduced in the 2016 legislative session of the South Dakota legislature. It requires the collection of sales taxes from certain remote sellers – those with “gross revenue” from sales in South Dakota of over $100,000 per calendar year or with 200 or more “separate transactions” in the state within the same timeframe.
S.B. 106 was signed into law on March 22, 2016, and the state Department of Revenue soon thereafter began issuing notices to sellers that it thought were in violation of the law. Several out-of-state sellers that received notices did not register for sale tax licenses as the law required. Consequently, the state brought a declaratory judgment action against the sellers in circuit court, and sought a judicial declaration that the S.B. 106 requirements were valid and applied to the sellers. The state also sought an order enjoining enforcement of S.B. 106 while the action was pending in court, and an injunction that required the sellers to register for licenses to collect and remit sales tax.
The sellers tried to remove the case to federal court based on federal question jurisdiction, but the federal court rejected that approach and remanded the case to the South Dakota Supreme Court. South Dakota v. Wayfair, Inc., 229 F. Supp. 3d 1026 (D. S.D. 2017). On remand, the South Dakota Supreme Court invalidated S.B. 106 on Commerce Clause grounds based on the U.S. Supreme Court precedent referenced above. State v. Wayfair, Inc., et al., 901 N.W.2d 754 (S.D. 2017). The state of South Dakota filed a petition for certiorari with the U.S. Supreme Court and the Court granted the petition.
U.S. Supreme Court Decision – The Importance of “Substantial Nexus”
Article I, Section 8 of the U.S. Constitution says that, “The Congress shall have the power...to regulate commerce…among the several states…”. That was the key point of the Court’s 1967 Bellas Hess, Inc. decision. As noted above, in that case the Court stated that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States.” In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided. Later, in the Quill case, the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement.
In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. But, the key point is that the “substantial nexus” test of Brady remains. Likewise, the other three requirements of Brady remain. A state can only impose sales (or use) tax on a remote seller without a physical presence in the state if the tax is fairly apportioned; does not discriminate against interstate commerce; and is fairly related to services that the state provides. In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce. The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – it had only a limited application due to the requirement of a de minimis a dollar amount of sales or transactions in the state; it was not applied retroactively; South Dakota was a member of the Streamlined Sales and Use Tax Agreement (SSUTA); the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden.
On August 1, 2019, the KDOR issued Notice 19-04 designed to provide “guidance” to remote sellers doing business in Kansas. https://www.ksrevenue.org/taxnotices/notice19-04.pdf In the Notice, the KDOR noted that Kansas law (Kan. Stat. Ann. §79-3702(h)(1)(F)) defines a “retailer doing business in this [Kansas]” as: “any retailer who has any other contact with this state that would allow this state to require the retailer to collect and remit tax under the provisions of the constitution and the law of the United States.” The KDOR also noted that the Kansas requires online (and other remote) sellers with no physical presence in Kansas to collect and remit “the applicable” sales and use tax on sales delivered into Kansas. KDOR indicated that remote sellers are to register and begin collecting and remitting Kansas sales and/or use tax by October 1, 2019.
The Notice, as strictly construed, is correct. The state can require a remote seller to register with the state and collect and remit sales and/or use tax “under the provisions of the constitution and the laws of the United States.” That would mean as the applicable law has been defined by the U.S. Supreme Court, including the Court’s most recent Wayfair decision – which involved a state law that contained a de minimis requirement based on amount of sales or number of transactions. However, the KDOR Notice did not specify any level of de minimis sales before sales tax was triggered. Indeed, the Director of Research and Analysis for KDOR was quoted in the Bloomberg Daily Tax Report (online) on August 1 as stating that KDOR “does not believe it needs a de minimis threshold” based on Kan. Stat. Ann. §79-3702. This is an inaccurate statement that will likely invite a legal challenge to the KDOR’s position. There simply is no protection in the Wayfair decision for KDOR’s position. The “substantial nexus” test still must be satisfied – even with a remote seller. Indeed, during the 2019 session of the Kansas legislature, a major tax bill contained de minimis requirements that mirrored the South Dakota legislation, but the Governor vetoed the bill and the Kansas House failed to override the veto. Presently, no other state has taken the position that the KDOR has taken.
The KDOR’s position amounts to a frontal assault on the Commerce Clause post-Wayfair. Presently, 23 states are “full members” of the SSUTA. For those states, Wayfair at least implies that membership in the SSUTA has the effect of minimizing the impact on interstate commerce. But, that doesn’t mean that SSUTA membership eliminates the “substantial nexus” requirement. Indeed, South Dakota was an SSUTA member and the Court still went through the “substantial nexus” analysis. Thus, it appears that any state legislation must have exceptions for small businesses with low volume transactions and sales revenue. Whether a series LLC (in some states such as Iowa) or subsidiaries of a business could be created, each with sales below the applicable threshold, remains to be seen.
On a related note, could the KDOR (or any other state revenue department) go after a portion of business income of the out-of-state business via income tax? That seems plausible. However, the Interstate Income Act of 1959 (15 U.S.C. §381-384), requires that a business (or individual – the business form does not matter because corporations have long held personhood status under the Constitution (see, Bank of the United States v. Deveaux, 9 U.S. 61 (1809); Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014)) have some sort of connection with a state before its income can be taxed (at least with respect to the solicitation of orders for tangible personal property). Is that legislation now unconstitutional too? Or, is there a distinction remaining between taxing receipts as opposed to income? That may be at issue in a future Supreme Court case.
For now, it’s practically a sure bet that, unless the Kansas legislature passes a bill containing de minimis thresholds that can withstand the Governor’s veto, the state will be devoting taxpayer resources to defending a lawsuit that will challenge the state’s (as of now) unsupportable position.
Wednesday, July 31, 2019
My blog article of July 17 concerning the tax treatment of settlements and court judgments raised an interesting question by a reader. For review, you can read that post here: https://lawprofessors.typepad.com/agriculturallaw/2019/07/tax-treatment-of-settlements-and-court-judgments.html. The reader wanted to know how the tax rules would apply to the Roundup jury verdict that was reached this past May.
Applying the tax Code rules to the Roundup jury verdict (and others) - that’s the topic of today’s post.
Review of the Applicable Rules
As I noted in the July 17 article, proper categorization of a court award or settlement amount is critical. Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1. However, recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness.
Tax Application to the Roundup Jury Verdict
Impact on the plaintiffs. In May, Alva and Alberta Pilliod a California jury awarded $2 billion in punitive damages and $55 million for pain and suffering as a result of their use of the common weed-killer, Roundup. From accounts that I have read and persons that I have talked to, it is estimated that if the award stands up on appeal (no sure thing), attorney fees would amount to nearly $1 billion. So, how would the tax rules apply to the total award? What would be the Pilliod’s “take-home” amount from the jury award?
It’s important to segregate the jury award for pain and suffering from the award for punitive damages. For starters, the $55 million in pain and suffering is tax-free because it is to compensate for physical injury and/or physical sickness. As for the $2 billion, that's a different story – that amount is fully taxable. So how does this break-out on the tax return? Assuming that this is the only income that the Pilliod’s have for 2019, consider the following:
At the federal level, the $2 billion would be subject to the highest marginal income tax rate of 37 percent, yielding a tax of $740,000,000. There would be a very slight off-set for the standard deduction.
Added to the $740,000,000 of federal income tax is the California state income tax. The state-level tax is a bit more complicated to compute. The top marginal rate of 12.3 percent would apply. To that top rate, an additional 1 percent “millionaire tax” is added. A taxpayer with California taxable income (i.e. as calculated on Form 540, Line 19) exceeding $1,000,000 during a given tax year is subject to the “Mental Health Services Tax.” The amount of the tax is 1% of the amount of the taxpayer’s income that exceeds $1,000,000.
However, California does not couple with the federal government on the issue of the non-deductibility of legal fees. As a result, taxable income for California tax purposes will be substantially less than taxable income at the federal level. Based on a “mocked-up” California tax return, the following results:
Gross income: $2,000,000,000
Deduction for legal fees: 857,341,000
Taxable income: $1,142,659,000
Applying the top California tax rate to the $1,142,659,000; adding in the “Millionaire’s tax” and state-level alternative minimum tax; and factoring in the standard deduction for a married couple, the result is a state-level tax of $151,416,590.
Thus, the total tax bite (federal and state) for the Pilliod’s will be approximately $851,416,590 – very close to one-half of the punitive damage award.
The Pilliod’s will also be responsible for paying attorney fees. If the accounts are correct that the amount will approach the $1 billion amount, the remaining balance of the punitive damage award that the Pilliod’s will actually pocket will be somewhere between $149,000,000 and zero.
Application to the attorneys. The attorneys involved will also have to pay tax on the amount received from the settlement. This is income that is received in the ordinary course of a trade or business, so the amount is subject to tax at the federal and state levels and is also subject to self-employment tax, payroll tax, etc.
Assuming that the attorneys receive $1,000,000,000 in fees, here’s how the tax impact breaks out:
Fed. tax rate of 37%: $370,000,000
CA tax rate of 13.3%: $133,000,000
Total tax: $503,000,000
Balance remaining: $497,000,000
Less s.e. tax; payroll tax; medicare tax, etc. – (assuming 7%: $38,081,260)
Final balance remaining: $458,918,740
In summary, of the total jury award of $2,055,000,000, the total taxes paid (federal and state) amounts to $740,000 + $151,416,590 + 541,081,260, for a total tax bite of $1,432,497,850. That’s an effective rate of 71.6%! The Pilliod’s “take-home” is the $55,000,000 of actual damages and somewhere between zero and $149,000,000 of the punitive damage award. The attorneys “take-home” is $458,918.740. On balance the plaintiffs pocket approximately 2-10 percent of the total award, the attorneys pocket approximately 19-29 percent of the total award, and the government somewhere in excess of 70 percent.
What About Syngenta Payments?
Corn farmers participating in the nationwide class action against Syngenta may begin receiving settlement payments in 2020. None of those payments are attributable to physical injury or sickness. Instead, they are related to market damage/loss. Thus, the settlement payments are fully taxable, and any attorney fees will not be deductible on the federal return.
The taxation of court awards and settlements can be surprising. In addition, the inability to deduct legal fees post-TCJA enhances the tax impact.
Friday, July 19, 2019
What Is An ESOP?
In existence since the 1970s, an employee stock ownership plan (ESOP) is a type of qualified retirement plan that is designed to provide employees with ownership in the company by investing (primarily) in shares of stock of the employer-company. According to data from the National Center for Employee Ownership, there are about 7,000 ESOPs in the United States covering approximately 14 million employees.
Does an ESOP work for employees of a farming/ranching operation or an agribusiness? In part one of a two-part series, today’s post lays out the basics of an ESOP – how it’s established and the potential benefits. In part two next week I will examine potential problem areas as well as how the new tax law (as of the beginning of 2018) impacts the use of an ESOP.
ESOPs in agriculture – it’s the topic of today’s blog post.
An ESOP involves employee ownership of the business. There are several ways that an employee can obtain ownership in the business. One is to buy stock in the company. Other ways involve an employee being gifted stock, receiving stock as a bonus or obtaining it via a profit-sharing plan. But, the most common way for an employee to obtain ownership in the business is by use of an ESOP.
In the typical ESOP transaction, the company establishes the plan by means of a trust fund – an “employee benefit trust” (hopefully with competent tax and legal counsel) and appoints an ESOP trustee. The trustee then negotiates with a selling shareholder to establish the terms of the sale of the shareholder’s stock to the ESOP. The company borrows the necessary funds from a third-party lender on the ESOP’s behalf and loans the funds to the ESOP which uses the funds to buy the stock from the selling shareholder with the seller receiving cash and taking a note for the balance. The company will make annual (tax-deductible) contributions of cash to the ESOP which the ESOP uses to repay the inside loan. The company uses the payment received from the ESOP to make payments on the third-party loan.
An alternative approach is for the company to have the trust borrow money to buy stock with the company making contributions to the plan so that the loan can be paid back. Unlike other retirement plans, an ESOP can borrow money to buy stock. Consequently, an ESOP can buy large percentages of the company in a single transaction and repay the loan over time using company contributions. The trustee is appointed by the company’s board of directors to manage the trust and can be an officer or other corporate insider. Alternatively, the trustee can be an independent person that is not connected to the corporation as an officer or otherwise. It is advisable that an external trustee be used to negotiate the terms and execute the transaction involving the purchase of shares of stock from a selling shareholder. The trustee has the right to vote the shares acting in a fiduciary capacity. However, the ESOP may require that certain major corporate transactions (i.e., mergers, reorganizations, and significant asset sales) involve the participation of ESOP participants in terms of instructing the trustee with respect to voting the stock shares that are allocated to their accounts. I.R.C. §409(e)(3). ESOP participants do not actually own the shares, the trust does. Thus, an ESOP participant has only the right to see the share price and number of shares allocated to their account on an annual basis. They have no right to see any internal financial statements of the company.
The ESOP shares are part of the employees’ remuneration. The shares are held in the ESOP trust until an employee either retires or otherwise parts from the company. The trust is funded by employer contributions of cash (to buy company stock) or the contributions of company shares directly.
Retirement Plan Characteristics
An ESOP is a qualified retirement plan that is regulated by I.R.C. §4975(e)(7) as a defined contribution plan. As such, ESOPs are regulated by ERISA which sets minimum standards for investment plans in private industry. Only corporations can sponsor an ESOP, but it is possible to have non-corporate entities participate in an ESOP. An ESOP must include all full-time employees over age 21 in the plan and must base stock allocations on relative pay up to $265,000 (2016 level) or use some type of level formula. ESOPs are provided enhanced contribution limits, which may include the amount applied to the repayment of the principal of a loan incurred for the purposes of acquiring employer securities. Employers are allowed to deduct up to an additional 25 percent of the compensation paid or accrued during the year to the employees in the plan as long as the contributions are used to repay principal payments on an ESOP loan. I.R.C. §404(a)(9)(A).
In addition, an employer with an ESOP may deduct up to another 25 percent of compensation paid or accrued to another defined benefit contribution plan under the general rule of I.R.C. §404(a)(3).
In addition, contributions made to the ESOP applied to the repayment of interest on a loan incurred for the purpose of acquiring qualifying employer securities are also deductible, even though in excess of the 25 percent limit. I.R.C. §404(a)(9)(B). But, these two provisions, do not apply to an S corporation. I.R.C. §404(a)(9)(C). As a qualified retirement plan, an ESOP must satisfy I.R.C. §401(a) to maintain its tax-exempt status. While an ESOP is not subject to the normal ERISA rules on investment diversification, the fiduciary has a duty to ensure that the plan’s investments are prudent. In addition to basic fiduciary duties designed to address the concern of an ESOP concentrating retirement assets in company stock, it is not uncommon for a company with an ESOP to also have a secondary retirement plan for employees.
What Happens Upon Retirement or Cessation of Employment?
When one the employee retires or otherwise parts from the company, the company either buys the shares back and redistributes them or voids the shares. An ESOP participant is entitled to a distribution of their account upon retirement or other termination of employment, but there can be some contingencies that might apply to delay the distribution beyond the normal distribution time of no later than the end of the plan year. For plan participants that terminate employment before normal retirement age, distributions must start within six years after the plan year when employment ended, and the company can pay out the distributions in installments over five years, with interest. If employment ceased due to death, disability or retirement, the distribution must start during the plan year after the plan year in which the termination event occurred, unless elected otherwise. If the ESOP borrowed money to purchase employer securities, and is still repaying the loan, distributions to terminating employees are delayed until the plan year after the plan year in which the loan is repaid. In addition, no guarantee is made that the ESOP will contain funds at the time distributions are required to begin to make the expected distributions.
What Are The Benefits of an ESOP?
For C corporations with ESOPS, the selling shareholder avoids the “double tax” inherent in asset sales because the sale is a stock sale. As such, gain can be potentially deferred on the sale of the stock to the ESOP. To achieve successful deferral, the technical requirements of I.R.C. §1042 must be satisfied and the ESOP, after the sale, must own 30 percent or more of the outstanding stock of the company and the seller must reinvest the sale proceeds into qualified replacement property (essentially, other securities) during the period beginning three months before the sale and ending 12 months after the sale. If the replacement property is held until the shareholder’s death, the gain on the sale of the stock to the ESOP may permanently avoid tax.
Corporate contributions to the ESOP are deductible if the contributions are used to buy the shares of a selling shareholder. As a result, an ESOP can be a less costly means of acquiring a selling shareholder’s stock than would be a redemption of that stock. Also, the ESOP does not pay tax on its share of the corporate earnings if the corporation is an S corporation. Thus, an S corporation ESOP is not subject to federal income tax, but the S corporation employees will pay tax on any distributions they receive that carry out the resulting gains in their stock value.
From a business succession/transition standpoint, an ESOP does provide a market for closely-held corporate stock that would otherwise have to be sold at a discount to reflect lack-of marketability of the stock, although the lack of marketability must be considered in valuing the stock. Indeed, one of the requirements that an ESOP must satisfy is that it must allow the participants to buy back their shares when they leave the company (a “repurchase obligation”).
Compared to a traditional 401(k) retirement plan, ESOP company contribution rates tend to be higher, and ESOPS tend to be less volatile and have better rates of return.
In part two next week, I will look at the potential drawbacks of an ESOP and why the U.S. Department of Labor (DOL) gets concerned about them. That discussion will include a recent DOL ESOP investigation involving a major ag operation. It will also involve a look at how the Tax Cuts and Jobs Act impacts ESOPs.