Thursday, January 13, 2022
The time has come to “unveil” the two biggest two developments in agricultural law and taxation for 2021. As I have been pointing out in the previous articles in this series, agricultural law and agricultural tax law intersect with everyday life of farmers and ranchers in many ways. Some of those areas of intersection are good, but some are quite troubling. In any event, it points to the need for being educated and having good legal and tax counsel that is well-trained in the special rules that apply to agriculture.
This is the fifth and final installment in my list of the “Top Ten” agricultural law and tax developments of 2021. The list is comprised of what are, in my view, the most important developments in agricultural law (which includes taxation that impacts farmers and ranchers) to the sector as a whole. The developments primarily are focused on the impact to production agriculture, but the issues involved will also have effects that spillover to rural landowners and agribusinesses as well as consumers of agricultural products.
The Second and First most important agricultural law and tax developments of 2021 – it’s the topic of today’s post.
2. Developments Involving “Waters of the United States” (WOTUS).
Background. The scope of the federal government’s regulatory authority over wet areas on private land, streams and rivers under the Clean Water Act (CWA) has been controversial for more than 40 years. Many court opinions have been filed attempting to define the scope of the government’s jurisdiction. On two occasions, the U.S. Supreme Court attempted to clarify the 1986 regulatory definition of a WOTUS, but in the process of rejecting the regulatory definitions of a WOTUS developed by the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COE), the Court didn’t provide clear direction for the lower courts. See Solid Waste Agency of Northern Cook County v. United States Army Corps of Engineers, 531 U.S. 159 (2001); Rapanos v. United States, 547 U.S. 175 (2006). The lower courts have also had immense difficulties in applying the standards set forth by the U.S. Supreme Court.
Particularly with its Rapanos decision, the Court failed to clarify the meaning of the CWA phrase “waters of the United States” and the scope of federal regulation of isolated wetlands. The Court did not render a majority opinion in Rapanos, instead issuing a total of five separate opinions. The plurality opinion, written by Justice Scalia and joined by Justices Thomas, Alito and Chief Justice Roberts, would have construed the phrase “waters of the United States” to include only those relatively permanent, standing or continuously flowing bodies of water that are ordinarily described as “streams,” “oceans,” and “lakes.” In addition, the plurality opinion also held that a wetland may not be considered “adjacent to” remote “waters of the United States” based merely on a hydrological connection. Thus, in the plurality’s view, only those wetlands with a continuous surface connection to bodies that are “waters of the United States” in their own right, so that there is no clear demarcation between the two, are “adjacent” to such waters and covered by permit requirement of Section 404 of the CWA.
Justice Kennedy authored a concurring opinion, but on much narrower grounds. In Justice Kennedy’s view, the lower court correctly recognized that a water or wetland constitutes “navigable waters” under the CWA if it possesses a significant nexus to waters that are navigable in fact or that could reasonably be so made. But, in Justice Kennedy’s view, the lower court failed to consider all of the factors necessary to determine that the lands in question had, or did not have, the requisite nexus. Without more specific regulations comporting with the Court’s 2001 SWANCC opinion, Justice Kennedy stated that the COE needed to establish a significant nexus on a case-by-case basis when seeking to regulate wetlands based on adjacency to non-navigable tributaries, in order to avoid unreasonable application of the CWA. In Justice Kennedy’s view, the record in the cases contained evidence pointing to a possible significant nexus, but neither the COE nor the lower court established a significant nexus. As a result, Justice Kennedy concurred that the lower court opinions should be vacated, and the cases remanded for further proceedings.
Justice Kennedy’s opinion was neither a clear victory for the landowners in the cases or the COE. While he rejected the plurality’s narrow reading of the phrase “waters of the United States,” he also rejected the government’s broad interpretation of the phrase. While the “significant nexus” test of the Court’s 2001 SWANCC opinion required regulated parcels to be “inseparably bound up with the ‘waters’ of the United States,” Justice Kennedy would require the nexus to “be assessed in terms of the statute’s goals and purposes” in accordance with the Court’s 1985 opinion in United States v. Riverside Bayview Homes. 474 U.S. 121 (1985).
The “Clean Water Rule.” The Obama Administration attempted take advantage of the lack of clear guidance on the scope of federally jurisdictional wetland by issuing an expansive WOTUS rule. The EPA/COE regulation was deeply opposed by the farming/ranching and rural landowning communities, and triggered many legal challenges. The courts were, in general, highly critical of the regulation, invalidating it in 28 states by 2019. The CWR became a primary target of the Trump Administration.
The “NWPR Rule.” The Trump Administration essentially rescinded the Obama-era rule and replaced it with its own rule – the “Navigable Waters Protection Rule” (NWPR). 85 Fed. Reg. 22, 250 (Apr. 21, 2020). The NWPR redefined the Obama-era WOTUS rule to include only: “traditional navigable waters; perennial and intermittent tributaries that contribute surface water flow to such waters; certain lakes, ponds, and impoundments of jurisdictional waters; and wetlands adjacent to other jurisdictional waters. In short, the NWPR narrowed the definition of the statutory phrase “waters of the United States” to comport with Justice Scalia’s approach in Rapanos. Thus, the NWPR excluded from CWA jurisdiction wetlands that have no “continuous surface connection” to jurisdictional waters. The rule much more closely followed the Supreme Court’s guidance issued in 2001 and 2006 that did the Obama-era rule, but it was challenged by environmental groups. Indeed, the NWPR has been challenged in 15 cases filed in 11 federal district courts.
2021 developments. In early 2021, the U.S. Court of Appeals for the Tenth Circuit reversed a Colorado trial court that had entered a preliminary injunction barring the NWPR from taking effect in Colorado as applied to the discharge permit requirement of Section 404 of the CWA. The result of the appellate court’s decision is that the NWPR became effective in every state. Colorado v. United States Environmental Protection Agency, 989 F.3d 874 (10th Cir. 2021).
A primary aspect of the litigation involving the NWPR is whether it should apply retroactively or whether it is limited in its application on a prospective basis. For example, in United States v. Lucero, 989 F.2d 1088 (9th Cir. 2021), the defendant, in 2014, operated a business that charged construction companies for the dumping of soil and debris on dry lands near San Francisco Bay. The Environmental Protection Agency (EPA) later claimed that the dry land was a “wetland” subject to the dredge and fill permit requirements of Section 404 of the Clean Water Act (CWA). As a result, the defendant was charged with (and later convicted of) violating the CWA without any evidence in the record that the defendant knew or had reason to know that the dry land was a wetland subject to the CWA.
On further review, the appellate court noted that the CWA prohibits the “knowing” discharge of a pollutant into covered waters without a permit. At trial, the jury instructions did not state that the defendant had to make a “knowing” violation of the CWA to be found guilty of a discharge violation. Accordingly, the appellate court reversed on this point. However, the appellate court ruled against the defendant on his claim that the regulation defining “waters of the United States” was unconstitutionally vague, and that the 2020 Navigable Waters Protection Rule should apply retroactively to his case.
The NWPR was also held to apply prospectively only in United States v. Acquest Transit, LLC, No. 09-cv-555, 2021 U.S. Dist. LEXIS 40143 (W.D. N.Y. Mar. 3, 2021) and United States v. Mashni, No. 2:18-cv-2288-DCN, 2021 U.S. Dist. LEXIS 123345 (S.D. S.C. Jul. 1, 2021).
Most recently, a federal district court in South Carolina remanded the NWPR to the EPA. South Carolina Coastal Conservation League, et al. v. Regan, No. 2:20-cv-016787-BHH, 2021 U.S. Dist. LEXIS 132031 (D. S.C. Jul. 15, 2021). The NWPR was being challenged on the scope issue. Even though the NWPR was remanded, the court left the rule intact. That fit with the strategy of present Administration. If the court had invalidated the NWPR, then the Administration would have had to defend the Obama-era rule in court. By not vacating the NWPR allows the current administration to proceed in trying to write a new rule without bothering to defend the Obama-era rule in court.
In Pasqua Yaqui Tribe v. United States Environmental Protection Agency, No. CV-20-TUC-RM, 2021 U.S. Dist. LEXIS 163921 (D. Ariz. Aug. 30, 2021). the court vacated the NWPR. The court’s order did not specify the scope of the vacatur, but the EPA and the COE soon announced that neither agency would implement the NWPR on a nationwide basis, and will rely on the pre-2015 regulatory definition of a WOTUS until a new rule is developed. This all means that projects that have already received a CWA permit based on the NWPR can continue to rely on the permit until it expires. If a project has received an approved jurisdictional determination based on the NWPR may rely on it for five years from the date of issuance regardless of whether the project has already received a CWA permit based on the jurisdictional determination. For projects that have received a preliminary jurisdictional determination after the date of the court’s opinion may continue to rely on it.
New proposed rule. On December 7, 2021, the EPA and the COE published a proposed rule redefining a WOTUS in accordance with the pre-2015 definition of the term. 86 FR 69372 (Dec. 7, 2021). Under the proposed rule, EPA states its intention to define a WOTUS in accordance with the 1986 regulations as further defined by the courts since that time. In addition, the proposed rule would base the existence of a WOTUS on the “significant nexus” standard set forth in prior Supreme Court decisions. As such, a WOTUS would include traditional navigable waters; territorial seas and adjacent wetlands; most impoundments of a WOTUS and wetlands adjacent to impoundments or tributaries that meet either the relatively permanent standard or the significant nexus standard; all waters that are currently used or were used in the past or may be susceptible to use in interstate or foreign commerce, including all waters that are subject to the ebb and flow of the tide. The proposed rule defines “interstate waters” as “all rivers, lakes, and other waters that flow across, or form a part of State boundaries” regardless of whether those waters are also traditionally navigable. A “tributary” is also defined as being a WOTUS if it fits in the “other waters” category via a significant nexus with covered waters or if it is relatively permanent. The EPA and COE further define the “relatively permanent standard” as “waters that are relatively permanent, standing or continuously flowing and waters with a continuous surface connection to such waters.” The “significant nexus standard” is defined as “waters that either alone or in combination with similarly situated waters in the region, significantly affect the chemical, physical, or biological integrity of traditional navigable waters, interstate waters, or the territorial seas (the "foundational waters").” The comment period on the proposed rule expires on February 7, 2022.
Related WOTUS issue. During 2021 another significant case with WOTUS-related issues continued to wind its way through the court system. In Sackett v. Environmental Protection Agency, 8 F.4th 1075 (9th Cir. 2021), the plaintiffs bought a .63-acre lot in 2004 on which they intended to build a home. The lot is near numerous wetlands the water from which flows from a tributary to a creek, and eventually runs into a lake approximately 100 yards from the lot. The lake is 19 miles long and is a WOTUS subject to the CWA which bars the discharge of a pollutant, including rocks and sand into it. The plaintiffs began construction of their home, and the EPA issued a compliance order notifying the plaintiffs that their lot contained wetlands due to adjacency to the lake and that continuing to backfill sand and gravel on the lot would trigger penalties of $40,000 per day. The plaintiff sued and the EPA claimed that its administrative orders weren’t subject to judicial review. Ultimately the U.S. Supreme Court unanimously rejected the EPA’s argument and remanded the case to the trial court for further proceedings. The EPA withdrew the initial compliance order and issued an amended compliance order which the trial court held was not arbitrary or capricious. The plaintiffs appealed and the EPA declined to enforce the order, withdrew it and moved to dismiss the case. However, the EPA still maintained the lot was a jurisdictional wetland subject to the CWA and reserved the right to bring enforcement actions in the future. In 2019, the plaintiffs resisted the EPA’s motion and sought a ruling on the motion to bring finality to the matter. The EPA claimed that the case was moot, but the appellate court disagreed, noting that the withdrawal of the compliance order did not give the plaintiffs final and full relief. On the merits, the appellate court noted that the lot contained wetlands 30 feet from the tributary, and that under the “significant nexus” test of Rapanos v. United States, 547 U.S. 715 (2006), the lot was a regulable wetland under the CWA as being adjacent to a navigable water of the United States (the lake).
Note: On September 22, 2021, the plaintiffs filed a petition with the U.S. Supreme court asking the Court to review the case. The Supreme Court set January 14, 2022, as the conference date to determine whether it will accept the case for review and decision.
1. The Failure of “Build Back Better” to Become Law.
Without doubt, the biggest development of 2021 was the failure of H.R. 5376, known as “Build Back Better” (BBB) to become law. The BBB would have also been the biggest development had it also become law. There are numerous provisions in the BBB that would have impacted farmers and ranchers significantly. While the bill did pass the U.S. House on November 19, the version that passed was a “slimmed-down” version that did not contain many of the more onerous (as viewed by agriculture) provisions that were originally included. The Senate failed to take up the legislation before the end of 2021.
The following are some of the more significant provisions that were originally included in H.R. 5376 that didn’t make it into the House passed version:
- Increase in corporate tax rate to 26.5 percent;
- Modifications to the “stepped-up” basis rule at death;
- Increase in top individual marginal rate to 39.6 percent;
- A phase-out or elimination of the 20 percent qualified business income deduction;
- Increase in top capital gain rate to 25%;
- Reduction in the federal estate/gift tax unified credit exemption equivalent;
- Change in the grantor trust rules;
- Change in the present interest annual exclusion rule;
- Increase in the top federal estate/gift tax marginal rate;
- Valuation discounting rules; and
- Increase in value reduction for land in decedent’s estate under Sec. 2032A
But, there remained certain provisions in H.R. 5376 of relevance to agricultural producers. Those include the following:
- An increase in the state and local tax deduction (SALT) from the present $10,000 amount to $80,000 (MFJ);
- A surcharge on high income earners;
- Expansion of the NIIT (3.8 percent) to trade or business income for taxpayers with taxable income exceeding $400,000 (single); $500,000 (MFJ), and application of the NIIT to trade or business income of estates/trusts;
- Limit on contributions to traditional or Roth IRAs for persons with combined IRA and defined contribution account balances exceeding $10 million and adjusted taxable income exceeds the $400,000/$500,000 thresholds; required distributions for accounts where owner has combined values exceeding $10 million; no “backdoor” Roths;
- Expansion of Medicare to cover dental, hearing and vision care;
- No oil and gas drilling on non-wilderness portion or ANWR; and
- Moratorium on offshore oil and gas leasing in Eastern Gulf of Mexico, Atlantic and Pacific federal waters.
Going forward into 2022, Democrats are expected to make efforts to advance their priorities in a filibuster-proof reconciliation bill containing the White House economic recovery “blueprint.” Disputes over the structure of several tax incentives remain at the center of bicameral talks aimed at clearing the way for the Senate to pass and the House to clear a revised version of H.R. 5376. The House appears to be focused on implementing H.R. 5376 and salvaging parts of it if the bill does not pass the Senate in the same form it passed the House. Democrats also are pushing to double the current IRS budget and are pitching the move as a revenue raiser by virtue of increased revenue from audits.
On the other side of the aisle, Republicans are pushing to make the point that temporary tax breaks followed by extensions would further fuel already high inflation and add to the deficit. Senate Republicans appear to be focused on keeping the corporate tax rate at 21 percent, the top individual rate at 37 percent and top capital gains rate at 20 percent.
As of today, there is no clear sign about how a deal will be cut on a fiscal 2022 omnibus spending deal before the February 18 expiration of the current stopgap spending law. There is no current ongoing negotiation with respect to H.R. 5376, Another issue for 2022 is what the Congress might do with respect to extending tax provisions that have currently expired. There are about two dozen provisions that expired at the end of 2021. Perhaps there will be a push for a separate extender bill for renewal of popular provisions such as a tax break for mortgage insurance premiums, the ($300/$600) above-the-line deduction for charitable deductions, and an increase to age 75 for the start of required minimum distributions from retirement plans.
So there you have it - five articles discussing the ten biggest developments in agricultural law and taxation for 2021. What else was the law concerned with involving agriculture in 2021 that didn’t make the “Top Ten” list? Next, I will start looking at those issues.
Tuesday, January 4, 2022
As I pointed out in Sunday’s article, agricultural law and agricultural tax law intersect with everyday life of farmers and ranchers in many ways. Some of those areas of intersection are good, but some are quite troubling. In any event, it points to the need for being educated and having good legal and tax counsel that is well-trained in the special rules that apply to agriculture.
This is the second installment in my list of the “Top Ten” agricultural law and tax developments of 2021. The list is comprised of what are, in my view, the most important developments in agricultural law (which includes taxation that impacts farmers and ranchers) to the sector as a whole. The developments primarily are focused on the impact to production agriculture, but the issues involved will also have effects that spillover to rural landowners and agribusinesses as well as consumers of agricultural products.
The Eighth and Seventh most important agricultural law and tax developments of 2021 – it’s the topic of today’s post.
8. Ag Nuisance Litigation in North Carolina. In recent years, North Carolina has been the focus of much ag nuisance litigation, particularly targeted at large-scale hog confinement operations. Legal developments flowing from the various cases has influenced the North Carolina legislature as well as legislatures in other states (such as Florida and Indiana) to modify their Right-To-Farm (RTF) laws in an attempt to provide greater legal protection to agricultural operations. In 2021, there were further developments in North Carolina involving nuisance and that state’s RTF law.
The North Carolina RTF law was originally enacted in 1979 with the state policy goal to: "[R]educe the loss to the State of its agricultural and forestry resources by limiting the circumstances under which an agricultural or forestry operation may be deemed a nuisance." After many nuisance suits were filed against confinement hog operations, the legislature amended the RTF in 2013. The amendment specified that an ag operation that has been in business for at least a year and has not fundamentally changed is protected from a nuisance action as a result of changed conditions surrounding it if the ag operation was not a nuisance at the time it began. The plaintiffs refiled their suits in 2014 in federal district court based on the amended law. The federal court held that the RTF law did not apply to shield hog producers and five juries rendered verdicts for the plaintiffs. The legislature again amended the RTF law in 2017 and 2018 to expand its protection for agricultural operations.
There were two additional court opinions in 2021 involving the North Carolina RTF law. In Barden v. Murphy-Brown, LLC, No. 7:20-CV-85-BR, 2021 U.S. Dist. LEXIS 47809 (E.D. N.C. Mar. 15, 2021), the plaintiff sued the defendant in 2020 for trespass, negligence, civil conspiracy and unjust enrichment arising from odor, dust, feces, urine and flies from a neighboring hog facility that housed 20,000-head of the defendant’s hogs. The plaintiff sought compensatory and punitive damages. The defendant sought to dismiss the complaint for failure to join to the lawsuit the farmer that operated the hog facility via a contact with the defendant as an indispensable party. The court disagreed, as the farmer’s conduct was likely irrelevant to the outcome of the litigation and any impact that an adverse judgment against the defendant might have on the farmer’s interests at the farm was speculative. The defendant also sought dismissal on the basis that the plaintiff’s complaint failed to state a claim for relief that was other than speculative. The defendant cited the North Carolina RTF law as barring all of the plaintiff’s claims.
The federal trial court disagreed with the defendant, noting that conditions constituting a nuisance can also constitute a trespass (and other causes of action). Thus, the plaintiff’s complaint was not restricted to allegations of a nuisance cause of action which the RTF law would bar. The court noted that the RTF law was different from other state RTF laws that covered non-nuisance tort claims related to farming operations along with nuisance claims. The RTF law only covered nuisance-related claims and had no application to non-nuisance claims. As to whether the plaintiff adequately alleged the non-nuisance claims, the court concluded that the plaintiff sufficiently alleged, at a minimum, a claim for unintentional trespass by not consenting to dust, urine and fecal matter from entering its property. On the plaintiff’s negligence claim, the court determined that it was reasonably foreseeable that if the defendant did not act reasonably in managing the facility that dust and animal waste would be present on the plaintiff’s property. As such, the defendant owed the plaintiff a duty and there was a causal link with any potential breach of that duty. Thus, the plaintiff properly stated a claim for negligence. The plaintiff also alleged that the defendant conspired with its corporate parent to mislead the public about the science of hog manure removal and various constitutional violations. The court rejected this claim because any conspiracy was between the defendant and its corporate parent and not with any independent party. The plaintiff also claimed that the defendant unjustly enriched itself by using the plaintiff’s property for a de facto easement without paying for it. The court rejected the claim because the plaintiff had conferred no benefit on the plaintiff which gave rise to any legal or equitable obligation on the defendant’s part to account for the benefit received. However, the court refused to strike the plaintiff’s allegations relating to the defendant’s Chinese ownership, influence and exploitation as well as the defendant’s financial resources. The court determined that such allegations had a bearing on the defendant’s motivation, extent of harm and ability to implement alternative technology.
A second court opinion involving the North Carolina RTF law was issued in late 2021. In Rural Empowerment Association for Community Help v. State, No. COA21-175, 2021 N.C. App. LEXIS 733 (N.C. Ct. App. Dec. 21, 2021), the plaintiffs filed suit in 2019 challenging the constitutionality of the RTF law. The plaintiffs sued in 2019 challenging the constitutionality of the RTF law on its face because they claimed the law exceeded the scope of the state’s police power. The defendants moved to dismiss the case and the trial court granted the defendant's motion to dismiss and denied the plaintiffs’ motion for summary judgment. On appeal, the appellate court affirmed. The state appellate court agreed with the trial court that limiting the potential nuisance liability from ag, forestry, and related operations furthered the state’s goal of protecting ag activities and encouraging the availability and continued production of agricultural products. The appellate court also determined that the RTF law amendments were a valid exercise of legislative and state police powers and did not violate the state Constitution’s Law of the Land Clause or the Due Process Clause. The appellate court also determined that the amendments were not a special or private law, and didn’t deprive any prospective plaintiff of the right to a jury trial.
Note: It is anticipated that the state appellate court opinion, if upheld on any appeal, will provide further guidance to other states and RTF laws.
7. Federal Court Determines Whether Withheld Taxes and Other Pre-Paid Taxes Can Be Deprioritized in Chapter 12 Bankruptcy. As originally enacted, Chapter 12 did not create a separate tax entity for Chapter 12 bankruptcy estates for purposes of federal income taxation. That shortcoming precludes debtor avoidance of potential income tax liability on disposition of assets as may be possible for individuals who file Chapter 7 or 11 bankruptcy. But, an amendment to Chapter 12 in 2005 made an important change. As modified, tax debt associated with the sale of an asset used in farming can be treated as unsecured debt that is not entitled to priority and ultimately discharged. Without this modification, a farmer faced with selling assets to satisfy creditors could trigger substantial tax liability that would impair the chance to reorganize the farming business under Chapter 12. Such a farmer could be forced into liquidation.
A question that was addressed by a federal trial court in Indiana in 2021 was how taxes that the debtor had already paid are to be treated. Can previously paid or withheld taxes be pulled back into the bankruptcy estate where they are “stripped” of their priority (i.e., deprioritized)? That is a very significant question for a Chapter 12 farm debtor that also has off-farm income of a spouse that helps support the farming operation.
In United States v. Richards, No. 1:20-cv-02703-SEB-MG, 2021 U.S. Dist. LEXIS (S.D. Ind. Sept. 30, 2021), the debtors, a married farm couple, filed Chapter 12 bankruptcy in 2018 after suffering losses from negative weather events and commodity market price declines during 2013 through 2015. The primary lender refused to renew the loan which forced liquidation of the farm’s assets in the spring of 2016. During 2016, the debtors sold substantially all of the farm equipment, vehicles and other personal property assets as well as grain inventory. The proceeds were paid to the primary lender as well as other lenders with purchase money security interests in relevant assets. After filing Chapter 12, the debtors sold additional farmland. The asset sales triggered substantial income tax obligations for 2016, 2017 and 2018 tax years. The debtors Chapter 12 plan made no mention concerning whether off-farm earnings, tax withholdings or payments the debtors voluntarily made to the IRS, or a claim or refund would remain property of the bankruptcy estate after Plan confirmation. The plan did, however, divide the debtors federal tax obligations into 1) tax liabilities for income arising from the sale, transfer, exchange or other disposition of any property used in the debtors’ farming operation “Section 1232 Income”; and 2) tax liabilities arising from other income sources – “Traditional income.” Tax liabilities associated with Traditional Income would retain priority status, but taxes associated with Section 1232 Income would be de-prioritized (regardless of when the liability was incurred) and treated as general unsecured claims that would be discharged upon Plan completion if not paid in full. Under the reorganization Plan, the debtors would pay directly the tax liability associated with Traditional Income incurred after the Chapter 12 filing date. Under the Plan, unsecured claims would be paid on a “pro rata” basis using the “marginal method” along with other general unsecured claims. The Section 1232 taxes would be computed by excluding the taxable income from the disposition of assets used in farming from the tax return utilizing a pro forma tax return. The Plan was silent concerning how the Debtors’ withholding payments and credits for each tax year were to be applied or allocated between any particular tax year’s income tax return and the corresponding pro forma return.
The IRS filed a proof of claim for the 2016 and 2017 tax years in the amount of $288,675.43. The debtors objected to the IRS’s claim, but did seek to reclassify $5,681 of the IRS claim as general unsecured priority status. The IRS failed to respond, and the bankruptcy court granted the debtors approximately $280,000 in tax relief for 2016 and 2017. The debtors then submitted their 2018 federal and state returns showing a tax liability of $58,380 and their pro forma return for 2018 excluding the income from the sale of farm assets which showed a tax liability of $3,399. The debtors, due to withholding and estimated tax, inadvertently paid $9,813 to the IRS during 2018. They claimed $6,414 was an overpayment and listed that amount on the Pro Forma return as a refund. The IRS amended its proof of claim and asserted a general unsecured claim of $42,200 for the 2018 tax year (excluding penalties and interest). The IRS claimed that none of the debtors’ tax liability qualified for non-priority treatment under 11 U.S.C. §1232, and that it had a general unsecured claim for $42, 220 for the 2018 tax year. To reach that amount, the IRS allocated tax withholdings and credits of $9,813 to the assessed tax due on the debtors’ pro forma return which reduced that amount to zero, and then allocated the remaining $6,414 of withholdings, payments and credits to the outstanding tax liability of $48,634. IRS later added $6,347 of net investment income tax that the debtors had reported on their return but IRS had excluded due to a processing error. The debtors objected to the IRS’s claim and asserted it should not be increased by either the $6,414 overpayment or the $6,347 of net investment income tax. The debtors sought to adjust the IRS claim to $54,981 and have the court issue a refund to them of $6,414 or reduce distributions to the IRS until the refund obligation had been satisfied. The IRS objected on the basis that the court lacked jurisdiction to compel the issuance of a refund or credit of an overpayment, and that the debtors were not entitled to the refund or credit of the overpayment shown on the pro forma return as a matter of law.
The bankruptcy court sustained the debtors’ objection to the extent the 2018 refund was applied to the IRS’s claim in a manner other than provided for under the confirmed plan. Specifically, the bankruptcy court held that the IRS had exercised a setoff that was not permitted under 11 U.S.C. §553 which violated the plan’s bar against any creditor taking any action “to collect on any claim, whether by offset or otherwise, unless specifically authorized by this Plan.” But, the bankruptcy court held that it lacked jurisdiction to compel the issuance of a refund or credit of an overpayment and that the debtors were not entitled to the refund or credit of overpayment as a matter of law. This was because, the court determined, the refund was not “property of the estate” under 11 U.S.C. § §542 and 541(a). Later, the bankruptcy court held that the overpayment reflected on the pro forma return was “property of the estate” and withdrew its prior analysis of 11 U.S.C. §§542 and 505(a)(2)(B). Thus, the bankruptcy court allowed the IRS’s 2018 general unsecured tax claim in the amount of $54,981 and ordered the Trustee to pay distributions to the debtors until the overpayments had been paid to the debtors.
The IRS appealed, claiming that the bankruptcy court erred in allowing the IRS’s proof of claim in the amount of $54,981 rather than $48,567, and ordering the IRS to issue the debtors a refund or credit of any overpayment in the amount of $6,414. Specifically, the IRS asserted that 11 U.S.C. §1232 did not provide the debtors any right to an “overpayment” or “refund” because it only applies to “claims” - tax liability after crediting payments and withholdings. The IRS based its position on Iowa Department of Revenue v. DeVries, 621 B.R. 445 (8th Cir. B.A.P. 2020). However, the trial court noted distinctions with the facts of DeVries. Here, the sale of property at issue occurred post-petition and involved a claim objection after the Plan had already been confirmed. The appellate court noted that the IRS did not object to the terms of the Plan, and under 11. U.S.C. §1232 the debtors can deprioritize all post-petition Sec. 1232 liabilities, not just a portion. The application of the marginal method resulted in a tax liability of $54,981 to be paid in accordance with 11 U.S.C. §1232. The non-§1232 tax liability was $3,399. The debtors inadvertently paid $9,813 to the IRS and were entitled to a refund of $6,414, and the IRS could not apply that amount against the Sec. 1232 liabilities in calculating its proof of claim. The refund amount was “property of the estate” under 11 U.S.C. §1207(a)(2).
Note: On November 30, 2021, an appeal was docketed with the U.S. Circuit Court of Appeals for the Seventh Circuit.
Devries and Richards are important cases for practitioners helping farmers in financial distress. 11 U.S.C. §1232 is a powerful tool that can assist making a farm reorganization more feasible. The Indiana case is a bit strange. In that case, the debtors were also due a refund for 2016. A pro-forma return for that year showed a refund of $1,300. Thus, the issue of a refund being due for pre-petition taxes could have been asserted just as it was in the Iowa case. Another oddity about the Indiana case is that the 2018 pro-forma (and regular) return was submitted to the IRS in March of 2019. Under 11 U.S.C. §1232, the “governmental body” has 180 days to file its proof of claim after the pro forma tax return was filed. The IRS timely filed its proof of claim and later filed an amended proof of claim which was identical to the original proof of claim. The IRS filed an untimely proof of claim in one of the other jointly administered cases.
Procedurally, in the Indiana case, a Notice regarding the use of 11 U.S.C. §1232 should have been filed with the court to clarify the dates of Notice to the IRS (and other governmental bodies) of the amount of the priority non-dischargeable taxes and 11 U.S.C. §1232 taxes to be discharged under the plan. That is when the issue of the refund would have been raised with the IRS. However, there was no Notice of the filing of the pro-forma return with the court. It will be interesting to see how the U.S. Court of Appeals handles the Indiana case on appeal.
Note: Going forward, Chapter 12 reorganization plans should provide that if a pro-forma return shows that the debtor is owed a refund the governmental bodies will pay it.
The next article will detail the Sixth and Fifth most important ag law and tax developments of 2021. Stay tuned.
Sunday, January 2, 2022
Agricultural law and agricultural tax law intersect with everyday life of farmers and ranchers in many ways. Some of those areas of intersection are good, but some are quite troubling. In any event, it points to the need for being educated and having good legal and tax counsel who is well-trained in the special rules that apply to agriculture.
Each year for the past 25 years I have compiled what are, in my view, the most important developments in agricultural law (which includes taxation that impacts farmers and ranchers) to the sector as a whole. The developments primarily are focused on the impact to production agriculture, but the issues involved will also have effects that spillover to rural landowners and agribusinesses as well as consumers of agricultural products.
The Tenth and Ninth most important agricultural law and tax developments of 2021 – it’s the topic of today’s post.
10. No Expansion of Public Trust Doctrine in Iowa. The “public trust doctrine” derives from the seas being viewed as the common property of the public that cannot be privately used or owned. They are held in “public trust.” This concept from England ultimately became part of the U.S. common law and has its primary application to the access of the seashore and intertidal waters.
The U.S. Supreme Court’s first application of the public trust doctrine was in 1842 in Martin v. Lessee of Waddell, 41 U.S.367 (1842). In the case, the issue was who had the right to submerged land and oyster harvesting off the coast of New Jersey. The Court, largely based on the language in the charter granted by the King to a Duke to establish a colony and for policy and economic reasons, determined that the land area in issue belonged to the state of New Jersey for the benefit of the people of the state. The Court dealt with the issue again in 1892 in a case involving a railroad that had been granted a large amount of the Chicago harbor. Illinois Central Railroad Company v. Illinois, 146 U.S. 387 (1892). The Court determined that the government cannot alienate (interfere with) the public’s right to access land under waters that are navigable in fact except for situations where the land involved wouldn’t interfere with the public’s ability to access the water or impair navigation.
A long-standing battle in Iowa over the level of nitrates and phosphorous in an Iowa waterway and farm field runoff came to a head in Iowa Citizens for Community Improvement, et al. v. State, 962 N.W.2d 780 (Iowa 2021). For approximately the past decade activist groups and certain academics have sought more regulatory control over farming practices that they deem contribute to excessive nutrients in an Iowa river and higher drinking water prices in Des Moines and elsewhere. They have sought to remove from the state legislature the power to make these decisions and have also sought more federal control.
The plaintiffs, two social justice organizations, sued the State of Iowa and state officials and agencies associated with agriculture and the environment, claiming that the public trust doctrine required them to enact legislation and rules forcing farmers to adopt farming practices that would significantly reduce levels of nitrogen and phosphorous runoff into the Raccoon River. The plaintiffs claimed that such a requirement would improve members’ feelings by enhancing aesthetics and recreational uses of the river and by reducing members’ water bills (at least in the Des Moines area). They sought declaratory and injunctive relief.
In response, the State argued that the plaintiffs lacked standing to sue and that the issue was nonjusticiable (i.e., not capable of being decided by a court). After the trial court denied the defendants’ motion to dismiss, the defendants sought an interlocutory appeal (i.e., an appeal of the trial court’s ruling while other aspects of the case proceeded).
On review, the state Supreme Court first noted that the scope of the public trust doctrine in Iowa is narrow, and that the doctrine should not be overextended. The Supreme Court noted that for a party to have standing to sue, they must have a specific personal or legal interest in the litigation and be “injuriously affected.” For a party to be injuriously affected, the Supreme Court stated that the injury complained of must be likely to be redressed by the court’s favorable decision. On that point, the Supreme Court determined that it would be speculative that a favorable court decision would result in a more aesthetically pleasing river or lower water rates.
Further, the Supreme Court determined the injunctive relief was not appropriate and that what the plaintiffs were seeking could only be accomplished through legislation. The Supreme Court pointed out that the plaintiffs admitted that the defendants lacked authority to require limits for nitrogen and phosphorous from agricultural nonpoint sources – the matter was up to the legislature. As a result, the Supreme Court determined the plaintiffs’ claims must be dismissed due to lack of standing.
The plaintiffs also claimed that constitutional due process rights were at stake and the Court should address them. The Supreme Court disagreed, pointing out that the plaintiffs’ own arguments cut against the Court being able to address such a claim. Because the plaintiffs were asking the Court to broaden the application of the public trust doctrine, the plaintiffs were essentially asking the Court to inject itself into political matters where there would be a lack of judicially discoverable and manageable standards. As the Supreme Court pointed out, “different uses matter in different degrees to different people.” Publicly elected policy makers decide these matters. Not the courts.
Consequently, the Court determined that granting any meaningful relief to the plaintiffs would result in the judicial branch asserting superiority over the legislature. An impermissible outcome under the co-equal system of government.
The Iowa Supreme Court decision has significant implications for agriculture in terms of the manner in which public policy decisions are made (by elected politicians and not non-elected government bureaucrats and/or courts). The reach of the Court’s decision is likely to have application beyond Iowa. Courts in other states facing novel issues tend to look at how courts in other states have ruled on those novel but similar issues.
9. IRS Regulations on Farm Net Operating Losses (NOLs). During 2021, the IRS issued guidance in Rev. Proc. 2021-14, 2021-29 I.R.B on how farm taxpayers are to handle carryback elections related to farm NOLs in light of all of the legislative rule changes in recent years. Those changes involved the Tax Cuts and Jobs Act (TCJA) of 2017, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) of 2020, and the COVID-Related Tax Relief Act (CRTA) of late 2020. The TCJA limited the deductibility of an NOL arising in a tax year beginning after 2017 to 80 percent of taxable income (computed without the NOL deduction). Under the TCJA, no NOL carryback was allowed unless the NOL related to the taxpayer’s farming business. A farming NOL could be carried back two years, but a taxpayer could make an irrevocable election to waive the carryback. The 80 percent provision also applied to farm NOLs that were carried back for NOLs generated in years beginning after 2017. Under the TCJA, post-2017 NOLs do not expire.
The CARES Act suspended the 80 percent limitation for NOLs through the 2020 tax year. The suspension applies to all NOLs, farm or non-farm, arising in tax years beginning in 2018-2020. The CARES Act also removed the two-year carryback option for farm NOLs and replaced it with a five-year carryback for all NOLs arising in a tax year beginning after 2017 and before 2021. Under the carryback provision, an NOL could be carried back to each of the five tax years preceding the tax year of the loss (unless the taxpayer elected to waive the carryback).
The COVID-Related Tax Relief Act (CTRA) of 2020 amended the CARES Act to allow taxpayers to elect to disregard the CARES Act provisions for farming NOLs. This is commonly referred to as the “CTRA election.” Under the CTRA election, farmers who had elected the two-year carryback under the TCJA can elect to retain that carryback (limited to 80 percent of the pre-NOL taxable income of the carryback year) rather than claim the five-year carryback under the CARES Act. In addition, farmers who previously waived an election to carryback an NOL can revoke the waiver.
The CTRA also specifies that if a taxpayer with a farm NOL filed a federal income tax return before December 27, 2020, that disregards the CARES Act amendments to the TCJA, the taxpayer is treated as having made a “deemed election” unless the taxpayer amended the return to reflect the CARES Act amendments by the due date (including extensions of time) for filing the return for the first tax year ending after December 27, 2020. This means that the taxpayer is deemed to have elected to utilize the two-year carryback provision of the TCJA.
On June 30, 2021, the IRS issued Rev. Proc. 2021-14, 2021-29 I.R.B. to provide guidance for taxpayers with an NOL for a tax year beginning in 2018-2020, all or a portion of which consists of a farming loss. The guidance details how the taxpayer can elect to not apply certain NOL rules of the CARES Act, and how the CTRA election can be revoked. Rev. Proc. 2021-14 is effective June 30, 2021.
The Rev. Proc. specifies that a taxpayer with a farming NOL, other than a taxpayer making a deemed election, may make an “affirmative CTRA election” to disregard the CARES Act NOL amendments if the farming NOL arose in any tax year beginning in 2018-2020. An affirmative election allows the farm taxpayer to carryback a 2018-2020 farm NOL two years instead of five years. Certain procedural requirements had to be satisfied. In addition, it’s an all-or-nothing election the taxpayer must choose either the two-year farm NOL carryback provision for all loss years within 2018-2020, or not. For taxpayers who follow the Rev. Proc. and make an affirmative election, the Rev. Proc. specifies that the 80 percent limitation on NOLs will apply to determine the amount of an NOL deduction for tax years beginning in 2018-2020, to the extent the deduction is attributable to NOLs arising in tax years beginning after 2017. In addition, the CARES Act carryback provisions will not apply for NOLs arising in tax years beginning in 2018-2020.
The IRS also set forth the procedure for a taxpayer to follow to not be treated as having made a deemed election. For taxpayers that made a deemed election under the CARES Act, the election applies unless the taxpayer amends the return. For a taxpayer that elected not to have the two-year carryback period apply to a farming NOL incurred in a tax year beginning in 2018 or 2019, the Rev. Proc. specifies that the taxpayer may revoke the election if the taxpayer made the election before December 27, 2020, and makes the revocation on an amended return by the date that is three years after the due date, including extensions of time, for filing the return for the tax year the farming NOL was incurred. If the NOL is not fully absorbed in the five-year earlier carryback year, the balance carries forward to the fourth year back and subsequent years in the carryback period until it is fully absorbed. The taxpayer may also amend the returns for the years in the five-year carryback period, if needed, to utilize the benefits of I.R.C. §1301 (farm income averaging).
Note: What remains unclear after the issuance of Rev. Proc. 2021-14 is whether the affirmative CTRA election can be made to use the two-year carryback if a farmer had previously waived the five-year carryback. The Rev. Proc. is not clear on this point.
If a taxpayer has an NOL that is a mixture of farm and non-farm activities, the portion of the NOL that is attributable to the farming activity may be carried back either two or five years consistent with the guidance of the Rev. Proc. The non-farm portion of the NOL may not be carried back two years. Also, the election to waive the carryback period is all-or-nothing. It is not possible to separately waive a farm NOL carryback from a non-farm NOL.
The next article will detail the Eighth and Seventh most important ag law and tax developments of 2021. Stay tuned.
Thursday, December 30, 2021
The Commodity Credit Corporation (CCC) is the USDA’s financing institution with programs administered by the Farm Service Agency (FSA). Among other things, the CCC makes commodity and farm storage facility loans to farmers where the farmers’ crops are pledged as collateral. These loans are part of the price and income support system of the federal farm programs.
How is the loan reported for tax purposes? What happens when the loan is paid back? What are the tax reporting rules that apply? These questions are the focus of today’s post.
Tax Reporting Options
A CCC loan involves a farmer pledging bushels of grain as collateral for a loan. The loan allows the farmer to create cashflow without the need to sell the grain. If prices rise, the grain can be sold, and the loan (and interest) paid off with the farmer keeping the balance.
What if prices don’t rise? This points out a key aspect of the CCC loan program. When a farmer seals grain (places it in storage and pledges it as collateral to secure a CCC loan), the farmer retains the ability to forfeit the grain in the future if the loan value exceeds commodity prices. Because most CCC loans are nonrecourse, upon maturity, if the loan plus interest is not paid, the forfeiting of the commodity to the CCC as full payment for the loan effectively establishes a minimum price. The farmer can forfeit the grain if prices drop below the loan value, and still retain the ability to market the grain later if the commodity price increases. The forfeiting of the loan to the CCC as full payment is known as “redemption.” Once redemption occurs, the farmer can then sell the grain, feed it to livestock or store it.
How are CCC loan proceeds handled for tax purposes? There are two possible methods.
Loan method. By presumption, every farmer treats CCC loans as loans for tax purposes. Thus, for a farmer on the cash method of accounting, there is no taxable income from the loan until the year in which the commodity is sold or the crop is forfeited to CCC in full satisfaction of the loan. If grain is forfeited to the CCC in satisfaction of the loan, the taxpayer will receive a Form 1099-A from the USDA. The amount of the loan forfeited is reported on line 5b of Schedule F with the same amount entered as taxable income on line 5c.
Farmers using the loan method (and their tax preparers) should recognize that the loan method can create a high income with no cash flow in the year the grain is sold. That’s because the loan amount was received in the prior year.
Income method. CCC loans may, by election (and without IRS permission), be treated as income in the year the proceeds of the loan are received. I.R.C. §77. The election can be made at any time (I.R.C. §77(a)), but the IRS has ruled that, if a farmer elects to treat CCC loans as income, it applies to all loans originating that year. Priv. Ltr. Rul. 8819004 (Jan. 22, 1988). Actually, the CCC loan is not income. Rather, the amount reported as income is the cash proceeds of the CCC loan which then serves as the grain’s income tax basis. I.R.C. §1016(a)(8). The amount of the income is entered on line 5a of Schedule F. The election constitutes an adoption of an accounting method and is binding for future years. Treas. Reg. §1.77-1. An election statement reporting the details of the loan must be attached to the farmer’s return for the year the election is made. See IRS Pub. 225 and the Instructions to Schedule F. Also, the election to treat CCC loans as income applies to all commodities for that taxpayer. Treas. Reg. § 1.77-1.
In addition, a taxpayer reporting CCC loans as income can switch automatically to treating CCC loans as loans. Rev. Proc. 2002-9, I.R.B. 2002-3, Section 1.01(1). Loans taken out previously continue to be treated as if the election to report loans as income was still in effect. Under the IRS guidance, the change is made on a “cut-off” basis. In other words, when a taxpayer changes CCC loan reporting methods, the new method applies to current year and subsequent loans. That means that a farmer could be reporting on both methods until prior loans are satisfied. In addition, even if a farmer had made the election to report the CCC loan as income within the past five years, the farmer is still eligible to switch to the loan method. The IRS, in Rev. Proc. 2015-13, Appendix Sec. 2.01(2), waives that five-year prohibition. But, Form 3115 must be attached to the return noting that the change is being made under the automatic consent procedures of Rev. Proc. 2015-14. Also, a copy of Form 3115 must be sent to the IRS in Washington, D.C.
Tax Planning Issues
It is important to understand the tax ramifications of making or not making the election to treat CCC loans as income. For example, assume a farmer is participating in a three-year farmer loan reserve program. If a year of high prices occurs and all of the grain under the three-year loan reserve program is sold, the result is a spike in the taxpayer's income for that year. That is because the grain is income in the year that it is disposed of if an election has not been made to treat the loan as income. In order avoid that result, the farmer is permitted to treat the loans as income. This means the farmer will report the crop into income in the year it was placed under loan. This has the favorable result of evening out year-to-year income by offsetting the income from the crop with the expenses of raising the crop. When the crop is eventually sold, there will be taxable income only to the extent that the sale price exceeds the loan amount.
However, there is an advantage in not paying tax any sooner than required and, therefore, farmers (particularly those in higher brackets) may not want to treat CCC loans as income. The preference may be to roll the income as far as possible without paying tax on it. Thus, it is an important consideration for tax planning purposes to consider whether to treat CCC loans as income or as loans. The point is that a choice is available.
As a summary of the income tax treatment of various dispositions of CCC loans and commodities, consider the following:
- If the loan is paid by forfeiting the commodity to the CCC, no income is reported if an election has been made to treat the loan as income upon receipt. The farmer’s basis in the grain offsets the loan liability. But, there could be either a gain or loss on the farmer’s Schedule F if the farmer’s liability on the loan is more or less than the farmer’s basis in the grain. However, if no election is made, the amount of the loan is reported as income upon forfeiture (redemption).
- If the commodity is redeemed by paying off the loan with cash, the farmer has a basis in the commodity equal to the loan amount if an election has been made to treat the loan as income. If no election was made, the farmer has a zero basis in the commodity.
- If the redeemed commodity is sold, the farmer has income (or loss) equal to the sale price of the commodity less the amount of the loan (which is the basis in the commodity), if an election to treat the loan as income was made. If not, the farmer has income equal to the selling price of the commodity.
- If the redeemed commodity is fed to livestock, the farmer has a feed deduction equal to the amount of the loan (which is the basis in the feed), if an election has been made to treat the loan as income. If no election was made, the farmer does not get a feed deduction.
- Regardless of whether the CCC loan is treated as a loan or as income, interest that the farmer pays to the CCC on the loan is deductible in the year it is paid for a cash-basis farmer.
What if the CCC Loan Is Redeemed in the Same Year It Is Taken Out?
As noted above, normally the repayment of a CCC loan has no tax impact. That’s the case regardless of whether or not the taxpayer has made an election to treat the loans as income. But if a farmer has elected to treat CCC loans as income, the courts are divided as to the outcome if the loans are redeemed in the same year they are taken out. The Fifth Circuit Court of Appeals has held that no income is realized from the loan on a crop redeemed in the same year. Thompson v. Comm’r, 322 F.2d 122 (5th Cir. 1963), aff'g and rev'g, 38 T.C. 153 (1962). On the other hand, the Ninth Circuit Court of Appeals has taken the position that the loan triggers income even though it is redeemed in the same year. United States v. Isaak, 400 F.2d 869 (9th Cir. 1968).
What About Market Gains on CCC Loans?
Similar rules to those discussed above apply to market gains triggered under the CCC nonrecourse marketing assistance loan program. The amount that a farmer has to repay for a loan that is secured by an eligible commodity is tied to the lower of the loan rate or the world market price for the commodity on the loan repayment date. If repayment occurs when the world price is lower than the loan rate, the farmer has “market gain” on the difference. For repayment in cash, the gain is reported on a CCC-1099-G. But, if a CCC certificate is used to repay the loan, there is no Form 1099 reporting. In addition, the farmer’s tax treatment of the market gain is tied to how the farmer treats CCC loans for tax purposes. For farmers that treat CCC loans as loans, the market gain is reported on line 4a of Schedule F and taxable income is reported on line 4b. If the farmer made an election treat CCC loans as income, the market gain is not taxable income. Instead, it reduces the basis in the commodity and defers income until the sale of the grain occurs.
CCC loans are another illustration of how agricultural tax is different from tax for non-farmers. It’s a unique aspect of tax law that is particular to farmers. This is another area of the law that makes having a practitioner that specializes in ag tax of great value – they might be able to help save taxes next year without the need to take low prices in the current year. Fortunately, that largely hasn’t been a problem recently, but with extremely high input costs facing farmers for the 2022 planting season, cash flow could become tight. Also, CCC loan tax planning should only be part of an overall tax plan for a farmer.
Tuesday, December 28, 2021
The mid-December wildfire in Kansas resulted in loss of livestock along with damage to farm/ranch buildings and structures. The wind damage was more widespread than just Kansas, and I wrote about the tax issues associated with demolishing farm buildings and structures that are no longer usable as a result of the storm here: https://lawprofessors.typepad.com/agriculturallaw/2021/12/inland-hurricane-2021-version-is-there-any-tax-benefit-to-demolishing-farm-buildings-and-structures.html.
What I didn’t address in that article are the tax issues associated with the receipt of USDA Livestock Indemnity Program (LIP) payments for livestock deaths and the tax issues associated with the receipt of those payments.
USDA LIP payments and the associated tax reporting – it’s the topic of today’s post.
The LIP Program
The LIP program, administered by USDA’s Farm Service Agency (FSA), was created under the 2014 Farm Bill to provide benefits to livestock producers for livestock deaths that exceed normal mortality caused by adverse weather and other events such as attacks by animals that have been reintroduced into the wild, as well as death caused by certain diseases. The 2018 Farm Bill expanded eligibility for LIP payments to contract growers. LIP payments are also available to livestock owners that sell livestock at a reduced price due to an eligible loss condition. Eligibility for LIP payments turns on the livestock owner providing sufficient evidence of an eligible cause of loss that was a direct cause of loss or death.
Note: Livestock deaths due to extreme cold are eligible losses (whether the livestock were vaccinated or not), as are livestock deaths due to disease as a result of particular causes.
Payment amount. The amount of a LIP payment is set at 75 percent of the market value of the livestock (as the USDA determines) on the day before the date of death. For contract growers of poultry or swine, LIP payments are capped at the rate for owners, but are based on 75 percent of the national average input costs for the livestock at issue.
Note: Eligible livestock are those that were used as part of a farming operation as of the day of death. This rule excludes animals such as those that are wild and free-roaming; pets; or animals used for recreational purposes (e.g., hunting, roping or for show).
The market value of the livestock is tied to a “national payment rate” for each eligible livestock category as published by the USDA. LIP payments are adjusted for normal mortality. If LIP payments are issued for injured livestock that are sold at a reduced price, the payments are reduced by the amount the owner received on sale. If the livestock are sold for more than the national payment rate there is no LIP payment.
For contract growers, the LIP national payment rate is based on 75 percent of the average income loss sustained by the contract grower with respect to the livestock that died. Any LIP payment that a contract grower is set to receive will be reduced by the amount of monetary compensation that the grower received from the grower’s contractor for the loss of income sustained from the death of the livestock grown under contract.
Eligibility. To be eligible for a LIP payment (for other than contract growers of poultry or swine), the livestock owner must have owned the livestock on the day the livestock died or were injured by an eligible loss condition. The owner must have suffered a death loss that exceeded normal mortality as a direct result of an eligible loss condition, or sold the livestock at a reduced price as a result of an injury incurred as a direct result of an eligible loss condition. Contract growers of poultry and swine must have had possession and control of the animals and a written agreement with the owner establishing the specific terms, conditions and obligations of the parties regarding the production of the livestock.
Note: Contract growers are not eligible for LIP payments based on injured livestock being sold at a reduced price due to an eligible loss condition.
Eligible livestock and poultry. Eligible livestock include beef bulls and cows, buffalo, beefalo and dairy cows and bulls. Non-adult beef cattle, beefalo and buffalo are also eligible livestock. Eligible poultry include chickens, broilers, pullets, layers, chicks, Cornish hens, roasters, super roasters, ducks, ducklings, geese, goslings, and turkeys. Swine is also eligible and includes nursery pigs, lightweight barrows and gilts, as well as sows and boars. Other eligible animals include alpacas, deer, elk, emus, equine, goats, llamas, ostriches, reindeer, caribou and sheep.
Eligible loss condition. An “eligible loss condition” includes an adverse weather event that was extreme and not expected to occur during the loss period for which it actually occurred. The weather event must be a direct cause of the livestock losses. An eligible disease is one that is made worse by an eligible adverse weather event that directly results in livestock losses. It also includes diseases caused or transmitted by vectors where vaccination or acceptable management practices are not available. An eligible loss condition may also be based on an attack by animals that have been reintroduced into the wild by the Federal Government. The attack must have resulted in either death of livestock in excess or normal mortality rates, or the sale of the livestock at below market value.
Note: The livestock must have died within 60 calendar days from the ending date of the “applicable adverse weather event” and in the calendar year for which benefits are requested.
Payment limitation. The general $125,000 per person payment limitation does not apply to LIP payments. But to be eligible for LIP payments, the applicant must have average adjusted gross income (AGI) over a three-year period that is less than or equal to $900,000. For 2021, the applicable three-year period is 2017-2019.
Note: For a particular producer, the application of the AGI limitation could mean that tax planning strategies to keep average AGI at or under $900,000 need to be implemented. That might include the use of deferral strategies, income averaging and/or amending returns to make or revoke an I.R.C. §179 election.
Direct attribution rules apply to LIP payments. That means that the AGI limitation applies to the person or legal entity that requesting payment as well as to those persons or entities with an interest in the entity or sub-entity.
Applying for payment. An eligible producer (owner or contract grower) must submit a notice of loss and an application for LIP payments with the local FSA office. A notice of loss must be submitted within the earlier of 30 days of when the loss occurred or became apparent. In addition, an application for payment must be filed within 60 calendar days after the end of the calendar year in which the loss occurred. Application for LIP payments is to be made with the local USDA/FSA office that serves the county in which the loss occurred. For contract growers, a copy of the grower contract must also be provided. For all producers, it is important to submit evident of the loss supporting the claim for payment via Form CCC-852. Photographs, veterinarian records, purchase records, loan documentation, tax records, and similar data can be helpful in documenting losses. Of course, the weather event triggering the livestock losses must also be documented. If the livestock owner/grower is not able to provide acceptable records to prove death or loss of value due to injury, the owner/grower is to use a third-party certification via Form CCC-854. The third party must be an independent source who is not affiliated with the farming/ranching operation, and cannot be a hired hand or family member.
Given that the Kansas wildfire occurred mid-December, it is likely that any LIP payments will not be received until 2022. For LIP payments that are paid out, the FSA will issue a 1099G for the full amount of the payment. That could create an issue for some livestock producers.
Death of breeding livestock. While the 1099G simply reports the gross amount of any LIP payment to a producer for the year, there may be situations where a portion of the payment is compensation for the death loss of breeding livestock. If the producer would have sold the breeding livestock, the sale might have triggered an I.R.C. §1231 gain that would have been reported on Form 4797. If LIP payments were received for cattle or horses that the owner had held for 24 months or more from the acquisition date and the animals were held for draft, breeding, dairy or sporting purposes (assuming the LIP payment applies to animals held for a sporting purpose), then the LIP payment would constitute I.R.C. §1231 gain. The holding period is 12 months or more for other livestock. I.R.C. §1231 gain is reported on Form 4797 rather than Schedule F. By being reported on Form 4797, self-employment tax will not apply. However, the IRS will look for Form 1099G amounts paid for livestock losses to show up on Schedule F – most likely on line 4a (Agricultural Program Payments). This raises a question as to whether it is possible to allocate the portion of the LIP payments allocable to breeding livestock from Schedule F to Form 4797.
Income inclusion and deferral. The general rule is that any indemnity payments (or feed assistance) are reported in income in the tax year that they are received. That would mean, for example, that payments received in 2021 for livestock losses occurring in 2021 will get reported on the 2021 return. Payments for livestock losses occurring in 2021 that were received in 2022 will be reported in 2022.
The receipt and inclusion in income of LIP payments could also put a livestock producer in a higher income tax bracket for 2021/2022. In that instance, there might be other tax rules that can be used to defer the income associated with the livestock losses. Under I.R.C. §451(f), the proceeds of livestock that are sold on account of weather-related conditions can be deferred for one year. Under another provision, I.R.C. §1033(e), the income from livestock (not poultry) sales where the livestock are held for draft, dairy or breeding purposes that are involuntarily converted due to weather can be deferred if the livestock are replaced with like-kind livestock within four years. The provision applies to the excess amount of livestock sold over sales that would occur in the course of normal business practices.
While I.R.C. §451(f) requires that a sale or exchange of the livestock must have occurred, that is not the case with the receipt of indemnity payments for livestock losses. So, that rule doesn’t provide any deferral possibility. The involuntary conversion rule of I.R.C. §1033(e) is structured differently. It doesn’t require a sale or exchange of the livestock, but allows a deferral opportunity until animals are acquired to replace the (excess) ones lost in the weather-related event Thus, only the general involuntary conversion rule of I.R.C. §1033(a) applies rather than the special one for livestock when a producer receives indemnity (or insurance) payments due to livestock deaths. Thus, for LIP payments received in 2022, they will have to be reported on the 2022 return unless the recipient acquires replacement livestock within the next two years – by the end of 2024. Any associated gain would then be deferred until the replacement livestock are sold. At that time, any gain associated gain would be reported and the gain in the replacement animals attributable to breeding stock would be reported on Form 4797.
Livestock losses due to weather-related events can be difficult to sustain. LIP payments can help ease the burden. Having the farming or ranching operation structured properly to receive the maximum benefits possible is helpful, as is understanding the tax rules and opportunities for reporting the payments.
Friday, December 24, 2021
For farmers, Christmas gifts to children might take the form of an ag commodity. Cash method farm proprietors have had several situations where gifts of farm commodities to family members are advantageous. The commodity gifts can be used to shift income to minor children to take advantage of their lower tax rates. Likewise, they could be used to assist with a child’s college costs or made to a child in return for the child support the donor-parents.
How should commodity gift transactions be structured? What are the tax consequences? What is the status of current law on commodity gifts to children?
Ag commodity gifts to children – it’s the topic of today’s post.
Tax Consequences to the Donor.
Avoid income and self-employment tax. A donor does not recognize income upon a gift of unsold grain inventory. Rev. Rul. 55-138, 1955-1 C.B. 223; Rev. Rul. 55-531, 1955-2 C.B. 520. Instead, a gift of unsold raised farm commodities represents a transfer of an asset (i.e., inventory) rather than an assignment of income. Estate of Farrier v. Comr., 15 T.C. 277 (1950); SoRelle v. Comr., 22 T.C. 459 (1954); Romine v. Comr., 25 T.C. 859 (1956). That means that the farmer, as the donor, sidesteps the income tax on commodities that are transferred by gift to another taxpayer. Further, self-employment tax is also eliminated on the commodities. That’s because excludable gross income is not considered in determining self-employment income. Treas. Reg. 1.1402(a)-2(a). This is particularly beneficial for donor-parents that have income under the Social Security wage base threshold - $142,800 for 2021.
Prior year’s crop. The gifted commodities should have been raised or produced in a prior tax year. If this is not the case, the IRS takes the position that a farmer is not 100 percent in the business of raising agricultural commodities for profit and will require that a pro rata share of the expenses of raising the gifted commodity will not be deductible on the farmer’s tax return. According to the IRS, if a current year’s crop is gifted, the donor’s opening inventory must be reduced for any costs or undeducted expenses relating to the transferred property. Rev. Rul. 55-138, 1955-1, C.B. 223. That means that the donor cannot deduct current year costs applicable to the commodity. See also Rev. Rul. 55-531, 1955-2 C.B. 522. However, costs deducted on prior returns are allowed. Thus, a farmer reporting on a calendar year basis under the cash method is allowed full deductibility of expenses if a gift of raised commodity is not made until the tax year after harvest (i.e., the grain which is the subject of the gift was raised in a year prior to the gift, and all associated expenses would have been deducted in the prior year).
Tax consequences to the Donee.
The donor's tax basis in the commodity carries over to the donee. I.R.C. §1015(a). Thus, in the case of raised commodities given in the year after harvest by a cash method producer, the donee receives the donor’s zero basis. Conversely, an accrual method farmer will have an income tax basis in raised commodities. If this tax basis approaches the market value of the commodity, there will be little income shifting accomplished from a gift.
Assuming that the donee has not materially participated in the production of the commodity, the income from the sale of the commodity by the donee is treated as unearned income that is not subject to self-employment tax. Even though the raised farm commodity was inventory in the hands of the farmer-donor, the asset will typically not have inventory status in the hands of the done. That means the sale transaction is treated as the sale of a capital asset that is reported on Schedule D.
The holding period of an asset in the hands of a donee refers back to the holding period of the donor. I.R.C. §1223(2). So, if the donee holds the commodity for more than a year after the harvest date, the donee has long-term capital gain or loss.
Gifts of Livestock?
A donee who receives raised animals and takes responsibility for the care and feeding of these animals after the date of gift may face the risk of materially participating in the raising of the animals, and thus be subject to self-employment tax. To help avoid that result, physical segregation of the livestock at the time of gift is helpful, and any post-gift maintenance expenses for the animals should be paid by the donees. See, e.g., Smith v. Comr., T.C. Memo. 1967-229; Alexander v. Comr., 194 F.2d 921 (5th Cir. 1952); Jones Livestock Feeding Co., T.C. Memo. 1967-57; Urbanovsky v. Comr., T.C. Memo. 1965-276.
Structuring the Transaction
Cash-method farm proprietors intending to gift raised commodities to a child or other non-charitable donee should structure the transaction in two distinct steps. First, the donor makes a gift of unsold inventory, using prior year crop or commodity, and documents the transfer of the title/ownership in the commodity as transferred to the donee. Second, the donee independently and at a later date accomplishes a sale of the commodity, recognizing income because of the zero basis in the commodity. The income is reported typically as a short-term capital gain. The donee, as the owner of the sold commodity, must retain full ownership and control of the sale proceeds from the commodity. Make sure that the transaction is not a loan.
“Kiddie Tax” Complications
The “Kiddie-Tax” taxes a child’s passive (unearned) income at the same rate of their parents to eliminate income shifting from the parent to the child. For most taxpayers, the Kiddie tax is based on the child’s taxable income. A child’s taxable income is computed by taking the child’s net earned income and adding to it the child’s net unearned income and then subtracting the child’s standard deduction.
For 2021, Kiddie Tax applies to a child who has not attained age 18 before the close of the year. It also applies to a child who has not attained the age of 19 as of the close of the year or is at least age 19 and under 24 at the close of the year and is a full-time student at an educational organization during at least five months of the year and the child’s earned income didn’t exceed one-half of the child’s own support for the year (excluding scholarships).
The “Kiddie Tax” has a small inflation-indexed exemption. I.R.C. §1(g). For dependent children who sell commodities received as a gift and are subject to the” Kiddie Tax,” the child’s unearned income in excess of $2,200 ($2,300 for 2022) is taxed at the parents’ top tax rate (and, it might be possible for the parents to elect to include this income on the parents’ return instead of filing a separate return for the child).
Under the Tax Cuts and Jobs Act (TCJA), the rate of the Kiddie tax was tied to the rates paid by trusts and estates. However, the SECURE Act repealed the TCJA change in the Kiddie tax and became effective for 2020 and beyond. There is also the option to apply the rules to 2019 returns and amend 2018. Thus, the fix is retroactive for 2019 and 2018 returns.
The new Kiddie tax formula under the Secure Act is as follows: Child’s net earned income + Child’s net unearned income – child’s standard deduction = child’s taxable income. Thus, if Billie (a dependent child) had no earned income and unearned income (dividends and interest, for example) of $5,000, and Billie’s parents had $170,000 of taxable income, the calculation would be:
$0 + $5,000 - $1,100 = $3,900 (taxable income).
$5,000 (unearned income) - $2,200 (Kiddie imputed exemption) = $2,800 (net unearned income)
Thus, $2,800 would be taxed. The first $2,600 would be taxed at 10%. The next $200 would be taxed at 24%.
Gifting commodities to a family member can produce significant tax savings for the donor, and also provide assistance to the donee. However, the commodity gifting transactions must be structured properly to achieve the intended tax benefits.
Merry Christmas to all!
Wednesday, December 22, 2021
Section 121 of the Internal Revenue Code provides for the exclusion of gain that is attributable to the sale of the taxpayer’s principal residence. The maximum exclusion is $500,000 for taxpayers that are married and file jointly. It’s one-half of that amount for single filers. Of course, the IRS just doesn’t give the exclusion away. The taxpayer has to meet certain requirements. In addition, the provision only applies to the taxpayer’s “principal residence.”
But, what if there is a farm sale and the residence is sold with the farm? In that event, how much (if any) of the farmland and outbuildings can be included with the residence to exclude gain under the provision? Also, what if the taxpayer uses a part of the residence for business? How does that impact the exclusion? What if the farm and residence are sold on an installment basis and the buyer defaults and the seller gets the property back? What then?
Excluding gain associated with the sale of the principal residence – it’s the focus of today’s blog post.
The two-year rule. To be able to claim the I.R.C. §121 exclusion, the taxpayer must have owned the residence for at least two years or more (in the aggregate) during the five years immediately preceding the sale date. Also, the taxpayer must have occupied and used the home as the taxpayer’s principal residence for at least two years (in the aggregate) of the five years preceding the sale date. In addition, the taxpayer must not have used the gain exclusion during the immediately preceding two years before the sale.
Treasury regulations address the eligibility of vacant land for the $500,000/$250,000 exclusion. Treas. Reg. § 1.121-1(b)(3). In general, the sale or exchange of vacant land is not included under the gain exclusion rule applicable to the principal residence unless: (1) the vacant land is adjacent land containing the principal residence; (2) the taxpayer owned and used the vacant land as part of the taxpayer’s principal residence; and (3) the taxpayer engages is a sale or exchange of the principal residence meeting the requirements of I.R.C. §121 either two years before or two years after the date of the sale or exchange of the vacant land. In addition, the requirements of I.R.C. §121 must be met with respect to the vacant land.
Note: It is important that the taxpayer owns the vacant land in the taxpayer’s name rather than via an entity that the taxpayer has an ownership interest in. See, e.g., Farah v. Comr., T.C. Memo. 2007-369.
Based on those requirements, land that has been used in farming within the two-year period before the sale won’t be eligible. If the land is used in farming, it’s not being used as part of the principal residence. Also, the sale of the principal residence and the adjacent land are treated as a single sale for purposes of the gain limitation amount. That’s the case even if the sales occur in different years. In addition, because the separate transactions are treated as a single sale for purposes of applying the rule under I.R.C. §121 that bars use of the provision more frequently than every two years. Thus, if the principal residence is sold in a later tax year than the qualified adjacent land is sold that is after the filing date (including extensions) for the return that includes the land sale, the gain from the land sale has to be reported as a taxable event. When the residence is later sold, the taxpayer then can claim the I.R.C. §121 exclusion with respect to the vacant land by filing an amended return. Procedurally, when calculating the maximum limitation for the gain exclusion, the sale of the principal residence is excluded before any gain for the sale of the vacant land. Treas. Reg. §1.121-1(b)(3)(ii)(C).
Note: In a situation where a fire destroyed the taxpayer’s principal residence, the IRS determined that I.R.C. §121 was applicable to the sale of the resulting vacant land on which the dwelling had been located. The gain exclusion provision applied to the gain from the receipt of insurance proceeds for the destruction of the principal residence and also to the sale of the vacant land in the next tax year. Priv. Ltr. Rul. 201944006 (Jul. 31, 2019).
How much land? It’s a factual question as to how much land can be included with the principal residence for purposes of I.R.C. §121. A relevant factor is whether the land has been for personal purposes, such as a garden to grow produce for the taxpayer’s consumption. Also, if the land is landscaped, that fact supports inclusion with the personal residence. On the other hand, if the land is used in the taxpayer’s farming business (or contains outbuildings used in the farming business) or otherwise to produce income, inclusion with the residence is not supported.
Business Use of the Residence
If part of the principal residence is used for business purposes, the I.R.C. §121 exclusion does not apply. At least that’s the rule to the extent any depreciation is claimed. Also, the exclusion is inapplicable to a portion of the property that is separate from the dwelling unit. On that separate portion, the problem is that the taxpayer hasn’t satisfied the personal occupancy requirement. So, in that case, only the gain that is allocated to the residential portion is excludible. But, no allocation is required is both the residential and business portions of the property are within the dwelling unit, other than to the extent that the gain is attributable to depreciation.
It might also be possible to trade the home that has an office in it for qualified replacement property and qualify the transaction as a tax-deferred exchange under I.R.C. §1031. Of course, this can only happen if both the principal residence that is traded away and the replacement property that is received both have at least a portion of the property that is used in the taxpayer’s trade or business or held for investment. But, legislation enacted in 2004 denies the I.R.C. § 121 exclusion to property acquired in a like-kind exchange within the prior five-year period beginning with the date of property acquisition. The provision is designed to counter situations where (1) the property is exchanged for residential real property, tax-free, under I.R.C. § 1031; (2) the property is converted to personal use; and (3) a tax-free sale is arranged under I.R.C. § 121. The provision applies to sales or exchanges after October 22, 2004. Legislation enacted in late 2005 clarifies that the five-year ineligibility period also applies to exchanges by the taxpayer or by any person whose basis in the property is determined by reference to the basis in the hands of the taxpayer (such as by gift)
The Gain Exclusion Rule and Like-Kind Exchange Treatment
However, if like-kind exchange treatment applies to the residence, the homeowner may also be able to benefit from exclusion of gain. In early 2005, IRS published guidance (Rev. Proc. 2005-14) on coupling the I.R.C. § 121 exclusion with like-kind exchange procedures. Under that guidance, the IRS said that the I.R.C. §121 exclusion is applied before the I.R.C. §1031 like-kind exchange rules, and that the I.R.C. §121 exclusion cannot apply to gain attributable to depreciation of the residence after May 6, 1997. But, the I.R.C. §1031 rules may apply to that gain. Also, the IRS said that when the I.R.C. §1031 rules are applied, any boot or non-like-kind property that is received is taxable only to the extent the boot exceeds the gain excluded under I.R.C. §121. In addition, when determining basis of the property received in the exchange, any gain that is excluded under I.R.C. §121 on the former property is treated as providing basis to the taxpayer in the replacement property. The impact of the guidance is that, for farm residences, the amount of the allowable exclusion will more than cover the gain involved. In other situations, the Rev. Proc. may allow deferral of realized gain into replacement property.
In Priv. Ltr. Rul. 201944006 (Jul. 31, 2019), a married couple lived in a home on a property that one of the spouses had purchased before the marriage. After the marriage, they continued to use the home as their principal residence. They later moved into a new home and offered the prior residence for rent. The prior home was rented for both short-term rentals and was also rented to full-time tenants. The rental use stopped when a fire destroyed the property. The couple received insurance proceeds for the destroyed residence and sold the land without rebuilding the residence. In the same transaction, they used the insurance and sale proceeds to acquire two other rental properties, and sought to defer the gain on the sale under I.R.C. §1031 in addition to the use of I.R.C. §121 to exclude the gain associated with the residence.
The gain on the sale exceeded the amount the couple could exclude under I.R.C. §121. They satisfied the ownership and use tests of I.R.C. §121. Thus, the question was whether they could use I.R.C. §1031 to defer the remaining gain to eliminate current tax on the transaction. The IRS determined that they could because excluding gain under I.R.C. §121 does not preclude the use of I.R.C. §1031 for property that involves an exchange of investment property. The IRS applied the same reasoning as it had in Rev. Proc. 2005-14, 2005-1 C.B. 528 which also provided the mechanics of recording the transaction. Under Section 4.02 of Rev. Proc. 2005-14, I.R.C. §121 is applied to the realized gain before I.R.C. §1031 is applied, and the basis of the property received in the exchange is increased by any gain attributable to the relinquished property that is excluded under I.R.C. §121.
What if the principal residence and the farmland are sold via an installment sale and the seller claimed the I.R.C. §121 exclusion on the principal residence? The normal rules would apply and the gain attributable to the principal residence would be excluded up to the applicable limit. But what if the buyer, after making a few payments, defaults on the contract and the seller gets the property back – including the principal residence on which the gain was previously excluded? This is not an unlikely possibility given the downturn in the farm economy in recent years which could result in a buyer not having the ability to make the annual payments that the installment contract requires. This situation occurred in Debough v. Comr., 142 T.C. 297 (2014). In that case, the taxpayer had purchased a personal residence in 1966 along with 80 acres for $25,000. He agreed to sell the residence and the land in 2006 for $1.4 million with the purchase price to be paid in installments through 2014. He reported the gain for the year of sale (computed in accordance with the calculated gross profit percentage) after excluding the gain attributable to the principal residence, and then received another $505,000 in payments that he reported on the installment method. The buyer defaulted and the seller reacquired the property in 2009. The reacquisition triggered tax to the taxpayer, but he didn’t report the portion of the gain that was previously excluded under I.R.C. §121. The IRS disagreed, pointing out that I.R.C. §1038(e) specifies that, with respect to I.R.C. §121, a taxpayer that reacquires property and sells it within one year can treat the subsequent sale as the original sale for I.R.C. §121 purposes. The taxpayer didn’t do that, so the provision didn’t apply. That meant that the only way to exclude the gain was to move back into the residence to meet the two-out-of-five-year ownership and use test. Of course, the taxpayer didn’t want to do that. The only relief available was that the reacquisition would cause an increase in the basis of the residence to the extent of the gain recognized on repossession which, in turn, would result in less gain on resale. In 2015, the U.S. Court of Appeals for the Eighth Circuit affirmed the Tax Court. Debough v. Shulman, 799 F.3d 1210 (8th Cir. 2015).
The home sale exclusion rule comes in handy when a principal residence is sold. But, careful planning is needed when the residence is sold with the farm, when a portion of the residence is used for business purposes, or when the transaction is structured as a deferred exchange or installment sale.
Monday, December 20, 2021
During the summer of 2022 Washburn Law School will be sponsoring farm income tax and farm estate and business planning conferences in Wisconsin and Colorado.
Please hold the following dates:
- June 13-14, Chula Vista Resort, Wisconsin Dells, Wisconsin
- August 1-2, Fort Lewis College, Durango, Colorado
The Chula Vista Resort has been in existence since the late 19th century, and is located three miles north of downtown Wisconsin Dells. In 2006, the Resort was expanded to add an indoor waterpark along with an 18-hole golf course. The resort property also contains a riverwalk, a steakhouse and an outdoor wave pool along the Wisconsin River.
The Durango event in early August will be a beautiful time of the year to be in southwest Colorado. Attractions include the Durango and Silverton narrow gauge railroad, and numerous historical sights, including Mesa Verde National Park. To the north of Durango is Telluride, Colorado, another historic western town.
The conferences will provide discussion and analysis of key issues of importance to income tax planning as well as estate and business planning for farm and ranch clients. The daily agenda’s for both events is currently being planned, and registration for the events should be available by mid-late January.
Until then, hold the dates for planning purposes. I look forward to seeing you at one of these events during the summer of 2022.
Thursday, December 16, 2021
Inland Hurricane – 2021 Version; Is There Any Tax Benefit to Demolishing Farm Buildings and Structures?
In August of 2020, I wrote an article for this blog discussing the tax issues associated with demolishing farm buildings and structures. The issue can arise when a farm is purchased, but my inspiration for writing that article was the inland hurricane (derecho) that stretched from Nebraska to almost the Ohio/Indiana line. Many structures were left in that storm’s wake that were irreparable and required demolition. Now, during the evening of December 15, 2021, a powerful and extremely unusual storm system swept across the Great Plains and Midwest amid unseasonably warm temperatures, spawning hurricane-force winds and tornadoes in Nebraska, Kansas, Iowa and Minnesota.
Again, this second inland hurricane damaged many farm buildings and structures that may now be irreparable and require demolition. Is there any tax benefit associated with demolishing buildings and structures? If not, perhaps it’s most economical to leave unused buildings and other improvements standing.
Tax issues associated with demolishing farm buildings and structures: derecho No. 2 for the Plains and Midwest. It’s the topic of today’s post.
Capitalize into land basis. I.R.C. §280B provides that “in the case of the demolition of any structure…no deduction otherwise allowable under this chapter shall be allowed to the owner or lessee of such structure for any amount expended for such demolition, or any loss sustained on account of such demolition.” Instead such amounts “shall be treated as properly chargeable to capital account with respect to the land on which the demolished structure was located.” Thus, the amounts must be capitalized and added to the income tax basis of the land on which the building or structure was located. Likewise, effective for tax years beginning after 1985, it became no longer possible to receive a tax deduction for the removal of trees, stumps and brush and for other expenses associated with the clearing of land to make it suitable for use in farming. I.R.C. §182, repealed by Pub. L. 99-514, Sec. 402(a), 100 Stat. 2221 (1986). Accordingly, the cost of removing trees and brush, capping wells and grading the land to make it suitable for farming cannot be presently deducted. Instead, such costs are treated as development expenses (capital investment) that are added to the basis of the land.
Use before demolishing. If a farm building or structure is used in the taxpayer’s trade or business of farming for a period of time before being demolished, depreciation can be claimed for the period of business use. Treas. Reg. §1.165-3. Upon demolition, the remaining undepreciated basis of the building or structure would be added to the basis of the land along with the demolition costs. In situations where the taxpayer purchased the property with the intent of demolishing the buildings and/or structures after using them in the taxpayer’s trade or business for a period of time, the fact that the taxpayer ultimately intended to demolish the buildings is taken into account in making an apportionment of basis between the land and the buildings under Treas. Reg. §1.167(a)-5. Treas. Reg. §1.165-3. In this situation, the amount allocated to the buildings/structures cannot exceed the present value of the right to receive rentals from the buildings/structures over the period of their intended use. Id.
Abandonment. If the buildings and structures are simply abandoned, any remaining basis is treated as a disposition or a sale at a zero price. That means that the remaining income tax basis becomes an ordinary loss that is reported on Form 4797. If the abandoned buildings and structures are eventually demolished at least one year after the taxpayer ceased using them in the farm business, they have now remaining basis and the only the cost of demolition would be added to the land’s basis.
Demolition After Casualty
As noted above, the most recent inland hurricane that pelted parts of Kansas, Nebraska, Iowa and Minnesota with sustained winds near 100 miles-per-hour created significant damage to farm structures. When a casualty event such as this occurs, the normal capitalization rule of I.R.C. §280B does not apply when a structure is damaged by the casualty is demolished. In Notice 90-21, 1990-1 C.B. 332, the IRS said that the capitalization rule does not apply to “amounts expended for the demolition of a structure damaged or destroyed by casualty, and to any loss sustained on account of such demolition.” Instead, the income tax basis of the structure is reduced by the deductible casualty loss before the “loss sustained on account of” the demolition is determined. That means for a farm building or structure destroyed in the recent inland hurricane, for example, the income tax basis in the building or structure at the time of the casualty would be deductible as a casualty loss but the cost of cleaning up the mess left behind would be capitalized into the land’s basis. In essence, the loss sustained before demolition is not treated as being sustained “on account of” the demolition with the result that the loss isn’t disallowed by I.R.C. §280B. It’s an “abnormal” retirement caused by the “unexpected and extraordinary obsolescence of the building.” See, e.g., DeCou v. Comr., 103 T.C. 80 (1994); FSA 200029054 (May 23, 2000); Treas. Reg. §1.167(a)-8(a). Conversely, if a taxpayer incurs a loss to a building or structure and decides to withdraw a building or structure from use in the trade or business and then demolish it in a later year with no tax event occurring in the interim, the demolition costs are subject to the disallowance rule of I.R.C. §280B. See, e.g., Gates v. United States, 168 F.3d 478 (3d Cir. 19998), aff’g., 81 AFTR 2d 98-1622 (M.D. Pa. 1998). In that situation, the taxpayer might be able to claim a casualty loss for the year in which the loss occurred (consistent with the casualty loss rules in place at the time), and if the structure is later demolished the structure’s basis must be reduced by the casualty loss that was allowed by I.R.C. §165 before the nondeductible loss sustained on account of the demolition can be determined. Notice 90-21, 1990-1 C.B. 332.
Tangible Property Regulations
In late 2013, the IRS released final regulations providing rules regarding the treatment of materials and supplies and the capitalization of expenditures for acquiring, maintaining, or improving tangible property (the final repair regulations). T.D. 9636 (Sept. 13, 2013). About a year later, the IRS issued final regulations on dispositions of tangible property, including rules for general asset accounts (GAAs) (the final disposition regulations). T.D. 9689 (Aug. 14, 2014). These regulations are generally effective for tax years beginning on or after Jan. 1, 2014. Under the regulations, a taxpayer generally must capitalize amounts paid to acquire, produce, or improve tangible property, but can expense items with a small dollar cost or short useful life. The regulations also provide a de minimis safe harbor that can be elected on a yearly basis to expense all items under a certain dollar cost. The repair regulations also contain specific rules for determining whether an expenditure qualifies as an improvement or a betterment (essentially following established caselaw) and provide a safe harbor for amounts paid for routine property maintenance. There is also an election that can be made to capitalize certain otherwise deductible expenses for tax purposes if they are capitalized for book purposes.
The repair/disposition regulations provide a potential opportunity for a taxpayer to continue depreciating a building/structure after demolition has occurred. Under the regulations, a taxpayer doesn’t have to terminate a GAA upon the disposition of a building/structure. Thus, the taxpayer that has included buildings and structures in a GAA may choose whether to continue to depreciate them when they are disposed of (e.g., demolished) or capitalize the adjusted basis into the land under I.R.C. §280B.
The adjusted basis of any asset in a GAA that is disposed of is zero immediately before its disposition. The basis associated with such an asset remains in the GAA where it will continue to depreciate. See Treas. Reg. §§1.168(i)-1(e)(2)(i) and (iii). Consequently, the basis of a demolished building/structure where the cost of the demolition would be subject to capitalization under I.R.C. §280B is zero and the taxpayer can continue to depreciate the basis in the GAA. But, if only one demolished building/structure is in a GAA and the taxpayer elects to terminate the GAA, the adjusted basis of the building/structure would, in effect, be capitalized in under I.R.C. §280B. Likewise, the strategy doesn’t apply if the building or structure is acquired in the same year that it is demolished or if the taxpayer intended to demolish the building/structure at the time it was acquired. See Treas. Reg. §§1.168(i)-(c)(1)(i); 1.168(i)-1(e)(3)(vii).
The opportunity to use the technique is further limited by a requirement that the taxpayer must have elected to include the building in a General Asset Account (GAA) in the year the taxpayer placed the building/structure in service and is in compliance with the GAA rules. The election must have been made on an original return.
The inland hurricane of August 10, 2020, and December 15, 2021, wreaked havoc on a great deal of agricultural assets that were in its path. The tax rules surrounding the disposition of disaffected assets is important to understand.
Monday, December 6, 2021
A recent news story involving a group of farmers in Mississippi reveals the potential downside of selling grain under a deferred payment contract. Unless a farmer-seller takes steps to gain protection, the farmer is an unsecured creditor of the buyer after delivery is made and before payment is made. If the buyer files bankruptcy in that interim period, the farmer-seller will be a general unsecured creditor and could lose out on the vast amount of income anticipated from the sale.
The risk of deferred payment ag commodity sales and what can be done for protection – it’s the topic of today’s post.
The Mississippi Matter
On November 8, a group of Mississippi farmers filed a class action against UMB Bank, N.A. for misleading them about the financial status of a grain elevator they sold grain to that filed bankruptcy before paying them. Island Farms, LLC, et al. v. UMB Bank, N.A., No.___, (S.D. Miss. filed Nov. 8, 2021).
Fact of the case. Based on the plaintiffs’ complaint as filed, they delivered grain to a grain elevator that, unbeknownst to them, was insolvent and being propped up by the defendant bank. The elevator’s grain purchases involved the farmers delivering and transferring title to the grain to the elevator. The elevator would then weigh, inspect and access the grain, and deliver payment in the form of a check within a period of a few days, or at another date if any particular farmer so desired
The grain elevator is one of the largest grain elevator operations serving farmers in the Mississippi Delta. However, the grain elevator was highly leveraged with massive amounts of debt. The grain elevator’s principal creditor was the bank, with loans dating back to 2015. The total balance on the loans was approximately $70 million as of September 2021. $37 million was the balance on a revolving loan and $33 million was the balance on a term note. The bank required the grain elevator to post collateral, which meant that virtually all of its assets were collateralized. The loan agreements gave the bank a continuing security interest upon all property of the grain elevator, whether then owned or later acquired. The grain elevator’s most valuable collateral was the grain they stored, and the amount they could borrow was determined in part by the amount of grain in inventory.
By the spring of 2021, the grain elevator was in serious financial distress, having less than $4,000 cash on hand, and was effectively insolvent. In addition, throughout 2021 the grain elevator failed to make payments to reduce the balance of the revolving loan, which it was contractually obligated to pay down. However, the bank permitted the grain elevator to keep the balance of the loan at the maximum level throughout the year. The elevator was required to furnish audited financial statements to the bank within 120 days of December 31, the end of its fiscal year.
The plaintiffs claim that the grain elevator was kept afloat by the bank’s forbearance on their loans. The bank was aware that if it called the loans, there would be little grain it could claim as security for the grain elevator’s debt. As a result, the plaintiffs claim that the bank proposed to wait until the grain elevator had as much grain as practicable before calling the loan and thereby effectively forcing the grain elevator into bankruptcy. The elevator ultimately filed Chapter 11 (reorganization) bankruptcy on September 29, 2021.
Although the grain elevator was in financial distress, it continued to hold out to farmers the opposite. In the spring of 2021, the grain elevator issued an update that stated the elevator would be better prepared financially than in years past. The update also mentioned that the grain elevator had funding in place from multiple sources to ensure everyone got paid on time. However, several checks that the grain elevator wrote bounced during the harvest season. By the end of September, the bank notified the grain elevator that all amounts owed under the loans would be due immediately. The effect of the elevator's bankruptcy was to place the bank in priority position as a secured creditor in accordance with its security agreements and the farmers in non-priority, general unsecured creditor status.
The plaintiffs claim that the grain elevator made knowingly false representations and concealed information that it had a duty to disclose. Additionally, the plaintiffs claim the bank aided and abetted the fraud perpetrated by the grain elevator by remaining silent, while knowing that the grain elevator’s customers would deliver their crops with a time interval before being paid. They specifically claim that the bank deliberately propped up the grain elevator until the crops were delivered during harvest season. The plaintiffs claim that the bank was the beneficiary of the fraud perpetrated by the grain elevator, and that it has been unjustly enriched at the plaintiffs’ expense. The plaintiffs further claim that in addition to equitable title of the crops, they had a constructive trust over the grain for the purpose of getting paid. They assert that had the grain elevator clearly indicated its financial position, the plaintiffs would have brought their crops elsewhere. Ultimately, the plaintiffs are seeking forfeiture of all money received by the bank through their alleged conduct.
Is There a Way That Cash Grain Sellers Can Achieve Security?
The Mississippi farmers’ plight points out the peril of selling grain on a deferred basis – whether via a properly structured deferred payment contract or by an informal understanding of the parties that there will be a time lag between delivery and payment. Every farmer must understand that, after an agricultural commodity is delivered to a buyer but before payment is made, the farmer-seller is an unsecured creditor of the buyer. If the buyer files bankruptcy in that interim period, the farmer-seller will likely not get paid. While state indemnity funds and bonding programs might be available, they often don’t go far in making any particular farmer whole.
Letter of credit. While there isn’t any indication in the Mississippi case, as filed, that the farmers were using a deferral strategy for tax purposes, there is legal risk involved anytime that grain is delivered and payment is delayed. This is typically not a problem with livestock sales because unpaid cash sellers of livestock to a buyer that is covered by the Packers and Stockyards Act (PSA) have their funds set aside for them in trust that remains outside of any bankruptcy filing of the buyer.
As for grain sales, is it possible to achieve legal protection comparable to that provided by a PSA trust and achieve income tax deferral? In some instances, farmers have tried the use of escrow accounts or letters of credit via third parties (an agent). However, with a handful of exceptions, the weight of the authority is that an agent’s receipt is considered the taxpayer’s (farmer’s) receipt. That means that such an arrangement is ineffective to defer income into the following tax year.
In Griffith v. Comr., 73 T.C. 933 (1980), a farm couple reported income on the cash method and sold cotton in 1973 under a deferred payment contract for payment in 1974. The buyer’s obligation under the contract was secured by a standby letter of credit. The Tax Court determined that the strategy didn’t work for deferral purposes, holding that the contractual rights and the letter of credit were the same as cash. The dissent pointed out the Tax Court’s prior decision in Oden v. Comr., 56 T.C. 569 (1971), where the Tax Court held that funds placed in escrow as security for payment on a deferred payment contract may not be constructively received in the year of sale based on the facts and circumstances of the case. While the taxpayer lost in Oden, the key to the case was that the taxpayer actually looked to and received payment from the escrow account. The taxpayer was not treating the account as intended for security. But, in Porterfield. v. Comr., 73 T.C. 91 (1979), the court determined that the parties intended an escrow account to serve as security for the buyer’s obligation and that, as a result, the taxpayer was entitled to report the sale on the installment method. The dissent in Griffith pointed out that a nontransferable letter of credit was used that specifically provided it was to serve as security and could only be collected in the event of the buyer’s default. The buyer didn’t default, and the couple looked to and received payment from the buyer.
This all means that if a letter-of-credit is not done absolutely correctly, it won’t achieve tax-deferral (including the interest on the funds in the account) and it may not even provide security. It is a fact-based determination despite what the majority in Griffith said.
Escrow account. Although the general rule is that funds placed in escrow as security for payment are not constructively received in the year of sale, it is critical for a farmer-seller to clearly indicate that the buyer is being looked to for payment and that the escrow account serves only as security for this payment. See, e.g., Watson v. Comr., 613 F.2d 594 (5th Cir. 1980); Busby v. Comr., 679 F.2d 48 (5th Cir. 1982); Scherbart v. Comr., 463 F.3d 987 (8th Cir. 2006). The cases point out that there is a possibility that an escrow account can successfully achieve deferral and provide security, but the account must be set-up and used properly. Clearly, the escrow arrangement should be a separate agreement between the buyer and the seller and not a self-imposed limitation that the seller creates.
The Mississippi case points out the problems that a farmer can encounter when a buyer fails before making paying on delivered grain. Certainly, the financial status of a buyer should be examined carefully before delivery is made. That means seeing a certified audit of the buyer before making delivery. Reliance on an audit can mean that the firm providing the audit can be held liable to a farmer that detrimentally relied on the audit. See, e.g., KPMG Peat Marwick v. Asher, 689 N.E.2d 1283 (Ind. Ct. App. 1997). Also, carefully using a letter of credit or an escrow account might provide security against a buyer’s default and achieve deferability. In any event, planning is required anytime an ag commodity is sold on a deferred basis to a buyer.
Friday, December 3, 2021
I always find it amazing how often legal issues present themselves for farmers and ranchers. In 30 years of being involved in issues involving agricultural law and taxation, I have never had a shortage of client issues to deal with or matters to write or speak about. It literally has been non-stop.
As usual, the courts continue to issue opinions involving farmers and ranchers and tax matters of importance to an even broader set of taxpayers. In today’s post, I highlight just a few of the recent ones.
Recent court opinions involving agricultural law and taxation – it’s the topic of today’s post.
Farmer’s Marijuana and Firearm Conviction Upheld
United States v. Lundy, No. 20-6323, 2021 U.S. App. LEXIS 33551 (6th Cir. Nov. 9, 2021)
After receiving a complaint that the defendant was growing cannabis on his property, state police officers investigated the property and found a large crop of cannabis plants, growing equipment, hundreds of pounds of processed cannabis with levels of THC meeting the standard for a controlled substance. The defendant had a past criminal history and unauthorized firearms were also found in his possession. The defendant had also been denied an application for a hemp license the previous year due to his criminal history involving marijuana and drug paraphernalia.
While being interviewed by police, the defendant emphasized that the marijuana on the property was for personal use and not for sale, though he admitted to giving marijuana away. He claimed that the firearms were for protecting his farm from nuisance animals and self-protection. Also at this interview, the defendant offered to smoke marijuana with the police officer conducting the interview. The defendant was arrested, charged with possession of a firearm by a user of controlled substances and ultimately sentenced to 46 months imprisonment.
The defendant appealed his conviction, claiming that the government failed to prove that he knew he was prohibited from possessing a firearm, and that the government failed to prove that he knew he was possessing and manufacturing marijuana. To sustain a conviction, the government bears the burden to prove that the defendant took drugs with regularity, over an extended period of time, and contemporaneously with his purchase or possession of a firearm. The defendant claimed that because he thought he was using hemp, the government failed to prove that he knew he used a controlled substance. In refuting the defendant’s claim, the government presented evidence of the defendant’s substance use, including prior testimony by the defendant about his use of marijuana throughout his entire adult life, testimony that he smokes pounds of marijuana a year, findings from the search of his property, testimony that the marijuana found was for personal use, the man’s offer to smoke marijuana with the police officer, and urine and hair samples that tested positive for high levels of THC. The court upheld the defendant’s conviction on the basis that there was overwhelming evidence that the defendant used marijuana with regularity and at the same time as his possession of firearms.
Note: Lundy clearly went, as the songwriter in the 1970s put it, “one toke over the line…”.
Rerouting of Irrigation Ditches Not a Taking
Ministerio Roca Solida_ Inc. v. United States, No. 16-826L, 2021 U.S. Claims LEXIS 2277 (Fed. Cl. Oct. 25, 2021)
The federal government has the right of eminent domain. In other words, it can take your property if it wants to. But, under the Constitution, a taking must be for a public purpose and the government must pay “just compensation” for what it takes.
In this case, a ministry owned a forty-acre parcel of land, which included a church camp, located within the boundaries of a national refuge. The refuge is home to many native plants and animals, including certain endemic species of fish that the United States Fish and Wildlife Service (USFWS) committed to protecting beginning in 1995. The USFWS’s protection plan included filling in irrigation ditches to return spring waters back to their historic paths. As a result of this plan, the ministry’s church camp was washed away in a series of floods caused by heavy rainfall. Camp buildings, access ways, and other improvements were swept away. The ministry alleged that construction of the spring water restoration channel caused the destructive flooding and constituted a total physical taking of its property, for which it was entitled to just compensation. Repairs were estimated at a cost of over $200.000.
While it is well-established that government-induced flooding of property can constitute a compensable taking for purposes of the Fifth Amendment, the court found that the ministry did not meet its burden of proving that the government’s construction of the restoration channel caused the flooding that occurred. The refuge had a long history of flooding, which was demonstrated by historical satellite images and expert testimony. Additionally, the Federal Emergency Management Agency had designated the ministry’s property as a high-risk flood zone, and informed it of floodplain ordinances requiring that buildings in flood zones be elevated or flood-proofed and anchored. Upon receiving this information, the ministry took no actions to bring itself into compliance with the ordinances. Consequently, the weight of the evidence showed that the flooding of the church camp would have occurred regardless of whether the restoration channel was built.
Farmers Detrimentally Relied on Crop Supply Salesman to Check Crops
Dettenhaim Farms, Inc. v. Greenpoint Ag, LLC, et al., No. 54,162-CA, 2021 La. App. LEXIS 1729 (La. Ct. App. Nov. 17, 2021)
The plaintiff corporation is a tenant farmer. Over a period of at least 25 years, a close friend would check the corporation’s crops for stinkbugs. The friend became employed by the defendant and continued checking the plaintiff’s crops for stinkbugs. Eventually, confusion over the corporation’s credit account arose and the defendant’s location manager told the friend that he should tell the plaintiff’s owner and his father that they probably needed to find somewhere else to do business. The manager also told the friend that the friend might not need to go back to the plaintiff’s fields. The friend never communicated this to farmers, and neither did anyone with the defendant. The manager did have a phone conversation with the farmers and thought they knew what he meant, but never told the farmers that the friend would no longer be checking their fields. In late summer, the farmers discovered that their soybean fields had not been checked and that, by then, stinkbugs had caused major damage to the crop.
Upon harvest, yield was dramatically reduced. The plaintiff sued the defendants after harvest for lost profit and also alleged that a different crop consultant could have been found if the friend and/or the defendants had given timely notice that crop consulting services had stopped. The plaintiff’s petition was later amended to add an allegation that the reduced soybean yield caused a premature sale of a cattle herd in order to compensate for the lack of revenue from the sale of harvested crops. The trial court heard testimony from various experts as to economic loss, and concluded that the plaintiff justifiably relied to its detriment on the defendants to advise concerning the products to use on the plaintiff’s fields and when to apply them. That justifiable reliance, the trial court concluded, caused the plaintiff to change position to its detriment. The trial court also determined that the defendants owed a duty to the plaintiff and failed to conform to that duty resulting in substantial crop damage which could have been avoided if the defendants had inspected the crops.
As to damages, the trial court accepted the methodology of a CPA that examined yield on nearby farms and concluded that the plaintiff sustained damages of $246,334, The trial court rejected the defendants’ argument that the plaintiff failed to mitigate damages by waiting at least two weeks to spray for stinkbugs after discovering the infestation. At the time of discovery of the stinkbug problem, the trial court determined, the crop damage had already occurred and the second wave of bugs didn’t arrive until two weeks later. However, the trial court, rejected the plaintiff’s claim that it was forced to sell 600 head of cattle to pay down debt because of the lost crop revenue. The trial court also rejected an emotional distress claim.
On appeal, the appellate court upheld the trial court’s finding of causation of damages to the soybean crop by the defendants. On the damages issue, the appellate court reduced the award to $148,946 based on the best historical yields over a five-year span rather than the yield from nearby field in 2016 (the year of the crop loss) based on the standard for calculating damages set forth in Aultman v. Rinicker, 416 So. 2d 641 (La. Ct. App. 1982). The appellate court also determined that, based on the evidence, the plaintiff failed to mitigate damages and, as a result, reduced the damage award further to $134,051.
No Deduction For Excess Rent – Bad Valuation
Plentywood Drug, Inc., et al. v. Comr., T.C. Memo. 2021-45
The petitioner, a drug store in a rural town in northeast Montana, claimed rent deduction for the main floor of the building it rented. The petitioner estimated the value of the main floor at $25 per square foot. Upon audit, the IRS rejected the petitioner’s valuation and pegged the value at $7.17 per square foot. The Tax Court rejected both valuations and determined that the rental value was $15.90 per square foot. As a result, the petitioner couldn’t claim approximately $40,000 in deductions attributable to “excess” rent. In addition, the rents paid exceeding the $15.90 per square foot threshold were non-deductible constructive dividends to the building owners. The Tax Court also rejected the IRS imposition of penalties under I.R.C. §6662. The Tax Court noted that real estate data are not publicly available in Montana which complicates efforts to appraise property values and reasonable rents.
EIP Not Exempt From Garnishment
United States v. Ruiz, No. EP-19-CR-03035(1)-DCG, 2021 U.S. Dist. LEXIS 217327 (W.D. Tex. Nov. 10, 2021)
The plaintiff was sentenced to five years in prison with five years of supervised release and ordered to pay restitution in early 2021. As of August of 2021, the plaintiff still owed the full amount. The government moved to garnish his bank account containing $3,982.23. The plaintiff claimed that $1,700 contained in the bank account was from a stimulus payment (“Economic Impact Payment”) paid under the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") and was exempt from garnishment as an unemployment benefit to provide relief from “economic challenges” faced as a result of the virus. The court noted that the statutory language providing for the payment classified it as a “recovery rebate” taking the form of a tax credit, and did not refer to it as an “unemployment” benefit. It was not conditioned on the lack of employment. The court held that the payment was also not properly classified as unemployment insurance, but was separate and distinct from unemployment insurance. Accordingly, the payment was not protected from garnishment under 18 U.S.C. §3613(a)(1) and 26 U.S.C. §6334.
Monday, November 29, 2021
On November 19, the U.S. House of Representatives passed H.R. 5376, the “Build Back Better Act,” on a 220-213 vote. The legislation is a multi-trillion-dollar tax and spend package that was supported by all Democrats except one and no Republicans. The massive bill contains numerous tax-related provisions. Fortunately, it contains neither the proposed reduction to the federal estate and gift tax exemption nor the modification to the current “stepped-up” basis rule at death. But, the bill still proposes to spend several trillion dollars on social programs which has implications for the economy.
Now the bill goes to the Senate where, most certainly, changes will be made – if the bill passes.
Selected tax-related provisions in H.R. 5376 and economic implications – it’s the topic of today’s post.
Provisions Not Included
Modifications were made to the bill before passage by the House. Numerous tax provisions that had been approved by the House Ways and Means Committee did not make it into the final bill that passed the House. The following is a list of the most significant tax-related provisions that did not make the cut:
- An increase in the corporate tax rate to 26.5 percent (the 21 percent corporate rate remains the law);
- Modification to the stepped-up basis rule at death (the rule that property included in a decedent’s estate at death receives an income tax basis in the hands of the heir equal to the property’s fair market value is retained);
- An increase in the top individual rate to 39.6 percent;
- An elimination of tax-deferred exchanges under I.R.C. §1031 (the rule allowing tax-deferred exchanges of real estate remains in place);
- An increase in the top capital gain rate to 25 percent;
- A limitation on the qualified business income deduction (I.R.C. §199A) for higher income eligible taxpayers;
- An acceleration in the reduction of the federal estate and gift tax exemption equivalent in the unified credit (the “sunset” of the existing federal estate and gift tax exemption remains the law through 2025 and will be $12.06 million per person for deaths occurring and gifts made in 2022).
- A change in the grantor trust rules (death benefits for grantor irrevocable life insurance trusts (ILITs) with future premiums due and death benefits for newly created grantor ILITs are not subject to federal estate tax).
- A change in the annual present interest gift tax exclusion (the current rules for the present interest annual exclusion remain the law with the annual exclusion being $16,000/donee in 2022).
- An increase in the top federal estate tax rate (the current top rate of 40 percent remains the law);
- Valuation rules for certain transfers of nonbusiness (passive) assets and passive interests in entities;
- An increase in the maximum value reduction of real estate for purposes of special use valuation.
Provisions Included in H.R. 5376
- Amounts received as paid leave that is provided under the Social Security Act is excluded from gross income. 130004 creating new I.R.C. §139J. Effective upon enactment.
- Increases and caps the state and local tax deduction at $80,000 (MFJ) or $40,000 (MFS; estate or trust). 137601, amending I.R.C. §164. Effective for tax years beginning after December 31, 2020 and before 2031. For 2031, the cap would be $10,000. Then there would be no cap for later years.
- Modifies the child tax credit and advance payment rules.
- IRS can recapture upon the Secretary determining a child was taken into account when determining the annual advance amount due to fraud or intentional disregard of the applicable rules. On a joint return, advance payments are treated as being made one-half to each spouse.
- Extended through 2022 the following:
- Full refundability for taxpayers with a principal place of abode in the U.S. for more than one-half of the year;
- Increase in age limit of qualifying child to those not having reached age 18;
- Increase in the amount of the credit to $3,000 and $3,600 for a qualifying child not having reached age 6;
- The phaseout range beginning at $150,000 (MFJ and surviving spouse); $112,500 (HoH); $75,000 (all others).
- Effective for tax years beginning and payments made after December 31, 2020, except that the 2021 ARPA expansions for 2022 are effective for tax years beginning and payments made after December 31, 2021.
- The child tax credit is made refundable for tax years beginning after 2022 with no provision for advance payments after 2022. 137103, modifying I.R.C. §24. Effective for tax years beginning after December 31, 2022.
- Extends through 2022 the reduction in the age to claim the Earned Income Tax Credit (EITC) from 25 to 19 (except for certain full-time students) and eliminates the upper age limit for the childless EITC. A taxpayer may also use their prior year earned income for EITC computational purposes if earned income in current year is less. 137201, modifying I.R.C. §32. Effective for tax years beginning after December 31, 2021.
- Allows Pell Grants that are not used for qualified tuition and related expenses to be excluded from gross income, and the amount of the American Opportunity Tax Credit or Lifetime Learning Credit is not reduced by any Pell Grant amount. 137502, modifying I.R.C. §117. Effective for tax years beginning after December 31, 2021.
- Imposes a tax equal to the sum of 5 percent of a taxpayer’s MAGI exceeding $10 million (MFJ) or $5 million (MFS), plus 3 percent of such taxpayer’s MAGI exceeding $25 million ($12.5 million for MFS). For purposes of this provision, MAGI is defined as AGI less any deduction allowed for investment interest (as defined by I.R.C. 163(d)) and business interest (as defined by I.R.C. §163(j). Sec. 138203, creating I.R.C. §1A.
- Extends through 2025 the eligibility for the Premium Assistance Tax Credit to individuals and families with household income above 400 percent of the Federal Poverty Level. In addition, the provision extends through 2025 the repeal of indexing of the individual or household’s share of premiums used in determining the premium assistance credit. 137301, amending I.R.C. §36B. Effective for tax years beginning after December 31, 2021.
- Excludes from MAGI any portion of a lump-sum payment of Social Security benefits received during the tax year that is attributable to months ending before the beginning of the tax year, for purposes of determining household income with respect to the premium assistance credit. 137303, amending I.R.C. §36B. Effective for tax years beginning after December 31, 2021.
- Excludes certain dependent income from household income for purposes of determining eligibility for and the amount of the premium tax credit. 137307, amending I.R.C. §36B. Effective for tax years beginning after December 31, 2022.
- A provision limiting the deduction of business interest expense to apply the limitation at the partner (or S corporation shareholder) level rather than the entity level such that the small business exemption of I.R.C. 163(j) would not apply with respect to a partner’s (or shareholder’s) allocable share of business interest expense or other items from a partnership that fails to meet the gross receipts test to qualify as a small business. Disallowed business interest expense under the provision could be carried forward indefinitely. Sec, 138111, amending I.R.C. §163. Effective for tax years beginning after December 31, 2021, with a transition rule.
- Expands the net investment income tax (NIIT) created under Obamacare to apply to trade or business income for taxpayers with taxable income exceeding $400,000 (single filer) or $500,000 (MFJ). The provision also applies the NIIT to trade or business income of trusts and estates. However, the provision does not apply the NIIT to wages on which FICA is already imposed. 138201, amending I.R.C. §1411. Effective for tax years beginning after December 31, 2021.
- Permanently disallows excess business losses for noncorporate taxpayers. Disallowed losses can be carried forward to the next tax year. 138202, amending I.R.C. §461. Effective for tax years beginning after December 31, 2020.
- Reinstates the corporate alternative minimum tax (AMT) by imposing a 15 percent minimum tax on corporations with adjusted financial statement income (AFSI) exceeding $1 billion. A corporation’s minimum tax equals the amount by which the tentative minimum tax exceeds the corporation’s regular tax for the year. Tentative minimum tax is determined by applying a 15 percent tax rate to the corporation’s AFSI for the tax year. AFSI is the corporation’s net income or loss stated on the corporation’s applicable financial statement (with certain modifications) – generally the corporation’s Form 10-K filed with the SEC, an audited financial statement or other similar financial statement. 138101, adding I.R.C. §56A. Effective for tax years beginning after December 31, 2022.
- Provides that the outstanding debt on direct farm loans to “socially disadvantaged” and “economically distressed” direct farm loan borrowers is not income. No deduction is to be denied, no tax attribute reduced, and no basis increase denied by reason of the exclusion from gross income. 135402. Effective upon enactment.
- Specifies that a distributing corporation in a divisive reorganization has gain to the extent of debt securities of the control corporation that are transferred to the creditors of the distributing corporation in excess of basis in the assets that are transferred from the distributing corporation to the controlled corporation. Any gain triggered is reduced by any amounts paid by the controlled corporation to the distributing corporation. S 138143, amending I.R.C. §361. Effective for reorganizations occurring on or after date of enactment.
- For taxpayers with AGI of $400,000 or more, the 75 percent and 100 percent exclusion rates applicable to gains realized from certain qualified small business stock is inapplicable. The 50 percent exclusion of I.R.C. 1202(a)(1) remains available. Sec. 138149, amending I.R.C. §1202. Effective for sales and exchanges after September 13, 2021, subject to a binding contract exception.
- Provides for a temporary increase in the employer-provided childcare credit for years beginning after December 31, 2021, and before January 1, 2026. The amount of childcare expenses eligible for the credit is increased from 25 percent to 50 percent. The maximum credit allowed for a year is increased to $500,000. 138515, amending I.R.C. §45F. Effective December 31, 2021.
- Extends through 2026 the existing credit for electricity produced from certain renewable resources. The provision also applies the extension to electricity produced from solar energy which had expired at the end of 2005. The provision also extends for five years the election to claim an investment tax credit in lieu of the production tax credit. 136101, amending I.R.C. §45. Effective for facilities placed in service after December 31, 2021.
- Extends the biodiesel and renewable diesel tax incentives; the alternative fuel credit and related payment provision; and the alternative fuel mixture credit through 2026. 136201, modifying I.R.C. §40.
- Extends the residential energy efficient property credit through 2033 and modifies the phaseout rules. “Qualified battery storage technology” is added to the list of expenditures eligible for the credit. 136302, amending I.R.C. §25D. Effective for expenditures incurred after December 21, 2021.
- Modifies the energy efficient commercial buildings deduction such that a building must only increase its efficiency relative to a reference building to be eligible for the deduction from 50 percent to 25 percent. The maximum deduction is also modified, and an alternative deduction for energy efficient retrofit property is provided. 136303, amending I.R.C. §179D. Effective for tax years beginning after December 31, 2021.
- Extends through December 31, 2031, the credit for new energy efficient homes, and changes the existing credit to a $2,500 credit for new home meeting certain energy efficiency standards, and a $5,000 credit for certified zero-energy ready homes. 136304, amending I.R.C. §45L. Effective for dwelling units acquired after December 31, 2021.
- A provision that limits annual contributions to a traditional or a Roth IRA for individuals with combined IRA and defined contribution account balances exceeding $10 million applicable in years in which the cap is exceeded and adjusted taxable income exceeds $400,000 (single and MFS); $450,000 (MFJ); $425,000 (HoH). The provision does not bar rollovers and does not apply to accounts obtained due to death, divorce or separation. Also, contributions to Simple IRAs, SEPs, employer-sponsored defined contribution plans or nonqualified deferred compensation plans are not restricted. Sec. 138301, adding I.R.C. 409B. Effective for taxable and plan years beginning after December 31, 2021.
- A requirement that individuals with combined IRA and defined contribution plan accounts (including employee-owned stock ownership plans but with a special rule for ESOPs holding securities that aren’t traded on an established securities market) exceeding $10 million take distributions equal to 50 percent of the amount exceeding $10 million in the year immediately following the year the $10 million cap is exceeded. The provision applies to individuals with adjusted taxable income in excess of $400,000 (single and MFS); $450,000 (MFJ) and $425,000 (HoH). 138302, amending I.R.C. 4974. Effective for plan years beginning after December 31, 2021.
Note: Required distributions from Roth accounts triggered by the cap would not be taxable even for persons not attaining age 59½ or for those who had not had the account at least five years.
· A provision that bars taxpayers from converting tax-deferred, employer-sponsored plan accounts and traditional IRAs to Roth accounts by paying income tax on the current balance to receive tax-free future growth. The provision applies to individuals with adjusted taxable income in excess of $400,000 (single and MFS); $450,000 (MFJ) and $425,000 (HoH). Sec. 138311, amending I.R.C. §408A(e). Effective for distributions, transfers, and contributions made in taxable years beginning after December 31, 2031.
H.R. 5376 also contains many other provisions, including programs to provide up to six semesters of free community college (Sec. 20021); free childcare for children under age six and free universal pre-school services (Sec. 23002), and; health benefits for eligible individuals wo reside in states that have not expanded Medicaid (Sec. 30701). The bill would also expand Medicare to cover dental, hearing and vision care (Sec. 30901), and provide up to 12 weeks of paid family and medical leave (Sec. 13001). The bill also repeals the oil and gas program for the non-wilderness portion of the Arctic National Wildlife Refuge, and cancels all associated leases. (Sec. 70804). Likewise, the bill imposes a “permanent” moratorium on offshore oil and gas leasing in the Eastern Gulf of Mexico, Atlantic and Pacific federal waters. Id.
Also, the bill creates a payroll tax credit on up to $12,500 of wages paid during any calendar quarter to “local news journalists” by local newspapers or broadcast stations through 2025. Sec. 138517.
The Congressional Budget Office estimates that the bill will result in a net increase in the on-budget deficit totaling $389.2 billion over the next 10 years. This figure does not account for any additional revenue that may be generated by additional IRS funding directed toward tax enforcement over the next decade.
Will the bill pass the Senate? That’s likely up to Sen. Manchin of West Virginia and Sen. Sinema of Arizona. Sen. Manchin has expressed concern about the cost of the legislation, while Sen. Sinema has publicly expressed her worries about the tax increases.
Then, there are also the problems with the economy at the present time. A University of Michigan Consumer Sentiment Survey indicates that consumer optimism about the economy has plunged to a new low. Complaints about falling living standards have quintupled since January of 2021. http://www.sca.isr.umich.edu/ Third quarter 2021 new home sales collapsed – an annualized quarterly drop of 12.6 percent. Also, the third quarter of 2021 showed the worst-ever 12-month, quarterly and monthly real merchandise trade deficit. Also, payrolls continue to be well short of economic recovery levels.
Perhaps most concerning is that October 2021 consumer inflation jumped to a four-decade high, with year-to-year consumer price inflation at a 31-year high of 6.2 percent. The money supply growth has been astronomical over the past 18 months – up 101.3 percent from February 2020. The inflation has been fueled by the massive spending by the Congress over the past 20 months. There simply is too much money in the economy. It’s not just a transitory supply chain problem.
In addition, other factors are responsible for the present inflation in the economy:
- The administration has engaged in policies that have increased the price of fossil fuels which means that the cost of production and transportation have risen. This increases the prices of all goods (price inflation).
- To encourage workers to re-enter the work force (after being paid by public tax dollars to stay at home), employers have raised wages (wage inflation).
- The federal government over the past two years has spent $6 trillion more than it has received in tax revenue (deficit spending). This creates excess demand that adds to inflation.
- The Federal Reserve is not doing anything to stop inflation by increasing interest rates to reduce demand in the economy. There simply is no reason to keep interest rates at near-zero levels which increases demand and further fuels inflation. Unfortunately, Paul Volcker is no longer the Chairman of the Federal Reserve.
Will this economic data matter to the Senate? It should matter before uncorking another multi-trillion dollar bill. In a capital-intensive economy such as the U.S. economy, more capital needs to be created. Unfortunately, H.R. 5376 would not lead to more capital formation, especially because of the increased tax rates on high income earners. That will lead to slower growth rates. The long-term inflationary factors are already present in the economy. Does the Senate understand? The real question is whether Sen. Manchin and/or Sen. Sinema do.
H.R. 5376 as passed by the House is not nearly as bad a bill as initially proposed. However, it is loaded with additional spending that will further harm the economy. The “ball” is now in the Senate’s “court.”
Friday, November 26, 2021
In recent weeks, the Tax Court and the U.S. Court of Appeals for the Fifth Circuit have issued important decisions relevant to income tax and estate planning. Today’ post highlights those decisions.
Recent court decisions with implications for income tax and estate/business planning – it’s the topic of today’s post.
IRS Legal Advice Lacks Force of Law
Peak v. Comr., T.C. Memo. 2021-128
The petitioner received distributions from three different pension or retirement plans. Each of the plans sent Form 1099-R to the IRS and to the petitioner indicating that the entire distribution was taxable and that it was a “normal distribution.” The petitioner filed his return for the year reporting the total amount of distributions, but that the “taxable amount” was far less. The IRS issued a CP12 Notice advising the petitioner that there were errors on the return and that the overpayment amount that he reported and that the refund due him was much less than he reported on the return. The petitioner did not respond to the Notice, thereby agreeing to its calculations. Later, the IRS relied on the various Forms 1099-R and issued the petitioner a notice of deficiency notifying the petitioner that the full amount of the distributions was taxable. The petitioner timely filed for a redetermination on the basis that he followed the advice of the IRS helpline representative with respect to the reporting of the distributions. He also claimed that the CP12 Notice confirmed his entitlement to a refund. The Tax Court rejected the petitioner’s arguments, noting that IRS employee legal advice has no force of law and cannot bind the IRS or the Tax Court. The Tax Court also determined that a CP12 Notice is not a settlement agreement and does not limit the IRS in assessing additional tax to be found due.
Note: Rely on the advice of IRS personnel to your own detriment. The same is true for USDA employees. They aren’t legally bound by any “advice” that they give.
For PTC Purposes, MAGI Includes Social Security Benefits
Knox v. Comr., T.C. Memo. 2021-126
The petitioners, a married couple, reported nearly $60,000 of Social Security benefits for 2015. During 2015, they also received $7,332 in advance premium tax credit (APTC) payments. They did not file Form 8962 for 2015 to reconcile the APTC with their eligible premium tax credit (PTC) at the end of the year. The IRS issued a Notice of Deficiency that the full $7,332 had to be paid back and that an accuracy-related penalty was due in the amount of $1,466. The Tax Court, citing its prior decision in Johnson v. Comr., 152 T.C. 121 (2019), held that, for purposes of determining PTC eligibility, the petitioners’ Social Security benefits were required to be included in their modified adjusted gross income, including their lump-sum amounts relating to prior years which they elected to exclude from gross income. By including such amounts in MAGI, the petitioners’ MAGI exceeded 400 percent of the federal poverty level thereby making them ineligible for the PTC.
Note: It is well settled law that Social Security benefits are include in MAGI for purposes of the PTC and the APTC.
“Immediate Supervisor” is Person Who Actually Supervised Exam
Sand Investment Co., LLC v. Comr., 157 T.C. No. 11 (2021)
Under the Code, an IRS examining agent must obtain written supervisory approval to the agent’s determination to assess a penalty on any asserted tax deficiency. Under I.R.C. §6751(b)(1), the approval must be from the agent’s “immediate supervisor” before the penalty determination if “officially communicated” to the taxpayer. In a partnership audit case under TEFRA, supervisory approval generally must be obtained before the Final Partnership Administrative Adjustment (FPAA) is issued to the partnership. See, e.g., Palmolive Building Investors, LLC v. Comr., 152 T.C. 75 (2019). If an examiner obtains written supervisory approval before the FPAA was issues, the partnership must establish that the approval was untimely. See, e.g., Frost v. Comr., 154 T.C. 23 (2020). In this case, the IRS opened a TEFRA examination of the petitioner’s 2015 return. The IRS auditor’s review was supervised by a team manager. While the audit was ongoing, the agent was promoted and transferred to a different team, but continued handling the audit still under the supervision of the former team manager. Ultimately, the agent asserted an accuracy-related penalty against the petitioner and the former team manager signed the approval form. The next day, the auditor sent the petitioner several documents indicating that a penalty might be imposed. Two days later the new team manager also signed the auditor’s penalty approval form. The petitioner challenged the imposition of penalties because the new team manager hadn’t approved the penalty assessment before the auditor sent the penalty determination to the petitioner. The Tax Court held that the supervisor who actually oversaw the agent’s audit of the petitioner was the “immediate supervisor” for purposes of the written supervisory approval requirement of I.R.C. §6751(b)(1). There was no evidence that the new team manager had any authority to supervise the agent’s audit of the petitioner.
Note: Pending legislation would remove the requirement of supervisor approval before IRS can assess penalties.
LLC Gifts Recharacterized
Smaldino v. Comr., T.C. Memo. 2021-127
The petitioner and wife had a real estate portfolio of nearly $80 million including numerous rental properties that they owned and operated. The couple agreed that the real estate should pass to the petitioner’s children and grandchildren from his prior marriage. To accomplish that goal, the petitioner put 10 of the real estate properties into a family limited liability company (LLC) that he formed in 2003 (and which he was designated as the manager) but which remained inactive until late 2012. The LLC, in turn, was placed into a revocable trust of which he was the trustee. In 2013, the petitioner transferred approximately eight percent of class B member interests in the LLC to an irrevocable trust (dynasty trust) that he had created a few months earlier for the benefit of his children and grandchildren. He named his son as trustee. At about the same time as the transfer to the dynasty trust, the petitioner transferred approximately 41 percent of the LLC membership interests to his wife (in an amount that roughly matched her then available federal estate and gift tax exemption), who then in turn transferred the same interests to the dynasty trust the next day. As a result, the dynasty trust owned 49 percent of the LLC. Simultaneously, the petitioner amended the LLC operating agreement to provide for guaranteed payments to himself and identified the dynasty trust as the LLC’s sole member. On his 2013 gift tax return, the petitioner reported only his direct transfer of LLC interests to the dynasty trust and not those of his wife. A valuation report dated four months after the transfers to the dynasty trust stated that the 49 percent interest in the LLC had a value of $6,281,000. The federal estate and gift tax exemption was $5,250,000 in 2013. The IRS asserted that the petitioner had underreported the 2013 taxable gifts by not reporting the wife’s gift to the dynasty trust, and asserted a gift tax deficiency of $1,154,000.
The Tax Court agreed with the IRS, concluding that the wife’s gift to the dynasty trust should be treated as a direct gift by the petitioner for numerous reasons. The Tax Court noted that the wife was not a “permitted transferee” under the LLC operating agreement and, thus, could not have owned the LLC interest. The Tax Court also pointed out that the petitioner had amended the LLC operating agreement on the same day of his transfer of LLC member units to the dynasty trust to reflect himself as the sole member. The Tax Court also pointed out that the transfers of the wife’s LLC member interest were undated – they only had “effective” dates, and that the assignments were likely signed after the valuation report was prepared four months later. This meant that the wife had no real ownership rights in the LLC. In addition, the Tax Court pointed out that the 2013 LLC income tax return did not allocate any income to the wife even though the petitioner claimed that she had an ownership interest for one day. The LLC’s return and associated Schedules K-1 listed the petitioner as a 51 percent partner and the dynasty trust as a 49 percent partner for the entire year. The petitioner’s wife was not listed as a partner for any part of the year.
Note: The case is a good one for learning what not to do when setting up a trust and transferring LLC interests as part of an estate plan. The wife’s holding of the LLC interests for a day (at most) before the transfer to the LLC and then transferring the exact same interests received as a gift to the dynasty trust is not a good approach. It shows a lack of respect for the transaction. The wife’s testimony at trial that she had no intent to hold the interest contradicted the alleged substance of the transaction. It also shows that she didn’t understand the planning that was being engaged in – that’s the fault of the attorneys involved. Also, the husband ‘s failure to report the gift to his wife on a gift tax return was further demonstration that he didn’t respect that transfer. With the amount of wealth involved in the case, a team of professionals should have been engaged, and all formalities of the various transactions should have been closely followed. This includes providing written consent for the wife’s admission as an LLC member; providing the dates that documents were actually signed; not transferring the precise amount to the trust as was initially gifted; and having more time pass between the date of the gift to the wife and her subsequent transfer. There was also no amended and restated LLC operating agreement to reflect her ownership (however brief). Also, tax returns did not properly reflect what the taxpayers were doing.
Sole Shareholder Responsible for Corporation's Tax Debt
United States v. Lothringer, No. 20-50823, 2021 U.S. App. LEXIS 30283 (5th Cir. Oct. 8, 2021)
The petitioner formed a corporation to operate used-car lots. The petitioner was the sole director, office and shareholder. He had complete control over the corporation. The IRS claimed that the corporation owed almost $2 million in federal taxes, and asserted that the petitioner, his wife and the corporation were responsible for the deficiency. The petitioner liquidated his corporation and various non-exempt assets to pay the tax and sued for a refund. The trial court determined that the corporation was the petitioner’s alter ego and, as such, the petitioner was personally responsible for the tax. The petitioner appealed and the appellate court affirmed. The appellate court noted that under applicable Texas law a court may disregard the corporate “fiction” when it has been used as an unfair device to achieve an inequitable result – including use as a taxpayer’s alter ego. There was no doubt, the appellate court concluded, that the facts established a unity between the corporation and the petitioner. The appellate court noted that the petitioner failed to observe certain corporate formalities; loaned substantial sums to the corporation; and made payments from the corporate bank account to service personal loans.
Note: Again, following corporate formalities is important.
Sunday, November 21, 2021
Last week, the IRS published guidance on two items of interest to many tax practitioners and clients. One item concerned clarification on the tax treatment of Paycheck Protection Program (PPP) loan forgiveness. The other item involved whether per diem meal reimbursements are 100 percent deductible or are limited to 50 percent. Also, the newly enacted “infrastructure” bill has a couple of tax provisions of relevance to many tax preparers and clients.
On another note, I will be teaching a two-hour tax ethics course on December 10.
IRS guidance, new law and tax ethics – it’s the topic of today’s post.
PPP Loan Forgiveness
In Rev. Proc. 2021-48, 2021-49 I.R.B., the IRS noted that while PPP loan forgiveness is excluded from gross income, as “tax-exempt” income it can be included in a taxpayer’s gross receipts for other purposes of the Code. For example, the IRS noted that “tax-exempt” income is included in the gross receipts test for purposes of determining whether a taxpayer qualifies to use cash accounting as a “small business taxpayer.” I.R.C. §448(c). The IRS also stated in the Notice that tax-exempt income is also counted for purposes of certain return filing requirement thresholds including that for tax-exempt organizations. See I.R.C. §6033.
The IRS also stated in Rev. Proc. 2021-48 that a taxpayer in receipt of PPP forgiveness can treat the income as received or accrued when the expenses that are eligible for forgiveness are paid or incurred, or an application for loan forgiveness is filed, or the loan forgiveness is granted. If the loan is only partially forgiven, the IRS stated that adjustments are to be made on an amended return, information return or as an administrative adjustment request.
Note: To the extent that PPP loan forgiveness is treated as gross receipts, the rules of Rev. Proc. 2021-48 apply for purposes of determining the timing and reporting those gross receipts.
Rev. Proc. 2021-48 is effective for any tax year that a taxpayer pays or incurs eligible expenses, as well as for any tax year that a taxpayer applies for or is granted PPP loan forgiveness.
The IRS also issued Rev. Proc. 2021-49, 2021-49 IRB, in which it provided guidance on the manner in which partners and partnerships allocate among partners in accordance with I.R.C. §704(b) each partner’s distributive share of loan forgiveness and associated deductions. Relatedly, the IRS noted how a partner’s basis adjustment in the partner’s interest is to occur under I.R.C. §705.
In Rev. Proc. 2021-50, 2021-50 I.R.B., the IRS provided guidance on the filing of amended returns by partnerships (Form 1065 and K-1) for tax years ending after March 27, 2020, which must be filed by the end of 2021 with the “Amended Return” box checked. An eligible partnership must have filed Form 1065 and issued K-1s for the partnership tax year ending after March 27, 2020, and before the IRS issued Rev. Procs. 2021-48 and 2021-49 (and satisfy certain other requirements).
Note: Only a partnership that is an “eligible BBA partnership” can utilize the provisions of Rev. Proc. 2021-50 for purposes of amending returns. Such a partnership is one that is subject to the Centralized Partnership Audit Regime that is effective for tax years beginning after 2017. The new audit process was created under the Bi-Partisan Budget Act (BBA) that was signed into law in late 2015. A partnership is subject to BBA unless it has 100 or fewer partners, all of whom are either individuals, C corporations, foreign entities that would be treated as a C corporation if it were domestic, S corporations or estates of deceased partners, partnership and makes an annual election out of the BBA on a timely filed Form 1065.
Under the Tax Cuts and Jobs Act (TCJA), business meal expenses are only fifty-percent deductible (with some limited exceptions) if they are not lavish or extravagant, are incurred when the taxpayer (or an employee of the taxpayer) is present and are for the taxpayer or business associate. Business meals include meals incurred during travel away from home, including meal per diem expenses. In addition, deductible meals include the cost of meals for a sole proprietor or business associate that are ordinary and necessary expenses paid or incurred in carrying on a trade or business.
Business meals or snacks provided in a restaurant or at the business premises would are 50 percent deductible under the TCJA. Likewise, food and beverage expenses provided on the business premises primarily for the convenience of the employer are typically 50 percent deductible. The same is true for meal expenses for employees or other attendees at a business meeting in a hotel, or when traveling away from home on business.
In late 2020, the Consolidated Appropriations Act (CAA) became law. The CAA included a provision making all business meals that a restaurant provides to be fully (100 percent) deductible. A restaurant is defined as having a primary business of preparing meals for consumption either on site or off. That definition eliminates grocery stores as well as convenience stores.
In Notice 2021-63, 2021-49 I.R.B., the IRS indicated that a business that reimburses employees for meals via per diem qualifies for the 100 percent meal deduction for 2021 and 2022. The employee need not show that the meal was from a restaurant.
Infrastructure Investment and Jobs Act (IIJA)
Cryptocurrency. In the recently enacted IIJA, an information reporting requirement for cryptocurrency was added. The bill amends I.R.C. §6045 by creating an information reporting requirement for “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” A “digital asset” is “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.” These assets are now defined as “securities” that trigger the information reporting requirements of I.R.C. §6045 and a Form 1099-B. IIJA, Title V, §80603.
The information reporting applies to businesses receiving at least $10,000 in digital assets. How the information is to be acquired that needs to be reported is not certain. Presently, a group of Senators is working on additional legislation designed to provide greater clarity.
Employee Retention Credit (ERC). The IIJA repeals the ERC effective for the fourth quarter of 2021 – except for a “recovery startup business” - a business that began operations on or after February 15, 2020, and has average annual gross receipts of $1 million or less. IIJA, Title V, §80604.
The retroactive (at least partially) repeal of the ERC for the fourth quarter will impact employers that were anticipating receiving the ERC during the last quarter of 2021. Those employers likely reduced tax deposits and may have accounted for the ERC in their budget projections. Any underpaid payroll taxes and associated employment tax compliance issues will need to be determined. It remains to be seen whether the IRS will grant relief on this issue.
Tax Ethics Seminar/Webinar
On December 10, I will be teaching a 2-hour tax ethics course. The session will originate from the law school and there is limited seating available for in-person attendance. The class will also be available online. I will be focusing on the practical application of the ethical rules to tax practice – a scenario-based approach to looking at how the ethical rules apply to various client situations. If you are in need of two hours of ethics, I encourage you to attend – either in-person or online. You can learn more about the event and register here: https://www.washburnlaw.edu/employers/cle/taxethics.html.
The tax mill never seems to stop churning out more developments. If the Senate and House reach an agreement over the “porkulus” bill, there will be more “tax stuff” to write and talk about.
Friday, November 19, 2021
Today’s article is the last in a three-part series on the self-employment taxation of Conservation Reserve Program (CRP) payments. In Part One, I set forth the background of the CRP and the history of the self-employment tax treatment of government payments that farmers receive. I then covered the significant IRS private rulings on the tax treatment of CRP payments, a Tax Court case in 1996 and another Tax Court decision a couple of years later that was subsequently reversed by the U.S. Court of Appeals for the Sixth Circuit. The IRS then announced that its historic position on the self-employment tax treatment of CRP payments was going to change (for the worse), but failed to formalize that change in policy. Next, the Congress provided partial relief in the 2008 Farm Bill, but the larger issue remained.
In Part Two, I discussed the litigation on the issue including a major federal appellate court decision in 2014 that wiped out the IRS position on the issue.
In today’s Part Three, I address the proper income tax reporting of CRP payments based on the taxpayer’s facts and circumstances.
Proper tax reporting of CRP payments – it’s the topic of today’s post.
The Morehouse Decision
As noted in Part Two, in 2014, the U.S. Court of Appeals for the Eighth Circuit reversed the Tax Court and held that CRP payments paid to non-farmers are rents from real estate that are excluded from self-employment tax under I.R.C. §1402(a)(1). Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014). In so holding, the court gave no deference to an IRS Notice of Proposed Revenue Ruling IRS Notice 2006-108, IRB 2006-51. Had the IRS formally adopted the Revenue Ruling it would have reversed the longstanding IRS position that land conservation payments paid to non-farmers are not subject to self-employment tax. See, e.g., Rev. Rul. 60-32, 1960-1 CB 23.
IRS non-acquiescence. In reaction to the Eighth Circuit’s Morehouse decision, the IRS did not appeal but instead issued a non-acquiescence, sticking to its (unofficial) position on the self-employment taxability of CRP payments. In its non-acquiescence, the IRS announced that audits would continue unabated – even in the Eighth Circuit. A.O.D. 2015-002, I.R.B. 2015-41 (Oct. 13, 2015). The IRS asserted that the Eighth Circuit “misinterprets” Rev. Rul. 60-32 and Rev. Rul. 65-149. Of course, Rev. Rul. 60-32 is a major obstacle to the IRS position on the self-employment taxability of CRP payments in the hands of a non-farmer. The IRS, in the A.O.D., claimed that Rev. Rul. 60-32 only applies in the context of landlords who do not materially participate in a farming operation on their land. Since Morehouse was not a landlord, IRS claimed that Rev. Rul. 60-32 didn’t apply to shield the CRP payments from self-employment tax. Under the IRS rationale, Morehouse was an “operator” of his CRP land which doesn’t require material participation to trigger self-employment tax. The IRS claimed to base its position on the exception to the rental real estate exception of I.R.C. §1402(a)(1) that is contained in I.R.C. §1402(a)(1)(a). That provision subjects income to self-employment tax that is derived under an arrangement between a farm owner or tenant and another individual which provides that the other individual will produce agricultural or horticultural commodities on the land and provides that there shall be material participation by the owner or tenant in the production or the management of the production of the commodities, and that there actually is material participation by the owner or tenant in the production of the commodities on the land. The IRS made no mention of the fact that the statute (I.R.C. §1402(a)), the U.S. Supreme Court (Comr. v. Groetzinger, 480 U.S. 23 (1987)) and the Eighth Circuit (at least during oral arguments in Morehouse), require income to be derived from the taxpayer’s trade or business for the income to be subject to self-employment tax.
To put it bluntly, the IRS position in the non-acquiescence is absurd. Rev. Rul. 60-32 states that payments and benefits attributable to the acreage reserve program (a.k.a. the Soil Bank – the precursor to the CRP) are includible in determining the recipient’s net earnings from self-employment if the taxpayer operates his farm personally or through agents or employees but if “. . . he does not so operate or materially participate, payments received are not to be included in determining net earnings from self-employment.” (Emphasis added). Notice that it says “personally” and “he does not so operate.” Thus, Rev. Rul. 60-32 is not limited in its application to landlords, it includes “operators” and it is directly applicable to the facts of Morehouse (and countless other non-farmers with CRP income), and remains a major obstacle to the changed position of the IRS first announced in 2003.
The IRS, in the A.O.D. also claimed that Rev. Rul. 65-149 merely elaborated the point made in Rev. Rul. 60-32 that the only situation addressed was that non-materially participating landlords would not have self-employment tax on their Soil Bank payments, but that non-landlord investors or non-farmer estate beneficiaries would. Again, that is a mischaracterization of Rev. Rul. 65-149. In that Revenue Ruling, the IRS stated that annual payments under farm programs comparable to the CRP are not subject to self-employment tax if the taxpayer was not materially participating in farming operations (either personally or via a lease) on land not in the government land diversion program. “Personally” refers to being the “operator.”
Note: The key to understanding the IRS position is that, with respect to the CRP, a recipient of CRP payments is either a farm landlord or a farmer. There is no room, in the IRS view, for a non-farmer who is not a landlord. A non-farmer is an “operator” for which the material participation requirement doesn’t apply. Thus, the CRP income is subject to self-employment tax without any requirement that the income be derived from the taxpayer’s conduct of a trade or business.
Also, the Eighth Circuit did not, as the IRS claims in the A.O.D., assert that either Rev. Rul. 60-32 or Rev. Rul. 65-149 support the conclusion that the CRP payments in Morehouse constituted rents from real estate. Instead, the Eighth Circuit opinion was two-pronged: (1) the CRP, as the modern-day version of the Soil Bank, resulted in payments that should be treated the same for self-employment tax purposes as Soil Bank Payments were under the Revenue Ruling that IRS had not obsoleted – not subject to self-employment tax in the hands of a non-farmer; and (2) the CRP payments in the hands of a non-farmer are real estate rentals that are statutorily excluded from self-employment tax under I.R.C. §1402(a)(1).
The IRS also claimed in the A.O.D. that the 2008 Farm Bill amendment to I.R.C. §1402(a)(1), by implication, meant that CRP payments paid before 2008 were not covered by the rental real estate exception of I.R.C. §1402(a)(1), and that for those payments made after 2007 are subject to self-employment tax unless the recipient is also receiving social security retirement or disability payments. However, as pointed out above, the dissent’s point in Morehouse that the court’s rent analysis was inapplicable to post-2007 payments seems to indicate that the dissenting judge believes that the statutory change to I.R.C. §1402(a)(1) means that CRP payments paid post-2007 are “rents” that are statutorily exempt from self-employment tax. That conclusion is precisely the opposite of the IRS statement in the A.O.D.
Proper Tax Reporting of CRP Payments
Inside the Eighth Circuit (AR, IA, MN, MO, NE, ND and SD). The effect of the Morehouse decision is that non-farmers do not have to pay self-employment tax on CRP payments. That is certainly the result within the Eighth Circuit. Active farmers still have self-employment tax to pay on CRP payments unless the 2008 Farm Bill provision applies to them.
Note. The 2008 Farm Bill provision excludes CRP payments from self-employment tax in the hands of an individual that is collecting retirement or disability benefits from the Social Security Administration, even though they would otherwise report CPR income on Schedule F due to other active farming activities. The exclusion is tied to receipt of benefits, not mere eligibility. If a taxpayer that is engaged in the trade or business of farming chooses to delay receipt of Social Security payments until age 70, any CRP payments received must be reported on Schedule F.
Even though the Morehouse opinion technically applies only to CRP rents paid before 2008, the opinion stands for the proposition that a non-farmer does not materially participate with respect to land in the CRP. In addition, for taxpayers in the Eighth Circuit, the court’s expansive view of the term "rent" provides authority for asserting that any taxpayer’s receipt of CRP is not self-employment taxable, since it is a receipt from real estate rental. Also, the dissent’s point that the court’s rent analysis was inapplicable to post-2007 payments seems to indicate that the dissenting judge believes that the statutory change to I.R.C. §1402(a)(1) means that CRP payments paid post-2007 are “rents” that are statutorily exempt from self-employment tax.
Inside the Sixth Circuit (KY, MI, OH and TN). For practitioners representing taxpayers in the Sixth Circuit (where the Wuebker matter arose), CRP payments are considered farm income rather than rents from real estate if there is a “nexus” with the taxpayer’s farming operation. The facts of Wuebker involved taxpayer’s that were engaged in the trade or business of farming and the CRP payments were from ground that had a nexus with their farming business. Thus, a taxpayer receiving CRP payments but who is not engaged in the trade or business of farming could reasonably take the position on the return that CRP payments are not subject to self-employment tax due to a lack of nexus with a farming operation. Likewise, a farmer with, for example, a hunting property or other farmland in the CRP with no nexus to the trade or business of farming would produce CRP rental income not be subject to self-employment tax.
Outside the Sixth and Eighth Circuits. For taxpayers in neither the Sixth nor Eighth Circuits, CRP payments could be treated as real estate rents that are excludible from self-employment tax under I.R.C. §1402(a)(1). This position is based on the full Tax Court opinion in Wuebker that CRP payments are “rents.” Also, all taxpayers (regardless of location) receiving Social Security retirement or disability payments can exclude CRP payments from self-employment income.
What To Do Now
Given the IRS non-acquiescence to Morehouse, what is a practitioner to do? In the A.O.D., the IRS said it will continue to audit returns where CRP income is not reported as subject to self-employment tax, and will maintain its position that all CRP income is subject to self-employment tax unless the 2008 Farm Bill provision applies. That position is certainly on display in the 2021 IRS Pub. 225. However, I don’t have any personal evidence that the IRS has the courage to follow through with its threats to enforce its flawed CRP self-employment tax theories. It appears that IRS is simply relying on misinformation in Pub. 225 to generate more revenue than it is legally entitled to.
Given that the IRS position is wholly without support, and substantial authority exists for excluding CRP rental income from self-employment tax in the hands of a non-farmer, or even in the hands of a farmer where the CRP land has no nexus with the farming operation, the guidance mentioned earlier still applies. The IRS still has no substantial authority for its position that CRP payments are subject to self-employment tax except for the application of the 2008 Farm Bill provision.
Given all of this, it’s important to point out that the IRS computers are programmed to look for CRP rental income on Schedule F in all situations. Thus, to avoid receiving a CP2000 Notice, CRP rents should be reported on Schedule F and then, in appropriate situations consistent with the analysis above, backed out via Schedule SE so that self-employment tax doesn’t apply.
It’s frustrating when a government agency continues to stick to its judicially-rejected position against citizens and taxpayers. It’s similarly frustrating when a government agency issues publications to provide education and guidance that deliberately misstates applicable law.
The three-part series is over. I rest…
Sunday, November 14, 2021
As noted in Part 1, the IRS continues to hold to its incorrect position on the self-employment tax treatment of Conservation Reserve Program (CRP) payments. In its 2021 version of Publication 225, the “Farmer’s Tax Guide,” the IRS states incorrectly with respect to Conservation Reserve Program (CRP) payments that, “You must include the annual rental payments…on the appropriate lines of Schedule F.” Of course, by reporting CRP rents on Schedule F the payments are subjected to self-employment tax.
In Part One of this three-part series, I set forth the background of the CRP and the history of the self-employment tax treatment of government payments that farmers receive. I then covered the significant IRS private rulings on the tax treatment of CRP payments, a Tax Court case in 1996 and another Tax Court decision a couple of years later that was subsequently reversed by the U.S. Court of Appeals for the Sixth Circuit. The IRS then announced that its historic position on the self-employment tax treatment of CRP payments was going to change (for the worse), but then failed to formalize that change in policy. Next, the Congress provided partial relief in the 2008 Farm Bill, but the larger issue remained.
This leads up to today’s discussion – further litigation leading up to a major federal appellate court decision in 2014. Part Two of the self-employment tax treatment of CRP payments – it’s the topic of today’s post.
The Intervening Years – The Storm Brews
Based on the court rulings, IRS Revenue Rulings and Private Letter Rulings, the IRS has always had significant support for its position that an active farmer is subject to self-employment tax on CRP income. As a result, many practitioners took the conservative approach of reporting CRP income as Schedule F income subject to self-employment tax on the tax returns of active farmers. The Ray case (Ray v. Comr., T.C. Memo. 1996-436) and Sixth Circuit’s Wuebker opinion (Wuebker v. Comr., 205 F.3d 897 (6th Cir. 2000)) represent strong authority for treating CRP income in the hands of an active farmer as business-related income subject to self-employment tax.
However, some practitioners, particularly those representing clients not within the Sixth Circuit (the Sixth Circuit is comprised of Kentucky, Michigan, Ohio and Tennessee) took a more aggressive approach, on a case-by-case basis, by advising active farmers of the controversy and continuing to report CRP income as non-SE income based on the Tax Court’s Wuebker opinion. (Wuebker v. Comr., 110 T.C. 431 (1998)).
For taxpayers who are not actively involved in farming (and not receiving Social Security benefits) the IRS position that CRP rents in the hands of these taxpayers are self-employment taxable is not correct. As noted in Part One, the IRS had always held that Soil Bank and CRP payments are not subject to self-employment tax in the hands of a non-farmer, and the courts had confirmed that view.
The Key Case - Morehouse
In 2013, the U.S. Tax Court released its opinion in Morehouse v. Comr. 140 T.C 350 (2013). In Morehouse, the taxpayer was a non-farmer that lived in Texas and worked for the University of Texas. In 1994, he inherited farmland in South Dakota and bought other farmland from his family members. He never personally farmed the land, but rented it out. In 1997, he put the bulk of the property in the CRP while continuing to rent-out the non-CRP land. He hired a local farmer to maintain the CRP land consistent with the CRP contract (e.g., plant a cover crop and maintain weed control). In 2003, the petitioner moved to Minnesota, but still never personally engaged in farming activities. Consequently, the petitioner reported his CRP income on Schedule E where it was not subject to self-employment tax.
The IRS took the position that the CRP rents were subject to self-employment tax, based on its administrative change of position that it first asserted in 2003. The Tax Court, in a full Tax Court opinion (Judge Paris not participating), agreed. 140 T.C. 350 (2013). The Tax Court found the existence of a trade or business based on either the petitioner’s personal involvement with the CRP contract or through the local farmer that he hired to maintain the land. The Tax Court noted that the CRP contract required seeding of a cover crop and maintenance of weed control. The Tax Court also found important that the taxpayer visited the properties on occasion to ensure that the CRP contract requirements were being satisfied, and participated in emergency haying programs, requested cost-sharing payments, and made the decision as to whether to re-enroll the properties in the CRP upon contract expiration.
The Tax Court cited the Sixth Circuit’s decision in Wuebker as controlling even though the taxpayer in that case was an active farmer and Morehouse had never been engaged in farming. Thus, Wuebker was factually distinguishable. However, the court stated that the petitioner was in the business of maintaining “an environmentally friendly farming operation.”
Note: While, as the Tax Court ruled in Morehouse, CRP payments may not constitute “rents from real estate” that are thereby exempt from self-employment tax under the exception of I.R.C. §1402(a)(1), that determination has no bearing on the issue of whether the taxpayer is engaged in a trade or business as required by I.R.C. §1402(a). That question can only be answered by examining the facts pertinent to a particular taxpayer. Mere signing of a CRP contract and satisfying the contract terms via an agent is insufficient to answer that question.
The Tax Court’s opinion was appealed to the U.S. Court of Appeals for the Eighth Circuit. The majority opinion, issued by Judge Beam, noted that the CRP is the current federal program in a long line of conservation programs and is similar to the old Soil Bank program – even noting that the CRP program has been referred to as the “Son of Soil Bank.” Based on that close tie, the court noted that the IRS, in Rev. Rul. 60-32, 1960-1 C.B. 23. said that Soil Bank payments paid to non-farmers were not subject to self-employment tax, but they were subject to self-employment tax if they were paid to materially participating farmers. The IRS again restated that position in Rev. Rul. 65-149, 1965-1 C.B. 434. The appellate court found those rulings to be persuasive and binding on the IRS given the similarities between the CRP and the Soil Bank program. Thus, the court held that “CRP payments made to non-farmers constitute rentals from real estate for purposes of I.R.C. §1402(a)(1) and are excluded from the self-employment tax.”
The court also pointed out that IRS issued Notice 2006-108, I.R.B. 2006-51 (Dec. 18, 2006), and “with little analysis, the proposed revenue ruling concluded CRP payments to non-farmers were not rentals from real estate and should be treated as income from self-employment.” IRS said in that Notice that the proposed Revenue Ruling would make obsolete Rev. Rul. 60-32, but the IRS never formally adopted the proposed revenue ruling, and the court refused to give it any deference.
The appellate court distinguished the Sixth Circuit’s opinion in Wuebker on the basis that the taxpayer in Morehouse was not a farmer and that the taxpayer in Wuebker was an active farmer. On that point, the appellate court noted that the Sixth Circuit “neither recognized nor rejected the IRS’s position in Rev. Rul. 60-32 that similar payments [i.e., Soil Bank payments] to non-farmers were not self-employment income.”
The appellate court also viewed the CRP payments that the taxpayer received as being for the use and occupancy of his land, noting that the CRP contract reserves the government’s right of entry on the land. The court also found it important that the IRS had represented that if the taxpayer had not fulfilled the contractual requirements, “the USDA could arrange for any needed work to complete ‘on his behalf.’ ” Similarly, the appellate court noted that, via a CRP contract, the government is using the taxpayer’s land for the government’s own purpose of removing sensitive cropland from production and other environmental purposes for the benefit of the public. Accordingly, the appellate court held that “the 2006 and 2007 CRP payments were “consideration paid [by the government] for use [and occupancy] of [Morehouse’s property]” and thus constituted rentals from real estate fully within the meaning of I.R.C. §1402(a)(1).
Because the appellate court determined that CRP payments paid to non-farmers are rentals from real estate that are not subject to self-employment tax under the statutory exclusion of I.R.C. §1402(a)(1), the appellate court did not analyze the trade or business issue. However, during oral argument, both justices Beam and Loken noted that if the CRP payments were not “rents” the CRP payments must still be derived from the taxpayer’s trade or business to be subject to self-employment tax. The appellate court clearly did not agree with the IRS argument that all arrangements entered into for profit, regardless of the level of the taxpayer’s involvement, are automatically deemed to constitute a trade or business. There is absolutely no support for that position.
The bottom line is that the Eighth Circuit reversed the Tax Court and distinguished the Sixth Circuit’s Wuebker opinion by holding that CRP payments in the hands of a non-farmer are not subject to self-employment tax. The court also held that CRP payments at issue (paid before 2008) qualify as “rentals from real estate” because they were payments for the government’s use and occupancy of the taxpayer’s land.
Note: However, because of the statutory change to I.R.C. §1402(a)(1) by virtue of the 2008 Farm Bill, CRP payments paid after 2007 are “rentals from real estate” for taxpayers receiving Social Security or disability payments. The dissent made this point clear when it stated, “whether CRP payments that the government made after December 31, 2007 or currently makes to a non-farmer qualify as rentals from real estate under amended §1402(a)(1) is a question that the court’s decision does not resolve.” This seems to indicate that this judge views CRP payments to be “rentals from real estate” in every situation when they are paid after 2007. If this is true, the differing holdings of the Eighth Circuit and the Sixth Circuit on this particular point were rendered meaningless by the 2008 amendment to I.R.C. §1402(a)(1), and CRP payments paid after 2007 are “rentals from real estate.”
The appellate court’s decision in Morehouse smashed the IRS position that all CRP payments must be reported on Schedule F. In Part Three, I will discuss the tax reporting implications of the Morehouse decision.
Friday, November 12, 2021
In its 2021 version of Publication 225, the “Farmer’s Tax Guide,” the IRS states with respect to Conservation Reserve Program (CRP) payments that, “You must include the annual rental payments…on the appropriate lines of Schedule F.” Of course, by reporting CRP rents on Schedule F the payments are subjected to self-employment tax. However, the IRS statement in Pub. 225 is an incorrect statement of the applicable law. Not all CRP rental payments are subject to self-employment tax.
In Part One of this three-part series, I lay out the background of the CRP and the history of the self-employment tax treatment of government payments that farmers receive. In Part Two, I get into the tax reporting of CRP payments before a significant federal court decision on the issue in 2014. In Part Three, I discuss the current rules for the proper reporting of CRP payments. By explaining the historical context of the CRP program, past IRS rulings and court cases, the proper tax reporting of the payments can be clearly understood and the IRS statement concerning the reporting of CRP rents in Pub. 225 will be thoroughly disembowled.
The background of the CRP and the history of the self-employment tax treatment of CRP payments – it’s the topic of today’s post. Part One of the three-part series.
The CRP, originally enacted in 1985, is an agricultural program administered by the U.S. Department of Agriculture (USDA). Under the program, the program participant agrees to remove the land from active farming, implement a conservation plan, and seed the tract to permanent grass or other vegetative cover to prevent erosion and improve soil and water resources. The USDA, in exchange, generally shares the initial cost of the conservation measures and makes an annual rental payment (reported on a Form 1099) to the owner of the land.
History of SE Tax Treatment of Government Payments
1960s IRS rulings. In 1965, the IRS ruled that grain storage fees paid under a price support loan program of the Commodity Credit Corporation (CCC) were self-employment (SE) income if they were paid to an active farm operator, but excludable from SE income if they were paid to a taxpayer who did not materially participate in the farming operation. Rev. Rul. 65-149, 1965-1 C.B. 434. That ruling followed-up on and is consistent with another ruling that IRS had released in 1960 in which the IRS took the position that payments received for acres idled under the Soil Bank program were SE income "if he operates his farm personally … or … if his farm is operated by others and he participates materially in the production of commodities." Rev. Rul. 60-32, 1960-1 C.B. 23.
When the CRP was created with the 1985 Farm Bill (the CRP has been termed the “son of Soil Bank”), the IRS maintained that its rulings from the 1960s applied and that CRP rents were not SE taxable in the hands of a non-farmer. CRP rents, according to the IRS, would only be SE taxable if the recipient was a farmer. For example, in Ray v. Comr., T.C. Memo. 1996-436, an active farmer who received income from CRP was required to pay SE tax on the CRP rents, because the farmer was found to already be in the business of farming and the CRP had a direct relationship (nexus) to the farming business. While the farmer was required to care for and conserve the acreage, he was required not to farm or graze the land.
Note. The Tax Court’s Ray decision reinforced the conclusion that a farmer actively involved in the business of farming who receives CRP income for not farming the acreage is still subject to SE tax on the CRP rents.
The Wuebker Case
In 1998, the Tax Court held that CRP payments in the hands of an active farmer were not subject to SE tax. Under the facts of the case, an active farmer received about $18,000 of CRP program payments in 1992 and 1993. The payments were reported on Schedule E as land rents. At the same time, the taxpayer was reporting other farming activity on Schedule F subject to SE tax. The IRS assessed SE tax on the CRP income. However, the Tax Court concluded that the CRP payments were rental income, and accordingly exempt from SE tax under I.R.C. §1402(a)(1). Wuebker v. Comr., 110 T.C. No. 31 (1998). The Tax Court noted that both the federal legislation authorizing the CRP program and the CRP contractual terms described the payments as “rental income.” Further, the court noted that the farmer’s service requirements with respect to the land (implementing a conservation plan and establishing ground cover) were incidental, particularly after the first year. Thus, the court concluded that the CRP payments represented rental for the use of land rather than payment for services, and excluded the payments from SE income as rentals from real estate. Having determined that CRP income qualifies as rental from real estate under I.R.C. §1402(a)(1), the Tax Court pointed out that, based on Treas. Reg. §1.1402(a)-4(d), the CRP income is exempt from SE tax even if the payments are associated with a taxpayer’s active farming operation. That regulations states that where an individual or partnership is engaged in a business and the income is classifiable in part as rental from real estate, only that portion of the income that is not classifiable as rental from real estate is subject to SE tax.
Note: The Tax Court, in Wuebker, distinguished its findings from its earlier opinion in Ray, noting that the issue of equating the CRP program payments with rental income had not been raised by the taxpayer in that case. The Ray case had focused exclusively on the nexus between the CRP payments and the taxpayer’s farming business, but the Tax Court stated that its determination of CRP income as rental income made that issue moot.
The IRS appealed the Tax Court’s decision, and the Sixth Circuit reversed in a split decision. Wuebker v. Comr., 205 F.3d 897 (6th Cir. 2000). In reaching its decision, the Sixth Circuit noted that the taxpayer was actively engaged in farming prior to and during the term of the CRP contract, and that the CRP payments were “in connection with” and had a “direct nexus to” the taxpayer’s ongoing farming business. The Sixth Circuit concluded that the key to the SE tax analysis was the substance, rather than the form, of the transaction. Even though the USDA program labeled the CRP payments as “rent,” the court reasoned that this fact alone was not determinative of the tax issue, given the connection of the CRP income to the active farm business. However, the Sixth Circuit did not clearly analyze where the line is between activity that constitutes a trade or business for purposes of self-employment tax and activity that does not rise to that level.
The Sixth Circuit also differed with the Tax Court on the basic issue of whether CRP income was rent. Noting that rent is defined as payment “for the use or occupancy of property,” the Sixth Circuit observed that the U.S. Department of Agriculture (the payor of the CRP revenue) was not using or occupying the farmland. The Wuebkers, the court noted, continued to have control over and access to their property, despite the CRP restrictions on the agricultural use of the land.
Observation. This split between the Tax Court and the Sixth Circuit appears to be a classic judicial difference in approach. The Tax Court took the more literal interpretation, considering CRP income to be exempt from SE tax because of its plain equivalence to cash rental income. On the other hand, the Sixth Circuit disregarded the rental terminology of the CRP program, and considered the revenue to be a USDA subsidy in lieu of active farming income.
In 2003, the IRS signaled that it was changing its position on the self-employment taxability of CRP payments. In a Chief Counsel Memo., the IRS took the position that a taxpayer’s mere signature on a CRP contract was sufficient to constitute a trade or business which would then make the CRP payments subject to self-employment tax. C.C.M. 200325002 (Jun. 20, 2003).
Note: There is absolutely zero authority for the position that a taxpayer’s signature on a document, by itself, is sufficient to constitute a trade or business triggering SE tax. The determination of SE tax is based on the totality of the facts and circumstances of each particular situation. See Comr. v. Groetzinger, 480 U.S. 23 (1987).
In late 2006, the IRS announced a proposed Revenue Ruling in which it would officially take the position of the 2003 Chief Counsel Memo, revoke the prior Revenue Rulings to the contrary, and thereby make official the government’s position that CRP payments are always subject to SE tax, whether received by an active farmer or an inactive landlord/investor. IRS Notice 2006-108. Thus, the IRS was announcing that it planned to change its official, long-held position that such payments were not subject to self-employment tax.
The proposed Revenue Ruling (which was never made final) contained two situations to illustrate its potential holdings:
- In the first situation, an individual actively engaged in the business of farming enrolled a portion of his land in the CRP program. The proposed ruling held that the individual would be subject to SE tax on the CRP income.
- In the second situation, individual B, a landowner, ceased all activities related to the business of farming in the year before entering into a CRP contract. In that subsequent year, B rented out a portion of his land to another farmer and entered into a 10-year CRP contract with respect to the remaining portion of his land. A third party performed the seeding and weed control required under the CRP contract. The proposed ruling held that the individual must treat the CRP rental income as subject to SE tax. This second situation relied on the Sixth Circuit’s Wuebker decision, and focused on the activities required under the CRP contract (tilling, seeding, fertilizing and weed control).
2008 Farm Bill Provision
As a result of a provision included in the 2008 Farm Bill effective for CRP payments made after tax years after 2007, individuals receiving benefits under Section 202 (i.e., retirement) or Section 223 (i.e., disability) of the Social Security Act are exempt from the payment of self-employment tax on CRP income. The provision amended I.R.C. §1402(a)(1). For other taxpayers, no change was made in the SE tax treatment of CRP payments. Indeed, the Committee Report to the 2008 Farm Bill states that “the treatment of conservation reserve payments received by other taxpayers is not changed.” The 2008 amendment applies even though the taxpayer begins receiving Social Security benefits before reaching full retirement age.
This statutory change clearly exempts individuals from SE tax imposition on CRP income, for those who are collecting retirement or disability benefits from the Social Security Administration, even though they might be reporting the CRP income on Schedule F due to other active farming activities.
Note: Railroad Retirement benefits Tier III is not a retirement benefit from the Social Security Administration. A person that receives Railroad Retirement and no Social Security benefit is not protected from self-employment tax on CRP payments.
For taxpayers covered by the 2008 amendment, the Schedule SE instructions note that CRP payments are included on Schedule F, line 4b or listed on Schedule K-1 (Form 1065), box 20, Code AH. If the taxpayer is receiving Social Security benefits at the time of receipt of CRP payments, the CRP payment amount is then to be subtracted on line 1(b) of Schedule SE. Instructions, 2021 Schedule SE.
Note: In its 2021 Pub. 225, the IRS correctly states that, “Individuals who are receiving social security retirement or disability benefits may exclude CRP payments when calculating self-employment tax.”
In Part Two, I will continue the discussion by diving deeper into the tax reporting of CRP payments leading up to a major federal appellate court opinion in 2014.
Sunday, October 31, 2021
A common year-end tax strategy for farmers is to pre-pay input expenses by the end of the current tax year. Pre-paying for next year’s seed, feed, fertilizer and chemicals, for a farmer on the cash method of farming, can reduce a current years’ tax burden. But, if those deductions could be better utilized in the next tax year, pre-paying may not be the best strategy.
Also, there have been several prominent cases in recent years involving the pre-paying of farming expenses by farmers on the cash method of accounting. One avenue of attack has been its attempt to deny the use of pre-paid expenses. Thus, it’s imperative for a farmer to properly pre-pay expenses to be able to claim the deduction in the year of the pre-payment. As we get closer to the end of the year, and the timeframe during which many pre-payments occur, it’s a good idea to review the rules and get pre-payment arrangements properly structured so that deductions can be taken in the year of the payment, favorable prices can be received for input supplies and planting can be made more efficient due to having adequate input supplies on hand.
The pre-paid expense rules. That’s the topic of today’s post.
The IRS issued a revenue ruling in 1979 that identified three conditions that must be satisfied for pre-paid expenses for inputs such as fertilizer, seed and chemicals to successfully generate a deduction in the year of pre-payment. Rev. Rul. 79-229, 1979-2 C.B. 210. Failure to meet any one of these conditions results in an allowable deduction only when the input is used or consumed.
Binding contract. The first condition requires the pre-purchase to be an actual purchase evidenced by a binding contract for specific goods (of a minimum quantity) that are deductible items that will be used in the taxpayer’s farming business over the next year. An absence of specific quantities or a right to a refund of any unapplied credit are indicative of a deposit. Likewise, if the farmer retains the right to substitute other goods or services for those denoted in the purchase contract, a deposit is indicated. For example, a 1982 case from the Fifth Circuit Court of Appeals involved a Texas farmer who went to the local elevator near year's end, wrote a check for $25,000, and told the elevator operator that he would be back sometime in the following year to pick up $25,000 worth of supplies. The farmer then deducted those expenses for that tax year and the IRS challenged the deductions. The farmer lost because the transaction looked like a mere deposit. Schenk v. Comr., 686 F.2d 315 (5th Cir. 1982).
While the IRS thinks that how the seller of the inputs characterizes the transaction on its books matters, that should be immaterial as to the characterization of the transaction for the farmer’s tax purposes. That’s particularly the case because of Treas. Reg. §1.451-5(c) which allows the seller to treat the transaction as a deposit without affecting the farmer’s ability to deduct for the amount of the pre-paid expenses. In addition, the farmer has no control over how an input seller treats the transaction on its books and deductibility should not turn on the seller’s characterization.
So, if a written contract is entered into for specific goods that are otherwise deductible items that will be used in the farming business within the next year, and the payment does not exceed (in total) the price and quantity established in the contract, the first condition is satisfied, and the transaction is a pre-payment rather than a deposit.
Business purpose. The second IRS condition that is used to determine whether pre-purchased items are deductible is whether the transaction has a business purpose or was entered into solely for tax avoidance purposes. This is the easiest of the three tests because if a taxpayer is not pre-purchasing to assure the taxpayer a set price, the taxpayer is pre-purchasing to assure supply availability. Another legitimate business purpose associated with pre-purchasing include avoiding a feed shortage. Thus, in practically all conceivable transactions, it is fairly easy to think of a business reason for what the taxpayer is doing. But see, Peterson v. United States, 6 Fed. Appx. 547 (8th Cir. 2001).
Material distortion of income. The third condition requires that the transaction must not materially distort income. While pre-purchasing distorts income, the key is whether the distortion is “material.” There is no bright-line test to determine whether income has been materially distorted in any particular case. The IRS, however, gets most upset when a taxpayer's pattern of pre-purchases bears a suspicious tandem relationship to income. For example, if a taxpayer's income goes up in one year and the level of pre-purchases also rises, and in a subsequent year, income goes down along with the level of pre-purchases, the IRS could question the transaction. In addition, the IRS will likely examine the relation of the purchase size to prior purchases and the time of year payment was made. Thus, it’s important for a farmer to stay consistent with their customary business practices in buying supplies and the business purpose(s) for the pre-payment. Also, the pre-payment transaction should not provide a tax benefit that extends longer than 12 months. See Treas. Reg. §1.162-3(c)(1)(iii).
Some courts have approved deductions for prepaid inputs if the expenditure was made in the course of prudent business practice unless a gross distortion of income resulted. However, recent cases have found material distortion of income and disallowed the deduction even though a legitimate purpose existed. In any event, a survey of the decisions indicates that for year-end purchases of the next year's supplies, a taxpayer should try to take delivery or at least enter into a binding, no refund, no substitutes contract. Likewise, it appears that if a taxpayer stays within the confines of the IRS rulings, the deduction will be allowed. See, e.g., Comr. v. Van Raden, 650 F.2d 1046 (9th Cir. 1981).
There is an overall limitation on the amount of deduction for pre-paid expenses. The limit is 50 percent of total deductible farming expenses excluding prepaid expenses. This is largely drawn right off of Schedule F (including current year depreciation expense). The taxpayer simply takes into account all of the expenses and is eligible to deduct up to 50 percent on a prepaid basis. Thus, if a taxpayer has total deductible farming expenses for the year of $80,000, and has prepaid an additional $50,000, the most the taxpayer could deduct would be $40,000 which means the other $10,000 is carried over and deducted the following year.
Exceptions. There are two exceptions to the 50 percent test. One of these exceptions is for a change in business operations caused by extraordinary circumstances. A farmer is permitted to continue to deduct prepaid expenses even though the prepaid expenses exceed 50 percent of the deductible farming expenses for that year if the failure to meet the 50 percent test was because of a change in business operations directly attributable to extraordinary circumstances. If the reason for a taxpayer's reduced level of inputs was because of something extraordinary such as a major change in federal farm programs, like a 1983-style payment-in-kind program that idled a lot of land, or because of a big casualty loss, or because of a disease outbreak in livestock or something of that nature, that constitutes an extraordinary circumstance and removes the taxpayer from the 50 percent rule.
The second exception permits a “qualified farm-related taxpayer” to meet the 50 percent test over the last three years (computed on an aggregate basis) rather than the last one year. A “qualified farm-related taxpayer” is a taxpayer whose principal residence is on a farm or whose principal occupation is farming or who is a member of the family of a taxpayer whose principal residence is on a farm or who has a principal occupation of farming. A corporation carrying on farming operations can qualify as a “farm-related taxpayer.” See Golden Rod Farms, Inc. v. United States, 115 F.3d 897 (11th Cir. 1997)
If the aggregate prepaid farm supplies for the three taxable years preceding the taxable year are less than 50 percent, then there is no limitation on deductibility of prepaid expenses. There is a question, however, concerning how the expenses over the past three years are to be aggregated. Guidance is needed as to whether carry-over expenses to or from the three-year period are ignored, or whether the 50 percent test applies each year with the excess carried over to the following year.
The ability of a cash method farmer to pre-pay and deduct expenses is a critical tax management tool. A typical famer’s amount of pre-payments can easily exceed $100,000. In addition, it should be noted that rent can also be pre-paid (and currently deducted) if it doesn’t extend beyond 12 months. Treas. Reg. §1.263(a)-4(f)(8), Example 10. But, for pre-paid rent, the potential application of §467 will need to be considered.
Make sure to follow the rules and structure pre-payment transactions properly.
Wednesday, October 27, 2021
Famers engage in numerous types of sales transactions. Of course, common sales involve sales of harvested crops and raised livestock. But, a farmer or rancher can receive income from other types of sales and for services rendered. Each of these transactions has its own income tax reporting requirements.
Income from sales of unique items and services by farmers and ranchers – it’s the topic of today’s post.
Amounts that a farmer or rancher receives as breeding fees are includible in gross income. If part or all of the fee is later refunded because the animal did not produce live offspring, you still report the breeding fees as income in the year received, but then you take a deduction when the refund is made.
Soil and Mineral Sales
Soil, sod and other minerals that are sold on a regular basis supports the characterization as sales of assets held primarily for sale to customers which would be reported as ordinary income. Indeed, the activity of growing and selling sod has been held to constitute the trade or business of farming for purposes of I.R.C. §180(a). Priv. Ltr. Rul. 8440003 (May 22, 1984). The U.S. Tax Court, in 1976, held that the proceeds from the sale of sod are subject to an allowance for depletion because sod is a “natural deposit.” Myers v. Comm’r, 66 T.C. 235 (1976), acq., 1977-2 C.B. 1.
For mineral deposits, the disposition could be held to be a sale that would be reported as capital gain. But, that probably is not going to be the case in most situations. It’s more likely that a lease is involved which produces ordinary gain. Whether a sale or lease takes place depends upon whether an economic interest was retained in the deposits in question. The answer to that question will depend on the facts of each situation. Regardless of whether the transaction is a sale or a lease, it is important for the taxpayer to determined income tax basis in the minerals.
Crop Share Rents
Crop share rents received by a farm landlord under a crop share or livestock share lease are included in income in the year the crop or livestock is reduced to money (or its equivalent), fed to livestock or donated to charity, whether the taxpayer is on the cash or accrual method of accounting. If crop share rents are received in one taxable year and fed to livestock in a later taxable year, the landlord includes in income an amount equal to the fair market value of the share rents at the time the crop share amounts are fed to livestock. An offsetting deduction is available at the same time.
Sale of Livestock
For livestock, the amount of cash and the value of other merchandise or other property received during the tax year from the sale of livestock (and other produce) is included in gross income. Raised livestock (and crops) typically have a zero basis, which will result in the entire amount of the cash and the value of other merchandise or other property received being reported in gross income.
Section 1231 Assets
In general, for gains and losses arising from the sale of certain capital assets - farmland, depreciable assets used in the farm business, livestock (held for draft, breeding, dairy and or sporting purposes), unharvested crops sold with the land, and some other transactions - a special form of tax treatment applies. I.R.C. §1231. For these assets, if the aggregation of these transactions produces a net gain, it is treated as long-term capital gain provided the assets were held for the requisite time period unless in the prior five years, there were net losses from such aggregation. If there were net losses, then the net gain for the year is treated as ordinary income to the extent of the prior losses. For this purpose, a net loss of a prior year is disregarded after it has once been used to convert a capital gain to ordinary income in a prior year. If aggregation of these transactions for the year produces a loss, the loss is deducted as an ordinary loss. For capital assets not used in the business, gains are capital gains and losses are capital losses. For individuals, capital losses offset capital gains and up to $3,000 of ordinary income each year. Corporations are not eligible for the $3,000 deduction against ordinary income.
For long-term capital gain treatment in general, assets must be held for more than one year. However, cattle and horses must be held for 24 months or more. For other livestock, they must be held for 12 months or more. An important point to remember is that the sale of animals that qualify for I.R.C. §1231 treatment is not reported on Schedule F. Instead, these transactions are reported on Form 4797 where the gains are not subject to self-employment tax and, as noted, a net gain is taxed at favorable capital gain rates.
Gains from the sale of land are taxed as long-term capital gain (e.g., preferential tax rate) if the land has been held for at least a year before the sale. The gain that is taxed is the difference between the selling price and the seller’s basis in the land.
Crops and Feed
Standing crops that are sold with the underlying land are taxed as capital gain. Harvested crops that are sold as inventory, however, are taxed as ordinary income. From a planning standpoint if farmland on which crops are growing is going to be sold in the fall and it has a crop on it that would be harvested in the fall, it might be better from a tax standpoint to sell the growing crop with the land rather than harvesting the crop and then selling it. Crops that are harvested and sold as feed should be accompanied by a bill of sale denoting the price that was paid for the crop.
These are just a few of the common sale transactions that farmers and ranchers enter into. This article is also not a deep dive into the details of each type of transaction. There are additional technical rules that might also be involved in some situations.
Tuesday, October 19, 2021
Operating a small business means, in part, paying business taxes. But, business taxes for many small businesses are different than those that are taken out of an employee’s paycheck. Under current law, there can be an advantage for many small businesses, particularly those engaged in professional services, to operate in the form of an S corporation. But, that advantage could be eliminated under a proposal that is under consideration in the Congress.
S corporation tax treatment and a current legislative proposal – it’s the topic of today’s post.
S Corporation Tax Treatment
Many small businesses are subject to the Self-Employment Contributions Act (SECA), and self-employment tax must be paid. But S corporation shareholders are not subject to SECA tax because the S corporation is treated as separate from the shareholders – its activities are not attributed to its shareholders. An S corporation must pay its owner-employees “reasonable compensation” for services rendered to the corporation. That compensation is subject to Federal Insurance Contributions Act (FICA) tax. But any non-wage distributions to S corporation shareholders are not subject to either FICA or SECA taxes. Therein lies the “rub.” Salary that is too low in relation to the services rendered results in the avoidance of payroll taxes. So, when shareholder-employees take flow-through distributions from the corporation instead of a salary, the distributions are not subject to payroll taxes (i.e., the employer and employee portions of FICA taxes and the employer Federal Unemployment Tax Act (FUTA) tax.
Note: FICA requires employers to withhold a set percentage of each employee’s paycheck to cover the Social Security tax, Medicare tax and other insurance costs. Employer’s must also equally match those withholdings, with the total amount being 15.3 percent of each employee’s net earnings. Under SECA, a small business owner is deemed to be both the employer and the employee and is, therefore, responsible for the full 15.3 percent “self-employment tax” that is paid out of net business earnings
In accordance with Rev. Rul. 59-221, S corporation flow-through income is taxed at the individual level and is (normally) not subject to self-employment tax. Also, in addition to avoiding FICA and FUTA tax via S corporation distributions, the 0.9% Medicare tax imposed by I.R.C. §3101(b)(2) for high-wage earners (but not on employers) is also avoided by taking income from an S corporation in the form of distributions. These are the tax incentives for S corporation shareholder-employees to take less salary relative to distributions from the corporation. With the Social Security wage base set at $142,800 for 2011, setting a shareholder-employee’s compensation beneath that amount with the balance of compensation consisting of dividends can produce significant tax savings.
Note: It is currently projected that the Social Security wage base will be $146,700 for 2022.
Who’s an “Employee”?
Most S corporations, particularly those that involve agricultural businesses, have shareholders that perform substantial services for the corporation as officers and otherwise. In fact, the services don’t have to be substantial. Indeed, under a Treasury Regulation, the provision of more than minor services for remuneration makes the shareholder an “employee.” Once, “employee” status is achieved, the IRS views either a low or non-existent salary to a shareholder who is also an officer/employee as an attempt to evade payroll taxes and, if a court determines that the IRS is correct, the penalty is 100 percent of the taxes owed. Of course, the burden is on the corporation to establish that the salary amount under question is reasonable.
Before 2005, the court cases involved S corporation owners who received all of their compensation in form of dividends. Most of the pre-2005 cases involved reclassifications on an all-or-nothing basis. In 2005, the IRS issued a study entitled, “S Corporation Reporting Compliance.” Now the courts’ focus is on the reasonableness of the compensation in relation to the services provided to the S corporation. That means each situation is fact-dependent and is based on the type of business the S corporation is engaged in and the amount and value of the services rendered.
So what are the factors that the IRS examines to determine if reasonable compensation has been paid? Here’s a list of some of the primary ones:
- The employee’s qualifications;
- the nature, extent, and scope of the employee’s work;
- the size and complexities of the business; a comparison of salaries paid;
- the prevailing general economic conditions;
- comparison of salaries with distributions to shareholders;
- the prevailing rates of compensation paid in similar businesses;
- the taxpayer’s salary policy for all employees; and
- in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.
According to the IRS, the key to establishing reasonable compensation is determining what the shareholder/employee did for the S corporation. That means that the IRS looks to the source of the S corporation’s gross receipts. If they came from services of non-shareholder employees, or capital and equipment, then they should not be associated with the shareholder/employee’s personal services, and it is reasonable that the shareholder would receive distributions as well as compensation. Alternatively, if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation. In addition to the shareholder/employee’s direct generation of gross receipts, the shareholder/employee should also be compensated for administrative work performed for the other income-producing employees or assets. As applied in the ag context, for example, this means that reasonable compensation for a shareholder/employee in a crop farming operation could differ from that of a shareholder-employee in a livestock operation.
For those interested in digging into the issue further, I suggest reading the following cases:
- Watson v. Comr., 668 F.3d 1008 (8th Cir. 2012)
- Sean McAlary Ltd., Inc. v. Comr., T.C. Sum. Op. 2013-62
- Glass Blocks Unlimited v. Comr., T.C. Memo. 2013-180
- Scott Singer Installations, Inc. v. Comr., T.C. Memo. 2016-161
Each of these cases provides insight into the common issues associated with the reasonable compensation issue. The last two also address distributions and loan repayments in the context of reasonable compensation of unprofitable S corporations with one case being a taxpayer victory and the other a taxpayer loss.
A current proposal, effective for tax years beginning after December 31, 2021, that would change the tax rules applicable to S corporations is being considered as part of the massive spending bills that are currently before the Congress. The proposal is an attempt to ensure that all of the pass-through business income that an individual receives that has more than $400,000 of adjusted gross income for the tax year is subject to the 3.8 percent Medicare tax – either through the tax on net investment income (I.R.C. §1411) or through the SECA tax. This outcome would be accomplished by the legislation amending the definition of “net investment income” so that it includes an individual’s gross income and gain from a pass-through business that is not otherwise subject to employment taxes. That means it would apply to S corporation shareholders who are active in the corporation’s business, but don’t receive a “sufficient” level of compensation. The proposal would also apply SECA tax to the distributive share of the business income that an S corporation shareholder receives who materially participates in the entity’s business
Note: The proposal would also apply SECA tax (above a threshold amount) to the distributive shares of partners in limited partnerships and limited liability company (LLC) members that provide services to the entity and materially participate.
If the legislative proposal is enacted into law, it would significantly change the taxation of pass-through entities and owners that have AGI above the $400,000 threshold. The technique of reducing employment tax by managing compensation levels withing the boundaries set by the IRS and the courts would no longer be a viable strategy. Also, if enacted, the proposal could incentivize the revocation of the S election in favor of C corporate status. But, that move depends, at least in part, on where the C corporate tax rate turns out to be - that’s under consideration in the Congress also.