Saturday, October 17, 2020
On May 7, 2020, the IRS issued proposed regulations providing guidance on the deductibility of expenses that estates and non-grantor trusts incur. REG-113295-18. The reason for the proposed regulations is that the Tax Cuts and Jobs Act (TCJA), effective for tax years beginning after 2017 and before 2026, bars individual taxpayers from claiming miscellaneous itemized deductions. I.R.C. §67(g). This TCJA suspension of miscellaneous itemized deductions for individuals raised questions as to whether and/or how estates and non-grantor trusts are impacted. In late September, the IRS finalized the regulations. TD 9918 (Sept. 21, 2020).
New guidance on handling deductions of a non-grantor trust or estate and those that flow to beneficiaries – it’s the topic of today’s post.
Computing Trust/Estate AGI
In general, a trust’s or estate’s AGI is computed in the same manner as is AGI for an individual. I.R.C. §67(e). However, when computing AGI for trust or an estate, deductions are allowed for administration costs that are incurred in connection with a trust or an estate if those costs would not have been incurred if the property were held individually instead of in a trust or in the context of a decedent’s estate. I.R.C. §67(e)(1). In addition, an estate or trust is entitled to a personal exemption (I.R.C. §642(b)), a deduction for current income distributed from a trust (I.R.C. §651), and a deduction for the distribution of income from an estate or a trust for accumulated income as well as the distribution of corpus (I.R.C. §661).
But, the TCJA added I.R.C. §67(g) which states, “…no miscellaneous itemized deduction shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.” That raised a question of whether the IRS would take the position that the new I.R.C. §67(g) caused the I.R.C. §67(e) expenses to be miscellaneous itemized deductions that a non-grantor trust or estate could no longer deduct. In 2018, however, the IRS issued Notice 2018-61 to announce pending regulations and stated that I.R.C. §67(e) expenses would remain deductible by virtue of removing them from the itemized deduction category.
Another aspect of non-grantor trust/estate taxation involves “excess deductions.” When an estate or trust terminates, a beneficiary gets to deduct any carryover (excess) amount of a net operating loss or capital loss. I.R.C. §642(h)(1). The beneficiary can also deduct the trust’s or estate’s deductions for its last tax year that are in excess of the trust’s or estate’s gross income for the year. I.R.C. §642(h)(2). These deductions are allowed in computing the beneficiary’s taxable income. While they must be taken into account in computing the beneficiary’s tax preference items, they cannot be used to compute gross income. Treas. Reg. §1.642(h)-2(a). In addition, the character of the deductions remains the same in the hands of a beneficiary upon the termination of an estate or a trust.
But, the TCJA suspension of miscellaneous itemized deductions clouded the tax treatment of how excess deductions were to be handled. When a trust or estate terminates with excess deductions they could be treated in the hands of a beneficiary as a miscellaneous itemized deduction that I.R.C. §67(g) disallows. I say “could be” because an excess deduction could take one of three forms. It is either comprised of deductions that are allowed when computing AGI under I.R.C. §§62 and 67(e); or it is an itemized deduction under I.R.C. §63(d) that is allowed when computing taxable income; or it is a miscellaneous itemized deduction that the TCJA disallows (through 2025).
The Proposed Regulations specify that certain deductions of an estate or trust are allowed in computing adjusted gross income (AGI) and are not miscellaneous itemized deductions and, thus, are not disallowed by I.R.C. §67(g). Instead, they are treated at above-the-line deductions that are allowed in determining AGI . The Proposed Regulations also provide guidance on determining the character, amount and manner for allocating excess deductions that beneficiaries succeeding to the property of a terminated estate or non-grantor trust may claim on their individual income tax returns.
Specifically, the Proposed Regulations amend Treas. Reg. §1.67-4 to clarify that I.R.C. §67(g) doesn’t disallow an estate or non-grantor trust from claiming deductions: (1) for costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in the trust or estate; and (2) for deductions that are allowed under I.R.C. §§642(b), 651 and 661 (personal exemption for an estate or trust; income distributed currently; and distributions for accumulated income and corpus).
As for excess deductions of an estate or trust, prior Proposed Regulations treated excess deductions upon termination of an estate or non-grantor trust as a single miscellaneous itemized deduction. The new Proposed Regulations, however, segregate excess deductions when determining their character, amount, and how they are to be allocated to beneficiaries. The new Proposed Regulations specified that the excess amount retains its separate character as either an amount that is used to arrive at AGI; a non-miscellaneous itemized deduction; or a miscellaneous deduction. That character doesn’t change in the hands of the beneficiary. The fiduciary is to separately identify deductions that may be limited when the beneficiary claims the deductions.
The Proposed Regulations utilize Treas. Reg. §1.652(b)-3 such that, in the year that a trust or estate terminates, excess deductions that are directly attributable to a particular class of income are allocated to that income. The Preamble to the Proposed Regulations states that excess deductions are allocated to beneficiaries under the rules set forth in Treas. Reg. §1.642(h)-4. After allocation, the amount and character of any remaining deductions are treated as excess deductions in a beneficiary’s hands in accordance with I.R.C. §642(h)(2). This accords with the legislative history of I.R.C. §642(h) in seeking to avoid “wasted” deductions.
The bifurcation of excess deductions into three categories by the Proposed Regulations rather than lumping them altogether miscellaneous itemized deductions disallowed by the TCJA is pro-taxpayer.
The IRS says that the Proposed Regulations can be relied on for tax years beginning after 2017, and on or before the proposed regulations are published as final regulations.
I.R.C. §67(g) doesn’t control. The Final Regulations affirm that deductions for costs which are paid or incurred in connection with the administration of an estate or trust and which would not have been incurred if the property were not held in such trust or estate remain deductible in computing AGI. In other words, I.R.C. §67(e) overrides I.R.C. §67(g). However, the Final Regulations do not provide any guidance on whether these deductions (including those under I.R.C. §§642(b), 651 and 661) are deductible in computing alternative minimum tax for an estate or trust. That point was deemed to be outside the scope of the Final Regulations.
Excess deductions. As for excess deductions, the Final Regulations confirm the position of the Proposed Regulations that excess deductions retain their nature in the hands of the beneficiary. Treas. Reg. §1.642(h)-2(a)(2). How is that nature determined? Excess deductions passing from a trust or an estate have their nature pegged by Treas. Reg. §1.652(b)-3. The nature of excess deductions of a trust or an estate is determined by a three-step process: 1) direct expenses are allocated first (e.g., real estate taxes offset real estate rental income); 2) the trustee can exercise discretion when allocating remaining deductions – in essence, offsetting less favored deductions for individuals by using them against remaining trust/estate income (also, if direct expenses exceed the associated income, the excess can be offset at this step); 3) once all of the trust/estate income has been offset any remaining deductions constitute excess deductions when the trust/estate is terminated that are allocated to the beneficiaries in accordance with Treas. Reg. §1.642(h)-4. Treas. Reg. 1.642(h)-2(b)(2).
Example 2 of the Proposed Regulations was modified in the Final Regulations to permit allocation of personal property tax to income, with any I.R.C. §67(e) expenses distributed to the beneficiary. Thus, the fiduciary has discretion to selectively allocate deductions to income or distribute them to a beneficiary. Those excess deductions that are, in a beneficiary’s hands, allowed at arriving at AGI on Form 1040 are to be deducted as a negative item on Schedule 1.
As the Proposed Regulations required and the Preamble to the Final Regulations confirm, the information concerning excess deductions must be reported to the beneficiaries when a trust or an estate terminates. Deduction items must be separately stated when, in the beneficiary’s hands, the deduction would be limited under the Code. The Preamble states that the Treasury Department and the IRS “plan to update the instructions for Form 1041, Schedule K-1 (Form 1041) and Form 1040…for 2020 and subsequent tax years to provide for the reporting of excess deductions that are section 67(e) expenses or non-miscellaneous itemized deductions.”
Because excess deductions retain their nature in a beneficiary’s hands, any individual-level tax limitations still apply. Thus, for example, if an excess deduction results from state and local taxes (SALT) that a non-grantor trust or estate pays, is still limited at the beneficiary’s level to the $10,000 maximum amount under the TCJA. The Final Regulations addressed this issue, but the Treasury determined that it lacked the authority to exempt a beneficiary from the SALT limitation.
The Preamble also notes that beneficiaries subject to tax in states that don’t conform to I.R.C. §67(g) may need access to miscellaneous itemized deduction excess deduction information for state tax purposes. This burden apparently rests with the fiduciary of the estate/trust and the pertinent state taxing authority. The IRS declined to modify federal income tax forms to require or accommodate the collection of this information because it is a state tax issue and not a federal one.
The Final Regulations clarify that a beneficiary cannot carry back a net operating loss carryover that is passed out of a trust/estate in its final year. Treas. Reg. §1.642(h)-5(a), Ex. 1. A net operating loss carryover from an estate/trust can only be carried forward by the beneficiary.
The Final Regulations apply to tax years beginning after their publication in the Federal Register. They do not apply to all open tax years. Thus, it is not possible to file an amended return to take advantage of the position of the Final Regulations with respect to excess deductions for a tax year predating the effective date of the Final Regulations.
The Proposed and Final Regulations are, in general, taxpayer friendly. Tax planning will likely focus on the allocation of deductions in accordance with classes of income over which the fiduciary can exercise discretion (amounts allowed in arriving at AGI; non-miscellaneous itemized deductions; and miscellaneous itemized deductions). To the extent that the fiduciary can have excess deductions on termination of an estate or non-grantor trust reduce AGI, that is likely to produce the best tax result for the beneficiary or beneficiaries (with consideration given, of course, to possible TCJA-imposed limitations). Given the compressed tax brackets applicable to trusts and estates, the position taken in the Proposed and Final Regulations on deduction items and the flexibility given to fiduciaries is welcome news.
Monday, October 12, 2020
The fields of agricultural law and agricultural taxation are dynamic. Law and tax impacts the daily life of a farmer, rancher, agribusiness and rural landowner practically on a daily basis. Whether that is good or bad is not really the question. The point is that it’s the reality. Lack of familiarity with the basic fundamental and applicable rules and principles can turn out to be very costly. As a result of these numerous intersections, and the fact that the rules applicable to those engaged in farming are often different from non-farmers, I started out just over 25 years ago to develop a textbook that addressed the major issues that a farmer or rancher and their legal and tax counsel should be aware of. After three years, the book was complete – Principles of Agricultural Law - and it’s been updated twice annually since that time.
The 47th edition is now complete, and it’s the topic of today’s post – Principles of Agricultural Law.
The text is designed to be useful to farmers and ranchers; agribusiness professionals; ag lenders; educational professionals; lawyers, CPAs and other tax preparers; undergraduate and law students; and those that simply want to learn more about legal and tax issues. The text covers a wide range of topics. Here’s just a sample of what is covered:
Ag contracts. Farmers and ranchers engage in many contractual situations, including ag leases, to purchase contracts. The potential perils of verbal contracts are numerous and can lead to unnecessary litigation. What if a commodity is sold under forward contract and a weather event destroys the crop before it is harvested? When does the law require a contract to be in writing? For purchases of goods, do any warranties apply? What remedies are available upon breach? If a lawsuit needs to be brought to enforce a contract, how soon must it be filed? Is a liability release form necessary? Is it valid? What happens when a contract breach occurs? What is the remedy?
Ag financing. Farmers and ranchers are often quite dependent on borrowing money for keeping their operations running. What are the rules surrounding ag finance? This is a big issue for lenders also? What about dealing with an ag cooperative and the issue of liens? What are the priority rules with respect to the various types of liens that a farmer might have to deal with?
Ag bankruptcy. A unique set of rules can apply to farmers that file bankruptcy. Chapter 12 bankruptcy allows farmers to de-prioritize taxes. That can be a huge benefit. Knowing how best to utilize those rules is very beneficial. That’s especially true with the unsettled issue of whether Payment Protection Program (PPP) funds can be utilized by a farmer in bankruptcy. The courts are split on that issue.
Income tax. Tax and tax planning permeate daily life. Deferral contracts; depreciation; installment sales; like-kind exchanges; credits; losses; income averaging; reporting government payments; etc. The list could go on and on. Having a basic understanding of the rules and the opportunities available can add a lot to the bottom line of the farming or ranching operation as well as help minimize the bleeding when times are tough.
Real property. Of course, land is typically the biggest asset in terms of value for a farming and ranching operation. But, land ownership brings with it many potential legal issues. Where is the property line? How is a dispute over a boundary resolved? Who is responsible for building and maintaining a fence? What if there is an easement over part of the farm? Does an abandoned rail line create an issue? What if land is bought or sold under an installment contract? How do the like-kind exchange rules work when farmland is traded?
Estate planning. While the federal estate tax is not a concern for most people and the vast majority of farming and ranching operations, when it does apply it’s a major issue that requires planning. What are the rules governing property passage at death? Should property be gifted during life? What happens to property passage at death if there is no will? How can family conflicts be minimized post-death? Does the manner in which property is owned matter? What are the applicable tax rules? These are all important questions.
Business planning. One of the biggest issues for many farm and ranch families is how to properly structure the business so that it can be passed on to subsequent generations and remain viable economically. What’s the best entity choice? What are the options? Of course, tax planning is a critical part of the business transition process.
Cooperatives. Many ag producers are patrons of cooperatives. That relationship creates unique legal and tax issues. Of course, the tax law enacted near the end of 2017 modified an existing deduction for patrons of ag cooperatives. Those rules are very complex. What are the responsibilities of cooperative board members?
Civil liabilities. The legal issues are enormous in this category. Nuisance law; liability to trespassers and others on the property; rules governing conduct in a multitude of situations; liability for the spread of noxious weeds; liability for an employee’s on-the-job injuries; livestock trespass; and on and on the issues go. Agritourism is a very big thing for some farmers, but does it increase liability potential? Nuisance issues are also important in agriculture. It’s useful to know how the courts handle these various situations.
Criminal liabilities. This topic is not one that is often thought of, but the implications can be monstrous. Often, for a farmer or rancher or rural landowner, the possibility of criminal allegations can arise upon (sometimes) inadvertent violation of environmental laws. Even protecting livestock from predators can give rise to unexpected criminal liability. Mail fraud can also arise with respect to the participation in federal farm programs. The areas of life potentially impacted with criminal penalties are worth knowing, as well as knowing how to avoid tripping into them.
Water law. Of course, water is essential to agricultural production. Water issues vary across the country, but they tend to focus around being able to have rights to water in the time of shortage and moving the diversion point of water. Also, water quality issues are important. In essence, knowing whether a tract of land has a water right associated with it, how to acquire a water right, and the relative strength of that water rights are critical to understand.
Environmental law. It seems that agricultural and the environment are constantly in the news. The Clean Water Act, Endangered Species Act and other federal (and state) laws and regulations can have a big impact on a farming or ranching operation. Just think of the issues with the USDA’s Swampbuster rules that have arisen over the past 30-plus years. What constitutes a regulatory taking of property that requires the payment of compensation under the Constitution? It’s good to know where the lines are drawn and how to stay out of (expensive) trouble.
Regulatory law. Agriculture is a very heavily regulated industry. Animals and plants, commodities and food products are all subject to a great deal of regulation at both the federal and state level. Antitrust laws are also important to agriculture because of the highly concentrated markets that farmers buy inputs from and sell commodities into. Where are the lines drawn? How can an ag operation best position itself to negotiate the myriad of rules?
It is always encouraging to me to see students, farmers and ranchers, agribusiness and tax professionals get interested in the subject matter and see the relevance of material to their personal and business lives. Agricultural law and taxation is reality. It’s not merely academic. The Principles text is one that can be very helpful to not only those engaged in agriculture, but also for those advising agricultural producers. It’s also a great reference tool for Extension educators. It’s also a great investment for any farmer – and it’s updated twice annually to keep the reader on top of current developments that impact agriculture.
If you are interested in obtaining a copy, perhaps even as a Christmas gift, you can visit the link here: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html. Instructors that adopt the text for a course are entitled to a free copy. The book is available in print and CD versions. Also, for instructors, a complete set of Powerpoint slides is available via separate purchase. Sample exams and work problems are also available. You may also contact me directly to obtain a copy.
If you are interested in obtaining a copy, you can visit the link here: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html. You may also contact me directly.
October 12, 2020 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Tuesday, September 29, 2020
The U.S. Tax Court and the other federal courts issue numerous tax opinions throughout each year. From my perspective, many of them deal with penalties and procedure and aren’t really that instructive on matters of substantive tax law. Recently, however, the Tax Court and the Colorado federal district court have issued some opinions that are very instructive on issues that practitioners need to pay attention to and clearly understand. Clients find themselves in these issues not infrequently.
Recent court opinions of relevance to taxpayers and their practitioners – it’s the topic of today’s post.
IRS Liens and the “Nominee” Theory
The IRS has numerous “weapons” at its disposal to collect on tax debts. One of those can come into play when a taxpayer with outstanding tax obligations transfers property to a third party or entity in an attempt to sever the taxpayer’s ties to the property. If those ties are indeed severed, perhaps the property can be effectively shielded from levy and execution to pay the taxpayer’s tax bills. But, if the taxpayer retains some (or all) of the beneficial use of the property, the IRS may be able to successfully claim that the third party or entity is really the taxpayer’s “nominee.” Actual transfer of legal title to the property really doesn’t matter. See Internal Revenue Manual, Part 18.104.22.168.4 (Jan. 24, 2012).
In Cantliffe, the defendant bought residential real estate in a wealthy Denver suburb and soon thereafter transferred it to a grantor trust naming the defendant and his then-wife as beneficiaries. The defendant’s father-in-law was named as the trustee. The trust terms gave the beneficiaries the “right to participate in the management and control of the Trust Property,” and directed the Trustee to convey or otherwise deal with the title to the Trust Property. The trust terms also gave the beneficiaries the right to receive the proceeds if the property was sold, rented or mortgaged. The defendant continued to personally make the mortgage payments, and pay the property taxes and homeowner association dues. In addition, the defendant personally paid the electricity, gas and water bills for the home. The defendant claimed a deduction on his personal tax return for mortgage interest and claimed a business deduction for an office in the home. While the defendant filed personal returns for 2005-2008 and 2010, he did not pay the tax owed. The IRS assessed tax, penalties and interest against the defendant personally.
In early 2019, the IRS notified the defendant of the balance due for each tax year and recorded a notice of federal tax lien with the county for each year at issue. The IRS also issued a lien for the Trust as the defendant’s nominee. The IRS subsequently sought to enforce its liens and a judgment that the defendant was the true owner of the trust property. The court, agreeing with the IRS, noted that the defendant’s property and rights to the property may include “not only property and rights to property owned by the taxpayer but also property held by a third party if it is determined that the third party is holding the property as a nominee…of the delinquent taxpayer.” The court noted that six factors were critical in determining that the Trust held the property as the defendant’s nominee: 1) the Trust paid only ten dollars for the property; 2) the conveyance was not publicly recorded; 3) the taxpayer resided in the property and made the property’s mortgage payments and property taxes and housing association dues payments; 4) the taxpayer enjoyed benefits from the property because he claimed mortgage interest deductions related to the property; 5) the taxpayer had a close relationship with the Trust because he created it and named himself as a beneficiary; and 6) the defendant continued to enjoy the benefits of the property transferred to the Trust.
Thus, the federal tax liens against the defendant also attached to the Trust property and the IRS could seize the property in payment of the defendant’s tax debt.
No Loss Deduction on Sale of Vacation Property.
Duffy v. Comr., T.C. Memo. 2020-108
The petitioners, a married couple, bought a vacation property but became unable to pay the debt on the property. They sold the property and the bank holding the obligation agreed to accept an amount of the sale proceeds that was less than the outstanding balance as full satisfaction of the debt. The debt was nonrecourse and, as such, the amount of discharged debt was included in the petitioner’s amount realized upon sale of the property and was not CODI. The petitioners claimed a loss on sale to the extent of the basis in the property exceed the amount realized from sale. However, the Tax Court noted that because the property was converted from personal use to rental use, the basis upon conversion cannot exceed the property’s fair market value for purposes of the loss computation. The Tax Court held determined that the petitioners failed to establish the basis in the property at the time of conversion.
These types of properties are commonly referred to as “mixed-use” properties. Many vacation homes may fall into this category. I.R.C. §280A(c)(5)(B) requires a vacation home rental expense (real estate taxes and mortgage expense) allocation be made. That allocation is particularly important when the property is unoccupied for significant periods of time. The expenses are to be allocated based on the ratio of total rental days to the total number of days in the year. Bolton v. Comr., 77 T.C. 104 (1981), aff’d., 694 F.2d 556 (9th Cir. 1982); McKinney v. Comr., T.C. Memo. 1981-337, aff’d., 732 F.2d 414 (10th Cir. 1983). However, the IRS has never amended IRS Pub. 527 to reflect its loss in the Bolton and McKinney cases and still maintains that its method is the only permissible method. The IRS position, which was rejected in both cases, is that the rental portion of real estate taxes and mortgage interest is to be allocated by the ratio of total rental days to the total number of days the property was used for any purpose during the year. Prop. Treas. Reg. §1.280A-3(c). The IRS position is also not supported by legislative history. See S. Rep. No. 94-938, 94th Cong. 2d Sess., at 154.
While not at issue in the case, the Tax Cuts and Jobs Act (TCJA), could influence the tax consequences for taxpayers with mixed-use properties. The TCJA increased the standard deduction (essentially doubling it) and also limited itemized deductions for state and local taxes and home mortgage interest. These aspects of the TCJA can have an impact on the affect the vacation home rental expense allocation under Sec. 280A(c)(5)(B) between personal and rental use, particularly for a dwelling that is unused for significant periods. Generally speaking, for taxpayers that itemize deductions the judicial method may produce a better tax result in situations where more of the real estate taxes and mortgage interest are allocated to personal use. That’s because they are deducted on Schedule A where they are not disallowed by exceeding rental income, along with other, direct rental expenses. See I.R.C. §280A(c)(5)). Taxpayers in states within the Ninth and Tenth Circuits have their option of which approach to use.
No $1.4 Million NOL Carryforward
Gebman v. Comr., T.C. Memo. 2020-1
The TCJA provided that for years ending after 2017, the rule allowing the carryback of a net operating loss (NOL) was repealed, except for farm NOLs, which are carried back two years. IRC § 172(b)(1)(B)(i). Taxpayers with a fiscal year ending in 2018 were denied the NOL carryback, except the farm NOL was allowed the two-year carryback. A taxpayer can elect to forgo the two-year carryback. The election is irrevocable. IRC § 172(b)(3). Under the TCJA, NOLs generated in years beginning after 2018 were allowed in the carryover year only to the extent of 80 percent of the taxpayer’s taxable income determined without regard to the NOL deduction. The 80 percent provision also applied to the two-year farm NOL carrybacks for NOLs generated in years beginning after 2017. Post-2017 NOLs do not expire. NOLs arising in taxable years ending December 31, 2017 and earlier retained their 20-year carryover restriction. NOLs can be carried forward indefinitely.
In early 2020, in response to the economic impact of the spread of a virus from China to the United States, the Congress enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Under that legislation, a taxpayer must carryback NOLs from the 2018, 2019 and 2020 tax years to the previous five years unless the taxpayer election to waive the carryback. The CARES Act also suspends the 80 percent of taxable income limitation through the 2020 tax year. IRC § 172(a)(1). The two-year carryback provision for farmers was temporarily removed. Post-2017 NOLs will be subject to the 80 percent of taxable income limitation for years beginning in 2021 and following.
The procedure to carryforward an NOL must be followed closely. In Gebman, the petitioners, a married couple, carried forward a $1.4 million net operating loss (NOL) and deducted it against their income for the carryforward year. The IRS denied the deduction for failure to satisfy Treas. Reg. §1.172-1(c) which requires that a taxpayer claiming an NOL deduction must file with the return “a concise statement setting forth the…amount of the [NOL] deduction claimed and all material and pertinent facts relative thereto, including a detailed schedule showing the computation of the…[NOL] deduction.”
The Tax Court agreed and noted that the regulation was in accordance with the burden of establishing both the existence of the NOLs for prior years and the NOL amounts that may properly be carried forward to the tax year at issue. The Tax Court determined that the petitioners failed to satisfy this burden because they provided no detailed information supporting the NOL – both the NOLs for the prior years and the amounts that can be carried forward. The only “proof” the petitioners had was submitted copies of tax returns on which they reported the losses. The Tax Court declined to hold that submitted copies of returns was sufficient substantiation.
Good tax planning requires an astute knowledge of the Code and an awareness of how those Code provision details apply in common situations. These recent Tax Cases are good illustrations of how complex the Code can be and how traps can be avoided and favorable tax results can be obtained.
Thursday, September 24, 2020
Two recent Tax Court opinions provide good guidance on some important issues associated with S corporation concepts and the need to substantiate meals and entertainment expenses.
Two recent Tax Court opinions and planning points for practitioners and taxpayers – it’s the focus of today’s post
Ownership of S Corporate Stock
General principles. A “qualified corporation,” with the consent of all its shareholders, can elect to be treated as an S corporation for tax purposes. Once the election is made, the entity is treated as a passthrough entity for federal income tax purposes. I.R.C. §§1361-1366. That means that an S corporation, unlike a C corporation pays no federal income tax at the corporate level. Instead, a shareholder of an S corporation must report a pro rata share of the S corporation’s taxable income, losses, deductions, and credits on the shareholder’s personal return. I.R.C. §1366(a)(1)(A); Treas. Reg. § 1.1366-1(a). See also Gitlitz v. Comm’r, 531 U.S. 206 (2001), rev’g 182 F.3d 1143 (10th Cir. 1999); Maloof v. Comm’r, 456 F.3d 645, 647 (6th Cir. 2006). The treasury regulations further provide: “Ordinarily, the person who would have to include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation) is considered to be the shareholder of the corporation.” Treas. Reg. §1.1361-1(e)(1). In essence, whether a person is a shareholder on the date of the S election is determined by whether that person would have to report as personal income corporate profits as of the election date. Cabintaxi Corp. v. Comm’r, 63 F.3d 614 (7th Cir. 1995); Treas. Reg. §1.1371-1(d)(1). The answer to that question, in turn, revolves around whether the person would have been deemed a beneficial owner of the corporate shares. See, e.g., Pahl v. Comm’r, 150 F.3d 1124; Wilson v. Comm’r, 560 F.2d 687 (5th 1977). A beneficial owner is entitled to demand from the nominal owner the dividends or any other distributions of earnings on those shares. Id. Beneficial ownership of corporate stock is determined by state law. See United States v. National Bank of Commerce, 472 U.S. 713 (1985).
Nonprofit corporations. As a general rule, a nonprofit corporation is not considered to have owners. See Farrow v. Saint Francis Medical Center, 407 S.W.3d 579 (Mo. 2013). This is because members of a nonprofit corporation are barred from receiving residual earnings, assets or property from the corporation. See Hansmann, “Reforming Nonprofit Corporation Law,” 129 U. Pa. L. Rev. 497 (1981); see also Austin v. Michigan Chamber of Commerce, 494 U.S. 652 (1990).
In a recent Tax Court case, Deckard v. Comm’r, 155 T.C. No. 8 (2020), the petitioner created a nonstock, nonprofit corporation in 2012 and was named as its president and one of its three directors. However, the corporation never applied for recognition of tax-exempt status with the IRS. In late 2014, the corporation mailed Form 2553 to the IRS seeking to elect S status retroactively to its 2012 incorporation date. The petitioner signed Form 2553 in his capacity as president. He also signed the shareholder’s consent statement indicating that he was the sole owner of the corporation. The corporation filed an S corporate return (Form 1120S) for tax years 2012 and 2013 on which it reported operating losses of $277,967 and $3,239 respectively, and issued Forms K-1 for the losses that flowed through to the petitioner.
In May of 2015, the petitioner filed his personal returns for 2012 and 2013. Neither return was filed timely, and both claimed the losses that flowed through from the corporation. The IRS denied the losses on the grounds that the S-election was invalid. The IRS also claimed that the petitioner was not a corporate shareholder. On the latter point, the Tax Court noted that the petitioner was not a shareholder of record and the corporation was not authorized to issue stock. In addition, there was no evidence that any stock had been issued.
The Tax Court also pointed out that a nonprofit corporation generally does not have shareholders, is not owned by third parties and there is no interest in a nonprofit corporation that is similar to that of a for-profit corporate shareholder. The petitioner also did not possess shareholder rights, had no ownership, had no right to profits, no dissolution rights and no right to corporate assets upon dissolution. In essence, the corporation was a state law nonprofit corporation controlled by a board of directors on which the petitioner only had one vote out of three. The Tax Court also noted that he would be bound by the form of the transaction that he chose, and he chose the nonprofit corporate form. As a result, he had to accept the tax consequences that flowed from that choice. Clearly, the petitioner should have filed Form 1023 to achieve tax-exempt status for the corporation.
Meals and Entertainment
The Tax Cuts and Jobs Act (TCJA) changed the rules on deductible meals and entertainment. For farming and operations, the tax rules governing meals often come into play at harvest. An example would be for part-time workers that are employed at times of planting and harvest. These part-time employees may be fed lunches on the farm. Before 2018, meals were normally deductible to an employer at 50 percent of the cost of the meals. But, where the meals are provided on the employer’s premises (i.e., at the farm) and for the convenience of the employer, the meals are 100 percent deductible by the employer and the employees do not have to report any of the amount of the meals as income. The 100 percent deduction is because farm workers generally work in remote areas where eating facilities are not near, and the farm employer finds it a more productive use of time to supply meals at the farm.
Under the TCJA, the 50 percent rule still generally applies to allow an employer to deduct 50 percent of the (non-extravagant) food and beverage expenses associated with operating the business (e.g., meals consumed by employees on work travel). I.R.C. §274(k). But, for amounts incurred and paid after Dec. 31, 2017, and until Dec. 31, 2025, the TCJA expands the 50% limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer. I.R.C. §274(n)(1). That means that the 100 percent deduction for the meals provided the part-time farm employees in the above example is reduced to 50 percent. The 50 percent limitation remains in place through 2025 for meals (food and beverages) that aren’t “lavish or extravagant” and the taxpayer or employee of the taxpayer is present when the meal is furnished. I.R.C. §274(k)(2). Of course, the 50 percent cut-down can be avoided by treating the food and beverages as compensation to the employee (i.e., wages for withholding purposes).
After 2025, none of the cost of meals is deductible.
Through 2017, deductions for entertainment were generally disallowed unless they were directly related to the taxpayer’s business or directly preceded or followed a substantial bona fide business discussion. In those instances, entertainment expenses were deductible at the 50 percent level. Under the TCJA, effective for tax years after 2017, no deduction is allowed for any activity that is generally considered to be entertainment, amusement, or recreation that is purchased as a business expense. Likewise, no deduction is allowed for membership dues for any club organized for business, pleasure, recreation, or other social purposes. Similarly, no deduction is allowed associated with a facility or portion thereof used in connection with the provision of entertainment, amusement or recreation.
Recent case. A recent Tax Court case illustrates the necessity of carefully substantiating meal and entertainment expenses. In Franklin v. Comr., T.C. Memo. 2020-127, the petitioner claimed deductions for meal and entertainment costs and travel expenses. The IRS denied the deductions for lack of substantiation and the Tax Court agreed. The Tax Court concluded that the petitioner failed to provide credible evidence that the expenses were incurred in the operation of his trade or business as I.R.C. §274(d) requires. The Tax Court also held that the petitioner couldn’t claim a deductible loss associated with loans he made to a real estate development company, as well as a loss on computer software that he used in his real estate consulting business.
As for the meal and travel costs, I.R.C. §274(d) disallows a deduction unless the taxpayer has substantiating records concerning the amount, time, place and business purpose for each expenditure. Those records must be contemporaneously made. While that doesn’t mean that a log must be created when the expenditure is incurred, it does mean that records created after-the-fact must be able to be reconstructed in a credible manner so that they are essentially the same as a contemporaneous log. In addition, if business and personal travel is combined, the taxpayer must prove what the primary purpose of the trip is. The Tax Court determined that neither the petitioner’s travel log nor testimony were credible. For example, he created his travel logs created after IRS notified him that he was under audit. That disqualified them as “adequate records” under I.R.C. §274(d). He also failed to establish the business purpose for his travel by distinguishing personal aspects of the travel.
As for the computer property, the Tax Court held that an associated loss wasn’t deductible because the petitioner couldn’t establish his basis in the property. For the loans, the petitioner couldn’t establish that the debt had become worthless. Under I.R.C. §166(a)(1), a deduction is allowed for any debt that becomes wholly worthless within the tax year. Worthlessness is a fact-based determination. Worthlessness cannot be established is the collateral that secures the debt has value. These points doomed the taxpayer’s attempted deduction.
These recent Tax Court cases provide some very good teaching points on some common issues. It’s always best to learn from the mistakes of others rather than learning tough lessons first-hand.
Monday, September 7, 2020
The rules surrounding the limitation on deducting business interest have changed significantly for tax years beginning after 2017. They were modified again earlier this year as part of one of the relief packages designed to deal with the 2020 self-inflicted recession related to the virus that originated in China and ultimately spread to the United States. Guidance was then provided about the ability of some taxpayers to elect out of the limitation and making late elections. Final and proposed regulations have also been issued as well as Frequently Asked Questions (FAQs) for determining a taxpayer’s gross receipts for purposes of the small business exception to the limitation.
The rules on deducting business interest – it’s the topic of today’s post.
The deduction limitation. The Tax Cuts and Jobs Act (TCJA) specified that, for tax years beginning after 2017, deductible business interest expense is limited to business interest income for the tax year plus 30 percent of the taxpayer’s adjusted taxable income (ATI) for the tax year that is not less than zero. I.R.C. §163(j). Not relevant to farmer and ranchers, “floor plan financing interest,” is fully deductible. That’s a “biggie” for automobile dealers.
Definitions. Business interest is defined as the amount of interest paid or accrued on indebtedness that is included in the taxpayer’s gross income for the tax year that is properly allocable to a trade or business. It does not include investment income within the meaning of I.R.C. §163(d). Defining a trade or business for purposes of the determining business interest is based on the passive loss rules of I.R.C. §469. I.R.C. §163(j) excludes I.R.C. §163(d) interest, which excludes trade or business interest as defined by the passive loss rules. I.R.C. §163(j)(5).
ATI is defined as the taxpayer’s taxable income computed without regard to any item of income, gain, deduction or loss that is not properly allocable to a trade or business; any business interest expense or business interest income; any NOL deduction and any I.R.C. §199A deduction, and (for tax years beginning before 2022) any deduction allowable for depreciation, amortization, or depletion.
Carryover. Any disallowed amount is treated as business interest paid or accrued in the succeeding tax year. I.R.C. §163(j)(2); Notice 2018-28. A taxpayer is to use Form 8990 to calculate and report the deduction and the amount of disallowed business interest expense to carry forward to the next tax year.
“Small business” exception. A “small business,” defined as a business entitled to use cash accounting (i.e., average gross receipts do not exceed $25 million (inflation-adjusted) for the three tax-year period ending with the tax year that precedes the tax year at issue) are not subject to the limitation. I.R.C. §163(j)(3). Thus, if average gross receipts are $25 million or less, there is no change in the rules concerning the deductibility of interest – business interest remains fully deductible. The threshold for being able to utilize cash accounting is, for 2020, set at average gross revenue not exceeding $26 million.
Gross receipts are defined as gross sales; investment income (regardless of whether it is earned in a business); and all amount received for services. Treas. Reg. §1.448-1T. The test applies to the taxpayer rather than the business. In addition, the receipts of all persons that are treated a single employer under I.R.C. §52(a) or (b) (businesses that are under common control) or I.R.C. §414(m) or (o) (employees of an affiliated service group) are aggregated. Id.
The threshold test applies to the taxpayer rather than the business. That has particular implications for partnerships. For a partnership, the business interest limitation applies at the partnership level. Thus, a partnership treats its business interest as a non-separately computed deduction for purposes of I.R.C. §702. Any business interest deduction that is allowed after being limited (if necessary) is combined with other non-separate deductions and income and passed through to the partners as ordinary income or loss. I.R.C. §163(j)(4)(i). Thus, each partner’s ATI is determined without regard to the partner’s distributive share of any of the partnership’s items of income, gain, deduction, or loss. Stated another way, a partner’s ATI is tied to the partner’s non-partnership income and the partner’s share of any excess taxable income of the partnership. I.R.C. §163(j)(4)(ii). Comparable rules apply to S corporations and their shareholders. I.R.C. §163(j)(4)(D).
Election out of the limitation. Two types of businesses can make an irrevocable election to avoid the limitation on interest deductibility – a “real property trade or business” and a “farming business.” For this purpose, a cash rent landlord is not engaged in a farming business. An “electing farm business” that is barred from using cash accounting because gross revenue exceeds the threshold can elect to not be subject to the limitation on the deductibility of interest. For this purpose, a “farm business” is defined as the trade or business of farming, including the trade or business of operating a nursery or sod farm, or the raising or harvesting of trees bearing fruit, nuts or other crops, or ornamental trees. An evergreen tree which is more than six years old at the time that it is severed from the roots is not treated as an ornamental tree. I.R.C. §263A(e)(4).
In return, such farm business must use the alternative depreciation system (ADS) on purchases of farm property with a recovery period of 10 years or more. The use of ADS will result in the inability to take bonus depreciation on otherwise eligible assets (in accordance with I.R.C. §263A). Also, the required switch to ADS for the taxpayer’s existing property is not a change in accounting method. It’s just a change in use. See Rev. Proc. 2019-8, 2019-3 I.R.B.
Treas. Reg. §1.168(i)-4(d) specifies that when a business switches to a longer ADS life as the result of a change in use, the depreciation deductions beginning with the year of the change are determined as though the taxpayer originally placed the property in service with the longer recovery period and/or the slower depreciation method. Then, the business uses the asset’s remaining basis and depreciates it via the straight-line method over the asset’s remaining life as if it had originally been placed in service with the ADS life. See Treas. Reg. §1.168(i)-4(d)(6), Example 3.
CARES Act Changes
The Coronavirus Aid, Relief, and Economic Security (CARES) Act enacted in late March of 2020 allows a business with gross receipts over $26 million (for 2020) to elect to increase the limitation on the deduction of interest from 30 percent of ATI to 50 percent of ATI for tax years beginning in 2019 and 2020. A business may elect to use 2019 ATI in calculating the 2020 limitation. If an election is made to compute the limitation using 2019 ATI for a tax year that is a short tax year, the ATI for the taxpayer’s last tax year beginning in 2019 which is substituted under the election will be equal to the amount which bears the same ratio to the ATI as the number of months in the short taxable year bears to 12. A taxpayer may elect out of the increase for any tax year beginning in 2019 or 2020. It is an irrevocable election unless IRS consents to a revocation.
IRS Guidance. In Rev. Proc. 2020-22, 2020-18 I.R.B., the IRS set forth the rules for making a late election or withdrawing an election for real property trades or businesses and farming businesses. The IRS, in the Rev. Proc, also provided guidance concerning the following:
- The time and manner for electing out of the 50 percent of ATI limitation for tax years beginning in 2019 and 2020;
- Using the taxpayer’s ATI for the last tax year beginning in 2019 to calculate the taxpayer’s limitation for tax year 2020; and
- Electing out of deducting 50 percent of excess business interest expense for tax years beginning in 2020 without limitation.
A farming business that previously elected not to have the interest limitation apply, can either make a late election or elect out of the election that was previously made. This provides flexibility and may allow the use of bonus depreciation on assets with a 10-year or longer life and MACRS depreciation.
The 50 percent of ATI limitation does not apply to partnerships for taxable years beginning in 2019. Rather, a partner treats 50 percent of the partner’s allocable share of the partnership’s excess business interest expense for 2019 as an interest deduction in the partner’s first taxable year beginning in 2020 without limitation. The remaining 50 percent of excess business interest from 2019 is subject to the ATI limitation as it is carried forward at the partner level. Effective for tax years beginning after 2018, a partner may elect out of the 50% limitation.
Regulations. In late July of 2020, the IRS issued final and proposed regulations that detail how to calculate the interest expense limitation, what constitutes “interest” for purposes of the limitation, the taxpayers that are subject to the limitation, and how the limitation applies to partnerships (among other types of taxpayers). T.D. 9505. In large part, the final regulations mirror the 2018 proposed regulations. However, while the proposed regulations provided a broad definition of “business interest,” the final regulations are narrower. The regulations are generally applicable to tax years beginning on or after November 13, 2020.
The proposed regulations issued along with the final regulations address the allocation of interest expense for passthrough entities, and propose a modification to the definition of a real property trade or business under I.R.C. §163(j)(7)(B).
FAQs. The IRS has also posted FAQs on it website concerning the aggregation rules that apply for purposes of the gross receipts threshold. https://www.irs.gov/newsroom/faqs-regarding-the-aggregation-rules-under-section-448c2-that-apply-to-the-section-163j-small-business-exemption#footnote-1
The typical farm and ranch business will have little business interest income unless sales are financed. However, livestock feedlots follow a highly leveraged business model with characteristically high levels of business interest income and expense. The substantial majority of farming/ranching businesses will be able to elect out of the limitation and fully deduct business interest. But the election out comes at a price. Once again, sage tax and legal counsel is a must.
Sunday, August 30, 2020
The Tax Code contains two significant provisions allowing farmers to derive a tax benefit from exporting ag products. One incentive is derived from the creation of an entity known as the Interest Charge Domestic International Sales Corporation (IC-DISC). An IC-DISC is a tax-exempt entity that was authorized by the Congress in 1971 to provide a tax incentive to help address the U.S. trade deficit at the time. It was restructured in 1984 into its present form. The Tax Cuts and Jobs Act (TCJA) added another export tax incentive that can also be available to agricultural producers – the Foreign-Derived Intangible Income (FDII) deduction. I.R.C. §250.
The IC-DISC, the FDII deduction and potential tax benefits for farmers and ranchers – it’s the topic of today’s post.
An IC-DISC allows a farmer that will be selling into an export market to essentially transfer income from the farmer to the tax-exempt IC-DISC via an export sales commission. An IC-DISC can be formed and utilized by any taxpayer that manufactures, produces, grows or extracts (MPGE) property in the U.S. that is held primarily for sale, lease or rental in the ordinary course of the taxpayer’s trade or business. That definition certainly includes farmers. The property to be exported is transferred to the IC-DISC which then sells the assets into an export market.
An IC-DISC has as its statutory basis I.R.C. §§991-997. It is a corporate entity (not an S corporation) that is separate from the producer, manufacturer, reseller or exporter. To meet the statutory definition of an IC-DISC, the entity must have 95 percent or more of its gross receipts consist of qualified export receipts, and the adjusted basis of the qualified export assets of the IC-DISC at the close of the tax year must equal or exceed 95 percent of the sum of the adjusted basis of all of the IC-DISC assets at the close of the tax year. Also, the IC-DISC cannot have more than a single class of stock and the par (stated value) of the outstanding stock must be at least $2,500 on each day of the tax year. In addition, the corporation must make an election to be treated as an IC-DISC for the tax year. I.R.C. §992(a)(1).
Properly structured, an IC-DISC is exempt from federal income tax under I.R.C. §991, and any dividends (actual and deemed) paid-out are qualified dividends that are taxed at a more favorable long-term capital gain rate by converting ordinary income from sales to foreign unrelated parties. I.R.C. §995(b)(1).
“Destination test.” As noted above, the property at issue must be held for sale, lease or rental in the ordinary course of the taxpayer’s trade or business for direct use, consumption or disposition outside of the U.S. This is known as the “destination test.” This test is satisfied if the IC-DISC delivers property to a carrier or a party that forwards freight for foreign delivery. It doesn’t matter when title passes or who the purchaser is or whether the property (goods) will be used or resold. The test is also met if the IC-DISC sells the property to an unrelated party for U.S. delivery with no additional sale, use assembly or processing in the U.S. and the property is delivered outside the U.S. within a year after the IC-DISC’s sale. Likewise, the “destination test” is satisfied if the sale of the property is to an unrelated IC-DISC for the same purpose of direct use, consumption or disposition outside the U.S.
The “destination test,” at least in the realm of agricultural products, has been made easier to satisfy with the advent of rules that require food tracing. This is particularly the case with fruits and vegetables. Growers can trace their products to grocery stores and other end-use foreign destinations. The same is true for grain producers that deliver crops to export elevators. They will likely be able to get the necessary documents showing the precise export location of their grain products.
IC-DISC income. The producer, manufacturer, reseller or exporter pays the IC-DISC a commission based on the amount of export sales for the year. See Treas. Reg. §1.993-6(e)(1). The commission paid to the IC-DISC (as a tax-exempt entity) is deductible and, as such, reduces the exporter’s taxable income by the marginal tax rate of the commission amount. As noted, the commission is tied to the exporter’s foreign sales or foreign taxable income for the tax year, and cannot exceed either 50 percent of net income on sales of qualified export property or four percent of gross receipts from sales from sales of qualified export property. I.R.C. §994(a). Both computations can be used on the same return if there are multiple transactions and grouping of transactions are allowed. Treas. Reg. §1.994-1(c)(7). Thus, the taxpayer can tailor the computational method and groupings to maximize the tax benefit of the IC-DISC.
The IC-DISC does not pay tax on the export sales because of its tax-exempt status.
The IC-DISC distributes its profits as qualified dividends to its shareholders. Qualified dividends are taxed at preferential capital gain rates – presently anywhere from zero to 20 percent for an active farmer.
Income deferral. Instead of paying tax currently in the form of a qualified dividend, the IC-DISC can also provide income deferral. Deferral is achieved by having each IC-DISC shareholder pay interest in an amount tied to the deferred tax liability associated with the IC-DISC times the base period T-bill rate. Each shareholder does their own computation. Thus, the ultimate tax liability of a shareholder will be determined by that particular shareholder’s marginal tax rate. Tax can be deferred on commissions on up to $10 million per year in export sales that the IC-DISC conducts.
The FDII allows a domestic C corporation that sells into foreign markets to claim a deduction for those sales in the amount of 37.5 percent of foreign-derived intangible income. The actual computation of the deduction is quite complex. See I.R.C. §§250(a)(1)-(2). With the C corporate rate currently §set at 21 percent, the FDII effectively reduces that rate to 13.125 percent through 2025. Income qualified for the FDII deduction is that derived from the sales of property or inventory to foreign persons and for foreign use (including any lease, license, exchange or other disposition), and income derived from services to any foreign person or income from providing services with respect to property not located in the U.S.
Under proposed regulations, a business is to exclude from qualifying sales any products that are sold to a foreign customer that the taxpayer has reason to know would ultimately return to the U.S. for domestic use. But, recently promulgated final regulations that are effective for tax years beginning on or after January 1, 2021 remove this limitation. The final regulations also ease up on the documentation requirements concerning foreign use of property. While specific ordering rules apply under the proposed regulations when applying the interest limitation of I.R.C. §163(j), the final regulations specify that any reasonable method can be used to order allowed deductions. Other rules can apply when the property sold is later incorporated into another finished product, and when related parties are involved.
Is the IC-DISC Better Than the FDII Deduction?
Which tax incentive is better depends on the taxpayer and the type of export income. The IC-DISC applies to goods that are produced in the U.S. from U.S. materials. Agricultural commodities meet that requirement. There is no comparable requirement for the FDII deduction – there just has to be a sale of property to a foreign person for a foreign use. While that can be an important distinction for many businesses, it is largely immaterial for ag businesses. The FDII deduction also applies to a much broader range of service income than does the IC-DISC. Again, however, that distinction is not a material one for most ag production operations. Also, while a distributor can be used to sell ag products in the IC-DISC context, a taxpayer that sells U.S. MPGE products to a distributor who then exports the products cannot claim and FDII deduction. Only direct sales count. See I.R.C. §250(b)(4).
The IC-DISC and the FDII deduction are designed to incentivize export sales. Both provisions may be unheard of by many farmers and practitioners. However, they can play a role in the overall income tax planning and business structuring process. As part of an estate plan, if the IC-DISC shareholders are the younger members of the family, value can be transferred to them without triggering federal transfer taxes. In addition, the IC-DISC shareholders don’t have to be involved in the farm business – they don’t have to be engaged in manufacturing, production growing, exporting or reselling. Thus, off-farm heirs can be set-up as IC-DISC shareholders and receive at least a portion of their anticipated inheritance in that manner without being engaged in the farming operation. That will please the on-farm heirs (and, likely, the parents).
The FDII deduction is only available to C corporate taxpayers, but there are no entity formation, operational and administrative costs associated with it as there are with the IC-DISC.
Both provisions are complex and require competent tax and legal assistance to maximize their potential benefits.
Monday, August 24, 2020
The cases and rulings involving agriculture keep on coming. In today’s post, I pick out just a few involving some rather common issues.
Ag law in the courts – it’s the topic of today’s post.
Railroad Responsible For Faulty Railroad Fence
Leslie v. BNSF Railway. Co., No. Civ. 1:16-cv-1208-JCH-JHR, 2019 U.S. Dist. LEXIS 154460 (D. N.M. Sept. 10, 2019)
Railroads are responsible for building and maintaining railroad fences. But, the nuances of each state’s fence law involving railroads can cause some interesting arguments. In a New Mexico case last year, the court was faced with addressing a previously unanswered application of the state fence law as applied to a railroad.
The plaintiffs collided with a cow on a public highway. The defendant was responsible for building and maintaining the adjacent fence along a ranch that it had a right-of-way through. The plaintiffs alleged that the railroad company negligently maintained the fence, which allowed a cow to escape onto the highway. The defendant claimed that it did not own the cow that escaped, and that the plaintiff’s theory for recovery hinged on the defendant first being found liable in an action against the owner of the livestock. The defendant removed the action from New Mexico state court to federal court and sought a judgment with respect to both of the plaintiffs’ negligence claims.
The court interpreted the New Mexico legislature’s intent of whether the plaintiffs were a protected class under the state’s fence law and determined that the plaintiff failed to establish a negligence per se claim requiring railroads to build fence lines. The purpose of the railroad fencing portion of the fence law, the court determined, was to protect owners of livestock rather than the motoring public. The plaintiffs’ second claim was that the defendant was per se negligent by permitting the cow to wander upon the road. The statute at issue stated that it was unlawful for “any person” to “negligently permit” livestock to wander upon any unfenced highway. The defendant argued that the term “permit” required that the negligence of the owner of the livestock must be established before liability would attach. Although the court determined that the phrase “any person” had not been construed to mean persons other than owners of livestock, it concluded that the New Mexico legislature had limited the application of similar statutes and failed to do so in this instance. According to the court, the failure to limit the statute by the state legislature meant the statute was intended to be interpreted broadly in order to protect a broader class of people. The court held that the plaintiffs had established themselves as members of the class sought to be protected by the fence law and that the defendant had permitted the cow to wander on the road. Upon further consideration, the plaintiff must establish whether the defendant had negligently permitted the cow to wander upon the road.
Paying Principal Amount Within Redemption Period is Insufficient to Redeem Property
When farmland is foreclosed upon, the owner is given a period of time to redeem the property by paying the price the property brought at the foreclosure sale plus costs. But details matter. In this case, the plaintiff purchased one of two parcels of land at a foreclosure action and another business purchased the other parcel. Under state (Iowa) law, the buyers took the property subject to the prior owner’s one-year right of redemption from the date of the sale. The prior owner assigned its redemption rights to the defendant 364 days after the foreclosure sale. The next day (the final day of the redemption period) the defendant tendered a check to the county court clerk for the principal amount of the two foreclosure bids and received a receipt from the clerk showing a “balance due” of zero.
Two days later, the plaintiff applied for a hearing on the redemption issue to refund the defendant’s check and sought a finding that no redemption had occurred because the amount tendered by the defendant did not include interest and fees. The defendant claimed that the court clerk would not tell him the exact amount that was necessary to redeem both properties upon his asking. The defendant further claimed that the clerk withheld the amount from him, and that he had acted in good faith in trying to redeem the properties by paying the full principal amount (well over $1 million). The trial court found that the defendant failed to inquire with either the bank or the bank’s attorney what the amount due for redemption would be. Additionally, the trial court held that the county clerk had no duty to the defendant to determine the redemption amount. On appeal, the defendant claimed that the trial court erred in not granting him equitable relief, and that he paid a sufficient amount to redeem at least one of the properties. The appellate court affirmed, holding that the mistake in calculating the payoff amount was the defendant’s sole fault. Further, the appellate court noted the defendant could have taken advantage of a safe harbor provision, as the redemption period was about to expire, but failed to do so. As for the defendant’s claim of partial redemption for having tendered an amount exceeding the redemption price of either property, the appellate court held that in order to redeem one tract required the defendant to specify which parcel was being redeemed. The appellate court held that an insufficient payment for redemption of two properties alone cannot result in an after-the-fact redemption of one of the properties.
A Prescriptive Easement May Be Created Over a Ditch or Waterway
Easement issues are frequently encountered with respect to agricultural properties. But, is an access easement restricted to land, or can it apply to water access? That was the issue involved in this case.
Here, the parties owned adjoining tracts that they used for duck hunting. The plaintiff sought a declaratory judgment against the defendant, claiming that the plaintiff had the right to control the use of a ditch that the defendant had been using to gain access to the plaintiff’s land. The plaintiff had built a bridge to block the defendant’s path to their property, and in years past had obstructed the defendant’s path on separate occasions. The plaintiff claimed that the defendant merely had permissive use of the ditch, but the defendant sought a prescriptive easement over the ditch and a road that ran parallel to the ditch. The defendant would use the road to gain access to the land during dry periods and travel by boat in the ditch during times where the road was underwater. The trial court held that the defendant was able to establish an easement by prescription over the ditch by establishing that a preponderance of the evidence showed that the use of the ditch was adverse to the plaintiff and under a claim of right for the seven-year statutory period. On appeal, the appellate court noted that under Arkansas law, any vehicle needed for the operation of the easement could be driven across the servient estate. A boat could be used to access the easement therefore a prescriptive easement could be created over a ditch or waterway. The plaintiff also argued on appeal that the defendant failed to prove the necessary elements of a prescriptive easement. The plaintiff argued that the use of the ditch was not continuous or uninterrupted for the required statutory period because the ditch was not always flooded. The appellate court, however, held that mere temporary absences of a claimant do not interrupt the “continuous” requirement for a prescriptive easement. Also, the plaintiff’s attempts to obstruct the defendant’s use of the ditch occurred after the defendant had met the statutory requirement for establishing a prescriptive easement. Finally, the appellate court noted that the trial court’s decision to not limit the prescriptive easement for the ditch to a shorter route was not in error as it created no additional burden to the plaintiff landowner.
Lack of Proof for Ag Sales Tax Exemption
Arkansas Dept. of Rev. Legal Counsel Op. No. 20200527 (Jul. 21, 2020)
In many states, personal property used in farming is exempt from sales tax. That is the case, for example, in Arkansas. But, it is important to be able to certify that the buyer is engaged in the trade or business of farming and that the item(s) purchased will be used in farming. Under many state provisions, to be exempt the item(s) purchased must be used directly in farm production activities. Indirect uses, such as an all-terrain vehicle used to spray weeds on the farm, don’t qualify.
Under the Arkansas procedure, a farmer provides a “Farm Exemption Certificate” to a seller so that the seller knows whether the sale of an item is exempt from sales tax because the buyer was engaged in farming and the item purchased would be used directly and exclusively in farming. Here, the question was whether livestock shade systems and mower covers qualified for the exemption. Based on the facts presented, it was determined that the taxpayer (seller) did not provide sufficient facts concerning any specific sale or transaction for a determination of exemption to be made. However, the seller could rely on the buyer’s Certificate and could accept a certification or other information from the buyer to establish that the sale was exempt. Alternatively, the taxpayer could accept a certification or other information that the buyer provided to establish that the sale was exempt. Such, other information could include the buyer certifying in writing on a copy of the invoice or sales ticket that the taxpayer would retain stating that the buyer was a farmer and that the items would be used exclusively and directly in farming as a business.
More Problems with Donated Permanent Conservation Easements
Belair Woods, LLC v. Comr., T.C. Memo. 2020-112 ; Cottonwood Place, LLC, et al. v. Comr., T.C. Memo. 2020-115
The Tax Court continues to render decisions involving claimed charitable deductions for the donation of “permanent” conservation easements. At the National Farm Income Tax/Estate and Business Planning Conference last month in Deadwood, SD, U.S. Tax Court Judge Elizabeth Paris stated that many cases remain in the Tax Court’s pipeline yet to decide. That vast majority of the decision so far have been decided in favor of the IRS. Don’t expect that trend to change.
I.R.C. §170(h)(5)(A) requires that an easement donated to a qualified organization to be “protected in perpetuity.” Treas. Reg. §1.170A-14(g)(6) requires that the easement grant must, upon extinguishment, result in the charity receiving a proportionate part of the proceeds when the property subject to the easement is sold. In Belair Woods, however, the deed language did not provide the charity with a proportionate part of the gross sales proceeds. Instead, it specified that the charity would receive the extinguishment proceeds reduced by any increase in value related to improvements that the donor had placed on the property. The deed language also required a reduction in the proceeds going to the charity by an amount paid to satisfy any and all prior claims regardless of whether a claim arose from the donor’s conduct.
The Tax Court strictly construed the regulation and denied a charitable deduction for the donation because the grantee was not in all cases absolutely entitled to a proportionate share of the proceeds upon extinguishment sale of the property. As such, the contribution was not protected in perpetuity. The Tax Court noted that the improvements were part of the donation rather than the donation being restricted just to the underlying land. The rights to construct improvements were restricted in meaningful ways by the easement, and also enhanced the property’s value. The petitioner also claimed that the IRS had accepted deed terms comparable to the petitioner’s deed via a stipulation in a case involving a different petitioner and, as such, should be estopped from disallowing the petitioner’s deduction. The Tax Court determined that the petitioner had failed to satisfy its burden in establishing that judicial estoppel should apply because the IRS position in the other case was merely a tactical stipulation and the case was settled.
In Cottonwood Place, LLC, the petitioner donated a conservation easement on land to a land trust (qualified charity), reserving the right to construct limited improvements in the area subject to the easement. The Tax Court determined that no charitable deduction was allowed because the deed language didn’t entitle the charity to a proportionate share of any easement extinguishment proceeds if a court were to extinguish the easement and order the property sold. Thus, the language violated Treas. Reg. §1.170A-14(g)(6). The Tax Court noted that the deed language specified that the charity’s share of such proceeds would be reduced by the value of improvements added to the property after the easement donation. The Tax Court rejected the petitioner’s substantial compliance argument.
As you can see, issues involving agricultural land and agricultural producers are prevalent. Good legal and tax counsel is a must. That’s what we are training at Washburn Law School in the Rural Law Program. This week we welcome new students to the program from state across the country!
Wednesday, August 12, 2020
The acquisition of a farm or changes in the farming business may lead to the need demolish existing buildings and structures. Also, the recent major wind and rainstorm that stretched from Nebraska to Indiana 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 – 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 no remaining basis and only the cost of demolition would be added to the land’s basis.
Demolition After Casualty
As noted above, the inland hurricane that pelted parts of Iowa and Illinois with sustained winds near 100 miles-per-hour that ultimately traveled nearly 800 miles in 14 hours, 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 that 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. 1998), aff’g., No. 1:CV-97-0676, 1998 U.S. Dist. LEXIS 5582 (M.D. Pa. Mar. 27, 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 wreaked havoc on a great deal of agricultural assets that were in its path. The tax rules surrounding the disposition of disaffected assets are important to understand.
Monday, August 10, 2020
Wild game “farms” are big business in the United States. In Texas alone, in excess of four million acres are devoted to wild game farming activities. Interest continues to grow in such activities such as the raising of captive deer, for example, often as a result of the possibility of greater profitability on fewer acres than is presently possible with raising cattle. But, how does the IRS view such activities? Is it a “farm” for purposes of tax Code provisions that provide special tax status to “farm” businesses?
The tax treatment of wild game activities – it’s the topic of today’s post.
Definition of “Farming”
I.R.C. § 464(e) broadly defines “farming” to include the feeding, caring for and management of animals. In addition, Treas. Reg. §1.61–4(d) defines “farm” as including stock farms and ranches owned and operated by a corporation. For purposes of the deduction for soil and water conservation expenses, I.R.C. §175(c)(2) defines “land used in farming” to include land used for the sustenance of livestock. Under the uniform capitalization rules, the term “farming business” includes a trade or business involving the raising, feeding, caring for, and management of animals. Treas. Reg. §1.263A–4T(c)(4)(i)(A). For purposes of ag labor I.R.C. §3121(g)(1) includes within the meaning of “agricultural labor,” service connected with raising wildlife. Taken together, these provisions are broad enough to classify the raising of exotic and wild game as a farm. Likewise, the tax Code defines an exotic game rancher as a “farmer.” Work on an exotic game ranch meets the definition as agricultural labor.
1996 IRS Technical Advice
In Tech. Adv. Memo. 9615001 (Oct. 17, 1995) involved a taxpayer (an S corporation) that maintained a hunting property where deer were raised and managed for ultimate “harvest” by hunters who paid to come onto the property to hunt. It was a “trophy deer” operation. The taxpayer operated the activity such that each animal attained a body weight and antler size far exceeding that occurring naturally among deer of the same species. The deer were enclosed behind a game fence and all native deer on the enclosed property were then hunted and killed. The taxpayer bought whitetail deer from various locations in the United States, and brought them to the property where they were tagged, medically examined and treated as necessary. The deer were then released into the enclosed property. The taxpayer hired a genetic and nutritional consultant to help assure the economic success of the activity and to structure it as a research project to that it was in compliance with state law. The state exercised substantial control over the activity, deeming the deer to be the state’s natural resources that could only be harvested by hunting. The taxpayer culled the deer herd with hunts by paying hunters. The taxpayer sought a private letter ruling which addressed the question of whether the taxpayer was a “farmer” operating a “farm for profit.”
The IRS, in answering that question, noted that Treas. Reg. §1.162-12 does not define the terms “farmer,” “farms” or the “business of farming.” But, the IRS referenced the Code sections discussed above and that I.R.C. §1231 property (characterizing gain or loss realized on the disposition of certain business property) includes livestock held by the taxpayer for draft, dairy or sporting purposes. I.R.C. §1231(b)(3). That’s virtually any mammal held for breeding or sporting purposes.
Also, the IRS noted that Treas. Reg. §1.1231-2(a)(3) provides that for purposes of I.R.C. §1231, the term “livestock” is given a broad, rather than a narrow, interpretation and includes cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals. It does not include poultry, chickens, turkeys, geese, pigeons, other birds, fish, frogs, reptiles, etc. When defining the term “gross income of farmers” the term “farm” includes stock, dairy, poultry, fruit and truck farms, as well as plantations, ranches and all other land used for farming operations. Treas. Reg. 1.61-4(d). The IRS also pointed out that “agricultural labor” includes services in connection with raising wildlife. I.R.C. §3121(g)(1).
Thus, the Code and Regulations broadly classified deer as “livestock,” a deer ranch as a “farm,” a deer rancher as a “farmer” and work on a deer ranch as agricultural labor. Likewise, the taxpayer’s activities involving the importing, breeding, raising, feeding, protecting and harvesting the captive deer involved the operation of a farm by a farmer similar to the production of more conventional livestock such as cattle and hogs. The Code makes no distinction as to the type of livestock or the method of harvest. What is key are the activities the taxpayer engaged in to produce stock of marketable size and quantity.
Thus, the IRS concluded that the taxpayer was engaged in the business of farming for purposes of Treas. Reg. §1.162-12 (deducting from gross income all amounts expended in carrying on the business of farming) if the activities were engaged in for profit.
What is the appropriate depreciable recovery period of exotic game animals, including domesticated deer under the Modified Accelerated Cost Recovery System (MACRS)? Under MACRS, cattle, sheep and goats have a five-year recovery period. Rev. Proc. 87-56, 1987-2 C.B. 647. Breeding hogs are three-year property. Id. Under Rev. Proc. 87-56, 1987-2 C.B. 647, any property that is not described in an asset class or used in a described activity defaults to the seven-year classification under MACRS (12 years for alternative MACRS). Rev. Proc. 87-56, 1987-2 C.B. 647 does not mention exotic game animals, thus the animals would be classified as seven-year property. But, as “farm animals” and, thus, a depreciable asset used in farming, a plausible argument can be made that while they would have a recovery period of seven years, their alternative live would be ten years (rather than twelve). Also, because there is no requirement for depreciation purposes that animals be domesticated, an argument could also be made that a five-year recovery period applies for certain types of exotic sheep and goats. Indeed, perhaps all ruminant exotic game animals could be classified as five-year MACRS property on the basis that the livestock species in the five-year category are ruminant animals – cattle, sheep and goats. Hogs and horses, non-ruminant animals, have different recovery periods than cattle, sheep and goats.
Because the activity is classified as a farming activity, the fencing used in exotic game (including captive deer) activities would be an agricultural asset and classified as seven-year MACRS property. In addition, as livestock that are tangible personal property, the game animals would qualify for expense method depreciation. I.R.C. §179. The same is true for qualifying costs of game fences and catch pens.
A question that the TAM lest unanswered is whether the hunters’ activity would meet the definition of “hunting” for tax purposes. That could have implications for the meal and entertainment rules as well as deducting travel and lodging costs.
With the increase in non-traditional uses of agricultural land, the questions of whether the use of the land is a “farming activity” and the assets involved are “farming” assets has become an important question.
Sunday, July 12, 2020
The tax Code often requires a taxpayer to materially participate in a farm business activity as a pre-requisite to receiving a tax benefit. This is not an issue if the taxpayer is directly involved in the farming activity. However, many farming activities are conducted by a tenant. In those situations, can the landlord receive the tax benefit or benefits that might be available? The answer is that it “depends.” What it depends upon is the particular Code section involved and whether the conduct of the tenant can be imputed to the landlord for tax purposes.
The issue of imputation and the tax Code – it’s the topic of today’s post.
A Bit of History
In Hoffman v. Gardner, 369 F.2d 837 (8th Cir. 1966), the court acknowledged the role of an agent in meeting the material participation requirement. The plaintiff grew up on a farm in south-central Iowa. After graduating college in 1913, he got married in 1914 and took a teaching job in Iowa almost two hours from where he grew up. That same year he bought two farms in the Iowa county where he was from. Two years later he moved to the St. Louis area where he continued to teach school for the next 40 years. He and his brother-in-law managed the farms by keeping in touch with the tenants. The brother-in-law lived near the farms. He compensated his brother-in-law with a percentage of the farms’ income. In 1957, a year after retiring from school teaching, the plaintiff entered into agreements with the tenants that gave him complete managerial control, subject only to the right of the tenants to make suggestions. The agreements specified that the plaintiff would pay for all grass seed, one-half of the corn seed, one-half of the baling expense and all of the fertilizer expense. The straw, threshed hay and stalks were to be fed to livestock on the farms. The plaintiff was not required to pay for the oats seed or the expense of threshing. The agreements further provided that he controlled the place and time of crop planting and crop cultivation and harvesting. He also retained decisionmaking control over the crops to be sprayed and how they were to be tended to. The plaintiff kept charts on his farms that detailed all types of crop and soil information, and he annually sent this information to the tenants along with information on fencing and terracing. He consulted periodically with his brother-in-law and the tenants by telephone and letter, and occasionally spent time on the farms with his daughter during which times he would inspect the crops and walk the fields and provide crop growing advice to his brother-in-law and the tenants. His brother-in-law inspected the farms several times monthly during the growing season and often served as a middleman between the tenants and the plaintiff in terms of conveying information about the farms.
Also in 1957, at the age of 71, the plaintiff applied for Social Security benefits based on his self-employment earnings by virtue of his management of the farms and the conduct of his brother-in-law and the tenants. In other words, the plaintiff claimed that he had been material participating in the operation of the farms that would entitle him to Social Security benefits. The local Social Security Office denied the claim as did the Hearing Examiner on appeal. The plaintiff’s request for formal review was denied, and the federal trial court also ruled against the plaintiff. On further review, the U.S. Court of Appeals noted that the facts showed that the plaintiff was the one that made the key decisions involving the production activities on the farms. The evidence also revealed that the plaintiff kept informed of issues that arose on the farms and educated himself by reading farm production literature and by seeking input from experts at agricultural colleges. He also made decisions to start new farming practices and establish longer term farming practices and techniques to improve the farms’ profitability. The appellate court also noted that the plaintiff kept close track of any new production technique or crop that was tried on the farms.
Based on the evidence, the appellate court reversed the trial court and held that the plaintiff had materially participated in crop production and in the management of crop production on the farms. Importantly, the appellate court determined that the plaintiff qualified for Social Security benefits based on his own material participation in the farming activities and the activities of his brother-in-law as his agent. In other words, the brother-in-law’s activities were imputed to the plaintiff for purposes of the material participation test.
In 1974, the Congress amended the material participation statute to provide that the activities of an agent were thereafter to be irrelevant in determining whether the material participation requirement has been met. Currently, I.R.C. §1402(a)(1) reads as follows:
“(a)Net earnings from self-employment. The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member; except that in computing such gross income and deductions and such distributive share of partnership ordinary income or loss—
(1) there shall be excluded rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares, and including payments under section 1233(a)(2) of the Food Security Act of 1985 (16 U.S.C. 3833(a)(2)) to individuals receiving benefits under section 202 or 223 of the Social Security Act) together with the deductions attributable thereto, unless such rentals are received in the course of a trade or business as a real estate dealer; except that the preceding provisions of this paragraph shall not apply to any income derived by the owner or tenant of land if (A) such income is derived under an arrangement, between the owner or tenant and another individual, which provides that such other individual shall produce agricultural or horticultural commodities (including livestock, bees, poultry, and fur-bearing animals and wildlife) on such land, and that there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) in the production or the management of the production of such agricultural or horticultural commodities, and (B) there is material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticultural commodity;…”
For purposes of imputation, the key is the parenthetical language contained in §1402(a)(1)(A) – “…there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant).” In addition, when read as a whole, the bar on imputation only applies when the production of agricultural or horticultural commodities is involved.
Satisfying Material Participation
For purposes of Social Security and “net earnings from self-employment” material participation must be achieved personally when agricultural or horticultural crop production is involved. How is that accomplished? The IRS has offered three safe harbors and one catchall for determining whether the material participation test has been satisfied. See Farmers Tax Guide, IRS Pub. 225, page 75 (2019). The first test requires the landlord to satisfy any three of the following: (1) advance, pay, or stand good for at least half of the direct costs of producing the crop; (2) furnish half of the tools, equipment and livestock used in producing the crop; (3) advise and consult with the tenant periodically; or (4) inspect production activities periodically. The second test requires the landlord to regularly and frequently make, or take an important part in making, management decisions substantially contributing to the success of the enterprise. Under this test, it appears that decisions should be made throughout the year, such as when to plant, cultivate, dust, spray, or harvest; what items to buy, sell or rent; what records to keep; what reports to make; and what bills to pay and when. Establishing a lease arrangement at the beginning of the season probably will not be regarded as making management decisions. The third test requires the landlord to work 100 hours or more over a period of five weeks or more in activities connected with producing the crop. The fourth test requires the landlord to do things which, in total affect, show that the landlord is materially and significantly involved in the production of farm commodities. This fourth test is the catchall that a landlord can attempt to utilize if the landlord is not able to satisfy any of the first three tests. The litigated cases on the material participation issue have arisen primarily from this catchall provision.
Other Code Provisions
“Material participation” is required by other tax provisions which are not subject to the 1974 amendment. In other words, when the issue of material participation does not route through I.R.C. §1402, imputation is not blocked. For example, the qualified business income deduction of I.R.C. §199A does not bar the imputation of an agent’s activity to the principal for purposes of the principal claiming the 20 percent deduction. There is also no specific statutory bar of imputing an agent’s activity to the principal for purposes of the passive loss rules of I.R.C. §469 (although Committee Report language seems to indicate that there is a bar).
Whether the landlord materially participates in the tenant’s farming business is irrelevant for farm income averaging purposes. I.R.C. §1301. Thus, non-materially participating landlords are eligible for income averaging if the landlord’s share of a tenant’s production is set in a written rental agreement before the tenant begins significant activities on the land. That places a premium on written leases.
There are other sections of the Code where the imputation issue also matters.
The Type of Lease Matters
If a landowner is in the business of farming, the landowner's expenses and income are reported on Schedule F where the net income is subject to self-employment tax. Income and expenses associated with a material participation crop share lease are reported on Schedule F. The rental income is subject to self-employment tax and the owner is able to deduct soil and water conservation expenses attributable to the real estate, as well as qualify for the exclusion of cost-sharing payments associated with the rented real estate. Similarly, the landlord could qualify for expense method depreciation under I.R.C. §179. In addition, CRP payments received by a materially participating landlord are subject to self-employment tax only if there is a nexus between the CRP land and the materially participating landlord’s farming operation. The IRS continues to deliberately misstate this point in IRS Publication 225.
A landlord who is not materially participating under a crop share lease receives the income from the lease not subject to self-employment tax. While the landlord still qualifies for special treatment of soil and water conservation expenses and is eligible for exclusion of cost-sharing payments, and may, as noted below, be eligible for expense method depreciation, the income is to be reported on IRS Form 4835 rather than the Schedule F.
Income under a cash rent lease is income from a passive rental arrangement and is not subject to self-employment tax. Cash rent landlords do not qualify for special treatment of soil and water conservation expenses but apparently qualify for the exclusion of cost sharing payments received from the USDA. At least that the conclusion to be drawn from an IRS Private Letter Ruling from 1990. See, e.g., Priv. Ltr. Rul. 9014041 (Jan. 5, 1990). In the ruling, there was no mention of the type of lease involved.
As for expense method depreciation, the landlord must be “meaningfully participating” in the management or operations of the trade or business, (Treas. Reg. §1.179-2(c)(6)(ii)) and avoid the “noncorporate lessor” rules. I.R.C. §179(d)(5). Income from a cash rent lease is to be reported on the Schedule E -Supplemental Income and Loss.
Imputation is a key concept in several areas of farm income taxation. It’s made trickier because sometimes it applies and sometimes it does not. It’s all a matter of which Code section applies and how the material participation requirement is routed through the Code.
Wednesday, July 8, 2020
The U.S. Tax Court continues to issue decisions involving conservation easements. The IRS has many of these cases in the pipeline which means that the decisions will keep on coming. This is definitely one area of tax that has been audited heavily and it can be anticipated that the audits will continue. I have written prior posts on the issues surrounding conservation easements. They can be beneficial for rural landowners from a tax perspective, but the deeds granting the easement must be drafted very carefully and attention to detail is a must.
In today’s post, I look at a few recent cases and an important IRS development concerning conservation easements.
Extinguishment Regulation Upheld.
Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020); Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54
In 2008, the petitioner donated a permanent conservation easement to a qualified organization and claimed a charitable deduction. The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution. That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement. The IRS denied the charitable deduction because (inter alia) the deed language violated the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6).
The full Tax Court, agreeing with the IRS, upheld the validity of the regulation on the basis that the extinguishment regulation had been properly promulgated and did not violate the Administrative Procedure Act. The full Tax Court also determined that the construction of I.R.C.§170(h)(5) (e.g., that the donated easement be exclusively for conservation purposes), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
In a related memorandum opinion, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made. It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed. However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable.
Charitable Deduction Denied – Bad Deed Language and Overvaluation
Plateau Holdings LLC, et al. v. Comr., T.C. Memo. 2020-93.
The petitioner, an entity, owned two parcels of rural land and donated two open-space conservation easements on the parcels to a land trust. The deeds were recorded the next day, and included language expressing an intent to ensure that the land “be retained forever in its current natural, scenic, forested and open land condition” and language preventing any use of the conserved area inconsistent with the conservation purpose. The petitioner claimed a $25.5 million charitable deduction for the donation. Eight days before the donation, an investor acquired nearly 99 percent ownership in the petitioner for less than $6 million.
The Tax Court determined that the deed language was similar to that deemed invalid in Coal Property Holdings LLC v. Comr., 153 T.C. 126 (2019) because the grantee wouldn’t receive a proportionate amount of the full sale proceeds. The Tax Court also upheld a 40 percent penalty under I.R.C. §6662(e) and I.R.C. §6662(h) for a gross misstatement of the value of the contribution. The Tax Court noted that the petitioner valued both properties well above 200 percent of market value, the cut-line for the gross misstatement penalty. One parcel was valued a$10.9 million, or 852 percent of its correct value. The other easement was valued at $14.5 million, or 1,031 percent of its proper value.
Conservation Easement Not Protected In Perpetuity – The Extinguishment Issue
Hewitt v. Comr., T.C. Memo. 2020-89.
The petitioner owned farmland and deeded a conservation easement on a portion of the property to a qualified charity as defined in I.R.C. §170(h)(3). The petitioner continued to own a large amount of agricultural land that was contiguous with the easement property, and he continued to live on the land and use it for cattle ranching. The petitioner claimed a charitable contribution deduction for the donation of $2,788,000 (the difference in the before and after easement value of the property) which was limited to $57,738 for the tax year 2012 – the year of donation. The petitioner claimed carryover deductions of $1,868,782 in 2013 and $861,480 in 2014.
The petitioner could not determine his basis in the property and, upon the advice of a CPA firm, attached a statement to Form 8283 explaining his lack of basis information. The deed stated that its purpose was to preserve and protect the scenic enjoyment of the land and that the easement would maintain the amount and diversity of natural habitats, protect scenic views from the roads, and restrict the construction of buildings and other structures as well as native vegetation, changes to the habitat and the exploration of minerals, oil, gas or other materials. The petitioner reserved the right to locate five one-acre homesites with one dwelling on each homesite. The deed did not designate the locations of the homesites but required the petitioner to notify the charity when he desired to designate a homesite. The charity could withhold building approval if it determined that the proposed location was inconsistent with or impaired the easement’s purposes.
The deed provided for the allocation of proceeds from an involuntary extinguishment by valuing the easement at that time by multiplying the then fair market value of the property unencumbered by the easement (less any increase in value after the date of the grant attributable to improvements) by the ratio of the value of the easement at the time of the grant to the value of the property, without deduction for the value of the easement at the time of the grant. The deed also stated that the ratio of the value of the easement to the value of the property unencumbered by the easement was to remain constant. The charity drafted the deed and a CPA firm reviewed it and advised the petitioner that it complied with the applicable law and regulations, and that he would be entitled to a substantial tax deduction.
The IRS denied the carryover deductions for lack of substantiation and assessed a 40 percent penalty under I.R.C. §6662(h) for gross valuation misstatement and, alternatively, a 20 percent penalty for negligence or disregard of the regulations or substantial understatement of tax. The petitioner bought additional land that he held through pass-through entities that would then grant easements. The petitioner recognized gain of over $3.5 million on the sale of interests in the entities to investors who then claimed shares in the easement deductions. The IRS claimed that these entities overvalued the easements for purposes of the deductions. Individuals in the CPA firm invested in the entities and claimed easement deductions. The Tax Court determined that the deed language violated the perpetuity requirement of I.R.C. §170 because of the stipulation that the charity’s share of proceeds on extinguishment would be reduced by improvements made to the land after the easement grant. The Tax Court did not uphold the penalties.
Conservation Easement Doomed by Bad Deed Language
Woodland Property Holdings, LLC v. Comr., T.C. Memo. 2020-55
The petitioner donated a conservation easement to a qualified charity. The deed conveying the property contained a judicial extinguishment provision stating that the easement gave rise to a vested property right in the donee, the value of which "shall remain constant." The value of the donee's property right was defined as the difference between (a) the fair market value (FMV) of the conservation area as if unburdened by the easement and (b) the FMV of the conservation area as burdened by the easement, with both values being "determined as of the date of this Conservation Easement." The IRS took the position that the language failed to satisfy the "in perpetuity" requirement for such gifts. The petitioner pointed to the following deed language for support of the his position that the perpetuity requirement was satisfied: "If any provision of this Conservation Easement is found to be ambiguous, an interpretation consistent with its purposes that would render the provision valid should be favored over any interpretation that would render it invalid."
The Tax Court, however, held that the provision did not help the taxpayer because it was a cure only for ambiguous provisions and the deed was unambiguous in limiting the donee's vested property right. In addition, the Tax Court noted that a statement from the donee organization that the easement be in full compliance with the tax law was immaterial.
Conservation Easement Deduction Allowed At Reduced Amount.
Johnson v. Comr., T.C. Memo. 2020-79
The petitioner is the president of a west-central Colorado company that manufactures and sells disposable ink pans for printing presses. He purchased a ranch in 2002 for 200,000 and carved out a permanent conservation easement that he donated to the Colorado Open Lands, a qualified charity. He made the donation in 2007. The easement encumbered 116.14 acres along with the water rights, leaving the remaining five acres unencumbered. The easement restricted the encumbered area from being subdivided, used as a feedlot, or used for commercial activities. It also restricted all construction within the encumbered area except for five acres that was designated a “building envelope”. The deed limited constructed floor space inside the building envelope to 6,000 square feet for single residential improvements and a cumulative maximum of 30,000 square feet for all improvements.
On his return for 2007, the petitioner claimed a $610,000 charitable contribution deduction for the donated easement, with carryover amounts deducted in future years. He also claimed certain farm-related expenses. The IRS denied the carryover charitable deductions in three carryover years on the basis that he had already deducted more than the easement’s value for previous tax years. The petitioner and the IRS agreed that the property’s highest and best use was for farming and a residence. The petitioner’s valuation expert used a quantitative approach by taking comparable sales adjusted by time between the time of those easement donations and when the petitioner donated his easement. The petitioner’s expert then adjusted for nearness of the encumbered property to town and size. He then factored in irrigation, topography and improvements to arrive at the value of the property before the easement. The expert did not have many post-donation comparable sales to work with in arriving at the value of the petitioner’s property after the easement donation.
The valuation expert for the IRS used the qualitative approach. By comparing several characteristics for each comparable, including market conditions at the time of sale, location/access, size, aesthetic appeal, zoning, and available utilities, to evaluate the relative superiority, inferiority, or similarity of each comparable to the ranch. The expert then evaluated the overall comparability of each property to the ranch.
The Tax Court preferred the approach of the petitioner’s expert, due to the IRS’s expert ignoring the quantitative factors. However, the Tax Court adjusted the value arrived at by the petitioner’s expert. Post-encumbrance nearby comparable sales were lacking, the Tax Court rejected both experts’ post-encumbrance direct comparable sales analyses. By ignoring an outlier from both of the experts, the parties were only two percent apart on value. The Tax Court split the difference between the parties and added it to the pre-easement value as adjusted to arrive at the easement’s value. Thus, the Tax Court allowed a $373,000 deduction for the easement. The Tax Court also disallowed various farming expense deductions including travel-related expenses due to the lack of substantiation.
The saga of claimed charitable deductions for donated conservation easements will continue. It seems that nothing generates more Tax Court litigation than a Code provision that the IRS despises.
Monday, July 6, 2020
Experiencing a tax audit can be a traumatic experience. Often, the level of trauma depends on the examining agent(s). It can also depend on how aggressive the IRS National Office is on the issue under examination. But, once an audit is completed can the IRS return to the same issue involving the same tax year and with the same taxpayer and get a “do-over”? In other words, how many times can the IRS audit the same issue?
The ability of IRS to re-audit issues that have been examined and resolved – it’s the topic of today’s post.
Applicable Code Section
In 1921, the Congress enacted I.R.C. 7605(b) as a reaction to constituent complaints that the IRS was abusing its power by subjecting taxpayers to unnecessary audits. See H.R. Rep. No. 67-350, at 16 (1921). Based on the recorded legislative history, the purpose of the new Code section was to relieve taxpayers from “unnecessary annoyance” by the IRS. See statement of Sen. Penrose at 61 Cong. Rec. 5855 (Sept. 28, 1921).
I.R.C. §7605(b) states as follows:
“No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.”
Thus, the provision bars the IRS from conducting “unnecessary examination or investigations” and conducting more than a single investigation of a taxpayer’s “books of account” for a tax year. But, if any investigation is legitimate, the courts generally don’t get in the way of the IRS. Instead, the courts have tended to focus on the “unnecessary” language in the statute rather than the “single investigation” part of the provision. See, e.g, United States v. Schwartz, 469 F.2d 977 (5th Cir. 1972); United States v. Kendrick, 518 F.2d 842 (7th Cir. 1975). In addition, the provision has been interpreted so as to not prevent an IRS agent from “diligently exercising his statutory duty of collecting the revenues.” Benjamin v. Comr., 66 T.C. 1084 (1976). The public purpose of collecting revenues duly owed is of utmost importance to the courts, and the statutory provision is not to be read in such a broad manner as to defeat that purpose. At least that’s how the U.S. Court of Appeals construed the statute in a 1963 case. DeMasters v. Arend, 313 F.2d 79 (9th Cir. 1963).
Earlier this year, the U.S. Tax Court addressed the application of I.R.C. §7605(b) in a case involving a surgeon (the petitioner) that inherited his mother’s IRA upon her death in 2013 – one that she had received upon her husband’s (the petitioner’s father) death. In Essner v. Comr., T.C. Memo. 2020-23, the petitioner then took distributions from the IRA in 2014 and 2015. He didn’t tell his return preparer that he had taken sizable distributions in either 2014 or 2015, and didn’t ask for guidance from the preparer on how to treat the distributions for tax purposes. Even though he received a Form 1099-R for the distributions received in 2014 and 2015, he didn’t report them in income for either year. The IRS Automated Underreporting (AUR) program, caught the discrepancy on the returns and generated a notice to the petitioner seeking more information and substantiation. After a second notice, the petitioner responded in handwriting that he disagreed with having the distributions included in income. While the AUR review was ongoing, the IRS sent the petitioner a letter in late 2016 informing him that his 2014 return had been selected for audit and requesting copies of his 2013 through 2015 returns. The audit focused on various claimed expenses, but did not focus on the IRA distributions. The examining agent was unaware of the AUR’s actions concerning the 2014 and 2015 returns. The examining agent sent the petitioner a letter in early 2017 with proposed adjustments, later revising it upon receipt of additional information. Neither letter mentioned the issue with the IRA distributions, and the petitioner sent a letter to the IRS agent requesting confirmation that his IRA distribution received in 2014 was not taxable. 17 days later, the petitioner filed a Tax Court petitioner challenging a notice of deficiency that the AUR had generated seven days before the examining agent’s original letter proposing adjustments to the 2014 return. About seven months later the IRS issued a notice of deficiency to the petitioner asserting a $101,750 tax deficiency for the 2015 tax year and an accuracy-related penalty. The petitioner filed another Tax Court petition concerning the 2015 tax year.
At trial, the petitioner couldn’t establish that any portion of the distributions he received represented a return of his father’s original investment and the Tax Court sustained the IRS position that the distributions were fully taxable. The petitioner also claimed that I.R.C. §7605(b) barred the IRS from assessing the proposed deficiency for 2014 because the concurrent review of the 2014 return by the AUR and the agent constituted a “second inspection” of his books and records for 2014. The Tax Court, based on its prior decision in Digby v. Comr., 103 T.C. 441 (1994), framed the issue of whether the examination was unnecessary or unauthorized, and noted that the U.S. Supreme Court has explained that I.R.C. §7605 imposes “no severe restriction” on the power of the IRS to investigate taxpayers. United States v. Powell, 379 U.S. 48 (1964). The Tax Court noted that the AUR didn’t inspect the petitioner’s books, but merely based its review on third-party information returns – there was no “examination” of the 2014 return. Accordingly, the Tax Court concluded that the AUR program’s matching of third-party-reported payment information against his already-filed 2014 return was not an “examination” of his records. There was no violation of I.R.C. §7605(b). The Tax Court also upheld the accuracy-related penalty.
Recent Chief Counsel Legal Advice
Just a few weeks ago the IRS Chief Counsel’s Office addressed the I.R.C. §7605(b) issue with respect to net operating loss (NOL) carrybacks. This time the outcome was favorable for the taxpayer. Under the facts of CCM 20202501F (May 7, 2020), the taxpayer was a hedge fund operator and a former investment banker that bought a vineyard. The vineyard also included a house, guesthouse, caretaker’s house, and olive grove. The IRS conducted an audit resulting in the issuance of a Notice of Proposed Adjustment disallowing all expenses and depreciation deductions related to the vineyard for the prior tax years under audit. The IRS took the position that the vineyard was a hobby activity under I.R.C. §183 for those years.
On further review, the IRS Appeals Office determined that the taxpayer’s vineyard activity was not a hobby for those tax years based on its conclusion that all of the nine-factors contained in Treas. Reg. §1.183-2(b) were in the taxpayer’s favor and, as a result, the deductions and expenses claimed in those years were allowable which resulted in a net operating loss (NOL). The IRS again audited the taxpayer in a later year on the hobby activity issue. Also at issue was whether the taxpayer could deduct an NOL carryforward originating from the tax years that had previously been audited and for which IRS Appeals had determined that the vineyard activity was not a hobby The taxpayer asserted that the second audit stemmed from previously audited tax years and violation I.R.C. §7605(b) as a repetitive audit. The IRS sought guidance from the IRS Chief Counsel’s Office (CCO).
The CCO noted that I.R.C. §7605 bars the IRS from conducting more than a single inspection of a taxpayer’s books of account for a tax year to prevent an “unnecessary” examination or “unnecessary annoyance.” As noted above, existing caselaw does not prevent the IRS from auditing a later year based on a taxpayer’s transactions that originated from records that had been part of a prior audit. However, the CCO concluded the taxpayer’s situation was different. Here, the CCO noted, the taxpayer had been previously examined and prevailed at the IRS Appeals Office level. The losses allowed in the prior years under examination were properly carried forward, and IRS was disallowing the NOL carryforward on the second audit for the same reason that the IRS Appeals Office had previously considered and ruled in the petitioner’s favor. The CCO determined that this amounted to a “second examination” or “repetitive audit” that I.R.C. §7605 barred. Had the NOL carryforward been disallowed for a different reason, the CCO noted, a second examination would have been proper.
Almost 100 years ago, the Congress determined that taxpayers needed protection against abuses from the IRS. That determination manifested itself in I.R.C. §7605(b) which was enacted within the first ten years of the creation of the tax Code. But, whether or not the IRS can get a “second-bite” at the audit apple is highly fact-dependent. However, it is probably a decent bet that audit activity will be extremely low in the coming months due to circumstances beyond the control of the IRS.
Tuesday, June 30, 2020
The Paycheck Protection Program (PPP) was enacted into law in late March and has now been statutorily modified by the Paycheck Protection Program Flexibility Act (PPFA). It is designed to provide short-term financial relief to qualified businesses that have been negatively impacted by the action of state Governors in response to the virus. The Small Business Administration (SBA) administers the law.
The Premium Assistance Tax Credit (PATC) is a refundable credit designed to offset the higher cost of health insurance triggered by Obamacare for eligible individuals and families that acquire health insurance purchased through the Health Insurance Marketplace. In recent days important developments have involved the PATC.
Prior posts have discussed various aspect of the PPP, particularly as applied to farm and ranch businesses. In today’s post I take a brief look at a couple of PPP court developments and key information involving the PATC. Recent developments of the PPP and the PATC – it’s the topic of today’s post.
PPP Court Developments
Maine case. The SBA has promulgated a rule taking the position that an individual PPP applicant that is in bankruptcy is ineligible for PPP funds. Also, if the applicant is an entity and a majority owner is in bankruptcy, the SBA also denies PPP eligibility to the entity. In recent days, two more courts have addressed various aspects of the SBA position.
In a recent case from Maine, the plaintiff had filed Chapter 11 and sought approval of a disclosure describing its Chapter 11 plan. The statement acknowledged the problems the virus presented to its business, but assured creditors that the plan was feasible. The plaintiff continued to project that its business would be viable and would continue in business and meet plan obligations. The statement also described a general effort to get assistance, but did not suggest any likelihood of suffering immediate and irreparable harm in the form of ceasing business if access to the PPP were denied. The plaintiff’s statement also pointed to a forecasted ability to weather the current economic problems after July 2020 and into 2022, even without receipt of funds under the PPP.
The court noted the devoid record of any showing of projected receipts and disbursements and determined that it didn’t have enough information to determine if the state Governor’s conduct seriously impaired the plaintiff’s financial projections. The court denied the temporary restraining order (TRO). In re Breda, No. 20-1008, 2020 Bankr. LEXIS 1246 (Bankr. D. Me. May 11, 2020). In a later proceeding the plaintiff claimed that the defendant violated the anti-discrimination provisions of 11 U.S.C. §525. The court granted the defendant’s motion to dismiss. In re Breda, No. 18-10140, 2020 Bankr. LEXIS 1626 (Bankr. D. Me. Jun. 22, 2020).
Fifth Circuit case. As noted above, the SBA created a regulation with respect to eligibility for the PPP that makes an applicant ineligible to receive program funds if the applicant is a debtor in a bankruptcy proceeding. 85 Fed. Reg. 23, 450 (Apr. 28, 2020). In In re Hidalgo County Emergency Service Foundation v. Carranza, No. 20-40368, 2020 U.S. App. LEXIS 19400 (5th Cir. Jun. 22, 2020), the debtor was in Chapter 11 bankruptcy and was denied PPP funds. The debtor claimed that such denial violated the anti-discrimination provisions of 11 U.S.C. §525(a) which bars discrimination based on bankruptcy status in certain situations. The debtor also claimed that the regulation was arbitrary and capricious and an abuse of the SBA’s discretion.
The bankruptcy court agreed and issued a preliminary injunction mandating that the SBA handle the debtor’s PPP application without considering that the debtor was in bankruptcy. The district court stayed the injunction and certified the case for direct appeal to the appellate court. On further review, the appellate court vacated the preliminary injunction noting that federal law prohibits injunctive relief against the SBA.
Premium Assistance Tax Credit
The IRS recently proposed regulations clarify that the reduction of the personal exemption deduction to zero for tax years beginning after 2017 and before 2026 does not affect an individual taxpayer’s ability to claim the PATC. The regulations essentially adopt the guidance set forth in Notice 2018-84. The proposed regulations apply to tax years ending after the date the regulations are finalized as published in the Federal Register. Taxpayers can rely on the proposed regulations for tax years beginning after 2017 and before 2026 that end on or before the date the Treasury decision adopting the regulations as final regulations is published in the Federal Register. Prop. Treas. Reg. 124810-19.
On another angle, the self-employed health insurance deduction may allow for a PATC. In Abrego, et ux. v. Comr., T.C. Memo. 2020-87, the petitioners, a married couple, received an advance premium assistance tax credit under I.R.C. §36B to help offset the higher cost of health insurance acquired through the Health Insurance Marketplace as a result of Obamacare. The advance credit was received for a tax year during which the wife worked as a housekeeper and the husband worked as a driver for a transport company. The husband also operated his own tax return preparation business. The IRS determined that the entire advanced credit had to be paid back based on the petitioners’ actual income for the year as reported on the tax return.
The Tax Court held that the repayment amount was capped under I.R.C. §36B(f)(2) when taking into account the partial self-employment health insurance deduction that lowered the petitioners’ “household income” to just under 400 percent of the federal poverty line. Thus, the petitioners were eligible for some advance credit amount under I.R.C. §36B(b)(2) rather than being completely ineligible.
These are just a small sample of what’s been happening in the courts that might impact a client’s return. Unfortunately, it’s still tax season. Fortunately, the IRS has announced that the end of tax season won’t be postponed again. You can sign up for two days of continuing education on these and other topics at the National Farm Income Tax & Estate and Business Planning Conference in Deadwood, SD on July 20-21. You may either attend in-person or online. For more information click here: https://washburnlaw.edu/employers/cle/farmandranchtax.html
Saturday, June 27, 2020
Either as part of an estate plan or for purposes of setting up another person in business or for other reasons, a gift might be made. But when is a transfer of funds really a gift? Why does it matter? The recipient doesn’t have to report into income gifted amounts. If the amount transferred is not really a gift, then it’s income to the recipient. When large amounts are involved, the distinction is of utmost importance.
When is a transfer of funds a gift? It’s the topic of today’s blog article
Definition of a “Gift”
Under the Internal Revenue Code (“Code”), gross income is income from whatever source derived unless otherwise excluded. I.R.C. §61(a). However, gross income does not include the value of property that is acquired by gift. I.R.C. §102(a). In Comr. v. Duberstein, 363 U.S. 278 (1960), the U.S. Supreme Court defined a gift under I.R.C. §102 as a transfer that proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses. As a result, the Supreme Court concluded that the most important consideration in determining whether a gift has been made is the donor’s intent. That’s a broader inquiry than simply looking at how the donor characterizes a particular transaction. A court will examine objectively whether a gift occurs based on the facts and if those facts support a donor that intended a transfer based on affection, etc. Detached and disinterested generosity is the key. If the transfer was made out of a moral duty or some sort of expectation on the recipient’s part, it is not a gift under I.R.C. §102 because it did not arise out of a detached and disinterred generosity. Similarly, when the recipient has rendered services to a donor, a payment for services is not a gift even if the transferor had no legal obligation to pay the remuneration for the services.
Apart from the Court’s analysis in Duberstein, a particular transaction may amount to a “common law” gift. A common law gift requires only a voluntary transfer without consideration. If the donor had no legal obligation to make the payment, the transfer is a gift under the common law standard. That’s an easier standard to satisfy than the Code definition set forth in Duberstein.
The recent Tax Court case of Kroner v. Comr., T.C. Memo. 2020-73 illustrates how the courts examine whether a particular transfer constitutes a gift and the consequences of misreporting the transaction(s) for tax purposes. The petitioner was the CEO of a business that bought and sold structured settlement payments and lottery winnings. The company would buy structured payments from lottery winners and resell the payments to investors. The petitioner had historically worked in the discounted cashflow industry and, as a result, met a Mr. Haring, a wealthy British citizen, sometime in the 1990s. Their business relationship lasted until 2007.
In 2003 and 2004, the petitioner was interested in protecting his assets and an attorney recommended the use of an “offshore” trust to hold the petitioner’s assets. An offshore trust is often associated with tax scams, but I reserve that discussion for another post in the future. In any event, the petitioner established the “Kroner Family Trust” in a small island in the Caribbean. The petitioner was the beneficiary of the trust along with his son. In 2007, the petitioner established another trust in the Bahamas to hold business assets. From 2005-2007, the petitioner received wire transfers from Mr. Haring totaling $24,775,000. Some of the transferred funds went directly to the petitioner, but others went to the trust in the Caribbean island and still others went to the petitioner’s business. The lawyer that set up the offshore trusts “advised” the petitioner that the transfers were gifts that the petitioner didn’t have to report as taxable income. The attorney’s legal “analysis” which led him to this conclusion was a conversation he had with the petitioner and a note that he drafted for Mr. Haring stating that the transfers were gifts. The attorney also advised the petitioner of the requirements to file Form 3520 every year that he received a transfer from Mr. Haring to report the gifts from a foreign person. A CPA prepared the Form 3520 for the necessary years. The petitioner never reported any of the transfers from Mr. Haring as taxable income.
The petitioner was audited for tax years 2005-2007. The IRS took the position that the transfers were not gifts, should have been reported as taxable income, and assessed accuracy-related penalties on top of the tax deficiency.
The Tax Court agreed that the transfers should have been included in the petitioner’s taxable income. They were not gifts. The Tax Court noted that Mr. Haring’s intention was the most critical factor in determining the status of the transfers. The petitioner bore the burden to establish Mr. Haring’s intent by a preponderance of the evidence. However, Mr. Haring never appeared at trial and didn’t provide testimony. Instead, the petitioner tried to establish the gift nature of the transfers by his own testimony. The petitioner and Mr. Haring had operated some business interests together in the 1990s, and the petitioner acted as a nominee for Mr. Haring for certain of Mr. Haring financial interests. He even formed a trust in Liechtenstein for Mr. Haring in 2000. Mr. Haring also provided a loan for the petitioner’s credit counseling business in 2000. That loan was paid off in 2007. Mr. Haring also held about a 70 percent equity interest in the petitioner’s cashflow industry business in exchange for providing funding and loan guarantees. He later liquidated his interest for $255 million.
The petitioner last saw Mr. Haring in 2002 and testified at trial that he didn’t know where he lived and that he didn’t know his telephone number. He did, however, receive a telephone call from Mr. Haring in 2005 that lasted no more than three minutes. The petitioner claimed that Mr. Haring told him during the call that Mr. Haring had a “surprise” for the petitioner. The petitioner later met with Mr. Haring’s associate and they set up the ability to receive wire transfers from Mr. Haring into the petitioner’s bank account. That’s when the attorney drafted a note to the petitioner from Mr. Haring stating that the transfers would be gifts.
The Tax Court didn’t buy the petitioner’s story, finding that neither the petitioner nor the attorney were credible witnesses. The Tax Court stated that the petitioner’s testimony was self-serving and that the attorney’s testimony was “simply not credible.” There was no supporting documentary evidence. In addition, the attorney represented both Mr. Haring and the petitioner. The Tax Court also noted that the attorney was “evasive in his answers and in his selective invocation of the attorney-client privilege with regard to the legal advice provided to Mr. Haring about the transfers.” The Tax Court also doubted the authenticity and credibility of the 2005 note allegedly from Mr. Haring but drafted by the attorney regarding his desire to gift funds to the petitioner. Thus, the note carried little weight in determining whether the transfers were gifts.
The Tax Court also determined that the petitioner failed to prove that the transfers were made with disinterested generosity. The record was simply devoid of any credible evidence to prove that Mr. Haring transferred the funds to the petitioner with detached and disinterested generosity. The Tax Court noted that timing of some of the transfers with liquidity events of the petitioner’s business of which Mr. Haring was an investor. That raised a question as to whether Mr. Haring was acting as the petitioner’s nominee.
The Tax Court determined that the petitioner need not pay the 20 percent accuracy-related penalty because the IRS failed to satisfy its burden of production under I.R.C. §6751(b).
The Kroner case is a textbook lesson on what constitutes a gift – detached and disinterested generosity. The burden of establishing that a transfer is a nontaxable gift is on the party asserting that the transfer amounted to a gift. The case is also a lesson into the messes that sloppiness and questionable lawyering can get a client into. When the amount of the gift (or gifts) is as large as that involved in the Kroner case, attention to detail is a must. The income tax consequences from being wrong are enormous.
Wednesday, June 17, 2020
As part of an estate plan, an heir may be given an option to buy certain assets of the decedent at a specified price. In agricultural estates, such an option is typically associated with farmland of the decedent, and often gives the optionee (the person named in the will with the right to exercise the option) a very good deal for the property upon exercise of the option.
Often the question arises as to the basis of the property in the hands of the optionee when the option is exercised and the resulting tax consequences when the property is later sold.
Tax issues associated with the exercise of an option – it’s the topic of today’s post.
Options – The Basics
There is no question that an option can be included in a will. A testator has the right to dispose of their property as desired. The only significant limitation on testamentary freedom involves the inability to completely disinherit a spouse. Even if the will leaves nothing for the surviving spouse, under state law the surviving spouse has a right to an elective share entitling the surviving spouse to “elect” to take a portion of the estate regardless of what the deceased spouse’s will says (except, of course, if a valid prenuptial agreement was executed). Under most state laws, a surviving spouse’s elective share comprises anywhere from between one-third to one-half of the decedent’s estate. In addition, in some states, the spousal elective share can include retirement assets or life insurance.
What are the tax consequences when an optionee exercises an option? Does the exercise result in tax consequences to the decedent’s estate? What are the tax consequences if the optionee later sells the property that was acquired by the exercise of the option?
Decedent’s estate. The exercise of an option results in no tax consequence to the decedent’s estate. The exercise of the option, followed by the sale of the property by the estate to the holder of the option does not result in gain or loss to the estate. In Priv. Ltr. Rul. 8210074, Dec. 10, 1981, the decedent's son was given an option under the terms of the parent’s will to purchase some of the parent’s farmland at $350/acre. The son exercised the option and paid the estate $26,668 for the land. At the time the option was exercised, the farmland was worth $114,293 (as valued on the parent’s estate tax return). The IRS determined that the combined basis of the option and the real estate subject to the option was $114,293 with $26,668 of that allocable to the land. Thus, when the real estate was sold to the son for $26,668, it equaled the basis in the land in the hands of the estate resulting in neither gain nor loss to the estate.
When the optionee exercises the option in a will or trust, the primary question is what the income tax basis of the property received under the option is in the optionee’s hands. I.R.C. §1014 is the applicable basis provision for property acquired from a decedent. The provision states in pertinent part, “(a)In general Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be— (1) the fair market value of the property at the date of the decedent’s death,… (b)Property acquired from the decedent For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (1) Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent….
This ‘”stepped-up” basis rule applies to property required to be included in the decedent’s gross estate, including property that is subject to an option in a will (or trust) that grants the beneficiary an option to purchase the property at a beneficial price from the estate. The option is treated as property acquired from the decedent and receives an income tax basis equal to its fair market value as of the date of the decedent’s death. Its basis is the estate tax value of the property subject to the option less the price the beneficiary must pay to exercise the option. A beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the optionee’s basis in the property.
In Cadby v. Comr., 24 T.C. 899 (1955), acq., 1956-2 C.B. 5, the decedent died in 1942. His will included a provision directing the executor and trustee to sell some of the decedent’s stock to a family member and another person for $25,000 upon proof that the family member had purchased from the decedent’s surviving spouse preferred stock in the same company for $6,000 if payment were made within two years of the decedent’s death. If payment wasn’t made within the specified timeframe, disposition of the stock was left to the discretion of the executor and trustee. Shortly after the decedent’s death, the family member sold his rights under the will to a third party for $13,000.
In determining the tax consequence of the transaction to the family member, the Tax Court noted that the fair market value of the decedent’s stock interest subject to the option was $55,243 as of the date of death as denoted on the decedent’s federal estate tax return. In addition, the family member paid $6,000 for the stock he purchased from the decedent’s surviving spouse. Thus, the family member’s income tax basis in the stock was $61,243.40. From that amount, the Tax Court subtracted the option price of $25,000 and the payment to the surviving spouse of $6,000. The result, $30,243.40, was the option price. Because the family member held a one-half interest in the option, that one-half interest was worth $15,121.70. Thus, the sale for $13,000 did not trigger any taxable income to the family member.
Twelve years after the Tax Court’s ruling in Cadby, the IRS issued a Revenue Ruling formally stating its position that a beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the beneficiary’s basis in the property. Rev. Rul. 67-96, 1967-1 C.B. 195. In 2003, the IRS issued a private letter ruling again confirming the Tax Court’s approach in Cadby. Priv. Ltr. Rul. 200340019 (Jun. 25, 2003). Under the facts of the ruling, under the terms of Mother's will, the taxpayer was given the right to purchase the Mother’s home upon the Mother’s death at an amount less than fair market value. The basis in the option and in the home upon exercise of the option was determined in accordance with Rev. Rul. 67-96. Thus, the basis in the option upon its exercise was measured by the difference between the value of the home for federal estate tax purposes and the option price. In addition, as a result of exercising the option, the taxpayer’s basis in the home was the sum of the basis of the option and the actual option price paid.
Options can play an important role in transitioning a farming or ranching business to the next generation. Not only must thought be given to the financial ability of the optionee to exercise the option, the income tax issues triggered upon exercise of the option and, when applicable, the subsequent sale of the property acquired by exercising the option must also be considered.
Wednesday, May 27, 2020
During the last couple of months while various state governors have issued edicts randomly declaring some businesses essential and other non-essential, the ag industry has continued unabated. The same is true for the courts – the ag-related cases and tax developments keep on coming in addition to all of the virus-related developments.
As I periodically do, I provide updates of ag law and tax issues of importance to agricultural producers and others in the ag industry, as well as rural landowners in general.
That the topic of today’s post – a few recent developments in ag law and taxation.
FSA Not Entitled To Set-Off Subsidy Payments
In Re Roberts, No. 18-11927-t12, 2020 Bankr. LEXIS 1338 (Bankr. D. N.M. May 19, 2020)
Bankruptcy issues are big in agriculture at the present time. Several recent blog articles have touched on some of those issues, including bankruptcy tax issues. This case dealt with the ability of a creditor to offset a debt owed to it by the debtor with payments it owed to the debtor. The debtors (husband and wife) borrowed $300,000 from the Farm Service Agency (FSA) in late 2010. The debtors enrolled in the Price Loss Coverage program and the Market Facilitation Program administered by the FSA. The debtors filed Chapter 11 bankruptcy in mid-2018 and converted it to a Chapter 12 bankruptcy in late 2019. The debtors defaulted on the FSA loan after converting their case to Chapter 12.
The debtors were entitled to receive approximately $40,000 of total MFP and PLC payments post-petition. The FSA sought a set-off of the pre-petition debt with the post-petition subsidy payments. The court refused to the set-off under 11 U.S.C. §553 noting that the offsetting obligations did not both arise prepetition and were not mutual as required by 11 U.S.C. §553(a). There was no question, the court opined, that the FSA’s obligation to pay subsidy payments arose post-petition and that the debtors’ obligation to FSA arose pre-petition. Thus, set-off was not permissible.
HSA Inflation-Adjusted Amounts for 2021
Rev. Proc. 2020-32, 2020-24 I.R.B.
Persons that are covered under a high deductible health plan (HDHP) that are not covered under any other plan that is not an HDHP, are eligible to make contributions to a health savings account (HSA) subject to certain limits. For calendar year 2021, an HDHP is a health plan with an annual deductible of at least $1,400 for individual coverage or $2,800 for family coverage, and maximum out-of-pocket expenses of $7,000 for individual coverage or $14,000 for family coverage. For 2021, the maximum annual contribution to an HSA is $3,600 for self-only coverage and $7,200 for family coverage.
Charitable Deduction Allowed for Donated Conservation Easement
Champions Retreat Golf Founders, LLC v. Comr., No. 18-14817, 2020 U.S. App. LEXIS 15237 (11th Cir. May 13, 2020), rev’g., T.C. Memo. 2018-146
The vast majority of the permanent conservation easement cases are losers for the taxpayer. This one was such a taxpayer loser at the Tax Court level, but not at the appellate level. Under the facts of the case, the petitioner claimed a $10.4 million charitable deduction related to the donation of a permanent conservation easement on a golf course. The IRS denied the deduction on the basis that the easement was not exclusively for conservation purposes because it didn’t protect a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem as required by I.R.C. §170(h)(4)(A)(ii). The IRS also asserted that the donation did not preserve open space for the scenic enjoyment of the general public or in accordance with a governmental conservation policy for the public’s benefit under I.R.C. §170(h)(4)(A)(iii). The Tax Court agreed with the IRS and denied the deduction. The Tax Court determined that the “natural habitat” requirement was not met – there was only one rare, endangered or threatened species with a habitat of only 7.5 percent of the easement area. In addition, the Tax Court noted that part of the golf course was designed to drain into this habitat area which would introduce chemicals into it. Thus, the easement’s preservation of open space was not for public enjoyment nor in accordance with a governmental policy of conservation.
On further review, the appellate court reversed. The appellate court found that the deduction was proper if the donation was made for the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem or was made for the preservation of open space for the scenic enjoyment of the general public. The appellate court noted that without the golf course, the easement would satisfy the requirements and an easement deduction is not denied simply because a golf course is included. The appellate court remanded the case for a determination of the proper amount of the deduction.
Residence Built on Farm Was “Farm Residence” For Zoning Purposes
Hochstein v. Cedar County. Board. of Adjustment, 305 Neb. 321, 940 N.W.2d 251 (2020)
Many cases involve the issue of what is “agricultural” for purposes of state or county zoning and related property tax issues. In this case, Nebraska law provided for the creation of an “ag intensive district.” In such designated areas, any “non-farm” residence cannot be constructed closer than one mile from a livestock facility. The plaintiff operated a 4,500-head livestock feedlot (livestock feeding operation (LFO)) and an adjoining landowner operates a farm on their adjacent property. The adjoining landowner applied to the defendant for a zoning permit to construct a new house on their property that was slightly over one-half mile from the plaintiff’s LFO. The defendant (the county board of adjustment) approved the permit and the plaintiff challenged the issuance of the permit on the basis that the adjoining landowner was constructing a “non-farm” residence. The defendant affirmed the permit’s issuance on the basis that the residence was to be constructed on a farm. The plaintiff appealed and the trial court affirmed. On further review, the appellate court affirmed. On still further review by the state Supreme Court, the appellate court’s opinion was affirmed. The Supreme Court noted that the applicable regulations did not define the terms “non-farm residence” or “farm residence.” As such, the defendant had discretion to reasonably interpret the term “farm residence” as including a residence constructed on a farm.
Ag Cooperative Fails To Secure Warehouse Lien; Loses on Conversion Claim.
I dealt with the issue in this case in my blog article of March 27. You may read it here: https://lawprofessors.typepad.com/agriculturallaw/2020/03/conflicting-interests-in-stored-grain.html In the article, I detail many of the matters that arose in this case.
The facts of the case revealed that a grain farmer routinely delivered and sold grain to the defendant, an operator of a grain warehouse and handling facility. The contract between the parties contemplated the sale, drying and storage of the grain. The farmer also borrowed money from the plaintiff to finance the farming operation and granted the plaintiff a security interest in the farmer’s grain and sale proceeds. The plaintiff filed a financing statement with the Secretary of State’s office on Feb. 29, 2012 which described the secured collateral as “all farm products” and the “proceeds of any of the property [or] goods.” The financing statement was amended in late 2016 and continued. The underlying security agreement required the farmer to inform the plaintiff as to the location of the collateral and barred the farmer from removing it from its location without the plaintiff’s consent unless done so in the ordinary course of business. It also barred the farmer from subjecting the collateral to any lien without the plaintiff’s prior written consent. However, the security agreement also required the farmer to maintain the collateral in good condition at all time and did not require the plaintiff’s prior written consent to do so.
The plaintiff complied with the 1985 farm products rule and the farmer gave the plaintiff a schedule of buyers of the grain which identified the defendant. From 2014 through 2017, the farmer sold grain to the defendant, and the defendant remitted the net proceeds of sale via joint check to the farmer and the plaintiff after deducting the defendant’s costs for drying and storage – a longstanding industry practice. The plaintiff, an ag lender in an ag state, claimed that it had no knowledge of such deductions until 2017 whereupon the plaintiff sued for conversion. The defendant did not properly perfect a warehouse lien and the lien claim was rejected by the trial court, but asserted priority on a theory of unjust enrichment. The trial court rejected the unjust enrichment claim.
The state Supreme Court agreed, refusing to apply unjust enrichment principles in the context of Article 9 of the Uniform Commercial Code (UCC). The court did so without any mention of UCC §1-103 (b) which states that, "Unless displaced by the particular provisions of the Uniform Commercial Code, the principles of law and equity” including the law merchant [undefined] and the law relative to capacity to contract; duress; coercion; mistake; principal and agency relationships; estoppel, fraud and misrepresentation; bankruptcy, and other validating or invalidating cause [undefined] supplement its provisions.” This section has been characterized as the "most important single provision in the Code." 1 J. White & R. Summers, Uniform Commercial Code § 5. “As such, the UCC was enacted to displace prior legal principles, not prior equitable principles.” However, the Supreme Court completely ignored this “most important single provision in the Code.” The Court also ignored longstanding industry practice and believed an established ag lender in an ag state that it didn’t know the warehouse was deducting its drying and storage costs before issuing the joint check.
The developments keep rolling in. More will be covered in future articles.
Monday, May 25, 2020
A taxpayer that donates a “qualified real property interest” to a “qualified organization” can receive a charitable contribution deduction upon satisfying numerous technical requirements. A primary requirement is that the easement donation be exclusively for conservation purposes. That requirement, however, can only be satisfied if the conservation purposes are protected in perpetuity. I.R.C. §§170(h)(2)(C); (h)(5)(A). Essentially, that means that legally enforceable restrictions must be in place that will bar the use of the portion of the property that the taxpayer retains from being used in a manner that is inconsistent with the conservation purposes of the donated easement.
But, can anything here on earth really last forever? What if the easement is extinguished by court action? There’s a rule for that contingency and it requires careful drafting of the easement deed. Numerous court opinions have dealt with the issue, including a couple in recent weeks.
Dealing with potential extinguishment of a perpetual conservation easement donation – it’s the topic of today’s post.
The Issue of Extinguishment – Treasury Regulation
While the law generally disfavors perpetual control of interests in land, for a taxpayer to claim a tax deduction for a donated conservation easement, the easement must be granted in perpetuity. But if the conditions surrounding the property subject to a perpetual conservation easement make impossible or impractical the continued use of the property for conservation purposes, a Treasury Regulation details the requirements to be satisfied to protect the perpetual nature of the easement if a judicial proceeding extinguishes the easement restrictions. Treas. Reg. §1.170A-14(g)(6)(i)-(ii).
The regulation requires that, at the time of the donation, the donor must agree that the donation gives rise to a property right that is immediately vested in the donee. Treas. Reg. §1.170A-14(g)(6)(ii). The value of the gift must be the fair market value of the easement restriction that is at least equal to the proportionate value that the easement restriction, at the time of the donation, bears to the entire property value at that time. See Treas. Reg. §1.170A-14(h)(3)(iii) relating to the allocation of basis. The proportionate value of the donee’s property rights must remain constant such that if the conservation restriction is extinguished and the property is sold, exchanged or involuntarily converted, the done is entitled to a portion of the proceeds that is at least equal to that proportionate value of the restriction. The only exception is if state law overrides the terms of the conservation restriction and specifies that the donor is entitled to the full proceeds from the conversion restriction. Treas. Reg. §1.170A-14(g)(6)(ii).
Extinguishment – Cases
The formula language necessary to comply with the regulation must be precisely drafted. The IRS has aggressively audited perpetual easement restrictive agreements for compliance. Consider the following:
- In Carroll, et al. v. Comr., 146 T.C. 196 (2016), the petitioner contributed a conservation easement on a tract of land to two qualified organizations. The easement provided that if the conservation purpose was extinguished because of changed circumstances surrounding the donated property, the donees were entitled to a proportionate share of extinguishment proceeds not to be less than the amount allowed as a deduction to the donor for federal income tax purposes over the fair market value of the property at the time of the contribution. The plaintiff claimed a charitable contribution for the year of the contribution and carried forward the remaining balance to tax years 2006-2008.
Because the easement at issue provided that the value of the contribution for purposes of the donees’ right to extinguishment proceeds was tied to the amount of the petitioner’s allowable deductions rather than the fair market value of the easement, the court determined that the easement violated the Regulation and was not protected in perpetuity under I.R.C. §170(h)(5)(A). The court also imposed an accuracy-related penalty.
- In Palmolive Building Investors, LLC v. Comr., 149 T.C. No. 18 (2017), the petitioner acquired a building in 2001 for $58.5 million. In 2004, the petitioner transferred a façade easement on the building via deed to a qualified charity (a preservation council) to preserve the exterior building perimeter. The easement deed placed restrictions on the petitioner and its successors with respect to the façade easement and the building – the petitioner and any subsequent owner couldn’t demolish or alter the protected elements without the charity’s permission. The building was subject to two mortgages, but before executing the easement deed, the petitioner obtained mortgage subordination agreements from its mortgagee banks. However, the easement deed provided that in the event the façade easement was extinguished through a judicial proceeding, the mortgagee banks will have claims before that of the donee charity to any proceeds received from the condemnation proceedings until the mortgage is satisfied.
By the time of the easement donation, the value of the building had increased to $257 million, of which $33.4 million was attributable to the easement. The petitioner claimed a $33.4 million charitable contribution deduction for the tax year of the easement contribution. The IRS disallowed the deduction, claiming that the easement deed failed to satisfy the perpetuity requirements of I.R.C. §170 and Treas. Reg. §1.170A-14(g)(6)(ii) because it provided the mortgagees with prior claims to the extinguishment proceeds in preference to the donee. Specifically, the lender had agreed to subordinate the debt to the charity's claims, but the easement deed said that the lender would have priority access to any insurance proceeds on the property if the donor had insurance on the property. The easement deed also said that the lender would have priority to any condemnation proceeds.
The petitioner claimed that the First Circuit's decision in Kaufman v. Comr., 687 F.3d 21 (1st Cir. 2012) applied. In that case, the First Circuit rejected the view that a subordination must remove any preferential treatment of the lender in all situations, creating an exception for unusual situations that could possibly occur at some point in the future. The First Circuit determined that the Tax Court's reading of what is necessary to grant a perpetual easement would eliminate easement donations because an easement represented only a partial interest in property. In addition, the First Circuit reasoned that a broad reading was improper because, for example, a tax lien could arise if the donor failed to pay property tax when they became due which could result in the loss of the property without the charity receiving a pro rata portion of the property value.
In the present case, the Tax Court rejected the view of the First Circuit, noting that its decision would be appealable to the Seventh Circuit and, thus, the Tax Court was not bound by the First Circuit's decision. The Tax Court reasoned that because the lender had superior rights in certain situations, the mortgages did not meet the subordination requirement of Treas. Reg. §1.170A-14(g). Thus, the donated easement did not meet the perpetuity requirement of I.R.C. §170(h)(5). The Tax court also pointed out that other Circuits had agreed with the Tax Court's interpretation of the subordination rule since Kaufman was decided. The Tax Court also noted a difference concerning what must be done to subordinate an existing liability at the time of the donation (such as a mortgage) as opposed to a possible future liability that was not yet in existence. The Tax Court also noted that the Treasury Regulations specifically mentioned mortgages in the list of requirements necessary to satisfy the perpetuity requirement, but made no mention of a need to have taxing agencies to agree to give up rights to a priority interest that might arise in the future for delinquent taxes when the taxes were not delinquent.
The IRS assessed a gross valuation misstatement penalty in 2008 and additional accuracy-related and negligence penalties in 2014. The petitioner contested the penalties, but the Tax Court, in a later proceeding, determined that there is no requirement that IRS determine the penalties at the same time or by the same IRS agent. The only requirement, the Tax Court held, was that each penalty, at the time of initial determination, was approved in writing by a supervisor before being communicated to the petitioner. That requirement was satisfied. That later proceeding on the penalty issue is at 152 T.C. No. 4 (2019).
- In Salt Point Timber, LLC, et al. v. Comr., T.C. Memo. 2017-245, the petitioner was a timber company that granted a perpetual conservation easement on a 1,032-acre property for which the petitioner claimed a $2.13 million deduction on its 2009 return. The easement preserved the view of natural, environmentally significant habitat on the Cooper River by barring development. The petitioner received $400,000 for the donated easement, and the done satisfied the definition of a “qualified organization” under I.R.C. §170(h)(1)(B). The appraised value of the easement was $2,530,000. The IRS disallowed the deduction on the basis that the easement grant allowed the original easement to be replaced by an easement held by a disqualified entity. In addition, the IRS claimed that the grant allowed the property to be released from the original easement without the extinguishment regulation being satisfied. The petitioner claimed that there was a negligible possibility that the easement could be held by a non-qualified party. The court agreed with the IRS, noting that the grant did not define the term “comparable conservation easement” or what type of organization could hold it, just that an “eligible donee” could hold it. The court noted that an assignment of the easement is different from a replacement of the easement. As such, the grant did not restrict that the holder of the easement had to be a “qualified organization.” The court also determined that the chance that the easement could be replaced was other than negligible as Treas. Reg. §1.170A-14(g)(3) required.
- In PBBM-Rose Hill, Ltd., v. Comr., 900 F.3d 193 (5th Cir. 2018), the petitioner owned a tract of land subject to a use restriction requiring it to only be used for recreational facilities open space for 30 years. At the time of the petitioner’s ownership, the property was a golf course with a clubhouse. The petitioner wanted to sell the property, but before doing so wanted to remove the use restriction. A local buyer expressed interest, but also wanted to block any removal of the use restriction. The sale went through after the buyer agree to allow the removal of the use restriction. However, before the sale closed, the petitioner conveyed a conservation easement of the property to a land trust. The terms of the easement stated that the property was to remain open for public use for outdoor recreation and that fees for such use could be charged. Upon extinguishment of the easement, the land trust would be entitled to a portion of the sale proceeds equal to the greater of the fair market value of the easement at the time of the donation or a share of the proceeds after expenses of sale and an amount attributable to improvements constructed on the property. The IRS denied the charitable deduction.
The Tax Court agreed with the IRS position based on its findings that the easement did not protect the conservation purpose under I.R.C. §170(h)(4)(A) and didn’t satisfy the perpetuity requirement of I.R.C. §170(h)(5)(A) because the easement deed’s extinguishment provision did not comply with Treas. Reg. §1.170A-14(g)(6). As such, the easement donation was not “exclusively for conservation purposes as required by I.R.C. §170(h)(1)(C). The Tax Court held that the easement value was $100,000 rather than the $15.2 million that the petitioner claimed. The Tax Court also upheld the gross valuation misstatement penalty that the IRS had imposed. On appeal, the appellate court affirmed that the petitioner was not entitled to any charitable deduction and upheld the penalty. The appellate court held that when determining whether the public access requirement for a recreation easement is fulfilled, the focus is to be on the terms of the deed and not the actual use of the land post-donation. The appellate court determined that the terms of the easement satisfied the public-access requirement of Treas. Reg. §1.170A-14(d)(5)(iv)(C). However, the appellate court concluded that the contribution was not exclusively for conservation purposes because the requirements of Treas. Reg. §1.170A-14(g)(6)(ii) were not satisfied. The deed, the appellate court noted, allowed the value of improvements to be subtracted from the proceeds before the donee took its share, and that Priv. Ltr. Rul. 200836014 no longer represented the current position of the IRS and could not be used to alter the plain meaning of the regulation which mandates that the donee receive at least the proportionate value of the “proceeds.” The appellate court also agreed with the Tax Court that the gross valuation misstatement penalty applied to the difference between the amount the petitioner deducted on its return ($15 million) and the $100,000 deduction allowed by the Tax Court.
- In Coal Property Holdings, LLC v. Comr., 153 T.C. No. 7 (2019), the petitioner donated to a qualified charity an open space conservation easement over property which was previously subjected to surface coal mining and which was also subject to oil and gas leases and certain improvements. The IRS denied a charitable deduction because the easement wasn’t protected in perpetuity, and the Tax Court agreed. The conservation purpose of allowing the land subject to the easement to continue to recover from and provide scientific insight into the long-term effects of mining didn’t entitle the charity to a proportionate part of the proceeds if the subject property were sold upon a judicial extinguishment of the easement. As such, the easement wasn’t perpetual in nature as required by I.R.C. §170(h)(5)(A) and I.R.C. §1.170A-14(g)(6). While the petitioner claimed that the deed language contained a “regulation override” mandating that the deed be interpreted to satisfy the perpetuity requirements of the Code and Regulations, the Tax Court rejected that argument because it was a condition subsequent constituting a savings clause that the court would not enforce.
On this issue, the IRS also argues that when an easement deed’s proceeds allocation formula deducts (from the proceeds allocable to the done) an amount attributable to “improvements” made by the owner after the donation, no charitable deduction is allowed. The IRS position is that the deduction violates the extinguishment regulation (Treas. Reg. 1.170A-14(g)(6)(ii)), making the charitable deduction unavailable. See, e.g., Priv. Ltr. Rul. 200836014 (Sept. 5, 2008).
- In Railroad Holdings, LLC, et al. v. Comr., T.C. Memo. 2020-22, the petitioner donated a permanent conservation easement to a qualified entity and claimed a $16 million charitable deduction. The deed granting the easement contained a clause specifying the result if the easement were extinguished as the result of a court order. The IRS pointed out that in the event of a forced judicial sale, Treas. Reg. §1.170A-14(g)(6)(ii) requires the charity to receive an equal proportionate value of the sale proceeds that extinguishes the interest to the value of the easement as compared to the value of the property at the date of the donation. The language of the deed at issue held the charity’s payment constant, equal to the value as of the date of the contribution. It did not tie the charity’s payment to a percentage of the value of the property at the time of the forced sale equal to the percentage of value the easement was to the property at the time of the donation. The IRS denied the entire $16 million donation and the Tax Court agreed.
The Tax Court noted that the deed language did not create a proportion or fraction representing the donee’s share of the property right and a corresponding fraction of the proceeds to which the donee was entitled in perpetuity. Rather, the Tax Court noted, the language gave the charity a “proportionate value…at the time of the gift” which guaranteed only that a fixed dollar amount would go to the charity. The Tax Court also held as irrelevant a declaration of intent executed by an officer of the charity that the deed language reflected the charity’s intent to be in full compliance with the Code. What mattered was the donor’s intent, not the charity’s intent. Even so, the deed language failed to conform to the Code. The Tax Court also determined that the deed language was not ambiguous. Thus, the easement was not protected in perpetuity and the full deduction was disallowed.
Challenge to the Validity of the Regulation
In Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020), the petitioner challenged the validity of the extinguishment regulation. In 2008, the petitioner donated a permanent conservation easement to a qualified organization and claimed a charitable deduction. The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution. That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement. The IRS denied the charitable deduction because (inter alia) violated the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6).
The Tax Court, agreeing with the IRS, upheld the validity of the regulation. The full Tax Court held that the extinguishment regulation (Treas. Reg. §1.170A-14(g)(6)) had been properly promulgated and did not violate the Administrative Procedure Act. The full Tax Court also determined that the construction of I.R.C.§170(h)(5), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
In a related memorandum opinion, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made. Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54. It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed. However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable.
The extinguishment regulation is, perhaps, the most common audit issue for IRS when examining permanent conservation easement donations. The clause specifying how proceeds are to be split when a donated conservation easement is extinguished is routinely included in easement deeds. The cases point out that the clause must be drafted precisely to fit the confines of the regulation. A regulation that now has survived an attack on its validity. Many perpetual easement donations will potentially be affected.
Thursday, May 21, 2020
The TCJA eliminated tax-deferred like-kind exchanges of personal property for exchanges completed after 2017. However, exchanges of real estate can still qualify for tax-deferred treatment if the exchange involves real estate that is “like-kind.” But, what if the exchange involves non-like-kind cash “boot” or otherwise fails the requirements of the Code? Is there a way to still achieve tax deferral?
“Fixing” a tax-deferred exchange that has failed – it’s the topic of today’s post.
The tax deferral of an IRC §1031 exchange is only achieved if the requirements of IRC §1031 are satisfied. If the requirements are not satisfied, the exchange is taxable as a sale or exchange under the general rules of IRC §1001.
There are four basic requirements to achieving tax-deferred treatment under IRC §1031:
- There is an exchange of property rather than a sale; IRC §1031(a)(1).
- The property exchanged and the property received must be like-kind real estate;
- The property exchanged and the property received must both be held for the productive use in a trade or business or for investment; and
- The exchange of properties must be simultaneous, or the replacement property must be identified within 45 days of the exchange and the identified property must be received within 180 days of the identification or the due date of the return (including extensions), if shorter. IRC §§1031(a)(3)(A)-(B)((ii).
If an exchange satisfies the requirements of IRC §1031, but property is received that is not like-kind (such as money or other non-like kind property, the recipient of the property recognizes gain to the extent of the sum of the money and the fair market value of the non-like-kind property received. I.R.C. §1031(b). That means that tax deferral is not achieved with respect to the non-like-kind property (or “boot”) received in the exchange. But a taxpayer may elect to recognize the gain on the boot under the installment method of I.R.C. §453. Similarly, a taxpayer that fails to satisfy the requirements of IRC §1031 may be able to defer gain on the transaction under IRC §453 by properly structuring the sale.
Treasury Regulation Example
Treasury Regulation §1.1031(k)-(1)(j)(2)(vi), Example 4, indicates that a buyer’s installment note issued to a seller qualifies for installment treatment under IRC §453. In the Example, the buyer offers to buy the seller’s real property, but doesn’t want to have the transaction structured as a like-kind exchange. As a result, the seller enters into an exchange agreement with a qualified intermediary to facilitate the exchange. Under the agreement, the seller transfers the real property to the qualified intermediary who then transfers the property to the buyer. The buyer pays $80,000 cash and issues a 10-year installment note for $20,000. The Example specifies that the seller has a bona fide intent to enter into a deferred exchange, and the exchange agreement specifies that the seller cannot receive, pledge, borrow or otherwise obtain the benefits of the money or other property that the qualified intermediary held until the earlier of the date the replacement property is delivered to the seller or the end of the exchange period. The Example also points out that the buyer’s obligation bears adequate stated interest and is not payable on demand or readily tradable. The qualified intermediary acquires replacement property having a fair market value of $80,000 and delivers it, along with the $20,000 installment obligation, to the seller.
While the $20,000 of the seller’s gain does not qualify for deferral under IRC §1031(a), the seller’s receipt of the buyer’s obligation is treated as the receipt of an obligation of the person acquiring the property for purposes of installment reporting of gain under IRC §453. Thus, the Example concludes that the seller may report the $20,000 gain on the installment method on receiving payments from the buyer on the obligation
A safe harbor exists that provides protection against an IRS assertion that a taxpayer is in actual or constructive receipt of money or other property held in a qualified escrow account, qualified trust, or by a qualified intermediary. Treas. Regs. §§1.1031(k)-1(g)(3)-(4); T.D. 8535 (Jan. 1994). With respect to a qualified intermediary, the determination of whether a taxpayer has received payment for purposes of IRC §453 is made as if the qualified intermediary is not the taxpayer’s agent. Treas. Regs. §§1.1031(k)-1(j)(2)(ii); (g)(4). Thus, when a taxpayer transfers property under such an arrangement and receives like-kind property in return, the transaction is an exchange rather than a sale, and the qualified intermediary is not deemed to be the taxpayer’s agent. See Priv. Ltr. Rul. 200327039 (Mar. 27, 2003). Similarly, when a buyer places money in an escrow account or with the qualified intermediary, the seller is not in constructive receipt of the funds if the seller’s right to receive the funds is subject to substantial restriction. See, e.g., Stiles v. Commissioner, 69 T.C. 558 (1978). The Treasury Regulations state that any agency relationship between the seller and the qualified intermediary is disregarded for purposes of IRC §453 and Treas. Reg. §15a.453-1(b)(3)(i) in determining whether the seller has constructively received payment. Treas. Reg. §1.1031(k)-1(j)(2)(vi), Example 2.
Exchange Transaction Example
Assume that Molly Cule owns a tract of farmland that she uses in her farming business and would like to exchange it for other farmland in an I.R.C. §1031 transaction. Bill Bored and Molly enter into a purchase contract, calling for Bill to buy Molly’s farmland. The purchase contract clearly states that Bill must accommodate Molly’s desire to complete an IRC §1031 exchange and states that Molly desires to enter into an IRC §1031 exchange. Molly and a qualified intermediary then enter into an exchange agreement specifying that the qualified intermediary agrees to acquire Molly’s farmland and transfer it to Bill. The agreement also states that the qualified intermediary will acquire like-kind farmland and transfer it to Molly. Molly assigns her rights in and to the farmland she gave up to the qualified intermediary. She also assigns her rights to the qualified intermediary in all contracts she enters into with the owner who holds title to the replacement farmland.
The exchange agreement requires Molly to identify replacement farmland within 45 days of the initial exchange and to notify the qualified intermediary of the identified parcel within that 45-day period. The exchange agreement allows Molly 180 days from the date of the first exchange to receive the identified property.
The exchange agreement specifies that the qualified intermediary will sell Molly’s farmland and hold the sales proceeds until the qualified intermediary buys replacement farmland. When the replacement farmland is purchased, it will then be transferred to Molly.
Structured sale aspect. The exchange agreement says that if the transaction qualifies under I.R.C. §1031, but Molly receives “boot,” the qualified intermediary and Molly must engage in a structured sale for the boot. This is to bar Molly from having any right to receive cash from the exchange. Similarly, the exchange agreement contains additional language stating that if the transaction fails to qualify for I.R.C. §1031 treatment for any reason, the qualified intermediary and Molly must engage in a structured sale. The structured sale involves the qualified intermediary making specified periodic payments to Molly pursuant to an installment sale agreement (based on the consideration the qualified intermediary holds) coupled with a note for a set number of years. Thus, the exchange agreement is drafted to specify that if an installment sale results, Molly will report each payment received into income in the year she receives it.
The assignment agreement. If the installment sale language is triggered, the exchange agreement specifies that the qualified intermediary will assign its obligations to make the periodic payments under the installment note to an assignment company pursuant to a separate assignment agreement between the qualified intermediary and the assignment company. Molly is not a party to this agreement. The assignment agreement requires the qualified intermediary to transfer a lump sum to the assignment company. The lump sum amount equals the discounted present value of the stream of payments that the qualified intermediary must make under the installment note and exchange agreement. In return, the assignment company assumes the qualified intermediary’s obligation to pay Molly. Thus, the assignment company becomes an obligor under the installment note.
As discussed above, Example 4 of Treas. Reg. §1.1031(k)-1(j)(vi), involves an installment note that the buyer issues to the seller of the property. That note qualifies for installment treatment under I.R.C. §453. In the example involving Molly, it is the qualified intermediary that issues the note. While the regulation states that the qualified intermediary is not the agent of the Molly for purposes of IRC §453, that is only the case until the earlier of the identification (or replacement) period, or the time that Molly has the unrestricted right to receive, pledge, borrow or otherwise benefit from the money or other property that the qualified intermediary holds. Treas. Reg. §1.1031(k)-1(j)(2)(ii). But, the risk of Molly being in constructive receipt of the buyer’s funds is eliminated if the exchange agreement is drafted carefully to fit within the safe harbor.
As an alternative to the approach of the example involving Molly, what if a different taxpayer, Millie, engaged in a similar transaction and used installment reporting but received all of the cash up front via a loan. Will an arrangement structured in this manner achieve tax deferral?
Facts of the example. Millie sells an asset to Howard’s Exchange Service (HSE) and HSE resells the asset to Andy. Millie receives a loan from Usurious Bank, an independent lender shortly after selling the asset to HSE for an amount equating the selling price to HSE. The repayment of the loan is funded by installment payments over a period of time that HSE makes to Usurious Bank. Three escrow accounts are established with an escrow company affiliated with Usurious Bank. The escrow company, on a monthly basis, takes funds from HSE and moves it into Escrow Account No. 1 as an interest payment on the loan; then to Escrow Account No. 2 (which is designated as Millie’s account); and then to Escrow Account No. 3 to pay interest on the loan. The transactions are conducted as automatic debit/credit transactions that occur on a monthly basis over the length of the installment period.
Analysis. IRC §453 requires that the initial debt obligation be that of the buyer of the property for the seller to receive installment treatment on the proceeds of sale. If the obligor is someone other than the buyer, the debt is treated as payment on the sale. Treas. Reg. §15a.453-1(b)(3)(i). Thus, for installment sale treatment to result, HSE must be both the buyer of the asset and the obligor on the installment note rather than only being the obligor. This means that the transaction must be structured such that the obligation is due to Millie from Andy, followed by a substitution of the obligor via an independent transaction in which Andy assigns the obligation. In Rev. Rul. 82-122, 1982-1 C.B. 80, amplifying Rev. Rul. 75-457, 1974-1 C.B. 115, the substitution of a new obligor on the note and an increase in the interest rate, together with an increase in the amount paid monthly to reflect the higher interest rate, was not considered to be a satisfaction or disposition of an installment obligation within the meaning of I.R.C. §453B(a).
As for the escrow accounts, generally an installment note of the buyer cannot be used as security or pledged to support any other debt that benefits the seller. If that happens, the net proceeds of the debt are treated as a payment received on the installment sale. See IRC §453A(d)(1); Treas. Reg. §15A.453-1(b)(3)(i); Rev. Rul. 79-91, 1979-1, C.B. 179; Rev. Rul. 77-294, 1977-2, C.B. 173; Rev. Rul. 73-451, 1973-2, C.B. 158. However, there is an exception to this “pledge rule” that triggers gain recognition if the seller uses an installment obligation to secure a loan. Property that is used or produced in the trade or business of farming is not subject to the rule. I.R.C. §453A(b)(3)(b). Thus, a taxpayer who sells farmland (or other farm property) in an installment sale may use that installment receivable as security, or in a pledged manner, to borrow funds from a third party. The third party should collateralize the payments and file a UCC-1 to formally pledge and secure the installment payments
Tax-deferred exchanges post-2017 are limited to real estate exchanges. Normally, only the like-kind portion of the exchange qualifies for deferral. However, if an exchange involving farm property is structured properly, tax deferral can be achieved for the entire transaction. Careful drafting of the contracts involved is critical.
Friday, May 15, 2020
The interest among some farmers and ranchers in converting some of their land into a “solar farm” is growing. The opportunity for additional cash in tough economic times is driving the interest. Is it a good investment? Of course, the boondoggles of Solyndra, LLC in California and Crescent Dunes in Nevada are a reminder that such ventures can turn up dry. In addition, the federal government encourages ventures into solar energy production with the use of taxpayer dollars.
Solar energy production and the tax credit for producing electricity from the sun – it’s the topic of today’s post.
Residential Energy Credit
Currently, a taxpayer may claim a residential energy efficient property credit of 26 percent credit for the costs of the solar panels and related equipment and material installed to generate electricity for use by a residential or commercial building. I.R.C. §25D. A taxpayer is “allowed as a credit against the tax imposed…for the taxable year, an amount equal to the sum [of] the qualified solar electric property expenditures” – expenditures “for property which uses solar energy to generate electricity for use in a dwelling unit located in the United States and used as a residence by the taxpayer.” I.R.C. §25D(2). The credit is computed by taking into account the cost of solar panels as well as piping or wiring to connect the property to the dwelling unit plus labor costs. For a newly constructed home, the taxpayer may request that the homebuilder make a reasonable allocation, or the taxpayer may use any other reasonable method to determine the cost of the property that is eligible for the credit. IRS Notice 2013-70, 2013-47 IRB 528, Q&A No. 21.
A taxpayer that claims the credit for solar energy property installed in the taxpayer’s principal residence or vacation home must reduce the taxpayer’s income tax basis in the property by the amount of the credit. A “home” includes a house, houseboat, mobile home, cooperative apartment, condominium, and a manufactured home. See Instructions to Form 5695, Residential Energy Credits.
Commercial (Business) Energy Credit
I.R.C. §48 provides a credit for “energy property placed in service during [the] taxable year.” I.R.C. §48(a)(1). The amount of the credit is a percentage of energy based on each energy property placed in service during the taxable year. The energy percentage is 26 percent for solar energy property that is under construction on or before December 31, 2020 and placed in service before January 1, 2024. The credit belongs to the owner of the solar energy property. The credit is claimed on Form 5695 with the amount of the credit carried to Form 1040.
IRS Notice 2013-70 provides taxpayers with two methods to establish the beginning of construction – either by starting physical work of a significant nature (the “Physical Work” test) or by satisfying a safe harbor (the “Five Percent Safe Harbor” test). Under the safe harbor, construction is deemed to begin when the taxpayer pays or incurs five percent or more of the total cost of the energy property and thereafter makes continuous efforts to advance towards completion of the energy property. While either method may be used, construction is deemed to have begun on the date the taxpayer first satisfies one of the two methods.
Energy property is defined as any “equipment which uses solar energy to generate electricity to…a structure” and “equipment which uses solar energy to illuminate the inside of a structure.” I.R.C. §48(a)(3). The regulations provide additional guidance. Treas. Reg. §1.48-9(d)(1) provides that “solar energy property’ includes equipment and materials (and parts related to the functioning of such equipment) that use solar energy directly to (i) generate electricity (ii) heat or cool a building or structure, or (iii) provide hot water for use within a building or structure.” Treas. Reg. §1.48-9(d)(3) defines electric generation equipment as follows:
“Solar energy property includes equipment that uses solar energy to generate electricity, and includes storage devices, power conditioning equipment, transfer equipment, and parts related to the functioning of those items. In general, this process involves the transformation of sunlight into electricity through the use of such devices as solar cells or other collectors. However, solar energy property used to generate electricity includes only equipment up to (but not including) the stage that transmits or uses electricity.”
In addition, Treas. Reg. §1.48-9(d)(4) specifies that “[p]ipes and ducts that are used exclusively to carry energy derived from solar energy are solar energy property.” Because the credit is part of the general business credit under I.R.C. §38. Property that is eligible for the general business credit is tangible property for which depreciation is allowable.
The solar energy credit is part of the investment credit under I.R.C. §46(2) which means that it is subject to the rules that apply to unused general business credits under I.R.C. §38(a). Unused credit amounts are carried back one year and then to each of the 20 years following the unused credit year. The credit is nonrefundable and may only be used against the taxpayer’s actual tax liability. The entire amount of the unused credit must be carried back one year before it may be carried over to the next 20 years. I.R.C. §39(a)(2)(A).
The solar equipment can be owned by one party and used on another person’s property. In that situation, the owner/lessor may claim the energy credit provided that the solar property is placed in service and meets the other requirements of I.R.C. §48. Rev. Rul. 79-264, 1979-2 C.B. 92.
As noted, the owner of the solar energy property is entitled to the energy credit. If IRS challenges the ownership issue in lessor/lessee situations, the most important factor in determining ownership is the source of capital for the solar energy property. The party that is exposed to the risk of loss from supplying the necessary capital for the asset and retaining an actual and legal proprietary interest in the asset is the owner of the property that is entitled to the credit.
A lessor of new solar energy property may elect to pass the credit to the lessee if the transaction involves a profit intent and the and the lease is a bona fide lease. The property is deemed to be place in service when it is first held out for leasing to others in a profit-motivated leasing venture. See, e.g., Cooper v. Commissioner, 88 T.C. 84 (1987). A sale/leaseback is also possible which allows the lessee to claim the credit or would permit the lessor to pass-through its credit to a lessee.
A recent U.S. Tax Court case, Golan v. Comr., T.C. Memo. 2018-76, involved the solar energy credit as well as associated income tax basis, depreciation, at-risk and passive loss issues. The case is a good illustration of the issues that can arise when a farmer or rancher (or other taxpayer) gets involved with a “solar farm” project.
Fact of the case. In 2010, the petitioners (a married couple), sought an income-producing investment and thought they would do so by purchasing solar equipment from a seller of such equipment. The seller identifies property owners and offers them discounted electricity in exchange for permission to install solar panels and related equipment on their properties (known as “host properties”) The seller remains the owner of the solar equipment and temporarily retains the burdens and benefits of ownership (including all resulting tax credits and rebates). Then, the seller sells the solar equipment (and the associated rights and obligations) to a buyer such as the petitioners. An owner of a host property filed an application with the local utility company for an interconnection agreement (for net energy metering), and the seller entered into a power purchase agreement (PPA) with the owner of the host property. The seller, as noted, temporarily retained ownership of the solar equipment and was responsible for any servicing or repairs. The PPA barred the owner of the host property from assigning the PPA to another party without the seller’s consent, but the seller could assign it interest in the PPA to another party with 30 days’ notice to the host. Once the solar panels were installed, the utility company informed the host property owner of eligible rebates, which the host property owner assigned to the seller.
The sale of the solar equipment to the petitioners was accomplished in 2010 under a solar project purchase agreement coupled with a promissory note and guarantee that the petitioner’s signed. It was completed with a bill of sale and conveyance. The solar equipment was installed on the host properties in 2010, but under the purchase agreement, the “original use” of the solar equipment “shall commence on or after the Closing Date.” The purchase price was set at $300,000, consisting of a $90,000 down payment due on closing in early 2011; a $57,750 credit for the rebates the seller received from the utility company before the sale; and the petitioners’ promissory note in the principal amount of $152,250 with interest at 2 percent. The solar equipment secured the note and all monthly revenue generated from the solar equipment was to be applied to the note. If accrued interest exceeded monthly receipts for any particular month, the difference was to be carried forward and the petitioners would owe it in future months. If monthly receipts exceeded accrued interest and amortized principal, the excess would accelerate the loan’s repayment. Upon default, the seller would seek recourse against the solar equipment before exercising any remedies against the petitioners, and the petitioners were liable to pay any deficiencies owed to the seller if sale of the collateral upon foreclosure didn’t pay outstanding amounts owed to the seller. The petitioners also signed a guarantee for the note.
Ultimately, the petitioners failed to pay the down payment in 2011 but did make partial payment in 2012 and 2013. In addition, the petitioners directed the owners of the host properties to make direct payment of electricity bills to the seller who then credited the payments toward the note. The seller continued to honor the purchase agreement.
On their 2011 return, the petitioners Schedule C reported no income, but claimed various deductions including depreciation of $255,000. The petitioners stated that the Schedule C business was as a “consultant” for the seller’s business. The petitioners were also on the cash method of accounting. The $255,000 figure was arrived at as the difference between their claimed $300,000 basis in the solar equipment and $45,000. The $45,000 was one-half of the $90,000 energy credit claimed reduced by one-half in accordance with IRC §§50(c)(1) and (3)(A). On their associated Form 4562, the petitioners stated that the $255,000 deduction was a “[s]pecial depreciation allowance for qualified property.” Also attached to the 2011 return was Form 3468 on which they claimed a $90,000 energy credit (30 percent of $300,000).
The IRS disallowed the depreciation deduction on the basis that the solar equipment did not qualify for “bonus” depreciation because it was neither acquired after September 8, 2010 nor placed in service before January 1, 2012. The IRS also disallowed the energy credit claiming that the petitioners did not have a basis in the energy property because no funds changed hands. In addition, the IRS asserted that the petitioners were not at-risk with respect to the promissory note and, as a result, could not claim any basis in the note. The IRS based its position that the seller had a prohibited continuing interest in the solar equipment activity. See I.R.C. 465(b)(3). The IRS also took the position that the passive loss rules applied to the petitioners’ Schedule C loss and claimed solar energy credit. An accuracy-related penalty was also applied.
The Tax Court’s holdings:
- Income tax basis. Because the down payment of $90,000 payment was not paid in 2011, that amount could not be applied to the petitioners’ basis in the solar property for 2011, citing Treas. Reg. §1.1012-1(a). As for the $57,750 credit for the rebates assigned to the utility company by the owners of the host properties, the petitioners neither received them nor reported them as income. This amount could also not be applied to the petitioners’ basis in the solar equipment. It was not part of the petitioners’ cost of the solar equipment. The $152,250 promissory note was a recourse obligation that was issued in exchange for the solar equipment. As such, the face amount of the note could be included in the petitioners’ basis in the solar equipment.
The result was that the petitioners’ income tax basis in the solar equipment was $152,250.
- Bonus depreciation. The Tax Court determined that the solar equipment (which has a recovery period of 20 years) did qualify for bonus depreciation because the petitioners acquired it (as the original user) in January of 2011 and placed it in service that year. While the solar property was installed on the host properties in 2010, the IRS failed to prove that the property was connected to the grid in before 2011. As such, the solar property was not ready and available for its intended use until it was connected to the electric grid, and that was in 2011 rather than 2010.
- At-risk rules. The Tax Court disagreed with the IRS claim that the seller had a prohibited continuing interest in the solar equipment activity under I.R.C. §465(b)(3). The IRS failed to identify any provision of the purchase agreement entitling the seller to the solar equipment upon liquidation. Similarly, the seller was not shown to have an interest in the net profits of the petitioners’ solar energy venture. The right to have monthly revenue applied to the note was a permitted gross receipts interest. It was immaterial that the seller was also a promoter of the transaction.
- Passive loss rules. The petitioners claimed that the husband participated in the solar energy venture for at least 100 hours in 2011 and that his participation was not less than that of any other individual, thus satisfying the material participation test of Temp. Treas. Reg. §1.469-5T(a)(3). The Tax Court viewed the husband’s testimony as credible and that the IRS failed to establish otherwise.
- The Tax Court did not uphold the accuracy-related penalty, finding that the petitioners made a good faith effort to determine their tax liability and reasonably relied on the advice of their tax preparer.
The tax credit for solar energy electricity production is designed to incentivize solar energy production. But, there are other considerations besides tax in determining whether a “solar farm” investment is a good one for any particular farmer or rancher. Each situation is dependent on the facts. For those interested in a “solar farm” investment, seek good legal and tax counsel.
Wednesday, May 6, 2020
On April 1, https://lawprofessors.typepad.com/agriculturallaw/2020/04/disasteremergency-legislation-summary-of-provisions-related-to-loan-relief-small-business-and-bankruptcy.htmlI published a detailed article on this blog concerning the CARES Act and, in particular, the Paycheck Protection Program (PPP). The PPP is an extension of the existing Small Business Administration (SBA) 7(a) loan program for a “qualified small business” with many of the existing restrictions on 7(a) loans waived for a set timeframe including guarantee and collateral requirements and the requirement that the borrower cannot find credit elsewhere. The purpose of the program is to support small businesses and help support their payroll during the coronavirus situation. In addition, a small business loan borrower is eligible for loan forgiveness on existing SBA 7(a) loans.
Over the past six weeks, the U.S. Treasury Department and the SBA have been issuing guidance concerning various aspects of the CARES Act, including the PPP. In spite of all of the guidance, questions remain for farmers and ranchers.
Lingering questions and issues surrounding the PPP – it’s the topic of today’s post.
Is Ag Eligible?
After some initial questions concerning whether farming and ranching businesses qualified for the PPP, the SBA issued an Interim Final Rule and an FAQ clarifying that ag businesses are eligible upon satisfying certain requirements. Unfortunately, while ag businesses are eligible apparently some lenders were apparently advising farmers that participation in the PPP would either reduce their USDA farm subsidies or eliminate their eligibility for them. That is not true. There is no basis for reaching that conclusion based on the statutory language. Some lenders were also apparently informing farmers that they wouldn’t be eligible for the ag part of the CARES Act Food Assistance Program. Again, there is no basis for that conclusion.
Other Areas of Concern
Loss on Schedule F? While the SBA has clarified that Schedule F income can be used for computing loan eligibility, the SBA has taken the position that a loss on line 34 of Schedule F disqualifies the farm/ranch taxpayer from loan eligibility based on earnings. Thus, such a farmer can only qualify for a PPP loan based on employee payroll costs (if any). That’s a harsh rule as applied to farmers and ranchers – particularly smaller operations that don’t have employees. Income that shows up on a form other than Schedule F doesn’t count toward for purposes of loan computation. While this could be changed in the future, the present position of the SBA is that eligible income is only that subject to self-employment tax.
Passive rental income. As noted above, the SBA position is that loan eligibility is tied to self-employment earnings. Apparently, that position means that rental income that is not reported on Schedule F fails to qualify (such as that reported on either Schedule E or on Form 4835).
Partnerships. For a partnership, PPP loan filing is at the partnership level. Thus, a partner is precluded receiving a loan at the partner level. A partnership can count all employee payroll costs for loan computational purposes and all self-employment income of partners reported on line 14a of Schedule K/K-1. That amount is then reduced by any I.R.C. §179 expense deduction claimed; unreimbursed partnership expenses claimed, and depletion claimed on oil and gas properties. The result is then multiplied by 92.35% to arrive at net self-employment earnings. If the final amount exceeds $100,000, it is to be reduced to $100,000. Whether that same computational approach applies to a Schedule F farmer (or Schedule C filer) is unclear. Relatedly, it’s unclear whether the ordinary income of manager-managed LLCs where self-employment tax is reduced counts toward the PPP loan computations purposes. Likewise, if a taxpayer has an interest in more than one partnership that are treated as self-employed entities, a question remains as to whether each entity can qualify for a loan or whether the $100,000 compensation limit must be allocated among the partnerships. The same lack of clarity applies to LLCs taxed as a partnership.
Commodity wages. In computing eligible wages, S or C corporations are only allowed to use taxable Medicare wages & tips from line 5c of Form 941 (Employer’s Quarterly Federal Tax Return). These wages are subject to FICA and Medicare taxes. If eligible wages must be subject to FICA and Medicare tax, agricultural commodity wages will not be eligible. Thus, the question is whether Form 943 (Employer’s Annual Federal Tax Return for Agricultural Employees) filers are to be treated as Form 941 filers.
Payroll costs. Certain sectors of the agricultural economy hire a significant amount of H2A workers. Recent guidance of the SBA and the Treasury indicate that wages paid to an H2A worker can count as eligible “payroll costs” if the worker satisfies the “principle place of residence” test under the Internal Revenue Code – at least 183 days present in the U.S. during the year. That would seem to mean that H2A workers in the U.S. year-round will also qualify. What’s not clear is whether wages paid to H2A workers count even if ultimately the worker is to return to the worker’s home country.
Loan forgiveness. As I noted in my article of April 1, https://lawprofessors.typepad.com/agriculturallaw/2020/04/disasteremergency-legislation-summary-of-provisions-related-to-loan-relief-small-business-and-bankruptcy.html loan proceeds that are forgiven and are not included in the recipient’s income do not give rise to deductible expenses by virtue of I.R.C. §265. On April 30, the IRS agreed. I.R.S. Notice 2020-32. Now certain members of the Congress are putting pressure on the I.R.S. to change its position. Another area needing clarification is how the amount of the loan that is forgiven is to be computed for a sole proprietor or self-employed taxpayer – is it based on eight weeks of self-employment income in 2019 plus qualified expenses, or is it simply limited to eight weeks of self-employment income? Is employer compensation counted as “wages”?
Bankruptcy. Can a debtor in reorganization bankruptcy apply for a PPP loan and receive funds upon satisfying the requirements for a loan? The answer, at least according to one bankruptcy court, is “yes.” In re Springfield Hospital, Inc., No. 19-10283, 2020 Bankr. LEXIS 1205 (Bankr. D. Vt. May 4, 2020). This is an important development for small businesses and farming operations.
The uncertainties surrounding the PPP are largely a result of the legislation being crafted in a rush without numerous hearings and vetting of the statutory language and thought being given to related impacts of the statutory provisions. Since enactment of the CARES Act in late March, guidance from the SBA and the Treasury/IRS has largely been of the non-substantial authority type. It’s not binding on the IRS or taxpayers. Unless the unclear aspects of the PPP are clarified substantially, it could mean that litigation could arise and be ongoing into the future.