Wednesday, January 20, 2021
Today's post is a bibliography of my ag law and tax blog articles of 2020. Many of you have requested that I provide something like this to make it easier to find the articles. If possible, I will do the same for articles from prior years. The library of content is piling up - I have written more than 500 detailed articles for the blog over the last four and one-half years.
Cataloging the 2020 ag law and tax blog articles - it's the topic of today's post.
Ag Law and Tax in the Courts – Bankruptcy Debt Discharge; Aerial Application of Chemicals; Start-Up Expenses and Lying as Protected Speech
Unique, But Important Tax Issues – “Claim of Right;” Passive Loss Grouping; and Bankruptcy Taxation
Disaster/Emergency Legislation – Summary of Provisions Related to Loan Relief; Small Business and Bankruptcy
Retirement-Related Provisions of the CARES Act
Farm Bankruptcy – “Stripping, “Claw-Black,” and the Tax Collecting Authorities
SBA Says Farmers in Chapter 12 Ineligible for PPP Loans
The “Cramdown” Interest Rate in Chapter 12 Bankruptcy
Bankruptcy and the Preferential Payment Rule
Partnership Tax Ponderings – Flow-Through and Basis
Farm and Ranch Estate and Business Planning in 2020 (Through 2025)
Transitioning the Farm or Ranch – Stock Redemption
Estate and Business Planning for the Farm and Ranch Family – Use of the LLC (Part 1)
Estate and Business Planning for the Farm and Ranch Family – Use of the LLC (Part 2)
The Use of the LLC for the Farm or Ranch Business – Practical Application
Top Ten Agricultural Law and Tax Developments from 2019 (Numbers 10 and 9)
Ag Law in the Courts – Feedlots; Dicamba Drift; and Inadvertent Disinheritance
Ag Law and Tax in the Courts – Bankruptcy Debt Discharge; Aerial Application of Chemicals; Start-Up Expenses and Lying as Protected Speech
Dicamba, Peaches and a Defective Ferrari; What’s the Connection?
Liability for Injuries Associated with Horses (and Other Farm Animals)
Issues with Noxious (and Other) Weeds and Seeds
Of Nuisance, Overtime and Firearms – Potpourri of Ag Law Developments
The Statute of Frauds and Sales of Goods
Disrupted Economic Activity and Force Majeure – Avoiding Contractual Obligations in Time of Pandemic
Is it a Farm Lease or Not? – And Why it Might Matter
Top Ten Agricultural Law and Tax Developments of 2019 (Numbers 2 and 1)
Concentrated Ag Markets – Possible Producer Response?
Is an Abandoned Farmhouse a “Dwelling”?
Top Ten Agricultural Law and Tax Developments of 2019 (Numbers 8 and 7)
Top Ten Agricultural Law and Tax Developments of 2019 (Numbers 6 and 5)
Top Ten Agricultural Law and Tax Developments of 2019 (Numbers 4 and 3)
Clean Water Act – Compliance Orders and “Normal Farming Activities”
Groundwater Discharges of “Pollutants” and “Functional Equivalency”
NRCS Highly Erodible Land and Wetlands Conservation Final Rule – Clearer Guidance for Farmers or Erosion of Property Rights? – Part One
NRCS Highly Erodible Land and Wetlands Conservation Final Rule – Clearer Guidance for Farmers or Erosion of Property Rights? – Part Two
NRCS Highly Erodible Land and Wetlands Conservation Final Rule – Clearer Guidance for Farmers or Erosion of Property Rights? – Part Three
The Prior Converted Cropland Exception – More Troubles Ahead?
TMDL Requirements – The EPA’s Federalization of Agriculture
Eminent Domain and “Seriously Misleading” Financing Statements
Ag Law in the Courts – Feedlots; Dicamba Drift; and Inadvertent Disinheritance
Recent Developments Involving Estates and Trusts
What is a “Trade or Business” For Purposes of Installment Payment of Federal Estate Tax?
Alternate Valuation – Useful Estate Tax Valuation Provision
Farm and Ranch Estate and Business Planning in 2020 (Through 2025)
Retirement-Related Provisions of the CARES Act
Are Advances to Children Loans or Gifts?
Tax Issues Associated with Options in Wills and Trusts
Valuing Farm Chattels and Marketing Rights of Farmers
Is it a Gift or Not a Gift? That is the Question
Does a Discretionary Trust Remove Fiduciary Duties a Trustee Owes Beneficiaries?
Can I Write my Own Will? Should I?
Income Taxation of Trusts – New Regulations
Merging a Revocable Trust at Death with an Estate – Tax Consequences
When is Transferred Property Pulled Back into the Estate at Death? Be on Your Bongard!
‘Tis the Season for Giving, But When is a Transfer a Gift?
Top Ten Agricultural Law and Tax Developments of 2019 (Numbers 2 and 1)
Does the Penalty Relief for a “Small Partnership” Still Apply?
Substantiation – The Key to Tax Deductions
Ag Law and Tax in the Courts – Bankruptcy Debt Discharge; Aerial Application of Chemicals; Start-Up Expenses and Lying as Protected Speech
Unique, But Important Tax Issues – “Claim of Right;” Passive Loss Grouping; and Bankruptcy Taxation
Conservation Easements and the Perpetuity Requirement
Tax Treatment Upon Death of Livestock
What is a “Trade or Business” For Purposes of I.R.C. §199A?
Tax Treatment of Meals and Entertainment
Farm NOLs Post-2017
Disaster/Emergency Legislation – Summary of Provisions Related to Loan Relief; Small Business and Bankruptcy
Retirement-Related Provisions of the CARES Act
Income Tax-Related Provisions of Emergency Relief Legislation
The Paycheck Protection Program – Still in Need of Clarity
Solar “Farms” and The Associated Tax Credit
Obtaining Deferral for Non-Deferred Aspects of an I.R.C. §1031 Exchange
Conservation Easements – The Perpetuity Requirement and Extinguishment
PPP and PATC Developments
How Many Audit “Bites” of the Same Apple Does IRS Get?
More Developments Concerning Conservation Easements
Imputation – When Can an Agent’s Activity Count?
Exotic Game Activities and the Tax Code
Demolishing Farm Buildings and Structures – Any Tax Benefit?
Tax Incentives for Exported Ag Products
Deducting Business Interest
Recent Tax Court Opinions Make Key Point on S Corporations and Meals/Entertainment Deductions
Income Taxation of Trusts – New Regulations
Accrual Accounting – When Can a Deduction Be Claimed?
Farmland Lease Income – Proper Tax Reporting
Merging a Revocable Trust at Death with an Estate – Tax Consequences
The Use of Deferred Payment Contracts – Specifics Matter
Is Real Estate Held in Trust Eligible for I.R.C. §1031 Exchange Treatment?
Recent Court Developments of Interest
Principles of Agricultural Law
Signing and Delivery
Abandoned Railways and Issues for Adjacent Landowners
Obtaining Deferral for Non-Deferred Aspects of an I.R.C. §1031 Exchange
Are Dinosaur Fossils Minerals?
Real Estate Concepts Involved in Recent Cases
Is it a Farm Lease or Not? – And Why it Might Matter
Top Ten Agricultural Law and Tax Developments from 2019 (Numbers 10 and 9)
Top Ten Agricultural Law and Tax Developments from 2019 (Number 8 and 7)
Hemp Production – Regulation and Economics
DOJ to Investigate Meatpackers – What’s it All About?
Dicamba Registrations Cancelled – Or Are They?
What Does a County Commissioner (Supervisor) Need to Know?
The Supreme Court’s DACA Opinion and the Impact on Agriculture
Right-to-Farm Law Headed to the SCOTUS?
The Public Trust Doctrine – A Camel’s Nose Under Agriculture’s Tent?
Roadkill – It’s What’s for Dinner (Reprise)
Beef May be for Dinner, but Where’s It From?
Of Nuisance, Overtime and Firearms – Potpourri of Ag Law Developments
What Farm Records and Information Are Protected from a FOIA Request?
Can One State Dictate Agricultural Practices in Other States?
Family Farming Arrangements and Liens; And, What’s a Name Worth?
Conflicting Interests in Stored Grain
Eminent Domain and “Seriously Misleading” Financing Statement
Summer 2020 Farm Income Tax/Estate and Business Planning Conference
Registration Open for Summer Ag Income Tax/Estate and Business Planning Seminar
Summer 2020 – National Farm Income Tax/Estate and Business Planning Conference
Year-End CPE/CLE – Six More to Go
2021 Summer National Farm and Ranch Income Tax/Estate and Business Planning Conference
Principles of Agricultural Law
More “Happenings” in Ag Law and Tax
Recent Cases of Interest
More Selected Caselaw Developments of Relevance to Ag Producers
Court Developments of Interest
Ag Law and Tax Developments
Recent Court Developments of Interest
Court Developments in Agricultural Law and Taxation
Ag Law and Tax in the Courtroom
Recent Tax Cases of Interest
Ag and Tax in the Courts
Of Nuisance, Overtime and Firearms – Potpourri of Ag Law Developments
January 20, 2021 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)
Sunday, January 17, 2021
For the Spring 2021 academic semester, Kansas State University will be offering my Agricultural Law and Economics course online. No matter where you are located, you can enroll in the course and participate in it as if you were present with the students in the on-campus classroom.
Details of this spring semester’s online Ag Law course – that’s the topic of today’s post.
The course provides a broad overview of many of the issues that a farmer, rancher, rural landowner, ag lender or other agribusiness will encounter on a daily basis. As a result, the course looks at contract issues for the purchase and sale of agricultural goods; the peril of oral contracts; the distinction between a lease and a contract (and why the distinction matters); and the key components of a farm lease, hunting lease, wind energy lease, oil and gas lease, and other types of common agricultural contractual matters. What are the rules surrounding ag goods purchased at auction?
Ag financing situations are also covered – what it takes to provide security to a lender when financing the purchase of personal property to be used in the farming business. In addition, the unique rules surrounding farm bankruptcy is covered, including the unique tax treatment provided to a farmer in Chapter 12 bankruptcy.
Of course, farm income tax is an important part of the course. Tax planning is perhaps the most important aspect of the farming business that every-day decisions have an impact on and are influenced by. As readers of this blog know well, farm tax issues are numerous and special rules apply in many instances. The new tax law impacts many areas of farm income tax.
Real property legal issues are also prevalent and are addressed in the course. The key elements of an installment land contract are covered, as well as legal issues associated with farm leases. Various types of interests in real estate are explained – easements; licenses; profits, fee simples, remainders, etc. Like-kind exchange rules are also covered as are the special tax rules (at the state level) that apply to farm real estate.
A big issue for some farmers and ranchers concerns abandoned railways, and those issues are covered in the course. What if an existing fence is not on the property line?
Farm estate and business planning is also a significant emphasis of the course. What’s the appropriate estate plan for a farm and ranch family? How should the farming business be structured? Should multiple entities be used? Why does it matter? These questions, and more, are addressed.
Agricultural cooperatives are important for the marketing of agricultural commodities. How a cooperative is structured and works and the special rules that apply are also discussed.
Because much agricultural property is out in the open, that means that personal liability rules come into play with respect to people that come onto the property or use farm property in the scope of their employment. What are the rules that apply in those situations? What about liability rules associated with genetically modified products? Ag chemicals also pose potential liability issues, as do improperly maintained fences? What about defective ag seed or purchased livestock that turns out to not live up to representations? These issues, and more, are covered in the scope of discussing civil liabilities.
Sometimes farmers and ranchers find themselves in violation of criminal laws. What are those common situations? What are the rules that apply? We will get into those issue too.
Water law is a very big issue, especially in the western two-thirds of the United States. We will survey the rules surrounding the allocation of surface water and ground water to agricultural operations.
Ag seems to always be in the midst of many environmental laws – the “Clean Water Rule” is just one of those that has been high-profile in recent years. We will talk about the environmental rules governing air, land, and water quality as they apply to farmers, ranchers and rural landowners.
Finally, we will address the federal (and state) administrative state and its rules that apply to farming operations. Not only will federal farm programs be addressed, but we will also look at other major federal regulations that apply to farmers and ranchers.
Further Information and How to Register
Information about the course and how to register is available here: https://www.enrole.com/ksu/jsp/session.jsp?sessionId=442107&courseId=AGLAW&categoryId=ROOT
You can also find information about the text for the course at the following link: https://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html
If you are an undergraduate student at an institution other than Kansas State, you should be able to enroll in this course and have it count as credit towards your degree at your institution. Consult with your academic advisor to see how Ag Law and Economics will transfer and align with your degree completion goals.
If you have questions, you can contact me directly, or submit your questions to the KSU Global Campus staff at the link provided above.
I hope to see you in class beginning on January 26!
January 17, 2021 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)
Friday, January 15, 2021
After many months of delay, the IRS has finally issued final regulations providing guidance to agricultural/horticultural cooperatives and patrons on the I.R.C. §199A(a) and I.R.C. §199A(g) deduction for qualified business income (QBI). The final regulations make several changes to the Proposed Regulations, and are important to patrons of ag cooperatives and return preparers.
The QBI Final Regulations applicable to agricultural/horticultural cooperatives – it’s the topic of today’s post.
The Consolidated Appropriations Act of 2018, H.R. 1625 (Act) became law. The Act contained a provision modifying I.R.C. §199A that was included in the Tax Cuts and Jobs Act (TCJA) enacted in late 2017. I.R.C. §199A created a 20 percent QBI deduction for sole proprietorships and pass-through businesses. However, the provision created a tax advantage for sellers of agricultural products sold to agricultural cooperatives. Before the technical correction, those sales generated a tax deduction from gross sales for the seller. But if those same ag goods were sold to a company that was not an agricultural cooperative, the deduction could only be taken from net business income. That tax advantage for sales to cooperatives was deemed to be a drafting error and has now been technically corrected.
The modified provision removes the TCJA’s QBI deduction provision for ag cooperatives and replaced it with the former (pre-2018) domestic production activities deduction (DPAD) of I.R.C. §199 for cooperatives. In addition, the TCJA provision creating a 20 percent deduction for patronage dividends also was eliminated. Also, the modified language limits the deduction to 20 percent of farmers’ net income, excluding capital gains.
The Modification: New I.R.C. §199A(g)
The provision in the Act removes the QBI deduction for agricultural or horticultural cooperatives. In its place, the former DPAD provision (in all practical essence) is restored for such cooperatives. Thus, an ag cooperative can claim a deduction from taxable income that is equal to nine percent of the lesser of the cooperative’s qualified production activities income or taxable income (determined without regard to the cooperative’s I.R.C. § 199A(g) deduction and any deduction allowable under section 1382(b) and (c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions)) for the taxable year. The amount of the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the cooperative during the calendar year that ends in such taxable year. For this purpose, W-2 wages are determined in the same manner as under the other provisions of section 199A (which is not repealed as applied to non-cooperatives), except that “wages” do not include any amount that is not properly allocable to domestic production gross receipts. A cooperative’s DPAD is reduced by any amount passed through to patrons.
Under the technical correction, the definition of a “specified agricultural or horticultural cooperative” is limited to organizations to which part I of subchapter T applies that either manufacture, produce, grow, or extract in whole or significant part any agricultural or horticultural product; or market any agricultural or horticultural product that their patrons have manufactured, produced, grown, or extracted in whole or significant part. The technical correction notes that Treas Reg. §1.199-6(f) is to apply such that agricultural or horticultural products also include fertilizer, diesel fuel, and other supplies used in agricultural or horticultural production that are manufactured, produced, grown, or extracted by the cooperative.
Note: As modified, a “specified agricultural or horticultural cooperative” does not include a cooperative solely engaged in the provision of supplies, equipment, or services to farmers or other specified agricultural or horticultural cooperatives.
Impact on patrons. Under the new language, an eligible patron that receives a qualified payment from a specified agricultural or horticultural cooperative can claim a deduction in the tax year of receipt in an amount equal to the portion of the cooperative’s deduction for qualified production activities income that is: 1) allowed with respect to the portion of the qualified production activities income to which such payment is attributable; and 2) identified by the cooperative in a written notice mailed to the patron during the payment period described in I.R.C. §1382(d).
Note: The cooperative’s I.R.C. §199A(g) deduction is allocated among its patrons on the basis of the quantity or value of business done with or for the patron by the cooperative.
The patron’s deduction may not exceed the patron’s taxable income for the taxable year (determined without regard to the deduction, but after accounting for the patron’s other deductions under I.R.C. §199A(a)).
What is a qualified payment? It’s any amount that meets three tests:
1) the payment must be either a patronage dividend or a per-unit retain allocations;
2) the payment, must be received by an eligible patron from a qualified agricultural or horticultural cooperative; and
3) the payment must be attributable to qualified production activities income with respect to which a deduction is allowed to the cooperative.
An eligible patron cannot be a corporation and cannot be another ag cooperative. In addition, a cooperative cannot reduce its income under I.R.C. §1382 for any deduction allowable to its patrons by virtue of I.R.C. §199A(g). Thus, the cooperative must reduce its deductions that are allowed for certain payments to its patrons in an amount equal to the I.R.C. §199A(g) deduction allocated to its patrons.
Transition rule. A transition rule applied such that the repeal of the DPAD did not apply to a qualified payment that a patron receives from an ag cooperative in a tax year beginning after 2017 to the extent that the payment is attributable to qualified production activities income with respect to which the deduction is allowed to the cooperative under the former DPAD provision for the cooperative’s tax year that began before 2018. That type of qualified payment is subject to the pre-2018 DPAD provision, and any deduction allocated by a cooperative to patrons related to that type of payment can be deducted by patrons in accordance with the pre-2018 DPAD rules. In that event, no post-2017 QBI deduction was allowed for those type of qualified payments. This simple statement created surprising results and added complexity to the computations for determining the proper 2018 QBID. Taxpayers needed to identify sales to non-cooperatives, sales to cooperatives during the year that began in 2017, and sales to cooperatives during the year that began in 2018 to properly compute their 2018 QBID.
Status of Ag Cooperatives and Patrons After the Act
With the technical correction to I.R.C. §199A, where did things stand for farmers?
- The overall QBI deduction cannot exceed 20 percent of taxable income less capital gain. That restriction applies to all taxpayers regardless of income. When income exceeds the taxable income threshold , the 50 percent of W-2 wages limitation and qualified property limit are phased-in.
- The prior I.R.C. 199 DPAD no longer exists, except as resurrected for agricultural and horticultural cooperatives as noted above. The 20 percent QBI deduction of I.R.C. §199A is available for sole proprietorships and pass-through businesses. For farming businesses structured in this manner, the tax benefit of the 20 percent QBI deduction will likely outweigh what the DPAD would have produced.
- While those operating in the C corporate form can’t claim a QBI deduction, the corporate tax rate is now a flat 21 percent. That represents a tax increase for those corporations that would have otherwise triggered a 15 percent rate under prior law and benefitted from DPAD in prior years.
- For C corporations that are also patrons of an agricultural cooperative, the cooperative’s DPAD does not pass through to the patron.
- For a Schedule F farmer that is a patron of an agricultural cooperative and pays no wages, there are two steps to calculate the tax benefits. First, the cooperative’s DPAD that is passed through to the patron can be applied to offset the patron’s taxable income regardless of source. Second, the farmer/patron is entitled to a QBI deduction equal to 20 percent of net farm income derived from qualified non-cooperative sales, subject to the taxable income limitation (presently $329,800 (mfj); $164,900 (single, MFS and HH for 2021).
- For farmers that pay W-2 wages and sell to ag cooperatives , the QBI deduction is calculated on the sales to cooperatives by applying the lesser of 50 percent of W-2 wages or 9 percent reduction limitation. Thus, for a farmer that has farm income beneath the taxable income limitation , the QBI deduction will never be less than 11 percent (i.e., 20 percent less 9 percent). If the farmer is above the taxable income limitation the 50 percent of W-2 wages limitation will be applied before the 9 percent limitation. This will result in the farmer’s QBI deduction, which cannot exceed 20 percent of taxable income. To this amount is added any pass-through DPAD from the cooperative to produce the total deductible amount.
- For farmers that sell ag products to non-cooperatives and pay W-2 wages, a deduction of 20 percent of net farm income is available. If taxable income is less than net farm income, the deduction is 20 percent of taxable income less capital gains. If net farm income exceeds the taxable income limitation the deduction may be reduced on a phased-in basis.
- The newly re-tooled cooperative DPAD of I.R.C. 199A may incentivize more cooperatives to pass the DPAD through to their patrons.
After a frustrating 2018 tax season experience with respect to associated IRS Forms and IRS computers not recognizing Forms as submitted in accordance with the instructions for the I.R.C. §199A(g) amount, the IRS issued Proposed Regulations concerning the computation of the I.R.C. §199A(g) amount. REG-118425-18. The Proposed Regulations clarified that patronage dividends include money, property, qualified written notices of allocations, qualified per-unit retain certificates for which a cooperative receives a deduction under I.R.C. §1382(b), nonpatronage distributions paid in money, property, qualified written notices of allocation, as well as money or property paid in redemption of a nonqualified written notice of allocation for which an exempt cooperative receives a deduction under I.R.C. §1382(c)(2). But, dividends on capital stock are not included in QBI. Prop. Treas. Reg. §1.199A-7(c)(1).
Under Prop. Treas. Reg. §1.199A-7(c), patronage dividends or similar payments may be included in the patron’s QBI to the extent that these payments: (i) are related to the patron’s trade or business; (ii) are qualified items of income, gain, deduction, or loss at the cooperative’s trade or business level; and (iii) are not income from a specified service trade or business (SSTB) (as defined in I.R.C. §199A(d)(2)) at the cooperative level. But, they are only included in the patron’s income if the cooperative provides the required information to the patron concerning the payments. Prop. Treas. Reg. §1.199A-7(c)(2). The transition DPAD rules were reaffirmed in Prop. Treas. Reg. §1.199A-7(h)(2) thus validating the related complex calculations on 2018 tax returns.
The patron’s QBID. The amount of a patron’s deduction that can be passed through to the patron is limited to the portion of the patron’s deduction that is allowed with respect to qualified production activities income (QPAI) to which the qualified payments (patronage dividends and per unit retains) made to the patron are attributable. I.R.C. §199A(g)(2)(E). In other words, the distribution must be of tax items that are allocable to the cooperative’s trade or business on behalf of or with a patron. The cooperative makes this determination in accordance with Treas. Reg. §1.199A-3(b). This is, essentially, the former DPAD computation except that account is taken for non-patronage income not being part of the computation.
There is a four-step process for computing the patron’s QBID: 1) separate patronage and non-patronage gross receipts (and associated deductions); 2) limit the patronage gross receipts to those that are domestic production gross receipts (likely no reduction here); 3) determine qualified production activities income from the domestic, patronage-sourced gross receipts; 4) apply a formula reduction (explained below). Prop. Treas. Reg. §1.199A-8(b).
The ”wages” issue. As noted, the farmer-patron must reduce the “patron’s QBID” by a formula that is the lesser of 9 percent of QBI that relates to qualified payments from the cooperative, or 50 percent of the patron’s W-2 wages paid that are allocable to the qualified payments from the cooperative. I.R.C. §199A(b)(7)(A)-(B). In Notice 2019-27, 2019-16 IRB, the IRS set forth various methods for calculating W-2 wages for purposes of computing the patron’s QBID. See also Prop. Treas. Reg. §1.199A-11. Because the test is the “lesser of,” a patron that pays no qualified W-2 wages has no reduction. Remember, however, under I.R.C. §199A(b)(4) and Prop. Treas. Reg. §1.199A-11(b)(1), wages paid in-kind to agricultural labor are not “qualified wages” but wages paid to children under age 18 by their parents are.
I.R.C. §199A(b)(7) requires the formula reduction even if the cooperative doesn’t pass through any of the I.R.C. §199A(g) deduction (the deduction for a patron) to the patron for a particular tax year. If the patron has more than a single business, QBI must be allocated among those businesses. Treas. Reg. §1.199A-3(b)(5). The Proposed Regulations do not mention how the formula reduction functions in the context of an aggregation election. For example, if an aggregation election is made to aggregate rental income with income from the farming operation, must an allocation be made of a portion of the rental income as part of the formula reduction?
The formula reduction applies to the portion of a patron’s QBI that relates to qualified payments from a cooperative. If the patron has negative QBI that is associated with business done with the cooperative, the 9 percent amount will always be lower than the W-2 wage amount.
An optional safe harbor allocation method exists for patrons with taxable income under the applicable threshold of I.R.C. §199A(e)(2) to determine the reduction. Under the safe harbor, a patron must allocate the aggregate business expenses and W-2 wages ratably between income from qualified payments and income from other than qualified payments to determine QBI. Prop. Treas. Reg. §1.199A-7(f)(2)(ii). Unfortunately, the example contained in the Proposed Regulations not only utilized an apparently unstated “reasonable method of allocation,” but also an allocation of W-2 wage expense that doesn’t match the total expense allocation.
The amount of deductions apportioned to determine QBI allocable to qualified payments must be equal to the proportion of the total deductions that the amount of qualified payments bears to total gross receipts used to determine QBI. The same proportion applies to determine the amount of W-2 wages allocable to the portion of the trade or business that received qualified payments.
The part of the Proposed Regulations attempting to illustrate the calculation only mentions gross receipts from grain sales. There is no mention of gross receipts from farm equipment, for example. Based on the language of Prop. Treas. Reg. §1.199A-7(f)(2)(ii), gross receipts from the sale of equipment and machinery should be included in the calculation and the farmer would have to allocate gross receipts from equipment sales between patronage and non-patronage income. Indeed, in prior years, depreciation may have been allocated between patronage and non-patronage income. Likewise, the example didn’t address how government payments, custom work, crop insurance proceeds or other gross receipts are to be allocated.
This meant that the patron must know the qualified payments from the cooperative that were allocable to the patron that were used in computing the deduction for the patron at the cooperative level that could be passed through to the patron. This information is contained on Form 1099-PATR Box 7.
A patron with taxable income above the threshold levels that receives patronage dividends (or similar payments) from a cooperative and is conducting a trade or business might be subject to the W-2 wages and “unadjusted basis immediately after acquisition” (UBIA) limitation. In that instance, the patron is to calculate the W-2 wage and UBIA limitations without regard to the cooperative’s W-2 or UBIA amounts. Prop. Treas. Reg. §1.199A-7(e)(2). That means the cooperative (unlike a RPE) does not allocate its W-2 wages or UBIA to patrons. Instead, a patron allocates (by election) W-2 wages and UBIA between patronage and non-patronage income using any reasonable method based on all the facts and circumstances that clearly reflects the income and expense of each trade or business. Prop. Treas. Reg. §1.199A-7(f)(2)(i).
The patron’s QBID that is passed through from the cooperative (which is not limited by W-2 wages at the patron level) is limited to the patron’s taxable income taking into account the non-patron QBID which is limited to 20 percent of taxable income not counting net capital gains. Any unused patron-QBID is simply lost – there is not carryover or carryback provision that applies.
Identification by the cooperative. A cooperative must identify the amount of a patron’s deduction that it is passing through to a patron in a notice that is mailed to the patron via Form 1099-PATR during the “applicable payment period” – no later than the 15th day of the ninth month following the close of the cooperative’s tax year. I.R.C. §199A(g)(2)(A); Prop. Treas. Reg. §1.199A-8(d)(3); I.R.C. §1382(d).
A patron uses the information that the cooperative reports to determine the patron’s QBID. If the information isn’t received on or before the Form 1099-PATR due date, no distributions from the cooperative will count towards the patron’s QBI if the lack of reporting occurs after June 19, 2019. Prop. Treas. Reg. §1.199A-7(c)(3); Prop. Treas. Reg. §1.199A-7(d)(3).
Final Regulations (TD 9947)
On January 14, 2021 the IRS issued Final Regulations on the cooperative QBI issue. The Final Regulations make several changes to the Proposed Regulations. One clarification that likely won’t impact many farmers requires a cooperative to separately determine the amounts of qualified items that relate to non-specified service trades or business (SSTBs) and those that relate to SSTBs when making distributions to patrons. Treas. Reg. §§1.199A-7(c)(3) and (d)(3). The cooperative is to report the net amount of qualified items from non-SSTBs in distributions to patrons without delineating on a business-by-business basis. Once a patron receives the information from the cooperative, the patron will have to determine if the qualified item is includible in the patron’s QBI under Treas. Reg. §1.199A-7(c)(2) and whether the qualified item from the SSTB is includible in the patron’s QBI based on the threshold rules of I.R.C. §199A(d)(3). Treas. Reg. §1.199A-7(d)(3)(i).
Under the Proposed Regulations, a question existed whether a patron needed to include gain on selling farm equipment, farm program payments, self-rentals, or other similar income sources in calculation of the I.R.C. §199A(g) amount. The Final Regulations didn’t answer the question. Under the Final Regulations, when calculating the I.R.C. §199A(b)(7) reduction, a patron is to use a “reasonable method” to allocated income between that from qualified payments and that not coming from qualified payments, based on all of the facts and circumstances. Treas. Reg. §1.199A-7(f)(2)(i). Basically, that means that a farmer/patron can make their own decision with respect to including or excluding such items. The only requirement is that a “reasonable method” be utilized.
The final regulations specify that a farmer/patron that aggregates a rental real estate busines and a farming business that does business with a cooperative is to exclude the rental income when calculating the I.R.C. §199A(b)(7) reduction for the patron’s aggregated trade or business. Similarly, the patron is to allocate rental expense against qualified payments when computing the reduction only to the extent rental expense is related to the qualified payments from the cooperative. Preamble to TD 9947.
On the wage issue, qualified payments need not be reduced if the cooperative was limited by the 50 percent of wage limitation.
The Final Regulations provide an example of the effect of negative QBI on the I.R.C. §199A(b)(7) reduction, pointing out that negative QBI from a cooperative results in no adjustment to the reduction computation:
“A farmer conducts two types of agricultural businesses (A and B). Assume the farmer treats A and B as one trade or business for purposes of the [I.R.C. §199A(a)] deduction. The farmer conducts A with non-Specified Cooperatives and B through a Specified Cooperative. The farmer generates $100 of qualifying income through A and receives $100 of qualifying income from a Specified Cooperative in B, all of which is also a qualified payment. The farmer has $180 of qualified expenses. For purposes of the [I.R.C. §199A(a)] deduction, the farmer’s QBI ($20) from the trade or business is used to calculate the deduction, resulting in a $4 deduction. The farmer then must determine if there is any [I.R.C. §199A(b)(7)] reduction to this amount. The farmer reasonably allocates its qualified expenses for purposes of calculating the I.R.C. §199A(b)(7)] reduction and determines $110 of the qualified expenses are allocable to B (and $70 to A). The farmer will use only QBI from B to calculate the [I.R.C. §199A(b)(7)] reduction because that is the only QBI properly allocable to qualified payments. Farmer’s QBI for purposes of [I.R.C. §199A(b)(7)(A)] is negative $10, resulting in a $0 [I.R.C. §199A(b)(7)] reduction (regardless of W-2 wages under [I.R.C. §199A(b)(7)(B)]). ((Preamble to TD 9947)).”
The Final Regulations are generally applicable to tax years beginning after January 19, 2021, but can be used for earlier tax years. Otherwise, for tax years beginning on or before January 19, 2021, the Proposed Regulations apply.
The Final Regulations do clarify a couple of issues that were unclear in the Proposed Regulations. However, the Final Regulations do not answer the question of whether gain from certain various sources of income for a farmer/patron in the I.R.C. §199A(g) computation.
Wednesday, January 13, 2021
The biggest three developments of 2020 in ag law and tax are up for discussion today. 2020 was a year of many important developments of relevance to the agricultural industry, but the top three stand out in particular.
The three most important developments of 2020 – it’s the topic of today’s post.
No. 3 – SCOTUS DACA Opinion
Background. In mid-2020, the U.S. Supreme Court issued its opinion in Department of Homeland Security, et al. v. Regents of the University of California, et al., 140 S. Ct. 1891 (2020) where the Court denied the U.S. Department of Homeland Security’s (DHS) revocation of the Deferred Action for Childhood Arrivals (DACA). The Court’s decision is of prime importance to agriculture because the case involved the ability of a federal government agency to create rules that are applied with the force of law without following the notice and comment requirements of the Administrative Procedure Act. Agricultural activities are often subjected to the rules developed by federal government agencies, making it critical that agency rules are subjected to public input before being finalized.
The DHS started the DACA program by issuing an internal agency memorandum in 2012. The DHS took this action after numerous bills in the Congress addressing the issue failed to pass over a number of years. The DACA program illegal aliens that were minors at the time they illegally entered the United States to apply for a renewable, two-year reprieve from deportation. The DACA program also gave these illegal immigrants work authorizations and access to taxpayer-funded benefits such as Social Security and Medicare. Current estimates are that between one million and two million DACA-protected illegal immigrants are eligible for benefits In 2014, the DHS attempted to expand DACA to provide amnesty and taxpayer benefits for over four million illegal aliens, but the expansion was foreclosed by a federal courts in 2015 for providing benefits to illegal aliens without following the procedural requirements of the Administrative Procedure Act as a substantive rule and for violating the Immigration and Naturalization Act. Texas v. United States, 809 F.3d 134 (5th Cir. 2015), aff’g., 86 F. Supp. 3d 591 (S.D. Tex. 2015). In 2016, the U.S. Supreme Court affirmed the lower court decisions. United States v. Texas, 136 S. Ct. 2271 (2016). Based on these court holdings and because DACA was structured similarly, the U.S. Attorney General issued an opinion that the DACA was also legally defective. Accordingly, in June of 2017, the DHS announced via an internal agency memorandum that it would end the illegal program by no longer accepting new applications or approving renewals other than for those whose benefits would expire in the next six months. Activist groups sued and the Supreme Court ultimately determined that the action of the DHS was improper for failing to provide sufficient policy reasons for ending DACA. In other words, what was created with the stroke of a pen couldn’t be eliminated with a stroke of a pen.
Administrative Procedure Act (APA). The APA was enacted in 1946. Pub. L. No. 79-404, 60 Stat. 237 (Jun. 11, 1946). The APA sets forth the rules governing how federal administrative agencies are to go about developing regulations. It also gives the federal courts oversight authority over all agency actions. The APA has been referred to as the “Constitution” for administrative law in the United States. A key aspect of the APA is that any substantive agency rule that will be applied against an individual or business with the force of law (e.g., affecting rights of the regulated) must be submitted for public notice and comment. 5 U.S.C. §553. The lack of DACA being subjected to public notice and comment when it was created and the Court’s requirement that it couldn’t be removed in like fashion struck a chord with the most senior member of the Court. Justice Thomas authored a biting dissent that directly addressed this issue. He wrote, “Without grounding its position in either the APA or precedent, the majority declares that DHS was required to overlook DACA’s obvious legal deficiencies and provide additional policy reasons and justifications before restoring the rule of law. This holding is incorrect, and it will hamstring all future agency attempts to undo actions that exceed statutory authority.”
Farmers and ranchers often deal with the rules developed by federal (and state) administrative agencies. Those agency rules often involve substantive rights and, as such, are subject to the notice and comment requirements of the APA. Failure to follow the APA often results in the restriction (or outright elimination) of property rights without the necessary procedural protections the APA affords. It’s also important that when administrative agencies overstep their bounds, a change in agency leadership has the ability to swiftly rescind prior illegal actions – a point Justice Thomas made clear in his dissent.
No. 2 - Public Trust Doctrine
Background. Centuries ago, the seas were viewed as the common property of everyone - they weren’t subject to private use and ownership. Instead, they were held in what was known as the “public trust.” This concept was later adopted in English law, the Magna Carta, and became part of the common (non-statutory) law of individual states in the United States after the Revolution. Over the years, this “public trust doctrine” has been primarily applied to access to the seashore and intertidal waters, although recently some courts have expanded its reach beyond its historical application.
But, any judicial expansion of the public trust doctrine results in curtailing vested property rights. That’s a very important concern for agriculture because of agriculture’s necessary use of natural resources such as land, air, water, minerals and the like. Restricting or eliminating property rights materially impacts agricultural operations in a negative manner. It also creates an economic disincentive to use property in an economically (and socially) efficient manner.
How could an expanded public trust doctrine apply? For farmers and ranchers, it could make a material detrimental impact on the farming operation. For instance, many endangered species have habitat on privately owned land. If wildlife and their habitat are deemed to be covered by the doctrine, farming and ranching practices could be effectively curtailed. What about vested water rights? A farming or ranching operation that has a vested water right to use water from a watercourse for crop irrigation or livestock watering purposes could find itself having those rights limited or eliminated if, under the public trust doctrine, a certain amount of water needed to be retained in the stream for a species of fish.
One might argue that the government already has the ability to place those restrictions on farming operations, and that argument would be correct. But, such restrictions exist via the legislative and regulatory process and are subject to constitutional due process, equal protection and just compensation protections. Conversely, land-use restrictions via the public trust doctrine bypass those constitutional protections. No compensation would need to be paid, because there was no governmental taking – a water right, for example, could be deemed to be subject to the “public trust” and enforced without the government paying for taking the right.
Nevada Case. Mineral County v. Lyon County, No. 75917, 2020 Nev. LEXIS 56 (Nev. Sup. Ct. Sept. 17, 2020), involved the state of Nevada’s water law system for allocating water rights and an attempt to take those rights without compensation via an expansion of the public use doctrine. The state of Nevada appropriates water to users via the prior appropriation system – a “first-in-time, first-in-right” system. Over 100 years ago, litigation over the Walker River Basin began between competing water users in the Walker River Basin. The Basin covers approximately 4,000 square miles, beginning in the Sierra Nevada mountain range and ending in a lake in Nevada. In 1936, a federal court issued a decree adjudicating water rights of various claimants to water in the basin via the prior appropriation doctrine.
In 1987, an Indian Tribe intervened in the ongoing litigation to establish procedures to change the allocations of water rights subject to the decree. Since that time, the state reviews all changes to applications under the decree. In 1994, the plaintiff sought to modify the decree to ensure minimum stream flows into the lake under the “doctrine of maintenance of the public trust.” The federal district (trial) court granted the plaintiff’s motion to intervene in 2013. In 2015, the trial court dismissed the plaintiff’s amended complaint in intervention on the basis that the plaintiff lacked standing; that the public trust doctrine could only apply prospectively to bar granting appropriative rights; any retroactive application of the doctrine could constitute a taking requiring compensation; that the court lacked the authority to effectuate a taking; and that the lake was not part of the basin.
On appeal, the federal appellate court determined that the plaintiff had standing, and that the lake was part of the basin. The appellate court also held that whether the plaintiff could seek minimum flows depended on whether the public trust doctrine allowed the reallocation of rights that had been previously settled under the prior appropriation doctrine. Thus, the appellate court certified two questions to the Nevada Supreme Court: 1) whether the public trust doctrine allowed such reallocation of rights; and 2) if so, whether doing so amounted to a “taking” of private property requiring “just compensation” under the Constitution.
The state Supreme Court held that that public trust doctrine had already been implemented via the state’s prior appropriation system for allocating water rights and that the state’s statutory water laws is consistent with the public trust doctrine by requiring the state to consider the public interest when making allocating and administering water rights. The state Supreme Court also determined that the legislature had expressly prohibited the reallocation of water rights that have not otherwise been abandoned or forfeited in accordance with state water law.
The state Supreme Court limited the scope of its ruling to private water use of surface streams, lakes and groundwater such as uses for crops and livestock. The plaintiff has indicated that it will ask the federal appellate court for a determination of whether the public trust doctrine could be used to mandate water management methods. If the court would rule that it does, the result would be an unfortunate disincentive to use water resources in an economically efficient manner (an application of the “tragedy of the commons”). It would also provide a current example (in a negative way) of the application of the Coase Theorem (well-defined property rights overcome the problem of externalities). See Coase, “The Problem of Social Cost,” Journal of Law and Economics, Vol. 3, October 1960.
Oregon Case. In Chernaik v. Brown, 367 Or. 143 (2020), the plaintiffs claimed that the public trust doctrine required the State of Oregon to protect various natural resources in the state from harm due to greenhouse gas emissions, “climate change,” and ocean acidification. The public trust doctrine has historically only applied to submerged and submersible lands underlying navigable waters as well as the navigable waters. The trial court rejected the plaintiffs’ arguments. On appeal the state Supreme Court affirmed, rejecting the test for expanding the doctrine the plaintiffs proposed. Under that test, the doctrine would extend to any resource that is not easily held or improved and is of great value to the public. The state Supreme Court held that the plaintiffs’ test was too broad to be adopted and remanded the case to the lower court.
No. 1 – CARES Act, CFAP Programs and Disaster Legislations and CAA, 2021
Quite clearly, the biggest development of 2020 involved the numerous tax and loan provisions enacted in an attempt to offset the loss of income and closure of business resulting from the actions of various state governors as a result of the virus. Also, the various pieces of legislation made some of the most significant changes to the retirement planning rules in about 15 years. In addition, tax provisions were contained in disaster legislation that took effect in 2020. In late December of 2020, the Consolidated Appropriations Act of 2021 (CAA, 2021) was signed into law. This law made significant changes to the existing Paycheck Protection Program (PPP), and provided another round of payments to farmers and ranchers under the Coronavirus Food Assistance Program (CFAP). The CAA, 2021 also extended numerous tax provisions that were set to expire at the end of 2020.
2020 was another big year in the ag law and tax world. There’s never a dull moment.
Friday, January 8, 2021
There are a couple of online continuing education events that I will be conducting soon, and the dates are set for two summer national conferences in 2021.
Upcoming continuing education events – it’s the topic of today’s post.
Top Developments in Agricultural Law and Tax
On Monday, January 11, beginning at 11:00 a.m. (cst), I will be hosting a two-hour CLE/CPE webinar on the top developments in agricultural law and agricultural taxation of 2020. I will not only discuss the developments, but project how the developments will impact producers and others in the agricultural sector and what steps need to be taken as a result of the developments in the law and tax realm. This is an event that is not only for practitioners, but producers also. It’s an opportunity to hear the developments and provide input and discussion. A special lower rate is provided for those not claiming continuing education credit.
You may learn more about the January 11 event and register here: https://washburnlaw.edu/employers/cle/taxseasonupdate.html
Tax Update Webinar – CAA of 2021
On January 21, I will be hosting a two-hour webinar on the Consolidated Appropriations Act, 2021. This event will begin at 10:00 a.m. (cst) and run until noon. The new law makes significant changes to the existing PPP and other SBA loan programs, CFAP, and contains many other provisions that apply to businesses and individuals. Also, included in the new law are provisions that extend numerous provisions that were set to expire at the end of 2020. The PPP discussion is of critical importance to many taxpayers at the present moment, especially the impact of PPP loans not being included in income and simultaneously being deductible if used to pay for qualified business expenses. Associated income tax basis issues loom large and vary by entity type.
You may learn more about the January 21 event and register here: https://agmanager.info/events/kansas-income-tax-institute
Summer National Conferences
Mark your calendars now for the law school’s two summer 2021 events that I conduct on farm income tax and farm estate and business planning. Yes, there are two locations for 2021 – one east and one west. Each event will be simulcast live over the web if you aren’t able to attend in-person. The eastern conference is first and is set for June 7-8 at Shawnee Lodge and Conference Center near West Portsmouth, Ohio. The location is about two hours east of Cincinnati, 90 minutes south of Columbus, Ohio, and just over two hours from Lexington, KY. I am presently in the process of putting the agenda together. A room block will be established for those interested in staying at the Lodge. For more information about Shawnee Lodge and Conference Center, you made click here: https://www.shawneeparklodge.com/
The second summer event will be held on August 2-3 in Missoula, Montana at the Hilton Garden Inn. Missoula is beautifully situated on three rivers and in the midst of five mountain ranges. It is also within three driving hours of Glacier National Park, and many other scenic and historic places. The agenda will soon be available, and a room block will also be established at the hotel. You may learn more about the location here: https://www.hilton.com/en/hotels/msogigi-hilton-garden-inn-missoula/
Take advantage of the upcoming webinars and mark you calendars for the summer national events. I look for to seeing you at one or more of the events.
January 8, 2021 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)
Thursday, January 7, 2021
After working through the “Almost Top Ten” agricultural law and tax developments of 2020, I have now reached what I consider to be the ten biggest developments of 2020 in terms of their significance to the agricultural sector as a whole. Agricultural law and agricultural tax intersects with everyday life of farmers and ranchers in many ways. Some of those areas of intersection of good, but some are quite troubling. In any event, it points the need for being educated and having good legal and tax counsel that is well-trained in the special rules that apply agriculture.
Developments 10 through 8 of the “Top Ten” agricultural law and tax developments of 2020 – it’s the topic of today’s post.
No. 10 – Department of Justice Announces Investigation of Meatpackers
In May of 2020, President Trump asked the U.S. Department of Justice (DOJ) to investigate the pricing practices of the major meatpackers. In addition, 11 state Attorneys General have asked the DOJ to do the same. They pointed out in the DOJ request that the four largest beef processors control 80 percent of U.S. beef processing. According to USDA data, boxed beef prices have recently more than doubled while live cattle prices dropped approximately 20 percent over the same timeframe. The concern is that the meatpackers are engaged in price manipulation and other practices deemed unfair under federal law.
Questions about the practices of the meatpacking industry are not new – they have been raised for well over a century. Indeed, a very significant federal law was enacted a century ago primarily because of the practices of the major meatpackers. So, why is there still talk about investigations? Is existing law ineffective?
Much of the matter is grounded in concerns about price manipulation by meatpackers. Section 2020 of the Packers and Stockyards Act (PSA), 7 U.S.C. §§192(a) and (e) makes it unlawful for any packer who inspects livestock, meat products or livestock products to engage in or use any unfair, unjustly discriminatory or deceptive practice or device, or engage in any course of business or do any act for the purpose or with the effect of manipulating or controlling prices or creating a monopoly in the buying, selling or dealing any article in restraint of commerce. This is a distinct concern in the livestock industry.
In June of 2010, the USDA issued proposed regulations providing guidance on the handling of antitrust-related issues under the PSA. 75 Fed. Reg. No. 119, 75 FR 35338 (Jun. 22, 2010). Under the proposed regulations, "likelihood of competitive injury" was defined as "a reasonable basis to believe that a competitive injury is likely to occur in the market channel or marketplace.” It includes, but is not limited to, situations in which a packer swine contractor, or live poultry dealer raises rivals' costs, improperly forecloses competition in a large share of the market through exclusive dealing, restrains competition, or represents a misuse of market power to distort competition among other packers, swine contractors, or live poultry dealers. It also includes situations “in which a packer, swine contractor, or live poultry dealer wrongfully depresses prices paid to a producer or grower below market value, or impairs a producer's or grower's ability to compete with other producers or growers or to impair a producer's or grower's ability to receive the reasonably expected full economic value from a transaction in the market channel or marketplace." According to the proposed regulations, a “competitive injury” under the PSA occurs when conduct distorts competition in the market channel or marketplace. The scope of PSA §202(a) and (b) is stated to depend on the nature and circumstances of the challenged conduct. The regulations specifically note that a finding that a challenged act or practice adversely affects or is likely to affect competition is not necessary in all cases. The proposed regulations note that a PSA violation can occur without a finding of harm or likely harm to competition, but as noted above, that is contrary to numerous court opinions that have decided the issue. The regulations eventually made it into the form of an Interim Final Rule but were later withdrawn. 82 FR 48594 (Oct. 18, 2017).
If the investigation is actually conducted, results could occur that would be very positive to livestock producers (and consumers) throughout the nation.
No. 9 – Conservation Easements
During 2020, the U.S. Tax Court and the appellate courts continued to issue numerous opinions involving the donation of permanent conservation easements to qualified organizations and the donor claiming an associated charitable deduction. Presently, the U.S. Tax Court has over 100 cases on its docket involving donated conservation easements. A donated conservation easement involves a legal agreement between a landowner and either a government agency or a land trust specifying that the donated land must be used in ways that preserve specified conservation/preservation goals.
Very specific requirements contained in the Internal Revenue Code must be satisfied to secure a charitable deduction for the donor. Those rules include a requirement that the donated easement be perpetual in nature and that any proceeds received upon judicial extinguishment of the easement be split between the donor and the donee in a prescribed manner. The easement must also be valued very carefully and meet IRS guidelines. In addition, syndicated easement transactions receive heightened scrutiny by the IRS. A syndicated conservation easement transaction is one where the tax benefit is split among various investors. It is a transaction that the IRS has identified as “abusive” when an appraisal is used to value the donated land that overvalues the land at issue and, thus, inflates the donor’s charitable deduction.
During 2020, the IRS offered a settlement program for persons and entities engaging in transactions that the IRS viewed as improper by allowed such taxpayers to avoid litigation by paying penalties and surrendering any tax benefits already received. Relatedly, in 2020, the U.S. Senate started investigations into potential abuses involving conservation easements. In August, the Senate published its findings, concluding the promoters of syndicated conservation easements and those participating in the transactions had avoided paying billions in taxes improperly. The Senate report termed syndicated conservation easement transactions as an “abusive tax shelter,” and that allowing such deals to continue “could undermine the U.S. Tax system.”
The heightened IRS scrutiny of conservation easement transactions, coupled with the very high rate of success in court challenging the claimed charitable deductions makes it critical that attorneys, other tax advisors and appraisers follow every rule. Deeds conveying the easement must be very carefully drafted. The IRS has indicated that it will examine every transaction and litigate all cases where it deems an inappropriate charitable deduction has been claimed.
No. 8 – Farm Records and FOIA
Telematch, Inc. v. United States Department of Agriculture., No. 19-2372, 2020 U.S. Dist. LEXIS 223112 (D.D.C. Nov. 27, 2020)
Farmers disclose a great deal of information and data to the USDA (federal government) to be able to participate in federal farm programs. The information/data is often tied to the particular farmer and farm location, thus raising privacy concerns over what persons and/or entities have access to it. Indeed, in recent years some animal activists opposed to large-scale confinement livestock production have committed acts of vandalism (and worse) against targeted facilities.
Because the information about farmers, their operations, and the locations of fields and facilities is in the hands of the USDA it is generally subject to disclosure to the public. In 1967, the Congress enacted the Freedom of Information Act (FOIA). 5 U.S.C. §552. The FOIA requires the disclosure of federal government documents upon request. The idea behind the law is to make federal agencies more transparent. But can a FOIA request reach private information of farmers that is in the USDA’s hands? Isn’t this personal information private? It’s an important concern for farmers. In 2020, a federal court issued an opinion that could prove to be very helpful toward easing the concerns of agricultural producers wanting to ensure that their private information is protected from public exposure.
In Telematch, the plaintiff was in the business of collecting and analyzing agricultural data from various sources, including the federal government. The plaintiff submitted seven FOIA requests to the USDA for specific records. The records sought included farm, tract, and customer numbers created by the USDA. The USDA created these numbers to assign them to land enrolled in USDA programs and to identify program participants. The USDA denied the plaintiff’s FOIA requests either in part or fully on the basis that the records at issue were geospatial information exempt from disclosure as relating to specific farm locations and specific farmers, and on the basis that the information sought would result in an unwarranted invasion of personal privacy.
The plaintiff administratively appealed the FOIA requests, and then sued in federal court three months later after being unsatisfied with the USDA’s failure to adjudicate the appeal. The plaintiff alleged that the USDA violated the FOIA by withholding the customer, farm, and tract numbers. Additionally, the plaintiff alleged the USDA violated the FOIA by following an unlawful practice of systematically failing to adhere to FOIA deadlines. The plaintiff claimed that no substantial privacy interest was at stake, and the public interest in obtaining the requested information outweighed any privacy concerns.
As a starting point, the trial court noted that the FOIA mandates that an agency disclose records on request, unless the records fall within an exclusion. As to the farm and tract numbers, the trial court held that the USDA properly withheld the information as geospatial information. The trial court held that the farm and tract numbers are geospatial information, as they refer to specific physical locations. Thus, USDA had properly not disclosed them to the plaintiff.
The trial court also held that the USDA also properly withheld the customer numbers from disclosure. Disclosing them, the trial court determined, would have been an invasion of personal privacy. The court noted that while the customer numbers alone did not reveal information about landowners, they could be combined with other public data to identify individual farmers and reveal information about their farms and financial status. The plaintiff claimed that disclosing the customer, farm, and tract numbers would allow the public to monitor how the USDA was administering its farm programs. Likewise, the plaintiff argued that the disclosure of the information would let the public determine whether the USDA was overpaying program participants and allow the public to determine whether farmers are complying with the USDA program. However, the trial court concluded that neither of the plaintiff’s arguments warranted the disclosure of the numbered information because the plaintiff showed no evidence to support its claim of fraud and because the FOIA’s purpose is to shed light on what the government is doing rather than the conduct of USDA program participants. As a result, the court held that the USDA also properly withheld the customer numbers.
As for the plaintiff’s claim that the USDA systematically failed to adhere to FOIA deadlines, the court held that the plaintiff lacked standing for failing to establish the existence of an unlawful policy or practice. The court noted that the USDA responded to the FOIA requests according to then-existing USDA regulations. The regulations stated that FOIA requests served on USDA required prepayments for the request to commence. The plaintiff failed to prepay on some of the requests, and the USDA completed the remainder of the requests within FOIA deadlines. Finally, the court held that the USDA’s failure to adhere to statutory deadlines to process the plaintiff’s administrative appeals did not rise to the level of systematically ignoring FOIA requests.
An appeal was filed in the case on December 21, 2020.
The DOJ investigating meatpackers; tax issues with donated conservation easements; and the privacy of farm data – developments ten through eight. Next time, I continue working my way toward the most significant ag law and ag tax development of 2020.
Sunday, January 3, 2021
I continue today with my perusal of the biggest developments in agricultural law and taxation from 2020 with the second installment of the “almost top 10” of 2020. In part one, I covered deprioritization (or the lack thereof) of withheld taxes in a Chapter 12 bankruptcy; the preferential payment rule in bankruptcy involving the Dean Foods matter; the significant ag nuisance jury verdict in North Carolina involving Murphy Brown; and a recent federal court opinion holding that filing a tax return with false information on
Part two of the “almost top ten of 2020” (in no particular order) – that’s the topic of today’s post.
“Renewable” Energy Cash Grants
Section 1603 of the American Recovery and Reinvestment Tax Act (ARRTA) was a green energy subsidy program created by the Congress and signed into law as a part of the 2009 economic “stimulus” package. The program created a system of cash grants in lieu of investment tax credits for entities that installed various types of alternative energy property such as solar, wind, geothermal, biomass, and hydropower. The purpose of payments (which were made after a qualified energy system was installed) was to reimburse grant recipients for a portion of the cost they incurred to install the energy systems at business locations. The program started in 2009 and ended in 2012.
The program is not without criticism and IRS scrutiny. The IRS rigorously audits companies utilizing the grants and, in some instances, the courts have ruled for the companies when the IRS partially denied the grants. Those cases primarily involved indemnity agreements that allowed the financiers of the projects to recover their funds elsewhere if the grant was improperly disallowed. In such “tax equity” deals it is common for the developer that finances a project to indemnify the tax equity investors if the tax benefits are less than expected. See, e.g., Alta Wind I Owner Lessor C v. United States, No. 13-402, 2020 U.S. Claims LEXIS 2071 (Fed. Cl. Oct. 21, 2020). In Alta, the wind energy company plaintiff claimed that the government underpaid on the Sec. 1603 grant. The court ruled that the company had alleged sufficient facts and injury to satisfy the constitutional standing requirement for the court to hear the case because the company had purchased the energy facilities at issue via a negotiated business transaction and alleged it had not been paid in full under Sec. 1603.
The IRS also won a significant case in 2020. In early 2012, the plaintiff placed a qualified wind facility into service at a cost of $433,077,031. The plaintiff applied for a Section 1603 grant (in lieu of tax credits) of $129,923,109. As part of the grant application, the plaintiff submitted a development agreement that claimed to show a “proof of payment” in support of a $60 million development fee. The plaintiff, a “project company,” paid the development fee to its parent company, Invenergy, LLC. The U.S. Treasury awarded the plaintiff a grant of $117,216,098. The Treasury explained that the reason for the $12.7 million shortfall was based on the plaintiff’s excessive cost basis in the facility based on the inclusion of the development fee in the cost basis calculation. The Treasury asserted that the development fee transaction was a sham lacking economic substance shaped solely by tax avoidance motives.
The court agreed. Bank records showed that money passed through the bank accounts of several entities related to the plaintiff by wire transfer and then back into the original account. The court determined that the plaintiff could not establish any business purpose or economic substance to the banking transactions. A CPA from a national firm, as the result of an audit, testified that the development agreement contained no quantifiable services. Invenergy, LLC, was not able to produce any accounting journal entries showing a business purpose for the banking transactions. Thus, the court determined that the evidence showed a development fee with no quantifiable services, circular wire transfers that started and ended in the same bank account on the same day, none of which were corroborated by independent testimony. The court denied the plaintiff reimbursement of the $12,707,011 cash grant, and the U.S. Treasury was entitled to recover an overpayment of $4,380,039. Bishop Hill Energy, LLC, et al. v. United States, 143 Fed. Cl. 540 (2019). The court also reached the same conclusion in California Ridge Wind Energy, LLC v. United States, 143 Fed. Cl. 757 (2019).
The appellate court affirmed, upholding the trial court’s finding that amounts stated by the plaintiff in development agreements pertaining to the wind farms did not reliably indicate the development costs. The appellate court, on a consolidated appeal of the two cases, noted the “round-trip” nature of the payments; the absence in the agreements of any meaningful description of the development services to be provided, and the fact that all, or nearly all, of the development services had been completed by the time the agreements were executed. The appellate court also determined that the services were not quantifiable. As a result, the government could recover $10 million in cash grants from the two companies. California Ridge Wind Energy, LLC v. United States, 959 F.3d 145 (Fed. Cir. 2020).
The case is significant because it could impact the computation of tax credits for future projects.
Trust Income Tax Regulations
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).
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.
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). 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).
Lying With Purpose of Harming Livestock Facility is Protected Speech
Animal Legal Defense Fund v. Schmidt, 434 F. Supp. 3d 974 (D. Kan. 2020)
Beginning with Kansas in 1990, several states have enacted legislation designed to protect confined animal production facilities from sabotage activity from groups and individuals opposed to animal agriculture. The laws generally forbid undercover filming or photography of activity on farms without the owner's consent. They have been challenged as unconstitutional on numerous occasions.
In this federal case involving Kansas law, the plaintiffs are a consortium of activist groups regularly conduct undercover investigations of livestock production facilities. Some of the plaintiffs gain access to farms through employment without disclosing the real purpose for which they seek employment (and lie about their ill motives if asked) and wear body cameras while working. For those hired into managerial and/or supervisory positions, they gain the ability to close off parts of the facility to avoid detection when filming and videoing. The film and photos obtained are circulated through the media and with the intent of encouraging public officials, including law enforcement, to take action against the facilities. The employee making the clandestine video or taking pictures, is on notice that the facility owner forbids such conduct via posted notices at the facility. The other plaintiffs utilize the data collected to cast the facilities in a negative public light but do no “investigation.”
In 1990, Kansas enacted the Kansas Farm Animal and Field Crop and Research Facilities Protect Act (Act). K.S.A. §§ 47-1825 et seq. The Act makes it a crime to commit certain acts without the facility owner’s consent where the plaintiff commits the act with the intent to damage an animal facility. Included among the prohibited acts are damaging or destroying an animal facility or an animal or other property at an animal facility; exercising control over an animal facility, an animal from an animal facility or animal facility property with the intent to deprive the owner of it; entering an animal facility that is not open to the public to take photographs or recordings; and remaining at an animal facility against the owner's wishes. K.S.A. § 47-1827(a)-(d). In addition, K.S.A. § 47-1828 provides a private right of action for "[a]ny person who has been damaged by reason of a violation of K.S.A. § 47-1827 against the person who caused the damage." For purposes of the Act, a facility owner’s consent is not effective if it is induced by force, fraud, deception duress or threat. K.S.A. § 47-1826(e). The plaintiff challenged the constitutionality of the Act, and filed a motion for summary judgment. The defendant also motioned for summary judgment on the basis that the plaintiffs lacked standing or, in the alternative, the Act barred trespass rather than speech.
On the standing issue, the trial court held that the plaintiffs lacked standing to challenge the portions of the Act governing physical damage to an animal facility (for lack of expressed intent to cause harm) and the private right of action provision, However, the trial court determined that the plaintiffs did have standing to challenge the exercise of control provision, entering a facility to take photographs, etc., and remaining at a facility against the owner’s wishes to take pictures, etc. The plaintiffs that did no investigations but received the information from the investigations also were deemed to have standing on the same grounds. On the merits, the trial court determined that the Act regulates speech by limiting what the plaintiffs could say and by barring pictures/videos. The trial court determined that the provisions of the Act at issue were content-based and restricted speech based on viewpoint – barring only that speech that would harm an animal facility. The trial court determined that barring lying is only constitutionally protected when it is associated with a legally recognizable harm, and the Act is unconstitutional to the extent it bars false speech intended to damage livestock facilities. Because the provisions of the Act at issue restrict content-based speech, its constitutionality is measured under a strict scrutiny standard. As such, a compelling state interest in protecting legally recognizable rights must exist. The trial court concluded that even if privacy and property rights involved a compelling state interest, the Act must be narrowly tailored to protect those rights. By focusing only on those intending to harm owners of a livestock facility, the Act did not bar all violations of property and privacy rights. The trial court also determined that the Governor was a proper defendant.
In a later action, the court entered a permanent injunction against enforcement of Kan. Stat. Ann. §§47-1827(b)-(d). Animal Legal Defense Fund v. Kelly, No. 18-2657-KHV, 2020 U.S. Dist. LEXIS 58909 (D. Kan. Apr. 3, 2020). A notice of appeal of the court’s decision was filed on May 1, 2020. In July, the court trimmed-down the plaintiff’s request of attorney fees and costs from almost $250,000 to slightly over $176,000. Animal Legal Defense Fund v. Kelly, No. 18-2657-KHV, 2020 U.S. Dist. LEXIS 124,480 (D. Kan. Jul. 15, 2020).
In the next post, I will continue the look at the “almost Top 10” of 2020 with Part 3.
Thursday, December 24, 2020
Farming and ranching, while it can provide a rewarding way of life for those involved, is a very dangerous occupation. Working with or around machinery and equipment, hazardous chemicals and pesticides, livestock, water, and projects that involve electricity are just some of the activities that can lead to injury or death. Sometimes, legal recourse is sought and that can lead to a court judgment or a settlement.
How is a monetary court award or settlement taxed? It’s an important question, particularly when the amount of the award or settlement is large. A recent IRS private ruling illustrates how the taxation of court awards and settlements are taxed.
The taxation of monetary court awards or settlements – it’s the topic of today’s post.
Generally, the courts use a fact based “origin of the claim” test to determine the tax character of court awards and settlement funds. See, e.g., French v. Comr., T.C. Sum. Op. 2018-36. Under the test, any funds the taxpayer receives are deemed to be a substituted payment for the damages that the taxpayer was alleging. As a result, an amount recovered will be determined either to be taxable or not subject to tax, with causality the key to the determination. See, e.g., Lindsey v. Comr., 422 F.3d 684 (8th Cir. 2005). Often, that causality is tied to extrinsic factors such as the details of the litigation, allegations contained in the complaint, and how the settlement negotiations were proceeding.
The “origin of the claim” test also determines the character of any taxable amount as either ordinary income or capital gain.
Physical injury or sickness. Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). Amounts received on account of mental distress may be received tax-free if the distress is directly related to personal injury. See, e.g., Barnes v. Comm’r, T.C. Memo. 1997-25. As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1.
Punitive damages. Legislation enacted in 1996 specifies that recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness. Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1605(a); See, e.g., O'Gilvie v. United States, 519 U.S. 79 (1996).
Lost profit. The 1996 enactment also made it clear that damages not attributable to physical injury or physical sickness are includible in gross income. In many lawsuits, there is almost always some lost profit involved and recovery for lost profit is ordinary income. See, e.g., Simko v. Comm’r, T.C. Memo. 1997-9. For recoveries in connection with a business, if the taxpayer can prove that the damages received were for injury to capital, no income results except to the extent the damages exceed the income tax basis of the capital asset involved. The recovery is, in general, a taxable event except to the extent the amount recovered represents a return of basis. Recoveries representing a reimbursement for lost profit are taxable as ordinary income.
In 2006, the U.S. Circuit Court of Appeals for the District of Columbia ruled that the distinction drawn in the 1996 amendment was unconstitutional. Murphy v. United States, 460 F.3d 79 (D.C. Cir. 2006). In the case, the plaintiff sued her former employer and was awarded $70,000 ($45,000 for mental pain and anguish and $25,000 for “injury to professional reputation”). The plaintiff originally reported the entire $70,000 as taxable and then filed amended returns excluding the income. The IRS maintained that the entire $70,000 was taxable, and the trial court agreed. On appeal, the court held that the $70,000 was not excludible from income under the statute, but that I.R.C. §104(a)(2) was unconstitutional under the Sixteenth Amendment since the entire award was unrelated to lost wages or earnings, but were, instead, payments for the restoration of the taxpayer’s human capital. Thus, the entire $70,000 was excludible from income. However, in late 2006, the court vacated its opinion and set the case for rehearing. Upon rehearing, the court reversed itself and held that even if the taxpayer’s award was not “income” within the meaning of the Sixteenth Amendment, it is within the reach of the power of the Congress to tax under Article I, Section 8 of the Constitution. In addition, the court reasoned that the taxpayer’s award was similar to an involuntary conversion of assets – the taxpayer was forced to surrender some part of her mental health and reputation in return for monetary damages.” The U.S. Supreme Court declined to hear the case. Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), reh’g. den., 2007 U.S. App. LEXIS 22173 (D.C. Cir. Sept. 14, 2007), cert. den., 553 U.S. 1004 (2008).
IRS Private Ruling
In Private Letter Ruling 202050009 (Sept. 10, 2020), the taxpayer was riding his bicycle on his way home from work when he was hit by an automobile. He was severely and permanently injured, including sustaining a traumatic brain injury resulting in his cognitive impairment. The taxpayer sued the company that employed the driver that hit him. The complaint alleged damages on account of the defendant’s negligence, recklessness and the driver’s willful and wanton acts. Damages were sought for the taxpayer’s medical bills; mental anguish; loss of enjoyment of life; disability; pain and suffering; and other injuries and damages, including loss of consortium for the taxpayer’s wife.
The trial court jury found the defendant liable and awarded the taxpayer (and spouse) damages for past and future economic damages (medical bills) and for past and future non-economic damages (mental anguish). The jury also awarded the taxpayer’s wife damages for past and future loss of consortium.
The IRS determined that the taxpayer’s damages were not taxable because the awarded damages were tied to the taxpayer’s physical injuries sustained as a result of the bicycle accident.
As a side-note, if the amount of an award or court settlement includes contingent attorney fees, the portion of the award representing contingent attorney fees is includible in the taxpayer’s gross income. Comm’r, v. Banks, 543 U.S. 426 (2005), rev’g and rem’g sub. nom., Banks v. Commr, 345 F.3d 373 (6th Cir. 2003).
For fees and costs paid after October 22, 2004, with respect to a judgment or settlement occurring after that date, legislation enacted in 2004 provides for a deduction of attorney’s fees and other costs associated with discrimination in employment or enforcement of civil rights. I.R.C. § 62(a)(20).
Most legal actions brought by farmers or ranchers against others as a result of business transactions or tort-type injuries often involve an element of lost profit and some involve recovery of basis. Therefore, there is likely to be at least a partially taxable event. The proper characterization of recoveries is vitally important. In addition, there may be a discharge of indebtedness involved and, in some instances, the transaction may be characterized as a “sale” of property to a creditor.
And a very Merry Christmas to all!
Saturday, December 19, 2020
The curtain has dropped on my 2020 agricultural law and taxation “tour.” As I write this, I am in transit returning to Kansas (and then Iowa) from the last stop of 2020 in San Angelo, Texas. Many of you have already asked about the 2021 National Summer Farm/Ranch Income Tax/Estate and Business Planning Conference.
In today’s article, I take a moment to mention an upcoming event and the summer conference(s).
On January 11, 2021, I will be doing a live webinar worth two hours of CLE/CPE credit on the biggest developments in agricultural law and taxation during 2020. I will also examine other significant developments and what the forthcoming legal and tax issues facing agriculture in the immediate future might be. This webinar is for lawyers and other tax practitioners as wells as farmer, ranchers, agribusiness professionals, rural landowners, ag media and any others that have an interest in what is going on in the legal and tax world that affects agricultural production and land ownership. I will dive into constitutional issues involving property rights; water law; environmental law and regulation, income tax issues; farm programs; and other legal and tax issues of importance.
You can learn more about and register for the January 11 event here: https://washburnlaw.edu/employers/cle/taxseasonupdate.html
Summer 2021 Conferences
Ohio conference. Two national conferences are being planned for the summer of 2021. The first event will be in Ohio either at the Salt Fork State Park Lodge and Conference Center near Cambridge, Ohio or at the Shawnee Lodge and Conference Center near Portsmouth, Ohio. The dates will be either June 1-2; June 7-8 or June 14-15. I am presently waiting on confirmation that the technology at the locations can meet our needs to provide a high-quality live simulcast of the conference over the internet. I will announce the dates and location as soon as I have the details finalized, which should be by the end of this month.
Missoula, Montana. The second summer national conference will be held in Missoula, Montana on August 2-3. You can learn more about the venue for the Montana conference here: https://www.hilton.com/en/hotels/msogigi-hilton-garden-inn-missoula/. It will also be simulcast live over the internet.
As the program details are put together, I will provide more details. Stay tuned.
Sunday, December 6, 2020
As 2020 winds down so do my continuing education events for the year. These late year events are important for practitioners that need additional education credit by the end of the year. I have six more events remaining this year, some in-person and some online. One event is a two-hour ethics session for those still needing ethics credit before the year ends.
Year-end continuing education opportunities – it’s the topic of today’s post.
This week finds me in Salina, Kansas for the second day of a two-day professional tax training event. This is a comprehensive conference digging into the specifics of what practitioners need to know for preparing 2020 tax returns for clients. Included will be up-to-the-minute relevant developments from the courts and the IRS as well as all trust return preparation issues and examples. More information about the Salina event can be found here: https://www.agmanager.info/events/kansas-income-tax-institute.
Later this week, on Wednesday, I will be speaking at the AICPA Agriculture Conference. This national conference is online. I will be speaking on financial distress tax and non-tax issues facing farmers and ranchers that are struggling financially. You can learn more about this event here: https://future.aicpa.org/cpe-learning/conference/aicpa-agriculture-conference. The next day, I will be doing another Day 2 of a tax conference. This event will be online, originating from the campus of Kansas State University (KSU). This is an approved NASBA event. Thus, CPAs can receive CPE credit for viewing online. You can learn more about this event here: https://www.agmanager.info/events/kansas-income-tax-institute.
On Friday, I will be doing a two-hour tax ethics session. This session originates from Washburn Law School and will involve discussion of ethical issues that tax practitioners face when representing clients with tax issues and the preparation of returns. Also, addressed will be Circular 230 issues and various ethical rules that CPAs and lawyers are subject to when representing clients. More information about the ethics event can be found here: https://washburnlaw.edu/employers/cle/taxethics.html.
The following week finds me in San Angelo, TX on December 17 and 18. This event is sponsored by the San Angelo Chapter of the Texas Society of CPAs. I will focus on farm estate and business planning as well as farm income tax. More information about this event can be found here: https://www.tscpa.org/sanangelo/news/details/2020/11/05/dec.-17---farm-and-ranch-estate-and-business-planning and here: https://www.tscpa.org/sanangelo/news/details/2020/11/05/dec.-17---farm-and-ranch-income-tax-update. The San Angelo event is my last scheduled event for the year. It’s been quite a year. While all of my professional engagements moved online from mid-March until mid-June, about half of them remained online since mid-June. I start out on the road during the first week of January 2021.
2021 summer events are being planned for Missoula, Montana as well as east Tennessee. There possibly will be a third national event in late September. I also do a number of in-house CPA and law firm training each year. If your firm is looking for in-house training in 2021 and have an interest in what I can offer, please contact me and I will do my best to get you on the calendar.
Also, tune in to RFD-TV/SiriusXM each week to hear the hosts interview me concerning various ag law and tax topics. You can also find me every other Monday morning at 6:00 a.m. (central) on WIBW radio (580 a.m.) and every other Wednesday on KFRM 550 a.m. discussing the biggest and most critical developments in agricultural law and taxation. All of these shows are captured and posted to the media page of the Washburn Agricultural Law and Tax Report – www.washburnlaw.edu/waltr.
2020 has been a challenge for many and has involved modifying the practice of law and/or tax and how client representation is engaged in. It’s also been a challenge given the new virus-related legislation and the frequent changes that have come by way of questions and answers and various notices, news releases and postings on the IRS website. Strange times, indeed.
Monday, November 30, 2020
A significant amount of farm and ranch land is held in a trust. Trusts are a popular part of many farm and ranch (and other) estate plans. If farmland or ranchland is contained in a trust, is it still eligible to be exchanged for other real property and have the gain (or loss) on the transaction deferred under I.R.C. §1031? If so, that means that placing land in a trust for estate planning (or other) reasons doesn’t eliminate the favorable tax consequences of I.R.C. §1031.
Whether real estate held in trust can qualify for like-kind exchange treatment – it’s the topic of today’s post.
Trusts and I.R.C. §1031 – The Basics
There is no absolute bar against a trust being part of an I.R.C. §1031 transaction. A trust can qualify if it otherwise satisfies the requirements of I.R.C. §1031. However, the taxpayer that owns the relinquished property must be the same taxpayer that takes ownership of the replacement property. This means that the taxpayer’s identity must not change between the time of the relinquishment of the real estate and the time the replacement real estate is received.
With respect to a trust, the key determinations to be made are who (or what) is the taxpayer and whether the taxpayer’s identity is preserved during the exchange process. A taxpayer’s identity is not necessarily the same concept than the manner in which property is titled. Instead, the question is whether the entity holding title to the real estate (such as a trust) that is involved in an exchange preserves the taxpayer’s identity. If the taxpayer’s identity changes between the time the taxpayer relinquishes the property and the time the replacement property is received, the same taxpayer will not have disposed of and received property.
Grantor trusts. If the trust is a grantor trust, such as a revocable trust, generally the grantor, trustee and beneficiary are same person. Such a trust is a “tax disregarded” entity and all items of income, loss, deduction and credit and are taxed to the grantor. The trust does not file a return in addition to that of the grantor. Thus, the grantor can meet the is the taxpayer and the taxpayer’s identity is preserved. This all means that a revocable living trust can be utilized as an ownership vehicle in a 1031 exchange - the grantor or trustee are considered the taxpayer. But, if the beneficiary is a different individual than the grantor, the beneficiary is not considered to be the taxpayer and cannot directly benefit from an I.R.C. §1031 exchange.
Non-grantor trusts. Conversely, if the trust is a non-grantor trust (such as an irrevocable trust where the grantor has not retained other powers), the trust is the taxpayer that is engaged in the like-kind exchange transaction. Unlike a revocable trust, an irrevocable trust has its own tax identification number and is not, for tax purposes, treated interchangeably with the grantor/settlor. But, an irrevocable trust can be a grantor trust if the grantor retains, for example, the “power to control beneficial enjoyment.” I.R.C. §674.
“Illinois” Land Trust
An Illinois land trust is comparable to a revocable living trust that is used to hold real estate. It can be revoked or amended during the grantor’s life. The trust’s grantor/beneficiary retains all rights and responsibilities of owning the real estate. A land trust can only hold real estate interests, and the trustee is a professional trustee. A land trust is recognized in a minority of states - Florida, Georgia, Hawaii, Illinois, Indiana, Montana, South Dakota and Virginia.
For land held in a land trust, title to the real estate is held by the trustee as the owner of the trust, and the trust owner holds the beneficial interest in the trust that holds the title to the property. That created some uncertainty as to whether a land trust can be involved in an I.R.C. §1031 exchange because I.R.C. §1031 restricts the exchange of a beneficial interest in an asset. However, the IRS issued a Revenue Ruling in 1992 taking the position that an interest in an Illinois Land Trust is an interest in real property that can be exchanged for like-kind real estate. Rev. Rul. 92-105, 1992-2 C.B. 204. While a beneficiary’s interest in a land trust was deemed to be personal property under state (IL) law, that characterization didn’t control the outcome. The IRS looked at the facts of the particular situation and noted that the trustee was only acting at the discretion of the taxpayer (beneficiary). The trustee merely held title and could only potentially transfer that title. Thus, the trust was an agency relationship between the trustee and beneficiary involving the holding and transferring of the title to the real estate contained in the trust. The taxpayer/beneficiary retained the right to manage and control the trustee, and remained the direct owner of the property for tax purposes. It was the beneficiary that remained obligated to pay the taxes and other liabilities associated with the trust property, and it was the beneficiary that had the exclusive right to the trust property’s earnings and profits. Based on those facts, the IRS determined that the beneficiary’s interest in the trust was an interest in real property that could be exchanged for other real property and qualify for deferral of gain (or loss) via I.R.C. §1031.
The trust and the relationship of the parties in the 1992 ruling was not determined to be a partnership. If the IRS had determined that a partnership was involved, that would have meant that the beneficiary’s interest in the real estate in the trust would not have qualified for like-kind exchange treatment – partnership interests are not eligible. Important to that point, only one beneficiary was involved under the facts of the ruling. With multiple beneficiaries, it may be easier for the IRS to asset that a partnership exists and deny I.R.C. §1031 eligibility.
Based on Rev. Rul. 92-105, if a trust (or similar arrangement created under state law) is merely an investment vehicle, it can qualify as like-kind to real property under I.R.C. §1031. That’s certainly the case for a trust if the trustee has title to the real property in the trust; the beneficiary has the exclusive right to direct or control the trustee in dealing with title to the property; and the beneficiary has the exclusive control of the property’s management as well as the obligation to pay any taxes and other liabilities that relate to the property. When those factors are present, an exchange transaction actually involves the exchange of the underlying trust property rather than an exchange of a certificate of trust beneficial interest, and the gain or loss on the transaction can be eligible for deferral under I.R.C. §1031.
Delaware Statutory Trust
Twelve years after Rev. Rul. 92-105, the IRS issued another revenue ruling on the issue. Rev. Rul. 2004-86, 2004-2 C.B. 191 involved a Delaware Statutory Trust (DST) that was formed to hold real property subject to a lease. A DST is a form of business trust where the owner of a DST share is regarded as owning a beneficial interest in the trust. Under the facts of the Rev. Rul., the trustee’s powers were limited to only collecting and distributing income. As such, the DST was merely an investment trust and its interests could be exchanged for real property in an I.R.C. §1031 transaction. Specifically, Rev. Rul. 2004-86, stands for the proposition that a DST can be utilized for the purchase of replacement property in an I.R.C. §1031 exchange. However, with more retained powers in the trustee, the IRS said that the trust would be a business trust rather than an investment trust and would not qualify for like-kind treatment. Consequently, Rev. Rul. 2004-86 is quite limited. But, if all of the interests in the trust are of a single class that represent undivided beneficial interests of the trust and the trustee cannot vary the trust’s investments, the trust will be an investment trust and its assets can be exchanged for real property with any gain qualifying for deferral under I.R.C. §1031. On the other hand, if the trustee has greater discretion with respect to the trust property, those additional powers could cause disqualification from I.R.C. §1031 treatment. Those additional powers could include, for instance, the power to dispose of the real property in the trust and acquire new property, the power to renegotiate leases on the trust property, or approve more than minor modifications or improvements to the property. If those powers are present, the IRS could take the position that the trust constitutes a business entity not eligible for I.R.C. §1031 treatment.
Perhaps the most important aspect of Rev. Rul. 2004-86 is that the IRS at least impliedly classified the DST as a grantor trust. Thus, real estate contained in a grantor trust could be exchanged for interests in a grantor trust containing real property and the transaction would qualify for deferral treatment under I.R.C. §1031. That has important estate planning implications.
Safe Harbor for Trusts Holding Rental Real Estate
An arrangement with a single class of ownership interests, representing undivided beneficial interest in the trust assets, is classified as a trust if there is no power under the trust agreement to vary the investment of the beneficiaries (“power to vary”). Treas. Reg. §301.7701-4(c). As noted above, in Rev Rul. 2004-86 the IRS took the position that a DST formed to hold real property subject to a lease was an arrangement classified as a trust for Federal tax purposes under Treas. Reg §301.7701-4(c). However, the trust would be a business entity and not a trust if the trustee had a power to, among other things, renegotiate the lease with the tenant, to enter into leases with other tenants, or to renegotiate or refinance the mortgage loan whose proceeds were used to purchase the real estate.
After the issuance of Rev. Rul. 2004-86, the IRS provided safe harbors for determining the Federal income tax status of certain securitization vehicles that hold mortgage loans. Under the safe harbors, certain modifications of mortgage loans in connection with forbearance programs described in that guidance are not treated as manifesting a power to vary. When those safe harbors were issued, the IRS received comments addressing arrangements organized as trusts under Treas. Reg. §301.7701-4(c), and Rev. Rul. 2004-86 that hold rental real property. As a result, the IRS in 2020 provided additional guidance detailing actions that will not constitute a power to vary for purposes of determining whether the arrangement is treated as a trust under Treas. Reg. §301-7701-4(c) and Rev. Proc. 2020-34, Sec. 7. Rev. Proc. 2020-26, I.R.B. 753. Section 6 of the safe harbor allows these arrangements to make certain modifications to their mortgage loans and their lease agreements and to accept additional cash contributions without jeopardizing their tax status as trusts.
Specifically, under Rev. Proc. 2020-26, the following do not constitute a power to vary in violation of the regulation: 1) modification of one or more mortgage loans that secure the trust’s real property in a CARES Act forbearance or a forbearance that the trust requested, or agreed to, between March 27, 2020, and December 31, 2020, and that were granted as a result of the trust experiencing a financial hardship due to the actions of state governments in reaction to the China-originated virus; 2) modification of one or more real property leases entered into by the trust on or before March 13, 2020, where the modifications were requested and agreed to on or after March 27, 2020 and on or before December 31, 2020, and the reason for the lease modification is to coordinate the lease cash flows with the cash flows that result from one or more transactions described in the Notice or to defer or waive one or more tenants’ rental payments for any period between March 27, 2020 and December 31, 2020 because the tenants are experiencing a financial hardship due to the COVID-19 emergency; and 3) the acceptance of cash contributions that were made between March 27, 2020, and December 31, 2020, as a result of the trust experiencing financial hardship due to state government conduct in reaction to the China virus. However, the contribution must be needed to increase permitted trust reserves, to maintain trust property, to fulfill obligations under mortgage loans, or to fulfill obligations under real property leases. A cash contribution from one or more new trust interest holders to acquire a trust interest or a non-pro rata cash contribution from one or more current trust interest holders must be treated as a purchase and sale under I.R.C. §1001 of a portion of each non-contributing (or lesser contributing) trust interest holder’s proportionate interest in the trust’s assets.
For real property contained in trust, if the trustee’s powers are limited, the real property can be exchanged for other real property and qualify for gain (or loss) deferral under I.R.C. §1031. Land contained in a grantor trust is deemed to be owned by the individual grantor and remains eligible for I.R.C. §1031 treatment. For land contained in a non-grantor trust, the language of the trust is critical. For non-grantor trusts, the trust language must place sufficient limitations on the trustee’s powers to allow the trust beneficiary to receive like-kind exchange treatment under I.R.C. §1031.
The virus-related relief granted in 2020 is also helpful for providing guidance on the “power to vary” issue.
Thursday, November 26, 2020
As readers of this blog know, periodically I write an article focusing on recent court developments. This is one of those articles. Recently, federal and state courts have issued some rather significant opinions involving livestock odors, overtime wages for dairy workers and the Second Amendment right to bear arms.
A potpourri of ag law and related issues – it’s the topic of today’s post.
Appellate Court Upholds $750,000 Compensatory Damage Award in Hog Nuisance Suit
A nuisance is an invasion of an individual's interest in the use and enjoyment of land rather than an interference with the exclusive possession or ownership of the land. The concept has become increasingly important in recent years due to land use conflicts posed by large-scale, industrialized confinement livestock operations. Indeed, the industrialization of agriculture has given rise to nuisance suits brought by farmers against large-scale agricultural operations.
Nuisance law prohibits land uses that unreasonably and substantially interfere with another individual's quiet use and enjoyment of property. The doctrine is based on two interrelated concepts: (1) landowners have the right to use and enjoy property free of unreasonable interferences by others; and (2) landowners must use property so as not to injure adjacent owners.
Nuisance law is rooted in the common law and has been developed over several centuries as courts settled land use conflicts. Nuisance law is always changing, and the legal rules vary between jurisdictions. Nuisance law is important to agriculture because of the noxious odors produced by many farm operations, especially those involving livestock production.
The two primary issues at stake in any agricultural nuisance dispute are whether the use alleged to be a nuisance is reasonable for the area and whether the use alleged to be a nuisance substantially interferes with the use and enjoyment of neighboring land. Another issue may be whether the complained-of activity is protected by a state right-to-farm statute.
All of these concepts were involved in this case. Here, the plaintiffs were pre-existing neighbors to the defendant’s large-scale confinement hog feeding facility conducted by a third-party farming operation via contract. The facility annually maintained nearly 15,000 of the defendant’s hogs that generated about 153,000 pounds of feces and urine every day. The waste was disposed of via lagoons and by spreading it over open “sprayfields” on the farm. The plaintiffs sued in state court in 2013 for nuisance violations, but later dismissed that action and refiled in federal court after learning of the defendant’s control over the hog feeding facility naming the defendant as the sole defendant.
The federal trial court coordinated 26 related cases against similar hog production operations brought by nearly 500 plaintiffs into a master case docket and proceeded with trials in 2017. In this case, the jury awarded $75,000 in compensatory damages to each of 10 plaintiffs and $5 million in punitive damages to each plaintiff. The punitive damage award was later reduced to $2.5 million per plaintiff after applying a state law cap on punitive damages.
On appeal, the appellate court determined that the trial court had properly allowed the plaintiffs’ expert testimony to establish the presence of fecal material on the plaintiffs’ homes and had properly limited the expert witness testimony of the defendant concerning odor monitoring she conducted at the hog facility. The appellate court also rejected the defendant’s claim that the third party farming operation should be included in the case as a necessary and indispensable party. The appellate court also affirmed the trial court’s holding concerning the availability of compensatory damages beyond the rental value of the property and the jury instruction on nuisance. The appellate court also concluded that the trial court properly submitted the question of punitive damages to the jury. The appellate court reversed the trial court’s admission of financial information of the defendant’s corporate grandfather and combining the punitive damages portion of the trial with the liability portion, but held that such errors did not require a new trial. However, the appellate court remanded the case for a consideration of the proper award of punitive damages without consideration of the grandparent’s company’s financial information (such as compensation amounts to corporate executives).
It’s also important to note that while North Carolina law was involved in this case, as a result of this litigation several states, including Nebraska and Oklahoma, have recently amended their state right-to-farm laws with the intent of strengthening the protections afforded farming operations.
Overtime Exemption for Dairy Workers Unconstitutional.
Martinez-Cuevas v. Deruyter Brothers Dairy, Inc., No. 96267-7, 2020 Wash. LEXIS 660 (Wash. Sup. Ct. Nov. 5, 2020)
Federal law provides an exemption from paying overtime wages for persons employed in agriculture. Many states have a comparable exemption. In this case, the exemption contained in Washington law was at issue.
The plaintiffs brought a class action on behalf of 300 of the defendant’s workers challenging the exemption of dairy workers from overtime pay under the Washington Minimum Wage Act. The plaintiffs also claimed that the defendant violated other wage and hour rules. The plaintiffs claimed that the overtime exemption violated the equal protection clause in the state constitution and was racially biased against Hispanic workers.
The state Supreme Court, in a 5-4 decision, the majority held that the exemption undermined a “fundamental right” to health and safety protections for workers in dangerous jobs that the state Constitution guarantees via the privileges and immunities clause. The majority focused on Article II, Sec. 35 of the Washington Constitution requiring the legislature to pass law necessary “for the protection of persons working in…employments dangerous to life or deleterious to health,” and Article I which the majority construed as protecting “fundamental rights of state citizenship.” The majority believed that there was a connection between the requirement that the legislature pass laws to protect workers in dangerous occupations and the minimum wage law, and that the legislature didn’t have a reasonable basis to exclude dairy workers from the overtime pay requirements of the law.
The dissenting justices pointed out that overtime pay is not a fundamental constitutional right and, as such, does not implicated the privileges and immunities clause. Instead, the state legislature has a “wide berth” to decide that laws that are required to carry out that purpose. The dissent pointed out that the legislature could simply repeal the overtime law and no person would have a personal or private common law right to insist on overtime pay absent an employment contract with a term promising overtime pay.
The ruling means that dairy farmers will be required to pay $20.54 per overtime hour beginning in 2021. That is the case, of course, for the workers that still have a job, have overtime hours and aren’t displaced by automation.
Lifetime Ban on Owning Firearms For Filing Tax Returns With False Statement
Folajtar v. The Attorney General of the United States, No. 19-1687, 2020 U.S. App. LEXIS 37006 (3rd Cir. Nov. 24, 2020)
Any law that impairs a fundamental constitutional right (any of the first ten amendments to the Constitution) is subject to strict scrutiny – or at least it’s supposed to be. The right to bear arms, as the Second Amendment, is a fundamental constitutional right. Thus, any law restricting that right is to be strictly scrutinized. But, does a convicted felon always permanently lose the right to own a firearm. What if the felony is a non-violent one? These questions were at issue in this case.
The plaintiff pleaded guilty in 2011 to willfully making a materially false statement on her federal tax returns. She was sentenced to three-years’ probation, including three months of home confinement, a $10,000 fine, and a $100 assessment. She also paid back taxes exceeding $250,000, penalties and interest. Her conviction triggered 18 U.S.C. §922(g)(1), which prohibits those convicted of a crime punishable by more than one year in prison from possessing firearms. The plaintiff’s crime was punishable by up to three years’ imprisonment and a fine of up to $100,000.
As originally enacted in 1938, 18 U.S.C. §922(g)(1) denied gun ownership to those convicted of violent crimes (e.g., murder, kidnapping, burglary, etc.). However, the statute was expanded in the 1968. Later, the U.S. Supreme Court recognized gun ownership as an individual constitutional right in 2008. District of Columbia v. Heller, 554 U.S. 570 (2008). In a split decision, the majority reasoned that any felony is a “serious” crime and, as such, results in a blanket exclusion from Second Amendment protections for life. The majority disregarded the fact that the offense was non-violent, was the plaintiff’s first-ever felony offense, and was an offense for which she received no prison sentence. The majority claimed it had to rule this way because of deference to Congressional will that, the majority claimed, created a blanket, categorical rule.
The dissent rejected the majority’s categorical rule, pointing out that the plaintiff’s offense was nonviolent, and no evidence of the plaintiff’s dangerousness was presented. The dissent also noted that the majority’s “extreme deference” gave legislatures the power to manipulate the Second Amendment by simply choosing a label. Instead, the dissent reasoned, when the fundamental right to bear arms is involved, narrow tailoring to public safety is required. Because the plaintiff posed no danger to anyone, the dissent’s position was that her Second Amendment rights should not be curtailed. Likewise, because gun ownership is an individual constitutional right, the dissent pointed out that the Congress bears a high burden before extinguishing it. Post-2008, making a categorical declaration is insufficient to satisfy that burden, according to the dissent.
Expect this case to be headed to the U.S. Supreme Court. Justices Barrett and Kavanaugh have already indicated that they agree with the dissent based on their comments in earlier cases.
There are always significant developments in the law impacting farmers and ranchers and rural landowners. The three court opinions discussed in this article are each significant in their own respect. Stay informed. And, on this Thanksgiving Day 2020, if you don’t have everything you want, be thankful for the things you don’t have that you don’t want.
Tuesday, November 24, 2020
On this blog, I rarely repeat the coverage of an issue that I have already addressed. The only exception to that basic rule is when there is a major development that materially alters the content of the issue or issues discussed. But, sometimes I am reminded that some tax issues that seem to me to be obvious and well understood still need to be occasionally repeated. One of those times is today, based on several recent calls and emails.
The proper structuring of deferred payment contracts – it’s the topic of today’s post.
A cash-basis taxpayer accounts for income in the tax year that it is either actually or constructively received. The constructive receipt doctrine is the primary tool that the IRS uses to challenge deferral arrangements. Under Treas. Reg. §1.451-2(a)), a taxpayer is deemed to have constructively received income when any of the following occurs:
- The income has been credited to the taxpayer’s account;
- The income has been set apart for the taxpayer; or
- The income has been made available for the taxpayer to draw upon it, or it could have been drawn upon if notice of intent had been given, unless the taxpayer’s control of the receipt of the income is subject to substantial limitations or restrictions.
However, income received under a properly structured deferred payment contract is taxed under the installment payment rules. IRC §§453(b)(2); 453(l)(2)(A).
Basic Deferral Arrangements
The most likely way for a farmer to avoid an IRS challenge of a deferral arrangement is for the farmer to enter into a sales contract with a buyer that calls for payment in the next tax year. This type of contract simply involves the buyer’s unsecured obligation to purchase the agricultural commodities from the seller on a particular date. Under this type of deferral contract, the price of the goods is set at the specified time for delivery, but payment is deferred until the next year. If the contract is bona fide and entered into at arm’s length, the farm seller has no right to demand payment until the following year, and the contract (as well as the sale proceeds) is non-assignable, nontransferable and nonnegotiable, the deferral will not be challenged by the IRS.
The following criteria for a deferred payment contract should be met in order to successfully defer income to the following year.
- The seller should obtain a written contract that under local law binds both the buyer and the seller. A note should not be used;
- The contract should state clearly that under no circumstances would the seller be entitled to the sales proceeds until a specific date (i.e., a date in a future tax year). The earliest date depends on the farmer’s tax yearend.
- The contract should be signed before the seller has the right to receive any proceeds, which is normally before delivery. That means that the contract should have been executed before the first crop delivery. If the contract was not executed until after the crop proceeds were delivered, IRS can argue that the farmer actually had the right to the income, but later chose not to take possession of it until the next calendar year. An oral agreement to the contrary can be difficult to prove.
- The buyer should not credit the seller’s account for any goods the seller may want to purchase from the buyer during the year of the deferred payment contract (such as seed and/or fertilizer). Instead, such transactions should be treated separately when billed and paid.
- The contract should state that the taxpayer has no right to assign or transfer the contract for cash or other property.
- The contract should include a clause that prohibits the seller from using the contract as collateral for any loans or receiving any loans from the buyer before the payment date;
- The buyer should avoid sales through an agent in which the agent merely retains the proceeds. Receipt by an agent usually is construed as receipt by the seller for tax purposes.
- Price-later contracts (where the price is set in a later year) should state that in no event can payment be received prior to the designated date, even if a price is established earlier.
- The contract may provide for interest. Interest on an installment sale is reported as ordinary income in the same manner as any other interest income. If the contract does not provide for adequate stated interest, part of the stated principal may be recharacterized as imputed interest or as interest under the original issue discount rules, even if there is a loss. Unstated interest is computed by using the applicable federal rate (AFR) for the month in which the contract is made.
Contracts that lack these specifics run the risk of subjecting the seller to the constructive receipt rules with income recognition in the year of delivery. Simply delivering the grain under a contract where the grain is credited to an open account with a delay in payment until proper accounting for grain deliveries and other required administrative steps have occurred will not likely be enough to deflect an IRS assertion of constructive receipt. It may not matter much to the IRS that the farmer-seller is subject to administrative and processing delays and, as a result, cannot actually receive payment until the next tax year. The deferred payment contract must be in the proper form. A contract that states that payment is deferred until the next tax year and that it constitutes a voluntary extension of credit by the seller coupled with language stating that it can be changed in writing by the buyer’s authorized agents invites IRS scrutiny.
Is There a Way To Provide Security?
After an agricultural commodity is delivered to the buyer but before payment is made, the seller is an unsecured creditor of the buyer. In an attempt to provide greater security for the transaction, a farmer-seller may use letters of credit or an escrow arrangement. This could lead to a successful challenge by the IRS on the basis that the letters of credit or the escrow can be assigned, with the result that deferral is not accomplished.
Although the general rule is that funds placed in escrow as security for payment are not constructively received in the year of sale, it is critical for a farmer-seller to clearly indicate that the buyer is being looked to for payment and that the escrow account serves only as security for this payment. In addition, any third-party guarantee or standby letter of credit should be nonnegotiable and set up so that it can only be drawn upon in the event of default. If the escrow account is set up properly, the funds held in escrow, and the accrued interest on those funds, is taxable as income in the year that it provides an economic benefit to the taxpayer.
For deferred sales that are structured properly and achieve income tax deferral, installment reporting is automatic unless the taxpayer makes an election not to use it. An installment sale is a sale of property with the taxpayer receiving at least one payment after the tax year of the sale. Thus, if a farmer sells and delivers grain in one year and defers payment until the next year, that transaction constitutes an installment sale. If desired, the farmer can elect out of the installment-sale method and report the income in the year of sale and delivery.
The election must be made by the due date, including extensions, of the tax return for the year of sale and not the year in which payment is to be received. The election is made by simply recognizing the entire gain on the taxpayer’s applicable form (i.e., Schedule D or Form 4797), rather than reporting the installment sale on Form 6252, Installment Sale Income.
Because of the all-or-nothing feature (on a per-contract basis) of electing out of installment reporting, it may be advisable for farm taxpayers to utilize multiple deferred payment sales contracts in order to better manage income from year to year. The election out is made by simply reporting the taxable sale in the year of disposition. But, when the election out of the installment method is made by reporting the income in the year of the sale, the seller must be careful to make sure that the gain recognized is also not recognized in the following year. A way to make sure that is done is to record a receivable for the amount of the accelerated sales, with the entry reversed after yearend.
Generally, if the taxpayer elects out of the installment method, the amount realized at the time of sale is the proceeds received on the sale date and the fair market value of the installment obligation (future payments). If the installment obligation is a fixed amount, the full principal amount of the future obligation is realized at the time of the acquisition.
What About An Untimely Death?
If a seller dies before receiving all of the payments under an installment obligation, the installment payments are treated as income in respect of a decedent (IRD). I.R.C. §691(a)(4). Therefore, the beneficiary does not get a stepped-up basis at the seller’s death. The beneficiary of the payments includes the gain on the beneficiary’s return subject to tax at the rate applicable to the beneficiary. The character of the payments is tied to the seller. For example, if the payments were long-term capital gain to the seller, they are long-term capital gain to the beneficiary.
Grain farmers often carry a large inventory that may include grain delivered under a valid deferred payment agreement. Grain included as inventory but more properly classified as an installment sale may not qualify for stepped-up basis if the farmer dies after delivering the grain but prior to receiving all payments.
The only way to avoid possible IRD treatment on installment payments appears to be for the seller to elect out of installment sale treatment. IRD includes sales proceeds “to which the decedent had a contingent claim at the time of his death.” Treas. Reg. §1.691(a)-1(b)(3). The courts have held that the appropriate inquiry regarding installment payments is whether the transaction gave the decedent at the time of death the right to receive the payments. See, e.g., Estate of Bickmeyer v. Comm’r, 84 TC 170 (1985). This means that the decedent holds a contingent claim at the time of death that does not require additional action by the decedent. In that situation, the installment payments are IRD.
Chapter 9 of the IRS Farmers Audit Technique Guide (ATG) provides a summary of income deferral and constructive receipt rules. The ATG provides a procedural analysis for examining agents to use in evaluating deferred payment arrangements. The ATG is available https://www.irs.gov/businesses/small-businesses-self-employed/farmers-atg.
Agricultural producers typically have income streams that are less consistent from year to year than do nonfarm salaried individuals. Deferred payment contracts can be used as key income tax planning tool for farmers. But, it’s important to make sure they are structured properly to produce the desired tax results.
Monday, November 16, 2020
A revocable trust is a popular estate planning tool that is utilized as a will substitute. Some people view it as a good alternative to a will for several reasons, including privacy and probate avoidance. Unfortunately, some believe that a revocable trust will also save estate taxes compared to a properly drafted will. It will not. The very nature of the revocability of the trust means that the trust property is included in the decedent’s estate at death.
While estate tax savings are not an issue with a revocable trust, it’s important to understand the income tax issues that can occur when the grantor of the trust dies and the trust assets become part of the grantor’s estate. There’s a special tax election involved for a “qualified revocable trust” (QRT) and it has particular accounting and income tax consequences. It can also provide some tax planning opportunities.
The tax and accounting rules surrounding the election to treat a QRT as an estate – it’s the topic of today’s post.
The I.R.C. §645 Election
The issue. When the grantor of a revocable trust dies, the trust becomes irrevocable. For tax purposes, the trust will have a calendar year – a short tax year from the date of death through December 31. In addition, the trust will be a complex trust if the trustee is not required to make immediate distributions. In that case, depending on the assets in the trust, the trust may earn income that will be taxed in accordance with the rate brackets applicable to a trust. For 2020, the top rate of 37 percent is reached at $12,951 of trust income. Of course, one possible solution to this problem is for the trustee to distribute the trust income to the beneficiaries so that it can be taxed at their (likely lower) tax rates. But, if that additional income has not been planned for it could create tax issues for the beneficiaries such as underpayment penalties.
Another option may be for the trustee/executor to make the I.R.C. §645 election for a QRT.
Mechanics. A QRT is a domestic trust (or portion thereof) that is treated as owned by a decedent (a grantor trust) on the date of the decedent’s death by reason of a power to revoke that was exercisable by the decedent or with the consent of the decedent’s spouse. I.R.C. §645(b)(1). For a QRT, the executor of the decedent’s estate, along with the trustee, can make an election to have the QRT taxed as part of the decedent’s estate for income tax purposes instead of as a separate trust. I.R.C. §645(a). In other words, a joint election by both the trust and the estate’s executor is required.
Without the election, the revocable trust becomes irrevocable upon the decedent’s death and requires a separate income tax return (Form 1041) to report trust income (using a calendar year-end) that is earned post-death. The merger of the trust and the estate for income tax purposes applies only to tax years that end before the date six months after the final determination of estate tax, or, if there is no estate tax return that is filed (Form 706), two years after the date of death. I.R.C. §645(b)(2).
If an executor is not appointed for the estate, the trustee files the election with an explanatory statement that no executor is being appointed for the estate. The election is made by completing Form 8855 and attaching a statement to Form 1041 providing the name of the QRT, its taxpayer identification number and the name and address of the trustee of the QRT.
Once made, the election causes the trust to be treated for income tax purposes as part of the decedent’s estate for all applicable tax years of the estate ending after the date of the decedent’s death. Id. The electing QRT need not file an income tax return for the short year after the date of the decedent’s death. Instead, the trustee of the electing QRT only need file one Form 1041 for the combined trust and estate under the estate’s TIN, and all income, deductions and credits are combined.
The election allows a fiscal year-end to be utilized, ending at the end of a month not to exceed one-year after the decedent’s death. The utilization of a fiscal year for income tax purposes can allow the estate executor to more effectively time the reporting of income and expense to achieve a more advantageous tax result. For example, assume that an election is made for a QRT resulting in a tax year of December 1, 2020 through November 30, 2021. A beneficiary receives a distribution on December 23, 2020. As a result of the election, the beneficiary won’t have to report any income triggered by the distribution until 2021 and will have until April 15, 2022 to file the return that reports the income from the distribution. Without the election, the distribution would have been taxed to the beneficiary in 2020 and reported on the 2020 return filed on or before April 15, 2021.
The election can also allow for the loss recognition when a pecuniary bequest is satisfied with property having a fair market value less than basis. I.R.C. §267(b). One $600 personal exemption is allowed; the QRT can deduct amount paid to, or permanently set aside for charity; and up to $25,000 in passive real estate losses can be deducted. I.R.C. §§642(b); 642(c); 469(i)(4).
Once the election is made, it is irrevocable.
Implications. The I.R.C. §645 election, while resulting in one tax return for purposes of reporting income and expense on Form 1041, the trust and the estate are still treated as separate shares for purposes of calculating the distributable net income (DNI) deduction. Treas. Reg. §1.645-1(e)(2)(iii). The election does not combine the estate and trust for purposes of computing the DNI deduction. Thus, distributions can result in different allocation to beneficiaries and different amounts of income tax paid by the estate/trust.
To illustrate, assume that an estate has $20,000 of income with no distributions made to the trust which, as typical, is the estate’s sole beneficiary. The trust has $40,000 of income and made a $60,000 distribution to a beneficiary. The income reported on Form 1041 is $60,000. Under the Treas. Reg., the estate’s DNI is calculated separately from that of the trust. In the example, the estate’s share of DNI is $20,000, but it gets no DNI deduction due to the lack of distributions during the tax year. Conversely, the trust’s share of DNI is $40,000 and the trust’s DNI deduction is the lesser of the total cash distributed or the DNI. Here, the DNI was less than the actual cash distributed resulting in a DNI deduction of $40,000. The filed Form 1041 recognizes the $20,000 of taxable income and the beneficiary has $40,000 of income reported on the beneficiary’s individual return.
Now assume that the estate distributes $20,000 to the trust, the trust’s share of income is $60,000 ($40,000 plus the $20,000 from the estate). The full $60,000 of income is DNI of the trust, and the $60,000 distribution to the beneficiary causes the full $60,000 to be taxed at the beneficiary’s level. There is no tax at the trust level to be taxed at the compressed bracket rates applicable to trusts and estates. This all means that separate accounting for the trust and the estate must be done while the estate is being administered.
When the election period ends or when the assets of the original trust are distributed to another trust, the new trust will file returns on a calendar year basis. Thus, a filing will be required for the timeframe from the end of the fiscal year to the end of the calendar year after the termination. In that instance, the beneficiaries could end up with two K-1s and the benefit of income deferral could be eliminated depending on the tax bracket that the beneficiary is in.
Clearly there are several things to consider before making an I.R.C. §645 election. For individuals that die late in the year, the election can allow estate administration to perhaps be completed before a tax return must be filed. Thus, the first tax return could end up being the final tax return for the estate if the estate is fully administered by the time the return is due. That would save administrative costs. Also, the election can provide the ability to shift income into a later tax year; allow funds to be set aside for charity and receive a deduction but not have to distribute the funds until a later time; eliminate the need for estimated tax payments; and hold S corporate stock during the period of estate administration – an advantage over a trust if administration extends beyond two years. But the separate share rule can complicate the accounting. The trust and the estate are not combined for calculating the DNI deduction. Separate accounting for the trust and estate is needed while the estate is being administered.
More things to think about when a decedent dies with a revocable trust.
Friday, November 13, 2020
Yesterday’s article focused on the legal aspects of farmer/landowner relationships – tenant, cropper or farm manager. Another aspect of leasing farmland involves the tax issues. What is the proper way to report farm rental income? Is the rental income subject to self-employment tax? What about estate planning implications?
The tax implications of farmland rental income – it’s the topic of today’s article.
Reporting Farmland Lease Income
Farmland lease income may be reported on one of three possible IRS Forms: (1) Schedule F (Farm Income and Expenses); Form 4835 (Farm Rental Income and Expenses); and Schedule E. The appropriate Form depends upon whether the landlord is "materially participating" in the farming operation. Generally, a landlord receiving cash rent should file Schedule E to report the rental income. The income is not from a farming operation, but from a rental. Reporting the rental income on Schedule E also does not trigger the application of self-employment tax. By statute, “rents from real estate and personal property leased with real estate” are not “trade or business income. I.R.C. §1402(a).
If the lease is a crop or livestock share-rent arrangement, a materially participating landlord should report the income on Schedule F. If a share-rent landlord is not materially participating, the landlord should report the income on Form 4835. For lease income that is reported on Schedule F, self-employment tax will apply, except for any portion of the rental income that relates to the rental of real estate improvements (e.g., a farm building or grain bin). The amount apportioned to real estate improvements should be reported on Schedule E.
Material participation is a key concept in the proper reporting of crop/livestock share lease income. If the landlord materially participates under the lease, the landlord’s rental income is subject to self-employment tax.
For purposes of self-employment tax being imposed under I.R.C. §1402, a landlord materially participates if all three of the following conditions are satisfied.
- There is an arrangement between the owner (landlord) of the property and another person, that provides that the other person is to produce agricultural or horticultural commodities on that land;
- Under the "arrangement", the landlord is to materially participate in the production or the management of the production of the commodities; and
- The landlord does actually materially participate. R.C. §1402(a)(1).
A landlord also materially participates if the landlord satisfies any one of the four following tests:
Test 1: The landlord does any three of the following:
- Advance, pay, or stand good for at least half the direct cost of producing the crop;
- Furnish at least half the tools, equipment, and livestock used in producing the crop;
- Consult with your tenant; or
- Inspect the production activities periodically.
Test 2: The landlord regularly and frequently makes, or takes an important part in making, management decisions substantially contributing to or affecting the success of the enterprise.
Test 3: The landlord works 100 hours or more spread over a period of five weeks or more in activities connected with crop production.
Test 4: The landlord does things that, considered in their total effect, show that the landlord is materially and significantly involved in the production of the farm commodities.
In situations where a farmer either owns land outright or in in entity and cash leases the land to a farming entity in which the farmer materially participates, the rental income can be subject to self-employment tax unless the lease rate is set at fair market value and there is no connection between the lease and the farmer’s employment agreement with the farming entity . Martin v. Comr., 149 T.C. 293 (2017). To bolster those points, the lease should be in writing and the labor provided to the farming entity should be under a written employment agreement calling for reasonable compensation.
While many farm landlords have only a verbal agreement with the tenant, clearly a written lease makes establishing the presence of material participation easier. While the presence of material participation causes the rental income to be subjected to self-employment tax, it also can be beneficial for other tax and non-tax reasons – including post-death estate planning purposes.
Cash Rent Income – Potential Drawbacks
While cash rental income is not subject to self-employment tax, other tax implications should be considered, such as the following:
- The rental income is not treated as gross farm income for the exception to the estimated tax penalty. R.C. §6654(i).
- The income does not count for the special treatment of soil and water conservation expenditures under I.R.C. 175.
- The income will count for the exclusion of cost-sharing payments under I.R.C. 126.
- The income is also potentially subject to the passive loss limitations of I.R.C. 469.
- The income won’t count for purposes of expense method depreciation under I.R.C. 179.
- With a very minor exception, farmland subject to an election under I.R.C. 2032A cannot be cash rented during the ten-year period following the date of the decedent’s death.
- For a retired farm landlord under age 65 receiving Social Security benefits, cash rental income won’t diminish the payments.
The proper structuring of a farm lease arrangement is important for numerous tax reasons. Some are more obvious than others, but all are important. Proper tax planning is the key to obtaining the best result and avoid unintended consequences.
Friday, November 6, 2020
The courts keep issuing rulings of importance to agricultural producers and others involved in agriculture or who own agricultural land. Also, tax issues of general relevance continue to be resolved in the courts. In today’s post, I take a look at some recent cases involving farm bankruptcy; the “public trust” doctrine; the proper tax classification of a work relationship; on-farm sales of processed beef; and zoning.
A potpourri of ag and tax legal issues – these are the topics of today’s post.
Court Denies Proposed Sale of Land by Chapter 12 Debtor
In re Holthaus, No. 20-40065, 2020 Bankr. LEXIS 3001 (Bankr. D. Kan. Oct. 26, 2020)
The debtors (a married couple) owned farmland in two counties. They filed Chapter 12 bankruptcy and sought to sell three tracts of land through two contracts. 11 U.S.C. §363(b)(1) provides that a trustee "after notice and a hearing, may use, sell or lease, other than in the ordinary course of business, property of the estate." In determining whether to approve a proposed sale under 11 U.S.C. §363, courts generally apply standards that, although stated various ways, represent essentially a business judgment test. The debtors had not filed a reorganization plan at the time of the proposed sale of the land.
The first contract consisted of two parcels totaling 200 acres which would be used as prime cropland. The second contract was for 120 acres of cropland in need of erosion remediation and not eligible for participation in government agricultural programs in its current condition. The debtors claimed that there was an oral agreement to lease the purchased properties back to the debtors for $175 per acre per year after the sale, as well as a right of first refusal if the buyer were to sell the properties, so that the debtors could continue to farm the land. Both contracts were silent as to the amount of rent to be paid and whether the right of first refusal applied to all three of the properties. The debtors proposed to sell the prime cropland for $4,000 per acre, based on a recent sale of another property in the county.
The creditors had mortgage liens on the properties and vigorously opposed the sale of the three properties. The creditors argued that the debtors were undervaluing all three tracts of land. Specifically, the creditors argued that the debtors erred in relying on a past sale in the county to arrive at $4,000 per acre. The creditor argued that the recent sale involved land that included a significant portion of pasture and wasteland, and that the debtors’ land was compromised of high-quality tillable land and no waste. As a result, the creditors argued that the sale price of the prime cropland should be $5,000 per acre.
The bankruptcy court agreed with the creditors and held that the debtors had inadequately priced the prime cropland. However, the bankruptcy court held that the second contract did not undervalue the less desirable cropland. The bankruptcy court noted that although the debtors’ sale did not require satisfaction of outstanding liens, there were significant concerns about some aspects of the proposed sale. First, the debtors’ ability to resume farming would be dependent upon the lease of the three tracts after the sale for rent that would be less than the debtor’s present debt service. Additionally, the debtors’ right to lease would only last as long as the proposed buyer owned the properties. Consequently, the bankruptcy court denied the debtors’ proposed sale primarily due to an inadequate sale price for the prime cropland.
Observation: Clearly, not having the prime cropland exposed to the market through a listing was a problem. If that had been done, there likely would have been testimony (and other evidence) to support the price in addition to the debtor's testimony. Having an appraiser testify could have helped the debtor.
Public Trust Doctrine Inapplicable to Natural Resources Allegedly Harmed by “Climate Change”
I wrote recently about attempts to expand the “public trust” doctrine and the impact such an expansion would have on agricultural production and land ownership. You can read that article here: https://lawprofessors.typepad.com/agriculturallaw/2020/10/the-public-trust-doctrine-a-camels-nose-under-agricultures-tent.html. In that article I discussed a Nevada Supreme Court opinion in which the Court refused to expand the doctrine. Now, the Oregon Supreme Court has likewise refused to expand the doctrine.
In the Oregon case, the plaintiffs claimed that the public trust doctrine required the State of Oregon to protect various natural resources in the state from harm due to greenhouse gas emissions, “climate change,” and ocean acidification. The public trust doctrine has historically only applied to submerged and submersible lands underlying navigable waters as well as the navigable waters. The trial court rejected the plaintiffs’ arguments. On appeal the state Supreme Court affirmed, rejecting the test for expanding the doctrine the plaintiffs proposed. Under that test, the doctrine would extend to any resource that is not easily held or improved and is of great value to the public. The state Supreme Court held that the plaintiffs’ test was too broad to be adopted. The Supreme Court remanded the case to the lower court.
Zoning Ordinance Bars Keeping of Farm Animals
Maffeo v. Winder Borough Zoning Hearing Board, 220 A.3d 1210 (Pa. Commw. Ct. 2019)
The plaintiff owned a two-acre property in an area zoned residential. She kept approximately 50 animals on the property including goats, donkeys, and chickens. The city manager’s office had received numerous noise and odor complaints regarding the animals. The city sent the plaintiff a cease and desist letter giving the plaintiff 20 days to remove the animals. A city ordinance prohibited any person from keeping goats, donkeys, and other farm animals on residentially zoned property. The plaintiff appealed the cease and desist letter to the defendant city, the zoning hearing board. The plaintiff admitted that most of her property was located within a residentially zoned district but argued that a small corner of the property was located in a conservation district allowing for agricultural uses. The zoning board denied the plaintiff’s argument and concluded that although part of the property was zoned for agricultural use, it was undisputed that the plaintiff’s animals were within 200 feet of a residential lot which violated a separate city ordinance.
The trial court affirmed. On appeal, the plaintiff argued the trial court failed to consider evidence that she properly cared for her animals and that her property had not been surveyed. Specifically, the plaintiff argued a letter from the county humane society should have been considered to show she properly cared for her animals. The appellate court held that although the letter was not in the record, both the zoning board and trial court had expressly considered the letter in making their respective rulings. The appellate court noted that the care for the animals was not at issue, but rather whether zoning rules and ordinance permitted the plaintiff to keep farm animals on her property. The appellate court also determined that a zoning survey of the property had been done recently, which showed that most of the property was within a residential district and only a small portion was zoned as conservation. The plaintiff failed to present any evidence to rebut the survey before the hearing board or trial court, therefore the appellate court held that the plaintiff was in violation of the city ordinance. Finally, the plaintiff argued the zoning board was unevenly enforcing its zoning ordinances because a neighbor had testified before the hearing board that he kept chickens on his property and a city officer had told him that doing so did not violate any city ordinance. The appellate court held that this evidence alone was insufficient to establish uneven enforcement without any other evidence presented.
On-Farm Sales of Processed Beef Subject to Sales Tax
Priv. Ltr. Rul. 8115 (Mo. Dept. of Rev., Sept. 25, 2020)
The taxpayer sought a ruling from the Missouri Department of Revenue (MDOR) concerning the sale of beef products from his farm. The taxpayer raises cattle, slaughters them, and then sends the beef out to be processed at a local processing plant. The taxpayer pays the processing plant for its services and then the taxpayer sells the resulting beef products to customers at his farm. The taxpayer’s question was whether the beef sales were subject to sales tax. The MDOR issued a ruling stating that the sales are subject to sales tax at the food tax rate of 1 percent. The MDOR noted that 7 U.S.C. §2012, defines “food” as "any food or food product for home consumption." The taxpayer was selling raw beef at retail for home consumption.
Payments Received By CPA Were Wages and Not S.E. Income; Deductions Disallowed
Thoma v. Comr., T.C. Memo. 2020-67
The petitioner acquired a partial interest in an accounting firm and ultimately became the sole owner of the firm that he operated as a sole proprietorship. The petitioner later went into business with another accountant pursuant to two contracts. One contract purported to be a partnership agreement and the second contract “restated” the first contract. The plaintiff provided accounting services to the firm and also brought his own clients to the firm. He later sold his interest back to the business under an agreement stating that he didn’t retain any management or supervisory role in the business.
During the year of sale of his interest and the following year (2010 and 2011), the business made bi-weekly payments to the petitioner for accounting services. The business issued Schedules K-1 reporting the payments as guaranteed payments to a limited partner with no withholding. The petitioner did not receive any paid sick leave or paid vacation time. The business had a professional liability policy that included the petitioner. The petitioner received a letter from the Department of Justice requesting the records of a client and the petitioner responded to the letter without informing the business. That ultimately resulted in the business locking the petitioner out, barring him from the computer network and placing him on administrative leave and his relationship with the business being terminated.
The petitioner reported his income for 2010 and 2011 as self-employment income allowing him to claim deductions for deposits into his SIMPLE IRA and for health insurance premiums that he paid as well as for one-half of his self-employment tax liability. The IRS disallowed the deductions, recharacterizing the income as wages. That resulted in his expenses being treated as unreimbursed employee expenses deductible only as miscellaneous itemized deductions subject to the two-percent of adjusted gross income floor. Likewise, the petitioner’s health insurance deductions were only deductible as a medical expense deduction and the SIMPLE IRA deduction was disallowed. The IRS also imposed accuracy-related penalties.
The Tax Court agreed with the IRS position, concluding that the petitioner and the other accountant did not intend to carry on a business together or share profit and loss. Thus, they never formed a partnership. The 2010 agreement, the Tax Court determined resulted in an at-will employment arrangement with the petitioner having no management authority. The issuance of the Schedules K-1 were not controlling, but merely a factor in determining the existence of a partnership. The Tax Court also held that the petitioner was not an independent contractor because of the longstanding relationship of the petitioner and the other accountant. The accountant/firm retained the right to fire the petitioner and provided him with professional liability insurance, office space and tax prep software. The firm also retained control over the details of his work and he did not have any opportunity for profit or loss independent of the business. The IRS-imposed penalties were upheld.
The courts again illustrate the numerous legal and tax issues that are relevant for farmers, ranchers rural landowners and taxpayers in general. It’s always a good idea to have competent legal and tax counsel within arm’s reach.
Monday, November 2, 2020
To claim a deduction on the current year’s tax return, a taxpayer using the accrual method must generally show “economic performance” concerning the item(s) for which a deduction is sought and that all events have occurred determining a liability and that the amount of the liability can reasonably be determined. Treas. Reg. §1.461-1(a)(2)(i).
These points came up recently in a case involving a California business that provides bulk-packaged tomato products to food processors. The company also provides customer-branded finished products to the food service industry. The question was whether the company could increase its cost of goods sold (COGS) for the costs it incurred to restore, rebuild, recondition and retest their manufacturing facilities for the tax years in issue.
When it comes to claiming a tax deduction, a taxpayer can take it on the return in the tax year that is consistent with the method of accounting that the taxpayer uses to compute taxable income. I.R.C. §461(a). That means that for an accrual method taxpayer, a business expense can be deducted in the year the expense is incurred. It doesn’t matter if the actual payment date is in a different year. See, e.g., Caltex Oil Venture v. Commissioner, 138 T.C. 18 (2012), citing Treas. Reg. §1.461-1(a)(2). So, when is an expense incurred? It’s when an “all events” test is satisfied. See Challenge Publications, Inc. v. Commissioner, T.C. Memo. 845 F.2d1541 (9th Cir. 1988). Under the test, an item allowable as a deduction, cost or expense (liability) for federal income tax purposes is incurred if: 1) all of the events establishing the liability have occurred; 2) the amount of the liability is determinable with reasonable accuracy; and 3) economic performance has occurred. Treas. Reg. § 1.446-1(c)(1)(ii)(B); I.R.C. §461(h)(4); Treas. Reg. §§1.461-1(a)(2); 1.461-4. It must be fixed and absolute. Brown v. Helvering, 291 U.S. 193 (1934). It also must be unconditional. Lucas v. North Texas Lumber Co., 281 U.S. 11 (1930).
The all events test isn’t satisfied, and a deduction isn’t allowed if the tax liability is contingent on the occurrence of a future event. See Lucas v. American Code Co., 280 U.S. 445 (1930). Conversely, a liability is established if the required performance is rendered or the date of payment is unconditionally due. See, e.g., VECO Corp. & Subsidiaries. v. Comr., 141 T.C. 440 (2013). Another way of stating the matter is that there must be something (such as a contract or a statute) that fixes the taxpayer’s obligation. See, e.g., Exxon Mobil Corp. v. Commissioner, 114 T.C. 293 (2000); Amergen Energy Co., LLC v. United States, 113 Fed. Cl. 52 (2013).
In The Morning Star Packing Company, L.P., et al. v. Comr., T.C. Memo. 2020-142, the petitioner provided bulk-packaged tomato products to food processors and customer-branded finished products to the food service and retail trades. The petitioner’s operation accounted for about 25 percent of the California processed tomato production and it supplied approximately 40 percent of the United States ingredient tomato paste and diced tomato markets.” The petitioner operated around-the-clock during tomato harvest season, and operated under numerous state and federal food safety/cleanliness regulations. Any violations (or even alleged violations) of those requirements could shut down the petitioner’s operation causing losses due to spoilage and contract defaults with growers and buyers. Specifically, after the end of a tomato harvest season, the petitioner engaged in extensive clean-up. If the petitioner didn’t engage in this meticulous post-harvest cleaning and the tomato line were to become contaminated all of the tomato products in the processing line would have to be dumped, the line sterilized at a large cost, and all had to be inspected by federal and state agricultural agencies. In addition, farmer-sellers would have to be paid for their tomato crops and the petitioner would be in breach of the covenants contained in the credit lines (that required the petitioner to maintain its licenses and keep the equipment in good repair) with its lenders as well as its delivery contracts for processed tomatoes.
The petitioner incurred costs to restore, rebuild, and retest the manufacturing facilities for use during the next production cycle. The accrued production costs included amounts to be paid for goods and services. The petitioner also maintained reserves to account for future costs associated with restoring, rebuilding, and retesting the manufacturing facilities for use during the next production cycle. The production accrual reserve accounts tracked amounts for production labor, boiler fuel, electricity, waste disposal, chemicals and lubrication, production supplies, repairs and maintenance, lease, production wages, and administration wages.
The accrued production costs were recurring, and the amounts set aside in the reserves covered the costs with reasonable accuracy. IRS did not challenge the accuracy of the reserves. The petitioner also documented the economic efficiency reasons why it delayed some of the restorative work as well as retesting and rebuilding work until near the beginning of the next production cycle.
The petitioner deducted its clean-up costs (good and services, etc.) after a tomato harvest season in that tax year, even though the clean-up work actually occurred in the following tax year. Economic performance of the production accrual liabilities didn’t occur until the petitioner’s next tax year. At least that was the position of the IRS. It claimed that the petitioner could not include the accrued costs in the cost of sales for the current year due to the economic performance requirement of I.R.C. §461(h)(3). In particular, the IRS asserted that the petitioner couldn’t increase its COGS for the amount of the accrued production costs because the petitioner had not shown that all events had occurred to establish the fact of the liabilities. Economic performance had not occurred with respect to the liabilities to qualify for accrual for the years claimed – the third prong of the “all events” test.
The petitioner claimed that it was entitled to the deduction because it had bilateral contracts for goods and services to recondition its manufacturing facilities, and that all events had occurred during the tax years in issue to establish the fact of the liabilities for the accrued production costs. The petitioner also took the position that its credit agreements and multiyear contracts to supply customers with tomato products obligated them to incur the accrued production costs to restore, rebuild, and retest the manufacturing facilities. The Tax Court disagreed. The Tax Court noted that the credit agreements did not specifically set forth the petitioner’s obligations to provide a comparably sufficiently fixed and definite basis. Instead, the Tax Court concluded that the credit agreements included nonspecific text and generalized obligations that merely required to maintain its licenses and permits, and secure governmental approvals. The agreements also also contained general language requiring the petitioner to comply with ‘all laws’, and ‘keep all property useful and necessary in its business in good working order and condition’. That language, the Tax Court concluded, didn’t specify which laws or regulations had to be complied with. It also didn’t identify with any precision which property must be kept in good working order. The generalized obligations, the Tax Court reasoned, did not establish the petitioner’s liabilities for the accrued production costs for the years in issue. In addition, the Tax Court determined that the petitioner’s inclusion of the production costs in COGS for the years in issue result in a more proper match against income than inclusion in the taxable year.
The petitioner also couldn’t avoid its tax problem by using a fiscal year from October 1 to September 30. While good business reasons would have supported using such a fiscal year, I.R.C. §706 prevented it.
Clearly, and accrual basis taxpayer must closely scrutinize the liabilities that it seeks to deduct to make sure that all of the requirements of the all-events test have been met to claim the deduction. Satisfying the economic performance part of that test also requires careful drafting of credit agreements to fix the liabilities in the appropriate tax year.
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 220.127.116.11.4 (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.