Wednesday, September 14, 2022

Ag Law and Tax Developments

Overview

It’s been a while since I last did an case and ruling update. So, today’s post is one of several that I will post in the coming weeks. 

Some recent developments in the courts and IRS – it’s the topic of today’s post.

Retained Ownership of Minable Surface Negates Conservation Easement Deduction

C.C.A. 202236010 (Sept. 9, 2022)

The Chief Counsel’s office of IRS has taken the position that a conservation easement donation is invalid if the donor owns both the surface estate of the land burdened by the easement as well as a qualified mineral interest that has never been separated from the surface estate, and the deed retains any possibility of surface mining to extract subsurface minerals.  In that instance, the conservation easement doesn’t satisfy I.R.C. §170(h).  The IRS said the result would be the same even if the donee would have to approve the surface-mining method because the donated easement would not be donated exclusively for conservation purposes in accordance with I.R.C. §170(h)(5).  The IRS pointed out that Treas. Reg. §1.170A-14(g)(4) states that a donated easement does not protect conservation purposes in perpetuity if any method of mining that is inconsistent with the particular conservation purposes of the contribution is permitted at any time.  But, the IRS pointed out that a deduction is allowed if the mining method at issue has a limited, localized impact on the real estate and does not destroy significant conservation interests in a manner that can’t be remedied.  Surface mining, however, is specifically prohibited where the ownership of the surface estate and the mineral interest has never been separated.  On the specific facts involved, the IRS determined that the donated easement would not be treated at being made exclusively for conservation purposes because the donee could approve surface mining of the donor’s subsurface minerals.

Use of Pore Space Without Permission Unconstitutional

Northwest Landowners Association v. State, 2022 ND 150 (2022)

North Dakota law provides that a landowner’s subsurface pore space can be used for oil and gas waste without requiring the landowner’s permission or the payment of any compensation. The plaintiffs challenged the law as an unconstitutional taking under the Fourth and Fifth Amendments. The trial court held that the law was unconstitutional on its face and awarded attorney’s fees to the plaintiff.  On further review, the North Dakota Supreme Court determined that the plaintiffs had a property interest in subsurface pore space and that the section of the law specifying that the landowners did not have to provide consent to the trespassers to use the land unconstitutionally deprived them of their property rights as a per se taking.  However, the Supreme Court determined that the section of the law allowing oil and gas producers to inject carbon dioxide into subsurface pore space was constitutional.  The Supreme Court upheld the award of attorney fees. 

Net Operating Loss Couldn’t Be Carried Forward

Villanueva v. Comr., T.C. Memo. 2022-27

The petitioner sustained a loss from the disposition of a condominium he owned as a rental property. He reported the date of the loss as August 2013, but a mortgage lender had foreclosed on the condo in May 2009 and the taxpayer lost possession on that date. The IRS denied the deduction on the basis that the petitioner had not claimed the loss on either an original or amended return which meant that there was no loss that could be carried forward. The Tax Court agreed with the IRS, noting that the Treasury Regulations for I.R.C. §165 provide that a loss is treated as sustained during the tax year in which the loss occurs as evidenced by a closed and completed transaction and fixed by identifiable events occurring in such taxable year.  A loss resulting from a foreclosure sale is typically sustained in the year in which the property is disposed of, and the debt is discharged from the proceeds of the foreclosure sale.  Thus, the Tax Court determined that the loss had occurred in 2009 and should have been claimed at that time where it could have then been carried forward. 

Overtime Pay Rate Not Applicable to Construction Work on Farm

Vanegas v. Signet Builders, Inc., No. 21-2644, 2022 U.S. App. LEXIS 23206 (7th Cir. Aug. 19, 2022)

The plaintiff, the defendant’s employee, worked overtime in building a livestock fence for the defendant.  The defendant refused to pay the plaintiff time and a half for overtime. The plaintiff sued the defendant to recover the extra wages. The defendant’s refusal was based on the plaintiff being an agricultural worker not entitled to overtime.  The trial court agreed and dismissed the plaintiff’s claim.  The plaintiff appealed. The appellate court looked to the language of 29 U.S.C. § 213(b)(12) and the work of the plaintiff to determine if the plaintiff would be considered an agricultural employee. The appellate court found the plaintiff’s work was carried out as a separately organized activity outside of the defendant’s agricultural operations. The plaintiff worked for the defendant, but he built the fence on his own without any aid from any of the farm employees. The appellate court noted that another indication the work would not be considered exempt is whether farmers typically hire someone out for the work at issue. If so, it could be an indication the work is separate from agricultural work and would qualify for overtime pay. The appellate court found the defendant failed to provide much evidence to show that the plaintiff worked with agricultural employees and did not show the work was commonly done by a farmer. The appellate court also reasoned that just because the plaintiff was given a visa for agricultural work did not mean his work for the defendant was agricultural. The appellate court reversed the trial court’s decision to dismiss the complaint.

Early Distribution “Penalty” is a “Tax” and Does Not Require Supervisor Approval

Grajales v. Comr., No. 21-1420, 2022 U.S. App. LEXIS 23695 (4th Cir. Aug. 24, 2022), aff’g., 156 T.C. 55 (2021)     

The petitioner borrowed money from her pension account at age 42.  She received an IRS Form 1099-R reporting the gross distributions from the pension of $9,025.86 for 2015.  She didn’t report any of the amount as income in 2015.  The IRS issued her a notice of deficiency for $3,030.00 and an additional 10 percent penalty tax of $902.00.  The parties later stipulated to a taxable distribution of $908.62 and a penalty of $90.86.  The petitioner claimed that she was not liable for the additional penalty tax because the IRS failed to obtain written supervisory approval for levying it under I.R.C. §6751(b). The Tax Court determined that the additional 10 percent tax of I.R.C. §72(t) was a “tax” and not an IRS penalty that required supervisor approval before it would be levied.  The Tax Court noted that I.R.C. §72(t) specifically refers to it as a “tax” rather than a penalty and that other Code sections also refer to it as a tax.  The appellate court affirmed. 

U.S. Fish & Wildlife Service Can Regulate Ag Practices on Leased Land

Tulelake Irrigation Dist. v. United States Fish & Wildlife Serv., 40 F.4th 930 (9th Cir. 2022)

The plaintiffs sued the defendant, U.S. Fish and Wildlife Service, claiming the defendant violated environmental laws by regulating leased farmland in the Tule Lake and Klamath Refuge. The trial court granted summary judgment in favor of the defendant.  The plaintiff appealed.  The appellate court noted that the Kuchel Act and the Refuge Act allow the defendant to determine the proper land management practices to protect the waterfowl management of the area.  Under the Refuge Act, the defendant was required to issue an Environmental Impact Statement (EIS) and Comprehensive Conservation Plan (CCP). The defendant did issue an EIS and CCP for the Tule Lake and Klamath Refuge area, which included modifications to the agricultural use on the leased land within the region. The EIS/CCP required the leased lands to be flooded post-harvest, restricted some harvesting methods, and prohibited post-harvest field work, which the plaintiffs claimed violated their right to use the leased land. The plaintiffs argued that the language, “consistent with proper waterfowl management,” within the Kuchel Act was “nonrestrictive” and was not essential to the meaning of the Act. The appellate court held it was improper to read just that portion of the Act without considering the rest of the Act to understand the intent. The appellate court found the Kuchel Act was unambiguous and required the defendant to regulate the leased land to ensure proper waterfowl management. The Refuge Act allows the defendant to regulate the uses of the leased land, but the plaintiffs argued the agricultural practices were a “purpose” rather than a “use” so the defendant could not regulate it under the Refuge Act. The appellate court found the agriculture on the leased land was not a “purpose” equal to waterfowl management. The appellate court also held the language of the act was unambiguous and determined that agricultural activities on the land was to be considered a use that the defendant could regulate.   The appellate court affirmed the trial court’s award of summary judgment for the defendant.

Crop Salesman Sued for Ruining Relationship with Landowner

Walt Goodman Farms, Inc. v. Hogan Farms, LLC, No. 1:22-cv-01004-JDB-jay, 2022 U.S. Dist. LEXIS 134192 (W.D. Tenn. Jul. 28, 2022)

The plaintiff, a farm tenant, sued the defendant landlord and a third-party ag salesman.  The plaintiff claimed that the salesman wrongly advised the landlord and encouraged the landlord to complain about the plaintiff’s farming practices.  Specifically, the plaintiff’s claims against the salesman were for interference with contract, interference with business relationship, and fraud.  The salesman moved to dismiss each claim, but the trial court denied the motion with respect to the contract interference and interference with business relationship claims.  The trial court, however, dismissed the fraud claim involving the efficacy of corn seed.

Standard Default Interest Rate Not Unconscionable

Savibank v. Lancaster, No. 82880-1-I, 2022 Wash. App. LEXIS 1558 (Wash. Ct. App. Aug. 1, 2022)

The defendant obtained a loan from the plaintiff to purchase his father’s farm before the virus outbreak. The loan agreement stated that the interest rate would increase to 18 percent upon default. The defendant did default when the pandemic hit, and the plaintiff filed a foreclosure and repossession action against the plaintiff. The trial court ruled in favor the plaintiff. The defendant appealed and asserted the 18 percent default interest rate was unconscionable during a pandemic. During the appeal, the defendant claimed the plaintiff should have alerted the defendant to any better loan alternatives but failed to do so. The appellate court, affirmed, finding that the plaintiff had no contractual obligation to make the defendant aware of any better financing agreement.  The appellate court also upheld the trial court’s finding that the 18 percent default interest rate was not unconscionable and was common for agricultural loans with other banks in the area.  The appellate court also noted that the defendant had the opportunity to consult with a lawyer about the loan terms before signing.  The loan terms were standard and straightforward, and the defendant failed to show any evidence as to how the virus caused his default or how it made the default interest rate unconscionable.  In addition, the court noted that the defendant had stopped making loan payments before the virus began to impact the United States. The appellate court also held that the defendant failed to provide any evidence for an unconscionability defense. 

Conclusion

I’ll post additional developments in a subsequent post.

September 14, 2022 in Civil Liabilities, Income Tax, Real Property, Regulatory Law | Permalink | Comments (0)

Sunday, September 11, 2022

September 30 Ag Law Summit in Omaha (and Online)

Overview

On September 30, Washburn Law School with cooperating partner Creighton Law School will conduct the second annual Ag Law Summit.  The Summit will be held on the Creighton University campus in Omaha, Nebraska.  Last September Washburn Law School conducted it’s first “Ag Law Summit” and held it at Mahoney State Park in Nebraska. This year the Summit returns in collaboration with Creighton University School of Law.  The Summit will be held at Creighton University on September 30 and will also be broadcast live online.

The Summit will cover various topics of relevance to agricultural producers and the tax and legal counsel that represent them. 

The 2022 Ag Law Summit – it’s the topic of today’s post.

Agenda

Developments in agricultural law and taxation.  I will start off the day with a session surveying the major recent ag law and tax developments.  This one-hour session will update attendees on the big issues facing ag clients and provide insight concerning the issues that look to be on the horizon in the legal and tax world.  There have been several major developments involving agricultural that have come through the U.S Supreme Court in recent months.  I will discuss those decisions and the implications for the future.  Several of them involve administrative law and could have a substantial impact on the ability of the federal government to micro-manage agricultural activities.  I will also get into the big tax developments of the past year, including the tax provisions included in the recent legislation that declares inflation to be reduced!

Death of a farm business owner.  After my session, Prof. Ed Morse of Creighton Law School will examine the tax issues that arise when a farm business owner dies.  Income tax basis and the impact of various entity structures will be the focus of this session along with the issues that arise upon transitioning ownership to the next generation and various tax elections.  The handling of tax attributes after death will be covered as will some non-tax planning matters when an LLC owner dies.  There are also entity-specific issues that arise when a business owner dies, and Prof. Morse will address those on an entity-by-entity basis.  The transition issue for farmers and ranchers is an important one for many.  This session will be a good one in laying out the major tax and non-tax considerations that need to be laid out up front to help the family achieve its goals post-death.

Governing documents for farm and ranch business entities.  After a morning break Dan Waters with Lamson Dugan & Murray in Omaha will take us up to lunch with a technical session on the drafting of critical documents for farm and ranch entities.  What should be included in the operative agreements?  What is the proper wording?  What provisions should be included and what should be avoided?  This session picks up on Prof. Morse’s presentation and adds in the drafting elements that are key to a successful business succession plan for the farm/ranch operation.

Fence law issues.  After a provided lunch, Colten Venteicher who practices in Gothenburg, NE, will address the issues of fence line issues when ag land changes hands.  This is an issue that seems to come up over and over again in agriculture.  The problems are numerous and varied.  This session provides a survey of applicable law and rules and practical advice for helping clients resolve existing disputes and avoid future ones. 

Farm economics.  Following the afternoon break, a presentation on the current economy and economic situation facing ag producers, ag businesses and consumers will be presented by Darrell Holaday.  Darrell is an ag economist and his firm, Advanced Market Concepts, provides marketing plans for ag producers.   What are the economic projections for the balance of 2022 and into 2023 that bear on tax and estate planning for farmers and ranchers?  How will the war in Ukraine continue to impact agriculture in the U.S.?  This will be a key session, especially with the enactment of legislation that will add fuel to the current inflationary fire – unless of course, the tax increases in the legislation slow the economy enough to offset the additional spending. 

Ethics.  I return to close out the day with a session of ethics focused on asset protection planning.  There’s a right way and a wrong way to do asset protection planning.  This session guides the practitioner through the proper approach to asset protection planning, client identification, and the pitfalls if the “stop signs” are missed.

Online.  The Summit will be broadcast live online and will be interactive to allow you the ability to participate remotely. 

Reception

For those attending in person, a reception will follow in the Harper Center Ballroom on the Creighton Campus. 

Conclusion

If your tax or legal practice involves ag clients, the Ag Law Summit is for you.  As noted, you can also attend online if you can’t be there in person.  If you are a student currently in law school or thinking about it, or are a student in accounting, you will find this seminar beneficial. 

I hope to see you in Omaha on September 30 or see that you are with us online.

You can learn more about the Summit and get registered at the following link:  https://www.washburnlaw.edu/employers/cle/aglawsummit.html

September 11, 2022 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)

Monday, September 5, 2022

Bibliography – January through June of 2022

Overview 

Periodically I post an article containing the links to all of my blog articles that have been recently published.  Today’s article is a bibliography of my articles from the beginning of 2022 through June.  Hopefully this will aid your research of agricultural law and tax topics.

A bibliography of articles for the first half of 2022 – it’s the content of today’s post.

Bankruptcy

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 8 and 7

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-8-and-7.html

Other Important Developments in Agricultural Law and Taxation

https://lawprofessors.typepad.com/agriculturallaw/2022/01/other-important-developments-in-agricultural-law-and-taxation.html

Recent Court Cases of Importance to Agricultural Producers and Rural Landowners

https://lawprofessors.typepad.com/agriculturallaw/2022/06/recent-court-cases-of-importance-to-agricultural-producers-and-rural-landowners.html

Business Planning

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

https://lawprofessors.typepad.com/agriculturallaw/2022/03/summer-2022-farm-income-taxestate-and-business-planning-conferences.html

Should An IDGT Be Part of Your Estate Plan?

https://lawprofessors.typepad.com/agriculturallaw/2022/03/should-an-idgt-be-part-of-your-estate-plan.html

Farm Wealth Transfer and Business Succession – The GRAT

https://lawprofessors.typepad.com/agriculturallaw/2022/03/farm-wealth-transfer-and-business-succession-the-grat.html

Captive Insurance – Part One

https://lawprofessors.typepad.com/agriculturallaw/2022/03/captive-insurance-part-one.html

Captive Insurance – Part Two

https://lawprofessors.typepad.com/agriculturallaw/2022/03/captive-insurance-part-two.html

Captive Insurance – Part Three

https://lawprofessors.typepad.com/agriculturallaw/2022/04/captive-insurance-part-three.html

Pork Production Regulations; Fake Meat; and Tax Proposals on the Road to Nowhere

https://lawprofessors.typepad.com/agriculturallaw/2022/04/pork-production-regulations-fake-meat-and-tax-proposals-on-the-road-to-nowhere.html

Farm Economic Issues and Implications

https://lawprofessors.typepad.com/agriculturallaw/2022/04/farm-economic-issues-and-implications.html

Intergenerational Transfer of the Farm/Ranch Business – The Buy-Sell Agreement

https://lawprofessors.typepad.com/agriculturallaw/2022/04/intergenerational-transfer-of-the-farmranch-business-the-buy-sell-agreement.html

IRS Audit Issue – S Corporation Reasonable Compensation

https://lawprofessors.typepad.com/agriculturallaw/2022/04/irs-audit-issue-s-corporation-reasonable-compensation.html

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

https://lawprofessors.typepad.com/agriculturallaw/2022/05/summer-2022-farm-income-taxestate-and-business-planning-conferences.html

Wisconsin Seminar and…ERP (not Wyatt) and ELRP

https://lawprofessors.typepad.com/agriculturallaw/2022/06/wisconsin-seminar-anderp-not-wyatt-and-elrp.html

S Corporation Dissolution – Part 1

https://lawprofessors.typepad.com/agriculturallaw/2022/06/s-corporation-dissolution-part-1.html

S Corporation Dissolution – Part Two; Divisive Reorganization Alternative

https://lawprofessors.typepad.com/agriculturallaw/2022/06/s-corporation-dissolution-part-two-divisive-reorganization-alternative.html

Farm/Ranch Tax, Estate and Business Planning Conference August 1-2 – Durango, Colorado (and Online)

https://lawprofessors.typepad.com/agriculturallaw/2022/07/farmranch-tax-estate-and-business-planning-conference-august-1-2-durango-colorado-and-online.html

Durango Conference and Recent Developments in the Courts

https://lawprofessors.typepad.com/agriculturallaw/2022/07/durango-conference-and-recent-developments-in-the-courts.html

Civil Liabilities

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 8 and 7

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-8-and-7.html

Agritourism

https://lawprofessors.typepad.com/agriculturallaw/2022/03/agritourism.html

Animal Ag Facilities and the Constitution

https://lawprofessors.typepad.com/agriculturallaw/2022/03/animal-ag-facilities-and-the-constitution.html

When Is an Agricultural Activity a Nuisance?

https://lawprofessors.typepad.com/agriculturallaw/2022/04/when-is-an-agricultural-activity-a-nuisance.html

Ag Law-Related Updates: Dog Food Scam; Oil and Gas Issues

https://lawprofessors.typepad.com/agriculturallaw/2022/06/ag-law-related-updates-dog-food-scam-oil-and-gas-issues.html

Durango Conference and Recent Developments in the Courts

https://lawprofessors.typepad.com/agriculturallaw/2022/07/durango-conference-and-recent-developments-in-the-courts.html

Dicamba Spray-Drift Issues and the Bader Farms Litigation

https://lawprofessors.typepad.com/agriculturallaw/2022/07/dicamba-spray-drift-issues-and-the-bader-farms-litigation.html

Tax Deal Struck? – and Recent Ag-Related Cases

https://lawprofessors.typepad.com/agriculturallaw/2022/07/tax-deal-struck-and-recent-ag-related-cases.html

 

Contracts

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 6 and 5

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-6-and-5.html

What to Consider Before Buying Farmland

https://lawprofessors.typepad.com/agriculturallaw/2022/02/what-to-consider-before-buying-farmland.html

Elements of a Hunting Use Agreement

https://lawprofessors.typepad.com/agriculturallaw/2022/02/elements-of-a-hunting-use-agreement.html

Ag Law (and Medicaid Planning) Court Developments of Interest

https://lawprofessors.typepad.com/agriculturallaw/2022/05/ag-law-and-medicaid-planning-court-developments-of-interest.html

Cooperatives

The Agricultural Law and Tax Report

https://lawprofessors.typepad.com/agriculturallaw/2021/05/the-agricultural-law-and-tax-report.html

Criminal Liabilities

Animal Ag Facilities and the Constitution

https://lawprofessors.typepad.com/agriculturallaw/2022/03/animal-ag-facilities-and-the-constitution.html

Is Your Farm or Ranch Protected From a Warrantless Search?

https://lawprofessors.typepad.com/agriculturallaw/2022/04/is-your-farm-or-ranch-protected-from-a-warrantless-search.html

Durango Conference and Recent Developments in the Courts

https://lawprofessors.typepad.com/agriculturallaw/2022/07/durango-conference-and-recent-developments-in-the-courts.html

Environmental Law

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 6 and 5

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-6-and-5.html

“Top Tan” Agricultural Law and Tax Developments of 2021 – Numbers 2 and 1

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-2-and-1.html

The “Almost Top Ten” (Part 3) – New Regulatory Definition of “Habitat” under the ESA

https://lawprofessors.typepad.com/agriculturallaw/2022/01/the-almost-top-ten-new-regulatory-definition-of-habitat-under-the-esa.html

Ag Law and Tax Potpourri

https://lawprofessors.typepad.com/agriculturallaw/2022/02/ag-law-and-tax-potpourri.html

Farm Economic Issues and Implications

https://lawprofessors.typepad.com/agriculturallaw/2022/04/farm-economic-issues-and-implications.html

Constitutional Limit on Government Agency Power – The “Major Questions” Doctrine

https://lawprofessors.typepad.com/agriculturallaw/2022/07/constitutional-limit-on-government-agency-power-the-major-questions-doctrine.html

Estate Planning

Other Important Developments in Agricultural Law and Taxation

https://lawprofessors.typepad.com/agriculturallaw/2022/01/other-important-developments-in-agricultural-law-and-taxation.html

Other Important Developments in Agricultural Law and Taxation (Part 2)

https://lawprofessors.typepad.com/agriculturallaw/2022/01/other-important-developments-in-agricultural-law-and-taxation-part-2.html

The “Almost Top Ten” (Part 4) – Tax Developments

https://lawprofessors.typepad.com/agriculturallaw/2022/01/the-almost-top-ten-part-4-tax-developments.html

The “Almost Top 10” of 2021 (Part 7) [Medicaid Recovery and Tax Deadlines]

https://lawprofessors.typepad.com/agriculturallaw/2022/02/the-almost-top-10-of-2021-part-7-medicaid-recovery-and-tax-deadlines.html

Nebraska Revises Inheritance Tax; and Substantiating Expenses

https://lawprofessors.typepad.com/agriculturallaw/2022/02/recent-developments-in-ag-law-and-tax.html

Tax Consequences When Farmland is Partitioned and Sold

https://lawprofessors.typepad.com/agriculturallaw/2022/02/tax-consequences-when-farmland-is-partitioned-and-sold.html

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

https://lawprofessors.typepad.com/agriculturallaw/2022/03/summer-2022-farm-income-taxestate-and-business-planning-conferences.html

Should An IDGT Be Part of Your Estate Plan?

https://lawprofessors.typepad.com/agriculturallaw/2022/03/should-an-idgt-be-part-of-your-estate-plan.html

Farm Wealth Transfer and Business Succession – The GRAT

https://lawprofessors.typepad.com/agriculturallaw/2022/03/farm-wealth-transfer-and-business-succession-the-grat.html

Family Settlement Agreement – Is it a Good Idea?

https://lawprofessors.typepad.com/agriculturallaw/2022/03/family-settlement-agreement-is-it-a-good-idea.html

Registration Open for Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

https://lawprofessors.typepad.com/agriculturallaw/2022/03/registration-open-for-summer-2022-farm-income-taxestate-and-business-planning-conferences.html

Captive Insurance – Part One

https://lawprofessors.typepad.com/agriculturallaw/2022/03/captive-insurance-part-one.html

Captive Insurance – Part Two

https://lawprofessors.typepad.com/agriculturallaw/2022/03/captive-insurance-part-two.html

Captive Insurance Part Three

https://lawprofessors.typepad.com/agriculturallaw/2022/04/captive-insurance-part-three.html

Pork Production Regulations; Fake Meat; and Tax Proposals on the Road to Nowhere

https://lawprofessors.typepad.com/agriculturallaw/2022/04/pork-production-regulations-fake-meat-and-tax-proposals-on-the-road-to-nowhere.html

Farm Economic Issues and Implications

https://lawprofessors.typepad.com/agriculturallaw/2022/04/farm-economic-issues-and-implications.html

Proposed Estate Tax Rules Would Protect Against Decrease in Estate Tax Exemption

https://lawprofessors.typepad.com/agriculturallaw/2022/04/proposed-estate-tax-rules-would-protect-against-decrease-in-estate-tax-exemption.html

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

https://lawprofessors.typepad.com/agriculturallaw/2022/05/summer-2022-farm-income-taxestate-and-business-planning-conferences.html

Ag Law (and Medicaid Planning) Court Developments of Interest

https://lawprofessors.typepad.com/agriculturallaw/2022/05/ag-law-and-medicaid-planning-court-developments-of-interest.html

Joint Tenancy and Income Tax Basis At Death

https://lawprofessors.typepad.com/agriculturallaw/2022/05/joint-tenancy-and-income-tax-basis-at-death.html

More Ag Law Court Developments

https://lawprofessors.typepad.com/agriculturallaw/2022/06/more-ag-law-court-developments.html

Farm/Ranch Tax, Estate and Business Planning Conference August 1-2 – Durango, Colorado (and Online)

https://lawprofessors.typepad.com/agriculturallaw/2022/07/farmranch-tax-estate-and-business-planning-conference-august-1-2-durango-colorado-and-online.html

IRS Modifies Portability Election Rule

https://lawprofessors.typepad.com/agriculturallaw/2022/07/irs-modifies-portability-election-rule.html

Income Tax

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 10 and 9

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-10-and-9.html

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 8 and 7

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-8-and-7.html

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 2 and 1

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-2-and-1.html

The “Almost Top Ten” (Part 4) – Tax Developments

https://lawprofessors.typepad.com/agriculturallaw/2022/01/the-almost-top-ten-part-4-tax-developments.html

The “Almost Top 10” of 2021 (Part 7) [Medicaid Recovery and Tax Deadlines]

https://lawprofessors.typepad.com/agriculturallaw/2022/02/the-almost-top-10-of-2021-part-7-medicaid-recovery-and-tax-deadlines.html

Purchase and Sale Allocations Involving CRP Contracts

https://lawprofessors.typepad.com/agriculturallaw/2022/02/purchase-and-sale-allocations-involving-crp-contracts.html

Ag Law and Tax Potpourri

https://lawprofessors.typepad.com/agriculturallaw/2022/02/ag-law-and-tax-potpourri.html

What’s the Character of the Gain From the Sale of Farm or Ranch Land?

https://lawprofessors.typepad.com/agriculturallaw/2022/02/whats-the-character-of-the-gain-from-the-sale-of-farm-or-ranch-land.html

Proper Tax Reporting of Breeding Fees for Farmers

https://lawprofessors.typepad.com/agriculturallaw/2022/02/proper-tax-reporting-of-breeding-fees-for-farmers.html

Nebraska Revises Inheritance Tax; and Substantiating Expenses

https://lawprofessors.typepad.com/agriculturallaw/2022/02/recent-developments-in-ag-law-and-tax.html

Tax Consequences When Farmland is Partitioned and Sold

https://lawprofessors.typepad.com/agriculturallaw/2022/02/tax-consequences-when-farmland-is-partitioned-and-sold.html

Expense Method Depreciation and Leasing- A Potential Trap

https://lawprofessors.typepad.com/agriculturallaw/2022/02/expense-method-depreciation-and-leasing-a-potential-trap.html

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

https://lawprofessors.typepad.com/agriculturallaw/2022/03/summer-2022-farm-income-taxestate-and-business-planning-conferences.html

income Tax Deferral of Crop Insurance Proceeds

https://lawprofessors.typepad.com/agriculturallaw/2022/03/income-tax-deferral-of-crop-insurance-proceeds.html

What if Tax Rates Rise?

https://lawprofessors.typepad.com/agriculturallaw/2022/03/what-if-tax-rates-rise.html

Registration Open for Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

https://lawprofessors.typepad.com/agriculturallaw/2022/03/registration-open-for-summer-2022-farm-income-taxestate-and-business-planning-conferences.html

Captive Insurance – Part One

https://lawprofessors.typepad.com/agriculturallaw/2022/03/captive-insurance-part-one.html

Captive Insurance – Part Two

https://lawprofessors.typepad.com/agriculturallaw/2022/03/captive-insurance-part-two.html

Captive Insurance – Part Three

https://lawprofessors.typepad.com/agriculturallaw/2022/04/captive-insurance-part-three.html

Pork Production Regulations; Fake Meat; and Tax Proposals on the Road to Nowhere

https://lawprofessors.typepad.com/agriculturallaw/2022/04/pork-production-regulations-fake-meat-and-tax-proposals-on-the-road-to-nowhere.html

Farm Economic Issues and Implications

https://lawprofessors.typepad.com/agriculturallaw/2022/04/farm-economic-issues-and-implications.html

IRS Audit Issue – S Corporation Reasonable Compensation

https://lawprofessors.typepad.com/agriculturallaw/2022/04/irs-audit-issue-s-corporation-reasonable-compensation.html

Missed Tax Deadline & Equitable Tolling

https://lawprofessors.typepad.com/agriculturallaw/2022/04/missed-tax-deadline-equitable-tolling.html

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

https://lawprofessors.typepad.com/agriculturallaw/2022/05/summer-2022-farm-income-taxestate-and-business-planning-conferences.html

Joint Tenancy and Income Tax Basis At Death

https://lawprofessors.typepad.com/agriculturallaw/2022/05/joint-tenancy-and-income-tax-basis-at-death.html

Tax Court Caselaw Update

https://lawprofessors.typepad.com/agriculturallaw/2022/05/tax-court-caselaw-update.html

Deducting Soil and Water Conservation Expenses

https://lawprofessors.typepad.com/agriculturallaw/2022/05/deducting-soil-and-water-conservation-expenses.html

Correcting Depreciation Errors (Including Bonus Elections and Computations)

https://lawprofessors.typepad.com/agriculturallaw/2022/05/correcting-depreciation-errors-including-bonus-elections-and-computations.html

When Can Business Deductions First Be Claimed?

https://lawprofessors.typepad.com/agriculturallaw/2022/05/when-can-business-deductions-first-be-claimed.html

Recent Court Decisions Involving Taxes and Real Estate

https://lawprofessors.typepad.com/agriculturallaw/2022/05/recent-court-decisions-involving-taxes-and-real-estate.html

Wisconsin Seminar and…ERP (not Wyatt) and ELRP

https://lawprofessors.typepad.com/agriculturallaw/2022/06/wisconsin-seminar-anderp-not-wyatt-and-elrp.html

Tax Issues with Customer Loyalty Reward Programs

https://lawprofessors.typepad.com/agriculturallaw/2022/06/tax-issues-with-customer-loyalty-reward-programs.html

S Corporation Dissolution – Part 1

https://lawprofessors.typepad.com/agriculturallaw/2022/06/s-corporation-dissolution-part-1.html

S Corporation Dissolution – Part Two; Divisive Reorganization Alternative

https://lawprofessors.typepad.com/agriculturallaw/2022/06/s-corporation-dissolution-part-two-divisive-reorganization-alternative.html

Farm/Ranch Tax, Estate and Business Planning Conference August 1-2 – Durango, Colorado (and Online)

https://lawprofessors.typepad.com/agriculturallaw/2022/07/farmranch-tax-estate-and-business-planning-conference-august-1-2-durango-colorado-and-online.html

What is the Character of Land Sale Gain?

https://lawprofessors.typepad.com/agriculturallaw/2022/07/what-is-the-character-of-land-sale-gain.html

Deductible Start-Up Costs and Web-Based Businesses

https://lawprofessors.typepad.com/agriculturallaw/2022/07/deductible-start-up-costs-and-web-based-businesses.html

Using Farm Income Averaging to Deal with Economic Uncertainty and Resulting Income Fluctuations

https://lawprofessors.typepad.com/agriculturallaw/2022/07/using-farm-income-averaging-to-deal-with-economic-uncertainty-and-resulting-income-fluctuations.html

Tax Deal Struck? – and Recent Ag-Related Cases

https://lawprofessors.typepad.com/agriculturallaw/2022/07/tax-deal-struck-and-recent-ag-related-cases.html

Insurance

Tax Deal Struck? – and Recent Ag-Related Cases

https://lawprofessors.typepad.com/agriculturallaw/2022/07/tax-deal-struck-and-recent-ag-related-cases.html

Real Property

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 4 and 3

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-4-and-3.html

Ag Law and Tax Potpourri

https://lawprofessors.typepad.com/agriculturallaw/2022/02/ag-law-and-tax-potpourri.html

What to Consider Before Buying Farmland

https://lawprofessors.typepad.com/agriculturallaw/2022/02/what-to-consider-before-buying-farmland.html

Elements of a Hunting Use Agreement

https://lawprofessors.typepad.com/agriculturallaw/2022/02/elements-of-a-hunting-use-agreement.html

Animal Ag Facilities and the Constitution

https://lawprofessors.typepad.com/agriculturallaw/2022/03/animal-ag-facilities-and-the-constitution.html

Recent Court Decisions Involving Taxes and Real Estate

https://lawprofessors.typepad.com/agriculturallaw/2022/05/recent-court-decisions-involving-taxes-and-real-estate.html

Recent Court Cases of Importance to Agricultural Producers and Rural Landowners

https://lawprofessors.typepad.com/agriculturallaw/2022/06/recent-court-cases-of-importance-to-agricultural-producers-and-rural-landowners.html

More Ag Law Court Developments

https://lawprofessors.typepad.com/agriculturallaw/2022/06/more-ag-law-court-developments.html

Ag Law-Related Updates: Dog Food Scam; Oil and Gas Issues

https://lawprofessors.typepad.com/agriculturallaw/2022/06/ag-law-related-updates-dog-food-scam-oil-and-gas-issues.html

Tax Deal Struck? – and Recent Ag-Related Cases

https://lawprofessors.typepad.com/agriculturallaw/2022/07/tax-deal-struck-and-recent-ag-related-cases.html

Regulatory Law

The “Almost Top 10” of 2021 (Part 5)

https://lawprofessors.typepad.com/agriculturallaw/2022/01/the-almost-top-10-of-2021-part-5.html

The “Almost Top 10” of 2021 (Part 6)

https://lawprofessors.typepad.com/agriculturallaw/2022/02/the-almost-top-10-of-2021-part-6.html

Ag Law and Tax Potpourri

https://lawprofessors.typepad.com/agriculturallaw/2022/02/ag-law-and-tax-potpourri.html

Animal Ag Facilities and the Constitution

https://lawprofessors.typepad.com/agriculturallaw/2022/03/animal-ag-facilities-and-the-constitution.html

Pork Production Regulations; Fake Meat; and Tax Proposals on the Road to Nowhere

https://lawprofessors.typepad.com/agriculturallaw/2022/04/pork-production-regulations-fake-meat-and-tax-proposals-on-the-road-to-nowhere.html

Farm Economic Issues and Implications

https://lawprofessors.typepad.com/agriculturallaw/2022/04/farm-economic-issues-and-implications.html

Ag Law (and Medicaid Planning) Court Developments of Interest

https://lawprofessors.typepad.com/agriculturallaw/2022/05/ag-law-and-medicaid-planning-court-developments-of-interest.html

Wisconsin Seminar and…ERP (not Wyatt) and ELRP

https://lawprofessors.typepad.com/agriculturallaw/2022/06/wisconsin-seminar-anderp-not-wyatt-and-elrp.html

More Ag Law Court Developments

https://lawprofessors.typepad.com/agriculturallaw/2022/06/more-ag-law-court-developments.html

Ag Law-Related Updates: Dog Food Scam; Oil and Gas Issues

https://lawprofessors.typepad.com/agriculturallaw/2022/06/ag-law-related-updates-dog-food-scam-oil-and-gas-issues.html

Constitutional Limit on Government Agency Power – The “Major Questions” Doctrine

https://lawprofessors.typepad.com/agriculturallaw/2022/07/constitutional-limit-on-government-agency-power-the-major-questions-doctrine.html

The Complexities of Crop Insurance

https://lawprofessors.typepad.com/agriculturallaw/2022/07/the-complexities-of-crop-insurance.html

Secured Transactions

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 6 and 5

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-6-and-5.html

Water Law

“Top Ten” Agricultural Law and Tax Developments of 2021 – Numbers 4 and 3

https://lawprofessors.typepad.com/agriculturallaw/2022/01/top-ten-agricultural-law-and-tax-developments-of-2021-numbers-4-and-3.html

Durango Conference and Recent Developments in the Courts

https://lawprofessors.typepad.com/agriculturallaw/2022/07/durango-conference-and-recent-developments-in-the-courts.html

September 5, 2022 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, September 2, 2022

Declaring Inflation Reduced and Being Forgiving – Recent Developments in Tax and Law

Overview

A lot has happened in the legal and tax world over the last couple of weeks. I fear that much of it is not good for many people or the country and is contrary to the principles of a democratic republic (if that is what we still have).   Agriculture is in the crosshairs of much of it over the long-term.  That last point is something I have been talking about for over 20 years – tax and energy policies that shift the problems of the urban areas of the coasts to the rural areas by using the space of those less populated and agricultural-heavy rural parts of the country and shifting the incidence of tax policy to those same areas disproportionately. 

Recent enacted legislation, an executive order and associated tax and legal issues - it’s all the topic of today’s post.

“Inflation Reduction Act”

I hesitate to call this Act by its name – the “Inflation Reduction Act” (Act).  If ever there has been a deceptively misnamed piece of legislation, this is it.  An Act with $750 billion of fake money to will not reduce inflation.  Words have no meaning.  I suppose that we are supposed to believe that the following provisions of the bill will reduce inflation:

  • $3 billion for the U.S. Postal Service to buy new electric mail trucks;
  • $3 billion for the EPA to oversee block grants for “environmental justice;”
  • $40 billion total to the EPA which includes $30 billion for “disadvantaged communities” (keep in mind that the total annual budget of the EPA is about $10 billion);
  • $750 million to the Interior Department for new hires;
  • $10 million to the USDA to be spent on “equity commissions” to “combat” racism;
  • $25 million to the Government Accountability Office to determine, “whether the economic, social and environmental impacts of the funds described in this paragraph are equitable;”
  • Via a budget gimmick to keep the amount outside of the Act’s price tag are amounts to the Energy Department for existing “green” energy loan programs and a new energy loan-guarantee program.

The above is only a listing of a few of the provisions in the several-hundred-page bill.  These are the ones that particularly stuck out to me.  Reduce inflation?  Not a chance.

Then there are numerous “renewable” energy-related tax credits that won’t reduce inflation either.  Indeed, it’s likely that the credits will increase inflation.  When education credits came on the scene several years ago, tuition increased, and university endowments began to bloat.  As of September 1, 2022, Harvard’s endowment is $53.2 billion, and Yale’s is $42.3 billion. 

Right after the Act was signed into law with an enhanced tax credit for electric vehicles, major U.S. automakers announced that the price of electric vehicles would be going up by almost exactly the amount of the new tax credit.  In an interesting twist, while CA has announced a ban on gas car sales after 2034, the state is already telling its citizens not to charge existing electric vehicles during a heat wave to avoid blackouts.   

Tax Provisions

The following provisions are some of the major tax provisions of the Act:

  • 15% minimum tax on corporate-book income (rather than taxable income) applicable to C corporations with annual adjusted financial statement income averaging over $1 billion in revenue over prior three years. The tax is on the higher of regular taxable income and financial statement income. In other words, it is a 15% tax on the excess of a corporation’s adjusted financial statement income over its corporate AMT foreign tax credit of I.R.C. §59(l)for the year. It’s also applicable to U.S. corporations with foreign parents if average 3-year revenue earned in the U.S. is $100 million or more.  R.C. §56A (new) defines "adjusted financial statement income” as a corporation's net income (or loss) as set forth in the taxpayer's applicable financial statement, as defined in Sec. 451(b)(3). Adjusted financial statement income is reduced by the amount of tax depreciation deductions the taxpayer claims when calculating taxable income for the year.

The provision also disallows the use of NOLs accruing before 2020.  That will have negative implications for companies that had virus-related shutdowns but had invested in 2018-2019 in equipment that created a loss. 

Note:  The provision is especially harmful to U.S. manufacturing firms, and will put pressure on U.S. manufacturers to cut labor costs or scale back U.S. operations.  The non-partisan Joint Committee on Taxation (JCT), in an initial report, determined that 49.7% of the tax would hit U.S. manufacturers that account for 11% of the economy.  By comparison, wholesale trade, information companies and retail trade get off relatively easy by comparison.  JCT says the biggest hit will be felt in IN, KY, MI, NC and WI.  In effect, the provision “claws back” part of the $280 billion subsidy for computer chip manufacturers (another bill that was signed into law before this one). While those numbers can be adjusted a bit due to the final provision exempting accelerated depreciation, the hit to the manufacturing sector will be big.  The Tax Foundation estimates that the provision will eliminate approximately 20,000 jobs.  The provision does not apply to a foreign company unless the company has significant U.S. operations. 

  • A nondeductible 1% excise tax on stock buybacks after 2022 of a “covered corporation.” That’s a domestic corporation with stock traded on an “established securities market.”  Under this provision, the value of stock that is treated as repurchased during the tax year for purposes of computing the excise tax is reduced by the value of any new issuances of stock by the corporation during the same tax year (“netting rule”).  The term “repurchase” is defined by reference to I.R.C. §317(b).  It includes any acquisition of stock by the corporation in exchange for cash or property other than the corporation’s own stock or stock rights, as well as any other “economically similar” transaction as Treasury determines.  Excluded from excise tax are repurchases if: 1) it’s part of a tax-free reorganization under I.R.C. 368(a) and no gain or loss is recognized by the shareholder as a result of the reorganization; 2) the repurchased stock (or an amount of stock equal to the value of the repurchased stock) is contributed to an ESOP or employer-sponsored retirement plan; 3) the total amount of repurchases within the tax year are $1 million or less; or 4) the repurchase is treated as  “dividend” for tax purposes. 

Note:  The Tax Foundation estimates that the provision will eliminate 7,000 jobs.

  • The excess business loss rule is extended for two more years – through 2028. That means that there will be a cap on net operating losses of $250,000 (single) and $500,000 (mfj).  Those amounts are adjusted for inflation.
  • Extension of the I.R.C. §25C energy-efficient property credit (personal credit for specified nonbusiness energy property expenditures) for property placed in service before 2033. It is renamed as the “energy-efficient home improvement credit” and is a 30% credit for qualified energy efficient improvements installed during the year, and the amount of residential energy property expenditures paid or incurred during the year. The credit is increased for amounts spent for home energy audit up to $150 and is limited to $1,200 per taxpayer/year.  The lifetime $500 limit on the credit is repealed.  Eligible property can be residential property that is not the taxpayer’s primary residence.  Other limits are $600 annually for residential energy property expenses such as windows and skylights; $250 for any exterior door ($500 total); and a $2,000 annual limit for amounts paid or incurred for specified heat pumps, heat pump water heaters and biomass stoves and boilers.
  • Extension of residential energy efficient property credit of I.R.C. §25D for property installed in years before 2035 - 26% through 2021; 30% if prop. placed in service from 2022-2032; 26% (2033); 22% (2034). Property that qualifies is solar electric; solar hot water; fuel cell; small wind energy; geothermal heat pumps; biomass fuel property; and qualified battery storage technology expenses.  The credit is renamed as the “residential clean energy credit.”
  • New energy efficient home credit under I.R.C. §45L for contractors that applies for qualified new energy efficient homes acquired before 2033. The credit varies from $500 to $5,000.
  • New clean-vehicle credit of I.R.C. §30D that is generally effective for vehicles places in service after 2022 and before 2033. This credit is the retitled qualified plug-in electric drive motor vehicle credit.  The maximum credit is $7,500 (2023-2032).  It eliminates the cap on the number of vehicles eligible (i.e., no per manufacturer credit).  For the credit to be available, a vehicle’s final assembly must be in the U.S. (effective upon enactment).  In addition, battery-making materials must be sourced in Canada or Mexico for full credit to apply.  However, presently most EV battery-making minerals (lithium, cobalt and nickel) are sourced from China.  No credit is available if a taxpayer’s lesser of MAGI for year of purchase or preceding year exceeds $300,000 (mfj or ss); $25,000 (hh) or $150,000 (others).  There is no phaseout.  No credit is available if a vehicle’s MSRP exceeds $55,000 ($80,000 for pickups, vans or SUVs).  Starting in 2024 the $7,500 credit only applies to vehicles made with parts and components sourced from U.S., Canada or Mexico, or countries with which U.S. has a free trade agreement.  The credit is split in half - $3,750 applies to vehicles having at least 40% of critical battery materials sourced from a free trade country or from material recycled in U.S.  This goes to 80% by 2026.  The remaining $3,750 applies to vehicles with 50% of battery component manufactured or assembled in North America.  The 50% goes to 100% after 2028

Note:  Sourcing requirements are dependent on the supply chain.  This will make it tough for manufacturers to comply with the requirement that almost all of the materials come from North America.  Manufacturers must prove that their vehicles comply with the sourcing requirements.  The Treasury is to develop guidelines by the end of 2022 to show how compliance will be measured.  Currently there are 72 EV models can be purchased in the U.S.  70% of them will become immediately ineligible.  100% will not qualify for the full credit

Note:  The credit is allowed once per vehicle, and taxpayers claiming the credit must include the vehicle identification number (VIN) on the return.    To verify whether a motor vehicle meets the final assembly requirement, dealers and consumers can follow a two-step process:  1) check to see if the vehicle appears on the Department of Energy's list of model year 2022 and 2023 electric vehicles that may qualify. But there may be vehicles on the Department of Energy list that do not meet the final assembly requirement in all circumstances; and 2) enter the vehicle's 17-character vehicle identification number (VIN) into the National Highway Traffic Safety Administration’s VIN Decoder tool and view the "Plant Information" field at the bottom of the results page.  A transition rule allows a buyer who entered into a written, binding contracts to buy a qualifying vehicle before August 16, 2022, but does not take possession of the vehicle until after that date, to avoid the final assembly requirement. 

  • Used clean vehicle credit of I.R.C. 25E. The credit is the lesser of $4,000 or 30 percent of the vehicle’s cost.  For the credit to apply, a vehicle’s sales price can’t exceed $25,000.

Comment on the vehicle tax credits:  The big issue is that the tax credits will increase inflation.  Electric vehicle manufacturers have already increased the price of their vehicles by the cost of the credit.  In essence, the government is paying a purchaser of an electric vehicle back their own money to buy an electric vehicle from a manufacturer that has raised the cost of the vehicle by the same amount.  Thus, the credit is a subsidy for the manufacturer.  It does not result in any real savings for the purchaser.

  • An extension of the credit for sales and use of biodiesel and renewable diesel used in a trade or business or sold at retails and placed in fuel tank of buyer through 2024. A refund of excise tax can be claimed for the use of biodiesel fuel mixtures for a purpose other than for which they were sold or for resale on or before 2025 and alternative fuel as that used in a motor vehicle or motorboat or as aviation fuel for a purpose other than for which they were sold or for resale on or before 2025.
  • The credit for energy produced from renewable resources under I.R.C. §45 is 1.5 cents per kilowatt hour. But, if prevailing wage paid to employees the credit is increased 10% by sourcing steel, iron or manufactured-product components from U.S. manufacturers or by locating in an “energy community” – area with significant employment in fossil fuel industry or which have experienced the closure of a coal mine or coal-fired plant.

Comment:  Apparently, the Administration is concerned that “green” energy jobs don’t actually generate “good-paying jobs” as the Administration likes to say.

  • With the research and development credit, for tax years beginning after December 31, 2022, an eligible small business can reduce payroll taxes by up to $500,000 annually (up from the prior limit of $250,000). An eligible small business is one having less than $5 million in revenue and revenue for less than five years.  The credit can now apply to the Medicare portion of taxes (previously, it only applied to the Social Security portion of payroll tax).  Unused amounts can be carried forward.  The credit can’t exceed tax imposed for any calendar quarter  The IRS will need to revise Forms 941, 6755 and 8794. 
  • Modifications to the I.R.C. §179D energy efficiency deduction. Previously, only commercial building owners or the designers of energy efficient systems in government-owned buildings qualified. Under the Act, designers of lighting, HVAC or building envelope systems in structures owned by other tax-exempt entities such as nonprofits, religious groups and educational institutions can also qualify.  The Act lowers the threshold for energy improvements needed to qualify. Under prior law, a building had to show a 50 percent energy savings over a benchmark structure.  The Act changes 50 percent to 25 percent and the base deduction begins at $.50/sq. foot for the 25 percent energy savings threshold, and increases by 2 cents per square foot for each percentage point above that, up to $1 per square foot.  Contractors can earn a “bonus” deduction by paying prevailing wages and meeting apprenticeship requirements on these jobs. This bonus deduction starts at $2.50 per square foot at the 25 percent threshold, and increases 10 cents per square foot beyond that, up to a $5 maximum.

The JCT has determined that the Act will reduce real GDP by $68.5 billion and cut labor income by $17.1 billion.  The JCT also says that average tax rates will increase for nearly every income category in 2023.  Specifically, the JCT says that taxes will rise by $16.7 billion in 2023 on those earning less than $200,000 annually and those making between $200,000 and $500,000 will pay $14.1 billion more.  The JCT also concluded that 61 percent of taxpayers making between $40,000 and $50,000 will see a tax increase, and that 91 percent of taxpayers making between $100,000 and $200,000 will see higher taxes. 

Ag Program Spending

The Act contains a great deal of spending on ag conservation-related programs.  Here are the primary provisions:

  • EQIP - $8.45 billion additional funding over Fiscal Years 2023-2026. Prioritizes funding for reduction of methane emissions from cattle (e.g., cattle passing gas) and nutrient management activities (e.g., diets to reduce bloating in cows).
  • CSP - $3.25 billion additional funding over same time frame.
  • Ag Conservation Easement Program (ACEP) - $1.4 billion over same time frame for easements or interests in land that will reduce, capture, avoid or sequester carbon dioxide, or methane oxide emissions with land eligible for the program. ACEP incorporates the Wetlands Reserve Program, the Grasslands Reserve Program and the Farm and Ranch Lands Protection Program. 
  • Regional Conservation Partnership Program - $4.95 billion over same timeframe for cover cropping, nutrient management, and watershed improvement.
  • $4 billion for drought relief that prioritizes the CO basin.
  • The U.S. Forest Service gets $1.8 billion for hazardous fuels reduction projects on USFS land.
  • $14 billion for rural development and lending projects.
  • $3.1 billion to USDA to provide payments to distressed borrowers.
  • $2.2 billion to USDA for farmers, ranchers and forest landowners that have been discriminated against in USDA lending programs (i.e., reparations).
  • $5 billion to USDA for National Forest System to fund forest reforestation and wildfire prevention.

Increased Obamacare taxpayer subsidies:

The Act provides $64 billion of taxpayer funds to extend expanded Obamacare subsidies.  Remember, President Obama said that the ACA would save the average family about $2,500 annually in health care costs.  Well, not so much.  In 2014, the first year of exchanges, the average premium was $353.  By 2019 it was $558.  Over the same time, the average subsidy increased from $383 to $524.  The subsidy is determined by taking cost of silver plan less the amount that Obamacare requires to be spent on an exchange plan (“expected contribution).  ARPA (2021) increased subsidies by $36 billion through 2022 (in other words the additional taxpayer subsidies cause the amount a person in an exchange pays to go down). 

Note:  From 2018-2020 the Trump Administration deregulated Obamacare exchanges and prices on the exchanges stabilized.  When the Biden Administration repealed the changes, prices began rising again.  The anticipated premium increase for 2023 is 10%. 

Under the Act, if a person is over 400 percent of the poverty line, the person can still qualify for the premium tax credit of I.R.C. §36B (through 2025) if the sliver plan would cost more than 8.5 percent of household income.  There is a lower applicable percentage of household income for all income levels.

Medicare provisions:

The Act allows Medicare to negotiate drug prices.  While that sounds good, the economics may not work out as anticipated.  In reality, while less expensive drugs may result, there will likely be fewer “miracle drugs” in the future due to a decreased incentive for pharmaceutical research and development.  The Act permits the Secretary of the Department of Health and Human Services to negotiate maximum “fair” prices for 50 drugs in Medicare Part D and 50 drugs in Medicare Part B on a phased schedule.  Drugs that are less than nine years (for small-molecule drugs) or 13 years (for biological products) from their U.S. Food and Drug Administration (FDA)-approval or licensure date would be held exempt from negotiation. To enforce the negotiation, the bill imposes a monetary penalty of 10 times the difference between the offered price and the “maximum fair price” for all applicable units.

The Act imposes rebates on drug manufacturers that increase prices faster than inflation to limit annual increases in drug prices for Medicare enrollees.  The rebate is based on the Average Sales Price beginning in 2023 relative to Q3 2021.  The rebates only apply to drugs in Medicare Part B without competition and Part D drugs that cost more than $100 a year.

The Act also makes a number of changes to the structure of Medicare Part D by eliminating the five percent cost-sharing in the catastrophic phase of Part D in 2024.  The Act also caps out-of-pocket costs at $2,000 in 2025, and limits premium growth to 6 percent each year for the next five years.

The Act also caps out-of-pocket costs for Medicare Part D purposes at $35 per month. 

Note:  On a related note, involving Medicaid, the Administration announced in mid-August its intent to stop paying for COVID vaccines and treatments.  Vaccines and treatments have been provided at no-charge to patients, but providers have been compensated with taxpayer dollars.  With any renewed mandates, private insurance companies will have to cover the costs of their insureds.  This will drive up premiums and create larger co-pays.  It’s practically a certainty that the Centers for Medicare and Medicaid Services will require all contracted insurance companies to provide vaccines, boosters and anti-viral drugs.  Fees will increase to do so, and the additional cost will be borne by taxpayers.  It is reasonable to anticipate that rural hospitals will be disaffected the most.    

More IRS funding and statute of limitation changes:

The IRS gets approximately $80 billion in IRS funding (over next 10 years) to hire 87,000 agents.  The IRS currently has 78,000 agents, but 50,000 are set to retire in the next few years.  $46 billion is to be dedicated to enforcement and is anticipated to increase the number of audits by $1.2 million annually.  $25 billion is earmarked for IRS operations, $5 billion for business systems modernization. IRS taxpayer services, which many tax practitioners would say as the most in need of funding, gets the short end of the stick with $4 billion.

Note:  Nikole Flax, most recently the deputy administrator in charge of the IRS’ Large Business & International Division, has been tabbed to lead the creation of a new centralized office for implementation of all IRS-related provisions in the Act.  Ms. Flax, it should be noted, worked alongside Lois Lerner during the Obama-era scandal involving the IRS targeting of conservative and tea party affiliated groups as a political arm of the Obama Administration.  She is one of several senior IRS officials during that scandal that had their emails conveniently “get lost.” 

Along with the increased IRS funding and additional taxpayer audits that will be forthcoming, the “PPP Bank Fraud and Harmonization Act of 2022” (HR7352) establishes a 10-year statute of limitations for criminal charges and civil enforcement against a borrower who engages in fraud with respect to a PPP loan.  Likewise, the “COVID-19 EIDL Fraud Statute of Limitations Act of 2022” (HR 7334) gives prosecutors 10 years to file fraud charges (from date offense was committed) connected to loan applications from the COVID-19-related EIDL program, including EIDL advances and targeted EIDL advances.

Student Loan Forgiveness

“People think that the President of the United States has the power for debt forgiveness. He does not.”  He can postpone, he can delay, but he does not have that power.  That has to be an act of Congress.”

U.S. House Speaker, Nancy Pelosi.  July 2021

On August 24, 2022, the Administration via the U.S. Department of Education announced that it would be canceling up to $20,000 in student debt for Pell Grant recipients and up to $10,000 in student loans for those making under $125,000 a year ($250,000 mfj).  The cost is projected to be more than $500 billion and effectively amounts to a debt transfer from borrowers to taxpayers.  Simultaneously with that announcement was the Administration’s announcement that the student-loan repayment moratorium would be extended through the end of 2022 (no interest has accrued since March of 2020 at a cost to the federal government of $5 billion per month).  The Committee for a Responsible Federal Budget estimates that since the moratorium on student-loan repayments began, those with medical degrees have received the equivalent of $48,500 in debt cancellation due to no interest payments required to be made, and those with law degrees have received the equivalent of $29,500. 

Note:  The Penn Wharton Budget Model estimates that about 70 percent of the borrowers qualifying for the $10,000 debt cancellation are in the top 60 percent of income earners because a disproportionate amount of debt is held by couples close to the applicable income threshold.  In addition, more than half of student-loan debt is held by households with graduate degrees.  Junlei Chen, “Forgiving Student Loans: Budgetary Costs and Distributional Impact,” Penn Wharton Budget Model, University of Pennsylvania, August 23, 2022, https://budgetmodel.wharton.upenn.edu/issues/2022/8/23/forgiving-student-loans. 

Constitutionality

The primary question, of course, is whether such executive action is constitutional or whether it is merely an unconstitutional exploitation of emergency powers. 

Administration’s position.  The administration is using a post-9/11 law, the Higher Education Relief Opportunities for Students (Heroes Act of 2003, to justify the action.  That Act gave the education Secretary authority to waive rules related to student financial aid programs in times of war or national emergency.  Because COVID was declared a national emergency in 2020, the Administration claims the forgiveness allows borrowers to not be placed in a worse position financially as a result of the emergency (“affected by an emergency”).    This is despite a memo from the Office of the General Counsel at the U.S Department of Education (DOE) detailing that the DOE has no authority to forgive or cancel student loans across the board.  Reed Rubinstein, “Memorandum to Betsy Devos, Secretary of Education, Re: Student Loan Principal Balance Cancellation, Compromise, Discharge, and Forgiveness Authority,” January 12, 2021, https://static.politico.com/d6/ce/3edf6a3946afa98eb13c210afd7d/ogcmemohealoans.pdf.  The current Administration now views the prior memo as “substantively incorrect” with no detailed legal analysis as to why.  Letter from Lisa Brown to Miguel A. Cardona, U.S. Department of Education, August 23, 2022, https://www2.ed.gov/policy/gen/leg/foia/secretarys-legal​-authority-for-debt-cancellation.pdf.   Specifically, the 2022 memo does not explain how forgiveness complies with the requirement of the HEROES Act that such forgiveness is necessary to protect borrowers that had the ability to repay their loans.    

SCOTUS opinion.  Article I of the Constitution states that, “All legislative powers herein granted shall be vested in…Congress…”.  This principle is commonly referred to as the “nondelegation doctrine.”  The Congress cannot delegate its legislative powers.  But, over the last 90 years, the Congress has delegated a great deal of legislative authority to administrative agencies with only an occasional pushback from the Supreme Court (SCOTUS).  See, e.g., Food and Drug Administration v. Brown and Williamson Tobacco, Co., 529 U.S. 120 (2000).  However, in West Virginia. v. Environmental Protection Agency, 142 S. Ct. 2587 (2022), the U.S. Supreme Court (SCOTUS) curtailed the EPAs authority to regulate greenhouse gas emissions at coal-fired plants without express Congressional authority under the “major questions” doctrine (a variation of the nondelegation doctrine).  Now, clear congressional authority is needed before executive branch agencies take “major” actions that will have large economic and political significance.  The Court’s analysis was not so much focused on whether a statute violates the nondelegation doctrine, but what is the specific scope of authority given to the Executive Branch via the administrative agency at issue.  

Note:  The SCOTUS opinion in West Virginia v. EPA is viewed as a big “win” for agriculture on issues such as wetlands and the WOTUS rule and other conflicts with federal government regulatory agencies (EPA; U.S. Army Corps of Engineers; U.S. Forest Service, USDA/NRCS, etc.). 

Application.  Does COVID-19 constitute a national emergency as of Aug. ’22 that justifies the action?  It’s really a big stretch to suggest that the U.S. of late Aug. ’22 is anything like the U.S. of post-9/11 or even the summer or fall of 2020.  Even if the virus is an emergency, is that enough post-West Virginia v. Environmental Protection Agency?  Now, merely fitting the text of the statute is just the first step.  It must also clear the “major question” hurdle.  The Administration’s legal counsel memo ignores the major questions doctrine which requires that the purpose of the governing statute must be taken into account along with the text in determining whether the Executive Branch (which includes administrative agencies) has the authority to bypass Congress on a particular issue.  In any event, basing it justification for the Executive Action on the HEROES Act is not likely to be bought by the SCOTUS.  The HEROES Act was written in and for the 9/11 context.  Using the HEROES Act for COVID is likely not a strong argument at the SCOTUS in the post-West Virginia v. EPA era. 

Note:     The Administration has already lost cases where it claimed to have emergency power – vaccine mandate imposed by the Occupational Safety and Health Administration; eviction moratorium imposed by the Centers for Disease Control and Prevention etc. 

The standing issue.  A lawsuit can only be brought if the party bringing the suit can prove that they have been harmed. This is known as “standing.”  In Lujan v. Defenders of Wildlife, 504 U.S. 555 (1992), the SCOTUS said that standing requires that the plaintiff suffer an injury in fact, that there be a causal connection between the injury and the complained-of conduct, and that that injury be “particularized.”   So, who has standing to challenge the student loan forgiveness hand-out?  Certainly, the U.S. House of Representatives and private banks or loan servicers that have a direct or indirect relationship to the loans have standing.  Remember, the U.S. House challenged Obamacare and was found to have standing to do so.  Also, any person with outstanding student loans with income slightly over the appliable threshold that lives in an area with a high cost of living would have standing.  $125,000 in New York City doesn’t go nearly as far as $125,000 does in Tightwad, MO. 

So, what happens if a lawsuit is filed?  First, the Administration must finalize the policy.  Then a court could issue an injunction forcing the Administration to either extend the repayment pause or have borrowers start repaying loans that may later be canceled.  This all may cause the Administration to more fully explain how COVID fits the purpose of the HEROES Act to better detail the legislative history of the statute to justify the current plan.  The Administration could also try to fit it under Section 432 of the Higher Education Act of 1965, where the Secretary of Education has the power to waive debts in non-emergency situations.  But, that still doesn’t meet the Administration’s conduct would pass muster under the rationale of recent SCOTUS opinions.  

Tax issues.  While debt forgiveness is normally taxable, this would not taxable on account of Sec. 9675 of the American Rescue Plan Act of 2021.  That provision modified I.R.C. §108(f) to exclude from gross income through 2025.  That’s amounts to another $34 billion in lost tax revenue.  While not taxable at the federal level, it would be in five states that don’t couple with the Internal Revenue Code (AR, MN, MS, NC and WI). 

Conclusion

The Act and the Executive action on student loan debt, are troubling on many fronts.  They essentially do nothing to address the core economic problems the nation faces at the present time.  Continuing to fund economically inefficient methods of energy production as a means of forcing the economy to shift to politically popular (currently) technologies will hit middle-to-lower income people the hardest.  It will also hit energy intensive industries (such as agriculture) particularly hard.  The massive increase in funding for the EPA also could be potentially very troublesome for agriculture.  Likewise, the increased funding of environmental ag programs will certainly come with strings.  Farmers that take the “carrot” will be more susceptible of being hit with the USDA’s regulatory “stick.”   Also, the tremendously enhanced funding of the IRS to be overseen by a political partisan with connections to a prior IRS scandal raises concerns as to how that additional resulting power will be used.

The Act and student loan forgiveness (if it withstands a court challenge) will pour more fuel on the current inflationary fire.  Stimulating inflation during an economic recession when inflation is already at a 40-year high is particularly a poor policy choice, as is increasing taxes on practically every income group.  The fourth quarter of 2022 promises to be very difficult for many people.  This Act does nothing to help that. 

While Midwest grain farmers look to have a high-income year for 2022, 2023 doesn’t look to be as good.   Also, while crop prices are good for Midwest grain farmers, livestock ranchers in the Plains and West don’t have it so good this year.   Drought and buyer-power being exerted by the major packers has caused economic pain for cattle ranchers.

For Midwest grain farmers, the traditional tax planning techniques in high-income years of deferring income and accelerating deductions don’t apply in the current economy.  Deferring taxes into next year with higher costs and taxes is not a good idea.  Likewise accelerating deductions related to input prices to the current year may not be a good idea either.  While it is not popular “medicine” for a farmer to take, 2022 may be a “good” year to pay tax.  It’s also a good year to pay down (or off) debt.  Interest rates will be going up further in the Federal Reserve’s attempt to reduce inflation.  Congress shows no interest in curbing spending or reducing tax rates.  This all means that “cash is king” and little-to-no debt will provide the greatest flexibility to adjust to future economic uncertainties.  Also, getting debt reduced or eliminated could provide an opportunity to buy land for cash as values fall in the future (which they will). 

One other problem that the Act does nothing to address are supply chain issues.  Getting needed parts and supplies on a timely basis is an issue for many farmers.  Throw in the possibility of a rail worker strike about the time harvest starts to heat up, and there is a toxic brew that could hit agriculture hard.  In addition, more IRS audits headed up by a person with an historic political bias spells trouble.   

Inflation Reduction?  About the only thing in the Act that will reduce inflation are the tax increases.  If those slow the economy enough, inflation might be reduced.  Indeed, that might be the quiet expectation of some.

And then there’s the continued funding of a war in Ukraine and its inflationary effect domestically.  And, what about China?  Will 2023 (or late 2022) involve a war on one side of world and another one on the other side?  What are the implications for U.S. agriculture if that happens? 

Much to think about and plan accordingly for.  2019 seems so far in the past….

September 2, 2022 in Income Tax | Permalink | Comments (0)

Tuesday, August 23, 2022

USDA’s Emergency Relief Program (Update on Gain from Equipment Sales)

Overview

The Extending Government Funding and Delivering Emergency Assistance Act (P.L. 117-43) (Act) was signed into law on September 30, 2021.  The Act includes $10 billion for farmers impacted by weather disasters during calendar years 2020 and 2021.  $750 million is to be directed to provide assistance to livestock producers for losses incurred due to drought or wildfires in calendar year 2021 (the Emergency Livestock Relief Program – (ELRP)).

USDA continues to release information about the ERP.  One bit of information came out last week and it involved the question of whether income from the sale of farm equipment counted as farm income for purposes of the ERP.  It was not the answer we were hoping for.

The ERP and the definition of farm income (among other aspects of the program) – it’s the topic of today’s post.

In General

Livestock provisions.  To receive a Phase 1 payment, a livestock producer must have suffered grazing losses in a county rated by the U.S. Drought Monitor as having a severe drought) for eight consecutive weeks or at least extreme drought during the 2021 calendar year been approved for the 2021 Livestock Forage Relief Program (LFP). Those who would have normally grazed on federal but couldn’t be due to drought are eligible for a Phase 1 payment if they were approved for a 2021 LFP.  Various FSA Forms will need to be submitted. 

ELRP Payment Calculation – Phase One

Payments are based on livestock inventories and drought-affected forage acreage or restricted animal units and grazing days due to wildfire reported on Form 2021 CCC-853.  A payment will equal the producer’s gross 2021 LFP calculated payment multiplied by 75% and will be subject to the $125,000 payment limitation. 

Crop insurance (or NAP) requirement.  In late 2021, the USDA provided some guidance to producers impacted by various weather-related events.  The former Wildfire and Hurricane Indemnity Program (WHIP+) was retooled and renamed as the ERP.  ERP will have two payments – two phases.  Phase 1 is presently underway, and Phase 2 may not happen until 2023.  ERP payments may be made to a producer with a crop eligible for crop insurance or noninsurance crop disaster assistance (NAP) that is subject to a qualifying disaster (which is defined broadly) and received a payment.  Droughts (a type of qualifying disaster) are rated in accordance with the U.S. Drought Monitor, where the qualifying counties can be found.

To reiterate, an ERP payment will not be made to any producer that didn’t receive a crop insurance or NAP payment in 2020 or 2021.  Because of this requirement, crop insurance premiums that an ERP recipient has paid will be reimbursed by recalculating the ERP payment based on the ERP payment rate of 85 percent and then backing out the crop insurance payment based on coverage level.     

In addition, the ERP requires that the producer receiving a payment obtain either NAP or crop insurance for the next crop years.  Also, a producer that received prevented planting payments can qualify for Phase 1 payments based on elected coverage. 

Note:  ERP payments are for damages occurring in 2020 and 2021 – so they are not deferable. 

Computation of Payment and Limits

Once a producer submits their data to the FSA, an ERP application will be sent out for the producer to verify.  Applications started going out to producers in late May.  An ERP payment replaces the producer’s elected crop insurance coverage.  It’s based on a percentage with the total indemnity paid using the recalculated ERP percentage with any crop insurance or NAP payment subtracted. 

Payment limit.  The ERP payment limit is $125,000 for specialty crops.  For all other crops, its $125,000 combined.  However, for an applicant with “average farm adjusted gross income” (average AGI) based on the immediate three prior years but skipping the first year back that is comprised of more than 75 percent from farming activities, the normally applicable $900,000 AGI limit is dropped, and the payment limit goes to $900,000 for specialty crops and $250,000 for all other crops.  There is separate payment limit for each of 2020 and 2021. 

Note:  ERP payments for “historically underserved producers” will be enhanced by an extra 15 percent.  Such producers include beginning farmers, veterans and “socially disadvantaged producers.”

Definition of farm income.  Farm income for ERP purposes includes net Schedule F income; pass-through income from farming activities; wages from a farming entity; IC-DISC income from an entity that materially participates in farming (has a majority of gross receipts from farming).  Also counting as farm income for ERP purposes is income from packing, storing, processing, transporting and shedding of farm products.  Gains from the sale of farm equipment count if farm income is at least two-thirds of overall AGI (excluding gains from equipment sales and the sale of farm inputs). 

Note:  Under the Tax Cuts and Jobs Act (TCJA) for tax years after 2017, a “trade-in” of farm equipment is treated as a sale that is reported on Form 4797.  As a result, many farmers may have little income reported on Schedule F for a tax year that they incurred a large gain from “trading in” farm equipment that is reported on Form 4797.  This could cause such a farmer to not receive an additional ERP payment. 

It is likely that the same rule will apply to income from custom farming or harvesting services as well as income derived from providing seed to farmers (offset by allocated expenses). 

Average AGI is “comparable to the net income from farming and related operations.”  FSA Handbook, 6-PL. This requires a determination of what qualifies as gross farm income from which net income from farming operations, or average AGI, can be derived.

Note:  Loss years can be used in the AGI calculation.  If negative farm AGI is greater than total negative AGI by at least 75 percent, the farmer qualifies.  In addition, the three-year computation is simply the applicant’s net income from farming compared with all of the applicant’s other sources of income as reported on the tax return. 

If an enhanced payment limit is sought on behalf of an entity, “all members of the entity must complete Form FSA-510 and provide the required certification according to their direct attributions of 7 C.F.R. 1400.105.”  This requires that the each of entity owners, up to four levels, also satisfy the more than 75 percent test.  For this purpose, wages the entity pays counts as farm income.  If one or more owners fails to satisfy the test, the extra payment limit is reduced by the disqualified owner(s) share(s), but there is no reduction to the original payment limit.  Wages and dividends paid by a materially participating farm corporation qualifies as farm income.  For this purpose, a materially participating farm corporation is one with more than 50 percent of gross receipts from farming.  If an entity has not been in existence for the three years for which average AGI is computed, AGI from processor entities can be used. 

Example:  Able Farm Co. is eligible for $300,000 of ERP related to crop insurance proceeds on account of drought damage to the farm’s 2021 wheat crop.  All of Able Farm Co.’s income is derived from farming.  Able Farm Co. is eligible for an original payment limit of $125,000 of ERP payments and could receive another $175,000 of the $250,000 additional payment limit depending on the facts.  Assume that Able Farm Co. has four shareholders.  Two of the shareholders that own 50 percent of Able Farm Co. actively farm and receive wages and dividends from the company.  They also rent land to the corporation.  Assume that their farm income meets the 75 percent of overall AGI test.  Conversely, the other two shareholders that also own 50 percent of Able Farm Co. are not involved in Able Farm Co.’s farming operations, have off-farm wages, and don’t satisfy the 75 percent test.  Their failure to meet the 75 percent test individually means that the additional $250,000 payment will be reduced by 50 percent ($250,000 - $125,000 = $125,000.  Thus, Able Farm Co. will receive $250,000 of ERP payments ($125,000 + $125,000). 

Example:  SunGro Cherry Farm qualifies for $950,000 of ERP because of weather damage to its cherry crop.  SunGro is owned equally by four owners, two of which meet the 75 percent test.  SunGro is eligible for the original payment limit of $125,000 and an additional payment limit of $775,000 ($900,000 - $125,000).  But, the additional payment limit must be reduced by the 50 percent ownership of the shareholders that don’t meet the 75 percent test.  Thus, the total ERP payment that SunGro Cherry Farm will receive is $125,000 + (.5 x $775,000) = $512,500.    

Certification.  To get the enhanced payment limit, a CPA or attorney must prepare a letter to be submitted with Form FSA-510 certifying that the applicant’s AGI is over the 75 percent threshold.  The FSA has a Form letter than can be used for this that is contained in its Handbook.  The FSA 6-PL, Apr. 29, 2022, Para. 489 discusses the 75 percent test and pages 8-73 through 8-74 is where the sample letter is located.  The “certification” may allow married farmers to eliminate the off-farm income of a spouse and make it possible to meet the 75 percent test if it otherwise would not be met.

Note:  An attorney may sign Form FSA-510, but a CPA should write the letter that FSA provides in the FSA Handbook, 6-P, pages 8-73 and 8-74. 

 Conclusion

The ERP is complicated and has a non-accounting measure of AGI in certain situations.  In addition, the exclusion of gains from equipment “trades” does not take into account the TCJA change on the matter.  Close monitoring of the USDA/FSA website and amendments to the 6-PL is a must.

August 23, 2022 in Income Tax, Regulatory Law | Permalink | Comments (0)

Sunday, August 21, 2022

LLCs and Self-Employment Tax – Part Two

Overview

In Part One of this two-part series, the discussion focused on how the determination is made of whether an LLC member is a limited partner.  There it was noted that the IRS/Treasury hadn’t yet finalized a regulation that was initially proposed in 1997 to address the issue.  The characterization of an LLC member’s interest is determinative of whether the member has self-employment tax liability on amounts distributed to the member (other than guaranteed payments). 

In today’s Part Two of this series, I dig into the self-employment tax issue further.  Proper structuring of the entity matters as does the drafting of the LLC operating agreement and the conduct of the members. 

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

LLCs and Self-Employment Tax

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

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

August 21, 2022 in Business Planning, Income Tax | Permalink | Comments (0)

Saturday, August 20, 2022

Ag Law Summit

Overview

Last September Washburn Law School conducted it’s first “Ag Law Summit” and held it at Mahoney State Park in Nebraska. This year the Summit returns in collaboration with Creighton University School of Law.  The Summit will be held at Creighton University on September 30, and will also be broadcast live online.

The Summit will cover various topics of relevance to agricultural producers and the tax and legal counsel that represent them. 

The 2022 Ag Law Summit – it’s the topic of today’s post.

Agenda

Survey of ag law and tax.  I will start off the day with a session surveying the major recent ag law and tax developments.  This one-hour session will update attendees on the big issues facing ag clients and provide insight concerning the issues that look to be on the horizon in the legal and tax world. 

Tax issues upon death of a farmer.  After my session, Prof. Ed Morse of Creighton Law School will examine the tax issues that arise when a farm business owner dies.  Income tax basis and the impact of various entity structures will be the focus of this session along with the issues that arise upon transitioning ownership to the next generation and various tax elections.

Farm succession planning drafting language.  After a morning break Dan Waters, and estate planning attorney in Omaha, NE, will take us up to lunch with a technical session on the drafting of critical documents for farm and ranch entities.  What should be included in the operative agreements?  What is the proper wording?  What provisions should be included and what should be avoided?  This session picks up on Prof. Morse’s presentation and adds in the drafting elements that are key to a successful business succession plan for the farm/ranch operation.

Fences and boundaries.  After a provided lunch, Colten Venteicher who practices in Gothenburg, NE, will address the issues of fence line issues when ag land changes hands.  This is an issue that seems to come up over and over again in agriculture.  The problems are numerous and varied.  This session provides a survey of applicable law and rules and practical advice for helping clients resolve existing disputes and avoid future ones. 

The current farm economy and future projections.  Following the afternoon break, a presentation on the current economy and economic situation facing ag producers, ag businesses and consumers will be presented by Darrell Holaday.  Darrell is an economist and his firm, Advanced Market Concepts, provides marketing plans for ag producers.   What are the economic projections for the balance of 2022 and into 2023 that bear on tax and estate planning for farmers and ranchers?  This will be a key session, especially with the enactment of legislation that will add fuel to the current inflationary fire – unless of course, the tax increases in the legislation slow the economy enough to offset the additional spending. 

Ethics.  I return to close out the day with a session of ethics focused on asset protection planning.  There’s a right way and a wrong way to do asset protection planning.  This session guides the practitioner through the proper approach to asset protection planning, client identification, and the pitfalls if the “stop signs” are missed.

Reception

For those attending in person, a reception will follow in the Harper Center Ballroom on the Creighton Campus. 

Conclusion

If your tax or legal practice involves ag clients, the Ag Law Summit is for you.  As noted, you can also attend online if you can’t be there in person.  If you are a student currently in law school or thinking about it, or are a student in accounting, you will find this seminar beneficial. 

I hope to see you in Omaha on September 30 or see that you are with us online.

You can learn more about the Summit and get registered at the following link:  https://www.washburnlaw.edu/employers/cle/aglawsummit.html

August 20, 2022 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, August 18, 2022

LLCs and Self-Employment Tax – Part One

Overview

Farmers and ranchers often desire to avoid the payment of self-employment tax.  Indeed, avoidance of self-employment tax sometimes seems to be a prerequisite for being engaged in a farming or ranching activity.  One way to structure the business to minimize self-employment tax might be as a limited liability company (LLC). For an LLC member that truly has a limited partnership interest, self-employment tax savings can be achieved.  But truly being a limited partner is the key.  The definition of a “limited partner” as an LLC member for self-employment tax purposes has been unclear and confusing for some time. 

In today’s Part One of a two-part series, I take a look at how the courts (and IRS) view a limited partner in the context of an LLC.  The analysis derives from the passive loss rules and from a proposed regulation issued in the late 1990s. 

LLCs and self-employment tax – Part One of a two-part series – it’s the topic of today’s post.

Background

In its 2017-2018 Priority Guidance Plan, the IRS stated that it planned to finalize regulations under I.R.C. §469(h)(2) – the passive loss rules.  That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations.  Those regulations were initially issued in temporary form and became proposed regulations in 2012. 2012-9, IRB 434

Passive Loss Rules 

The passive loss rules of I.R.C. §469 can have a substantial impact on farmers and ranchers as well as investors in farm and ranch land.  The effect of the rules is that deductions from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income.

The proper characterization of the loss depends on whether the taxpayer is materially participating in the business.  I.R.C. §469(h).  But, I.R.C. §469(h)(2) creates a per-se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations.  The statute was written before practically all state LLC statutes were enacted and before the advent of LLPs, and the Treasury has never issued regulations to detail how the statue is to apply to these new types of business forms.

Material participation tests.  The key question presented in the cases was whether the taxpayer satisfied the material participation test.  As mentioned above, a passive activity is a trade or business in which the taxpayer does not materially participate.  Material participation is defined as “regular, continuous, and substantial involvement in the business operation.” I.R.C. §469(h)(1).   The regulations provide seven tests for material participation in an activity. Temp. Treas. Reg. §1.469-5T(a)(1)-(7). 

The tests are exclusive and provide that an individual generally will be treated as materially participating in an activity during a year if:

  • The individual participates more than 500 hours during the tax year;
  • The individual’s participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals (including individuals who are not owners of interests in the activity) for the tax year;
  • The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of anyone else (including non-owners) for the tax year;
  • The activity is a significant participation activity and the individual’s aggregate participation in all significant participation activities during the tax year exceeds 500 hours;
  • The individual materially participated in the activity for any five taxable years during the ten taxable years that immediately precede the tax year at issue;
  • The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years preceding the tax year at issue; or
  • Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the tax year

As noted, if the taxpayer is a limited partner of a limited partnership, the taxpayer is presumed to not materially participate in the partnership’s activity, “except as provided in the regulations.”  I.R.C. §469(h)(2). The regulations provide an exception to the general presumption of non-material participation of limited partners in a limited partnership if the taxpayer meets any of one of three specific material participation tests that are included in the seven-part test for material participation under Treas. Reg. 1.469-5T(a)(1)-(7).  Those three tests are:

  • The 500-hour test;
  • The five out of 10-year test; and
  • The test involving material participation in a personal service activity for any three years preceding the tax year at issue.

Thus, the standard of “material participation” for a limited partner is different than that for a general partner, and the question presented in the cases was whether the more rigorous standard for material participation for limited partners in a limited partnership under I.R.C. §469(h)(2) applied to the taxpayers (who held membership interests in LLCs and LLPs) with the result that their interests were per-se presumptively passive.

Relevant Court Opinions

Courts have concluded, in certain instances, that the holder of a limited liability company (LLC) interest is not treated as holding an interest in a limited partnership as a limited partner for purposes of applying the I.R.C. §469 material participation tests. 

For example, in Garnett v. Comr. 132 T.C. 368 (2009), the taxpayers were a married couple that owned interests in various LLCs and partnerships organized under Iowa law, as well as certain tenancy-in-common interests that were all engaged in agricultural production activities.  They held direct ownership interests in one LLP and LLC and indirect interests in several other LLPs and LLCs.  Their ownership interests were denoted as “limited partners” in the LLP and “limited liability company members” in the LLC – which did have a designated manager.  The interests that they held in the two tenancies-in-common were also treated similarly.  For tax years 2000-2002, the taxpayers ran up large losses and treated them as ordinary losses.

The IRS claimed that an LLC member is always treated as a limited partner because of limited liability under state law and because the Code specifies that a limited partnership interest never counts as an interest with respect to which the taxpayer materially participates. I.R.C. §469(h)(2).   Thus, the IRS characterized the losses as passive, basing their position on the regulation which, for purposes of I.R.C. §469, treats a partnership interest as a limited partnership interest if “the liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount.” Temp. Treas. Reg. §1.469-5T(e)(3)(i)(B).   On the other hand, the taxpayers argued that the Code and regulations did not apply to them because none of the entities that they had interests in were limited partnerships and because, in any event, they were general partners rather than limited partners.  The taxpayers also pointed out that the Federal District Court for Oregon had previously ruled that, under the Oregon LLC Act, I.R.C. §469(h)(2) did not apply to LLC members.  Gregg v. United States, 186 F. Supp. 2d 1123 (D. Ore. 2000).

The Tax Court first noted that I.R.C. §469(h)(2) was enacted at a time when LLCs and LLPs were either new or nonexistent business entities and, as such, did not refer to those entities.  The court also pointed out that the regulations did not refer explicitly to LLPs or LLCs.  Accordingly, the court rejected the IRS argument that a limitation on liability automatically qualifies an interest as a limited partnership interest under I.R.C. §469(h)(2).  On the contrary, the court held that the correct analysis involved a determination of whether an interest in a limited partnership (or LLC) is, based on the particular facts, actually a limited partnership interest.  That makes a state’s LLC statute particularly important.  Does it grant LLC and LLP members power and authority beyond those that limited partners have traditionally been allowed.?  The IRS conceded that the statute at issue in the case did just that.  Other distinguishing features were also present.  The court noted that limited partnerships have two classes of partners, one of which runs the business (general partners) and the other one which typically involves passive investors (limited partners).  The limited partners enjoy limited liability, but that protection can be lost by participating in the business.  By comparison, an LLP is essentially a general partnership in which the general partners have limited liability even if they participate in management.  Likewise, the court noted that LLC members can participate in management and retain limited liability.

Note:  The court made a key point that it was not invalidating the temporary regulations but was simply declining to write a regulation for the Treasury that applied to interests in LLCs and LLPs.  Importantly, the court refused to give deference to the Treasury’s litigating position in absence of such a regulation.

In Thompson v. United States, 87 Fed. Cl. 728 (2009), the taxpayer held a 99 percent interest in an LLC that was formed under the Texas LLC statute.  He held the other one percent interest indirectly through an S corporation.  The LLC’s articles of organization designated the taxpayer as the manager.  The LLC did not make an election to be taxed as a corporation and, thus, defaulted to partnership tax status.  The LLC, which provided charter air services, incurred losses in 2002 and 2003 of $1,225,869 and $939,878 respectively which flowed through to the taxpayer.  The IRS disallowed most of the losses on the basis that the taxpayer did not meet the more rigorous test for material participation that applied to limited partners in limited partnerships.  The taxpayer paid the additional tax of $863,124 and filed a refund claim for the same amount.  The IRS denied the refund claim and the taxpayer sued for the refund, plus interest.  Both the taxpayer and the IRS moved for summary judgment.

The IRS stood by its position that the more rigorous material participation test applied because the taxpayer enjoyed limited liability by owning the interests in the LLC just like he would if he held limited partnership interests.  Thus, according to the IRS, the taxpayer’s interest was identical to a limited partnership interest and the regulation applied triggering the passive loss rules.

The court disagreed with the IRS.  While both parties agreed that the statute and regulations trigger application of the passive loss rules to limited partnership interests, the taxpayer pointed out that he didn’t hold an interest in a limited partnership.  The court noted that the language of Treas. Reg. § 1.469-5T(e)(3) explicitly required that the taxpayer hold an interest in an entity that is a partnership under state law, and that the Treasury had never developed a regulation to apply to LLCs.  It was clear that the taxpayer’s entity was organized under Texas law as an LLC.  In addition, the court pointed out that the taxpayer was a manager of the LLC, and IRS had even conceded at trial that the taxpayer would be deemed to be a general partner if the LLC were a general partnership.  The court noted that the position of the IRS that an LLC taxed as a partnership triggers application of the Treas. Reg. §1.469-5T(e)(3)(ii) was “entirely self-serving and inconsistent.”  The court also stated that it was irrelevant whether the taxpayer was a manager of the LLC or not – by virtue of the LLC statute, the taxpayer could participate in the business and not lose the feature of limited liability.

Hegarty v. Comr., T.C. Sum. Op. 2009-153, is a Tax Court summary opinion where the Tax Court reiterated its position that the reliance by IRS on I.R.C. § 469(h)(2) to treat members of LLCs as automatically limited partners for passive loss purposes is misplaced.  Instead, the general tests for material participation apply and the petitioners in the case (a married couple) were determined to have materially participated in their charter fishing activity for the tax year at issue.  They participated more than 100 hours and their participation was not less than the participation of any other individual during the tax year.

In Newell v. Comr., T.C. Memo. 2010-23, the taxpayer’s primary business activity was managing various real estate investments.  He spent more than one-half of his time and more than 750 hours annually in real property trade or business activities.  During the years at issue, the taxpayer was the sole owner of an S corporation that manufactured and installed carpentry items, and his participation is that business qualified as a significant participation activity for purposes of the passive loss rules.  He also owned 33 percent of the member interests in a California-law LLC engaged in the business of owning and operating a golf course, restaurant and country club.  The LLC was treated taxwise as a partnership.  It was undisputed that the taxpayer was the managing member of the LLC.  For tax years 2001-2003, IRS claimed that the losses the taxpayer incurred from both the S corporation and the LLC were passive losses that were not currently deductible.  While the parties agreed that the taxpayer’s participation in both the S corporation and the LLC satisfied the significant participation activity test under the passive loss rules, IRS again asserted its position that I.R.C. §469(h)(2) required that the taxpayer’s interest in the LLC be treated as a passive limited partnership interest, even though IRS conceded that the taxpayer held the managing member interest in the LLC.

The Tax Court rejected the IRS’ argument, noting again that the general partner exception of Treas. Reg. §1.469-5T(e)(3)(ii) was not confined to the situation where a limited partner also holds a general partnership interest.  Under the exception, an individual who is a general partner is not restricted from claiming that the individual materially participated in the partnership.  Here, it was compelling that the taxpayer held the managing member interest in the LLC.  As such, the taxpayer’s losses were properly deducted.

In Chambers v. Comr., T.C. Sum. Op. 2012-91, the taxpayer owned rental property with his spouse that produced a loss. The taxpayer was also a managing member of an LLC that owned rental properties.  The LLC also owned rental property, and produced losses with one-third of the losses allocated to the taxpayer.  The taxpayer was also employed by the U.S. Navy.  He deducted his rental losses in full on the basis that he was a real estate professional.  In order to satisfy the “more than 50 percent test,” he combined his hours spent on his personally-owned rental activity with his management activity for the LLC.  The IRS invoked I.R.C. §469(h) to disallow the taxpayer’s LLC managerial hours, but the court disagreed.  The court held that the taxpayer’s LLC interest was not defacto passive.  Thus, his hours spent in LLC managerial activities counted toward his total “real estate” hours.  However, he still failed to meet more than 50 percent test.  In addition, the court noted that the fallback test of active participation allowing $25,000 of rental real estate losses was not available because the taxpayer’s AGI exceeded $150,000 for the year in issue.

Conclusion

Whether a member of an LLC is a limited partner or not boils down to the particular provisions of a state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership.  That will be the case until IRS issues regulations dealing specifically with LLCs and similar entities.

As noted above, in late 2011, the Treasury Department proposed regulations defining “limited partner” for purposes of the passive loss rules. Notice of Proposed Rulemaking REG-109369-10 (Nov. 28, 2011).  The proposed definition would make it easier for LLC members and some limited partners to satisfy the material participation requirements for passive loss purposes, consistent with the court opinions that IRS has recently lost on the issue.  Specifically, the proposed regulations require that two conditions have to be satisfied for an individual to be classified as a limited partner under I.R.C. §469(h)(2): (1) the entity must be classified as a partnership for federal income tax purposes; and (2) the holder of the interest must not have management rights at any time during the entity’s tax year under local law and the entity’s governing agreement.  Thus, LLC members of member-managed LLCs would be able to use all seven of the material participation tests, as would limited partners that have at least some rights to participate in managerial control or management of a partnership.

In Part Two, I will dig deeper into the self-employment tax issue.

August 18, 2022 in Business Planning, Income Tax | Permalink | Comments (0)

Thursday, August 4, 2022

What is “Reasonable Compensation”?

Overview

One of the areas of “low-hanging fruit” for IRS auditors in recent years involves the issue of reasonable compensation in the S corporation context.  Salary that is too low in relation to the services rendered results in the avoidance of payroll taxes.  So, when shareholder-employees take flow-through distributions from the corporation instead of a salary, the distributions are not subject to payroll taxes (i.e., the employer and employee portions of Federal Insurance Contributions Act (FICA) taxes and the employer Federal Unemployment Tax Act (FUTA) tax. 

Note:  The issue of the reasonableness of compensation also can arise in the context of a C corporation.  Salaries and benefits to a C corporation shareholder/employee that is “too high” can bring an IRS challenge that some of the compensation is really disguised dividends.  An “ostensible salary” paid by a closely held C corporation to one of its few shareholders is likely to constitute a disguised dividend where the amount is “in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees.”  Treas. Reg. §1.162-7(b)(1).

“Reasonable compensation” in the context of an S corporation (with a bit of C corporation discussion thrown in) – it’s the topic of today’s post.

Background

In accordance with Rev. Rul. 59-221, S corporation flow-through income is taxed at the individual level and is (normally) not subject to self-employment tax.  Also, in addition to avoiding FICA and FUTA tax via S corporation distributions, the 0.9% Medicare tax imposed by I.R.C. §3101(b)(2) for high-wage earners (but not on employers) is also avoided by taking income from an S corporation in the form of distributions.  These are the tax incentives for S corporation shareholder-employees to take less salary relative to distributions from the corporation.  With the Social Security wage base set at $147,000 for 2022, setting a shareholder-employee’s compensation beneath that amount with the balance of compensation consisting of dividends can produce significant tax savings.  The savings will likely increase in 2017.  It is currently projected that the Social Security wage base will be $155,100 in 2023.

Who’s an “Employee”?

Most S corporations, particularly those that involve agricultural businesses, have shareholders that perform substantial services for the corporation as officers and otherwise.  In fact, the services don’t have to be substantial.  Indeed, under a Treasury Regulation, the provision of more than minor services for remuneration makes the shareholder an “employee.”  Once, “employee” status is achieved, the IRS views either a low or non-existent salary to a shareholder who is also an officer/employee as an attempt to evade payroll taxes and, if a court determines that the IRS is correct, the penalty is 100 percent of the taxes owed.   Of course, the burden is on the corporation to establish that the salary amount under question is reasonable.  

Determining Reasonableness

Before 2005, the court cases involved S corporation owners who received all of their compensation in form of dividends.  Most of the pre-2005 cases involved reclassifications on an all-or-nothing basis.  In 2005, the IRS issued a study entitled, “S Corporation Reporting Compliance.”  Now the courts’ focus is on the reasonableness of the compensation in relation to the services provided to the S corporation.  That means each situation is fact-dependent and is based on the type of business the S corporation is engaged in and the amount and value of the services rendered. 

So what are the factors that the IRS examines to determine if reasonable compensation has been paid?  Here’s a list of some of the primary ones:

  • The employee’s qualifications;
  • the nature, extent, and scope of the employee’s work;
  • the size and complexities of the business; a comparison of salaries paid;
  • the prevailing general economic conditions;
  • comparison of salaries with distributions to shareholders;
  • the prevailing rates of compensation paid in similar businesses;
  • the taxpayer’s salary policy for all employees; and
  • in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

According to the IRS, the key to establishing reasonable compensation is determining what the shareholder/employee did for the S corporation.  That means that the IRS looks to the source of the S corporation’s gross receipts. If they came from services of non-shareholder employees, or capital and equipment, then they should not be associated with the shareholder/employee’s personal services, and it is reasonable that the shareholder would receive distributions as well as compensation.  Alternatively, if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation. In addition to the shareholder/employee’s direct generation of gross receipts, the shareholder/employee should also be compensated for administrative work performed for the other income-producing employees or assets.  As applied in the ag context, for example, this means that reasonable compensation for a shareholder/employee in a crop farming operation could differ from that of a shareholder-employee in a livestock operation.

Recent Cases

Over the past decade there have been some significant cases involving the issue of reasonable compensation in the S corporation context.  Some of the prominent ones include:

  • David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), cert. den., 568 U.S. 888 (2012)
  • Sean McAlary Ltd., Inc. v. Comr., T.C. Sum. Op. 2013-62
  • Glass Blocks Unlimited v. Comr., T.C. Memo. 2013-180
  • Scott Singer Installations, Inc. v. Comr., T.C. Memo. 2016-161

Each of these cases provides insight into the common issues associated with the reasonable compensation issue.  The last two also address distributions and loan repayments in the context of reasonable compensation of unprofitable S corporations with one case being a taxpayer victory and the other a taxpayer loss. 

In early 2021, the U.S. Tax Court issued its opinion in Ward v. Comr., 2021-32.  In Ward, the petitioner conducted her law practice as an S corporation.  She was the sole shareholder.  For the three tax years at issue, the petitioner reported the net profit or loss from the S corporation on her Form 1040.  In addition, for 2011, the S corporation did not treat any of the amount paid to her as wages on Form 941 and did not report any of it as income.  In 2012, the petitioner reported $73,448 in payments as income, but neither she nor the S corporation reported the amounts as wages.  The petitioner conceded that she was an officer of the S corporation.  The IRS asserted that the amounts were wages, and the Tax Court agreed.  The de minimis exception of Treas. Reg. §31.3121(d)-1(b) didn’t apply because, as the sole shareholder, she was performing services for the corporation.  While the S corporation employed an associate attorney, the petitioner could have claimed that some of the firm’s net profit distributed to the petitioner attributable to the associate attorney’s efforts would not be wages.  However, the petitioner provided no evidence of the value that the associate attorney added to the S corporation or whether that value exceeded the associate’s compensation.  Thus, the salary payments reported to the petitioner by the S corporation were reportable as compensation. 

Note:  A side issue in Ward was that the petitioner also had canceled debt income in years when lenders discharged portions of her debt.  She failed to provide sufficient evidence of her assets and liabilities for a solvency determination to be made. 

And…a C Corporation Reasonable Compensation Case

Another recent case on the reasonable compensation issue illustrates that the matter, as indicated above, can also be a concern for C corporations.  In Clary Hood, Inc. v. Comr., T.C. Memo. 2022-15, a married couple were the sole shareholders of a corporation engaged in the construction business that graded and prepared land.  The corporation’s growth was irregular from 2000 on. The principal took a relatively modest salary between 2000 and 2012 but took a big increase in the years 2013 to 2016, ostensibly to compensate for earlier years. The company had an outside consulting firm perform an analysis to determine what the principal's compensation should be.

The IRS challenged the compensation amounts for 2015 and 2016. The Tax Court examined the usual factors considered in such a case including the employee's qualifications; the nature, extent, and scope of the employee's work; the size and complexities of the business; a comparison of salaries paid with gross income and net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; and the salary policy of the taxpayer as to all employees.  On these points, the relevant facts showed that the corporation had revenue of almost $44 million (net revenue of $7 million) in 2015 and $68 million (net revenue of $14 million in 2016.  The principal’s compensation was set at $168,559 with a $5 million bonus in 2015.  A comparable arrangement was established for 2016.  The principal set the compensation of the other four executives, and none of them were compensated in excess of $234,000.  None of them had a bonus exceeding $100,000. 

The Tax Court denied a deduction for the full amount of the compensation.  While certain factors favored the corporation, the factors addressing comparable pay by comparable concerns, the corporation’s shareholder distribution history, the manner of setting compensation, and the principal’s involvement in the corporation’s business were the most relevant and persuasive factors for the Court.  The Tax Court allowed a deduction of no more than $3,681,269 for the 2015 tax year and $1,362,831 for the 2016 tax year.  

In addition, the IRS assessed an accuracy-related penalty for both years. The taxpayer was able to show that he relied in good faith on the advice of the accounting firm and the Tax Court did not sustain the penalty. However, for the second year the corporation could not substantiate its reliance on the outside adviser and was responsible for an accuracy-related penalty under I.R.C. §6662 for 2016. 

Conclusion

The bottom line is that “reasonable compensation” means that is must be reasonable for all of the services the S corporation owner performs for the corporation.  Because there is no safe harbor for reasonable compensation, the best strategy is to research and document reasonable compensation every year.  That will provide a defensible position if the IRS raises questions on audit. 

August 4, 2022 in Business Planning, Income Tax | Permalink | Comments (0)

Thursday, July 28, 2022

Tax Deal Struck? – and Recent Ag-Related Cases

Overview

Reports are that Senator Joe Manchin has come to an agreement with Senate leadership on tax legislation that is part of a larger package, termed the “Inflation Reduction Act of 2022.”  It’s apparently part of the 2022 budget reconciliation bill which only requires a simple majority of the Senate to pass.  What are the tax provisions that have been agreed to? 

Proposed tax provisions apparently agreed to, and some recent ag-related court decisions – it’s the topic of today’s post.

Tax Agreement

Reports are that the agreed upon tax package includes a 15 percent corporate alternative minimum tax (AMT) applied to adjusted financial statement income of corporations with profits exceeding $1 billion.  A corporation subject to the AMT would be able to claim net operating losses and tax credits against the AMT.  In addition, a corporation subject to the AMT would be able to claim tax credits against the AMT as well as regular corporate tax for AMT paid in prior years to the extent the regular tax liability in any year exceeds 15 percent of the corporation’s adjusted financial statement income.  The provision would be effective for tax years after 2022.

Also included in the agreement is a change in the tax treatment of carried interest (e.g., the share of profit that general partners receive to compensate them for managing a venture capital fund). 

Another proposal would apply the net investment income tax (NIIT) of I.R.C. §1411 to all income.  Presently this 3.8 percent tax (which was created as part of Obamacare) applies only to passive income above a threshold.  Under the proposal, the additional 3.8 percent tax would apply to adjusted gross income over $400,000 (single) and $500,000 (mfj).  This means that there is a substantial “marriage penalty.”  In addition, the qualified business income deduction (QBID) of I.R.C. §199A is not part of a taxpayer’s AGI computation.  In other words, AGI is not reduced by the 20 percent QBID – AGI is computed before accounting for the QBID. Thus, for a taxpayer that has taxable income at or below the threshold for application of the NIIT as a result of the QBID, the NIIT would be computed on AGI first. 

Note:  Applying the NIIT to adjusted gross income (including income from both passive and active sources) could result in a sizeable tax increase for many farmers – particularly dairy operations.

There are other tax provisions reported to be in the agreement, including those dealing with “renewable” energy credits.  The projected additional revenue from the tax increases is to fund certain “green energy” initiative.  The actual text of the legislation is presently slated for the Senate parliamentarian to review on August 3.  Full Senate consideration would occur after that date. 

Note:  There presently is no word on how Senator Sinema views the proposal, although she has stated in the past that she will not support legislation that increases corporate or personal tax rates.  While the proposals don’t increase actual rates, they do increase effective rates on certain corporations and individuals. 

Also, Senate Finance Committee Chairman Charles Grassley has introduced legislation that would index certain tax benefits to adjust for inflation.  The indexed provisions include certain tax credits and deductions such as the Child Tax Credit and the Non-Child Dependent Credit.  The bill, known as the “Family and Community Inflation Relief Act,” would also adjust for inflation the American Opportunity Tax Credit, Lifetime Learning Credit, and the Student Loan Interest Deduction.  The proposal would also extent the current $10,000 limitation on state and local taxes through 2026. 

 Recent Ag-Related Court Opinions

Child Support Obligation Computed Based on All Income and Loss from Farming. 

Gerving v. Gerving, 969 N.W.2d 184 (N.D. 2022) 

The issue in this case was the proper way to calculate a father’s child support obligation.  The father conducted a farming operation, and a primary issue was whether only income and gains from farming should count for purposes of child support, or whether losses should also be accounted for. Under child support guidelines, the court must determine the payor’s net income and use that amount to calculate the child support obligation.  The trial court calculated the father’s income based only on gains and did not include any related losses incurred from equipment trades and other farm-related transactions.  The appellate court held that the trial court erred by not including the farm losses to calculate the father’s self-employment income because those losses must be considered to show actual profit from the farming operation.  The appellate court also determined that the father had no income from subleases of farmland.  

Deduction for Full Amount of C Corporate Shareholder Compensation Not Deductible 

Clary Hood, Inc. v. Comr., T.C. Memo. 2022-15

A big audit issue for farming (and other) corporations is reasonable compensation.  This case illustrates that point in a non-farm context.  Here, a married couple were the sole shareholders of the petitioner, a corporation engaged in the construction business that graded and prepared land.  The petitioner’s growth was irregular from 2000 on. The principal took a relatively modest salary between 2000 and 2012 but took a big increase in the years 2013 to 2016, ostensibly to compensate for earlier years. The company had an outside consulting firm perform an analysis to determine what the principal's compensation should be. The IRS challenged the amount in 2015 and 2016.

The Tax Court examined the usual factors considered in such a case including the employee's qualifications; the nature, extent, and scope of the employee's work; the size and complexities of the business; a comparison of salaries paid with gross income and net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; and the salary policy of the taxpayer as to all employees. The Tax Court denied a deduction for the full amount of the compensation. In addition, the IRS assessed an accuracy-related penalty for both years. The taxpayer was able to show that he relied in good faith on the advice of the accounting firm and the Tax Court did not sustain the penalty. However, for the second year the taxpayer could not substantiate its reliance on the outside adviser. 

Homeowner’s Policy Doesn’t Cover Farming Injury

Mills v. CSAA General Insurance. Co., No. 21-CV-0479-CVE-JFJ, 2022 U.S. Dist. LEXIS 114741 (N.D. Okla. Jun. 29, 2022)

It’s always good to make sure you understand the extent of coverage you have under an insurance policy, and what is excluded from coverage.  This case illustrates that point.  Here, the plaintiff became pinned between a trailer and barn while loading cattle, and was hospitalized for several days as a result of his resulting injuries.  The plaintiff had a homeowner’s insurance policy with the defendant and filed a claim for coverage under the policy for his injuries.  The defendant denied coverage on the basis that the policy only covered claims for bodily or personal injury brought by third parties against the plaintiff, and that the farming endorsement did not extend coverage for the plaintiff’s own bodily injury and incorporated the policy’s exclusion for bodily injury into the farming endorsement. 

The plaintiff sued, claiming that he intended to purchase coverage for personal injuries he might suffer while operating his farm and that he had a reasonable expectation of coverage under the policy.  He also claimed that the exclusions were “buried in the more than 100 pages of the policy.”  The trial court disagreed, determining that the policy’s liability provisions applied only to claims for bodily or personal injury brought by third parties against the plaintiff.   The trial court also determined that the policy language was not ambiguous and was not “buried deep” into the policy documents. 

Gross Acres, not Tillable Acres, Used for Partition-in-Kind

Mueggenberg v. Mueggenberg, No. 21-0887, 2022 Iowa App. LEXIS 510 (Iowa Ct. App. Jun. 29, 2022)

The two parties were comprised of five siblings, who each had an undivided one-fifth interest in 179.61 acres of farmland. The plaintiffs, three of the siblings, filed for a partition in kind. The court appointed an appraiser to analyze and equally divide the farmland between the three parties. The appraiser determined that partitioning the land into five equal sections would be unworkable because the land’s topography varied greatly. The appraiser recommended the defendants should receive an approximate share of 40 percent comprised of 62 gross acres and all the future easement payments from the energy company that operated a windmill on the land. The appraiser allocated 117.61 gross acres to the plaintiffs. The defendants claimed that they were entitled to 68.64 tillable acres. The appraiser explained that while the acre division was not necessarily 40/60, the land awarded to the defendants was overall more desirable and expensive as it had a higher CSR2 rating.

The trial court agreed with the appraiser and assessed fees and costs to the defendants.  On appeal, the appellate court found the defendants’ calculations for a different split were inaccurate as the defendants used tillable acres when they should have used gross acres in the calculation. The defendants also failed to account for the difficulty of dividing the land caused by a non-uniform property line and the existence of terraces. The appellate court affirmed the trial court’s decision to adopt the appraiser’s division but reversed the trial court’s award of attorney’s fees and costs. Accordingly, the appellate court vacated the trial court’s assessment of costs and remanded the case with instructions that only costs arising from the contested matter be assessed to the defendants.  The parties were to share all remaining costs proportionately. 

Conclusion

Keep your eyes on what, if any, tax proposals come out of the Senate.  Increasing taxes on individuals whether via the NIIT or the corporate tax in a recessionary economy (despite the changed definition from the White House) is not a good idea.  It’s particularly a bad idea when any additional revenue is to be used to fund inefficient and costly energy proposals to further energy policies that are the driver to the current inflationary problems in the economy. 

On the ag law front, make sure to understand how child support is computed in the context of a farmer’s divorce; pay reasonable compensation to shareholder/offices for services rendered; know what is and what is not covered under an insurance policy; and avoid partition actions – they rarely end up in family harmony. 

July 28, 2022 in Civil Liabilities, Income Tax, Insurance, Real Property | Permalink | Comments (0)

Friday, July 8, 2022

Using Farm Income Averaging to Deal with Economic Uncertainty and Resulting Income Fluctuations

Overview

Economic conditions swing back and forth for agricultural producers.  Grain farmers in the Midwest have benefitted from high grain and oilseed prices during the Spring of 2022.  New crop prices are presently very high.   However, the conflict in Ukraine has had global impacts, including a significant increase in fertilizer prices.  Farmers that had already pre-paid for inputs last year before the significant run-up in price avoided the higher prices, but input costs will likely be significantly higher for Spring 2023 crops.  That will have an impact on net profit for farmers next year.  The World Bank is estimates that crop fertilizer prices will rise about 70 percent in 2022 before falling slightly in 2023.  Compared to the Spring of 2021, prices for Anhydrous Ammonia, Potash and Phosphorous have were 116 percent, 103 percent and 54 percent higher in the Spring of 2022. 

Commodity prices will remain strong as long as the Ukraine conflict continues, but if the conflict ends, some are estimating that the price for corn could drop about $1.50 per bushel and soybeans could drop $2 to $3 per bushel.  Over the long-run prices will eventually drop. The question is how long the long-run will be. There certainly is more uneasiness and uncertainty among agricultural producers presently.  Inflation and supply chain issues creates that uncertainty. 

With respect to farmland, the underlying drivers of value are constantly shifting.  Those drivers are interest rates; commodity prices; on-farm profitability; and supply of farms.  Interest rates are rising and must in order to deal with the enormous amount of inflation in the economy.  Commodity prices are high, but as noted above will come down at some point.  Farm profitability will not be as good in 2023 as it is in 2022.  So, the long-term outlook for land value is that the upward trend over the past couple of years will likely not last to much longer.

What does all this mean for tax planning?  It means that farm income will likely be lower next year than this year.  The uncertainty also means that there will be a significant swing in farm income over multiple years. 

One tool for “smoothing-out” fluctuations in income from year-to-year for farmers is income averaging.  It’s a tax planning tool that may be more important now than ever.

Farm income averaging – it’s the topic of today’s post.

In General

An individual engaged in a farming (or fishing) business can elect to spread whatever portion of current taxable income attributable to any farming business (termed “elected farm income”) evenly over the three prior taxable years by using Schedule J.  I.R.C. §1301.  Thus, if rates were lower in the prior years, the taxpayer will get the benefit of applying the lower rates to current taxable income from farming.  The current year's income tax liability is calculated by determining the current year's tax (without the amount of elected farm income) plus the increases in income tax for each of the three prior taxable years by taking into account the allocable share of elected farm income for each of those years.  Any adjustment for any taxable year is taken into account for income averaging purposes in subsequent tax years.

Basics of Averaging

In General.  Farm income averaging is a tax management tool that farmers and ranchers can elect after the tax year ends to spread a certain amount of income from the year to be spread over a three-year period.  The technique can be used to prevent a farmer or rancher from being pushed into a higher tax bracket in a high-income year, such as 2022 will likely be for many farmers.  An income averaging election is made on Form 1040 Schedule J. 

Who is eligible?  Only individuals with farm (or fishing) income are eligible to utilize income averaging.  The individual must be involving engaged in farming in the year for which the election is made.   It isn’t required that the taxpayer have been engaged in farming in prior years.  Estates and trusts are not eligible and C corporations are not considered to be individuals. For entities taxed as partnerships, it is the individual partners or members, that can be eligible to elect income averaging.  For Subchapter S corporations engaged in farming, the S corporation is not eligible to make an income averaging election, but the S corporation individual shareholder is.  Treas. Reg. §1.1301-1(b)(1)(iii).  Likewise, income attributable to a farming business carried on by a partnership can be averaged without regard to the partner’s level of participation in the partnership or the size of the ownership interest.

Engaged in a “farming business.”  An individual electing income averaging must be “engaged in a farming business” in the year for which the election is made.  But, as noted above, the individual doesn’t need to necessarily have been engaged in a farming business in the three prior carryback years.  A “farming business” means a trade or business involving the cultivation of the land or the raising and harvesting of any agricultural or horticultural commodities, but does not include the processing of commodities or products “beyond those activities which are normally incident to the growing, raising or harvesting of such products.”

An individual's relationship to the “farming business” is critical in determining eligibility.  Clearly eligible for income averaging are operators of farming businesses that bear the risks of production and the risks of price change and provide substantial involvement in management. That means that a landlord is engaged in a rental activity and not in a farming business if the rental is a fixed rent (cash rent).  Whether the landlord materially participates in the tenant’s farming business is irrelevant for income averaging purposes.  But, non-materially participating landlords are only eligible for income averaging if the landlord’s share of a tenant’s production is set in a written rental agreement before the tenant begins significant activities on the land. 

What about a recently retired farmer?  Individuals who have ceased farming operations with the only activity in the year in question being the sale of inventory and the sale of machinery are not engaged in a “farming business” in that year. However, gains or losses from property regularly used in a farming business after cessation of the farming business are treated as attributable to a farming business if the property is sold within a reasonable time after cessation of the farming business. If the sale or other disposition of such assets occurs within one year of the cessation of farming, it is presumed to be within a reasonable time. After that, it is a facts and circumstance test.

Are gains eligible?  Gains from the “sale or other disposition of property (other than land) regularly used by the taxpayer in such a farming business for a substantial period” are eligible for averaging. I.R.C. § 1301(b)(1)(B).  Clearly, gains from the sale or exchange of land do not qualify.  Although not completely clear, it would appear that gain from land sales is ineligible for averaging whether that gain is taxed as capital gain, ordinary income, recaptured depreciation or “unrecaptured § 1250 gain” and where that gain is attributable to the soil.

Note:  The IRS position is that gains from assets considered to be part of the land (buildings, fences and tile lines, for example) are eligible for income averaging. 

Planning Points

Phase-outs, rates and limitations.  Income averaging doesn’t impact the taxable income or tax of any of the three base years.   That means that it is not a “carryback” of current income to the base year.  Instead, it’s just a reference to the base year’s marginal income tax rate for the purpose of applying that rate to a portion of current year taxable income.  What that means is that income averaging does not change the phase-outs or percentage limitations of the base year tax returns.  Treas. Reg. §1.1301-1(d)(1).  Also, when tax rates go up, all else staying the same, an income averaging election can benefit top bracket filers.  In that situation, the election will always reduce the tax rate.  While an increase in rates isn’t going to happen in the near future, when they increased starting in 2013, top bracket filers benefited from income averaging for 2013, 2014 and 2015.

Capital gain rate reduction.  The averaging election can be made on both ordinary and capital gains, but clarification by the IRS indicates that an equal portion of each type of income must be carried to each prior year.  From a tax planning standpoint, an income averaging election can be made on ordinary income and, with proper planning, the effective rate on non-farm capital gains can be reduced.  Likewise, when the top capital gain rate increased 33 percent to a 20 percent rate beginning in 2013, the averaging election had the impact of reducing the rate to 15 percent.  It also could, perhaps, eliminate it.  That could be a big deal for a farmer that sells breeding stock or other assets that trigger capital gain. 

Alternative minimum tax.  The income averaging election has no direct impact on how the alternative minimum tax (AMT) is calculated.  The taxpayer can’t “average” the AMT calculation.  But, look to make the averaging election in a year in which the farmer triggers AMT.  A tax benefit can be derived.  Also, see whether an increase in taxable income might decrease the AMT.  In that event, the marginal tax rate for top bracket farmers will drop.  Likewise, look for situations where AMT income exceeds the phase-out of the AMT exemption and the tentative minimum tax exceeds the regular income tax before averaging both before and after adding incremental income.  If you have that situation, the AMT will decline.  Also, because there is no AMT floor on the use of averaging, the election can be quite beneficial in a year when a farmer has an income spike (maybe from a machinery sale or because a large amount of carryover grain is sold (especially at high prices).  In addition, watch for planning opportunities when the farmer has substantial nonbusiness expenses that exceed nonbusiness income in the base years. 

Note:  The Tax Cuts and Jobs Act increased the AMT exemption amount.  For 2022, the amount is $75,900 for single filers and $86,200 for married filing joint filing status. 

Other tax items.  There are numerous other tax items that can potentially be impacted by an averaging election.  Here’s a listing of a few of the more prevalent ones:

  • An income averaging election doesn’t impact self-employment tax. But, it can generate big self-employment tax savings if it drops income beneath the social security base.   
  • As for the “kiddie tax,” making the election on the parents’ return will cause the child’s tax on investment income to be applied by using the parents’ rate after shifting the elected farm income. But, in the base years, the kiddie tax is not affected by the election.   §1.1301-1(f)(5).
  • For losses and carrybacks, any net operating loss carryovers or net capital loss carryovers to an election year are applied to the election year income before the elected farm income is subtracted. Think that one through.  The election could create a tax advantage.
  • An individual is not prohibited from making an income averaging election solely because the individual’s filing status is not the same as in the base years.  § 1.1301-1(f)(2).However, the IRS has not provided guidance on how the remaining bracket amounts are to be divided between the spouses if both spouses have elected income averaging in a year following divorce.
  • In addition, negative figures can be utilized. That’s good news for many farmers that are presently experiencing tough economic times. However, it appears that negative elected farm income figures in the year of election cannot be used to reduce tax liability as calculated with reference to the three carryback years. 
  • An income averaging election can be made on a late or amended return if the period of limitations on filing a claim for credit or refund has not expired. Also, a previous election can be changed or revoked if the period of limitations has not expired.  This feature provides great flexibility in utilizing the election.

Conclusion

Farm income averaging can provide a significant tax savings for farm (and fishing) clients in certain situations.  One of those is the retiring farmer that has carryover grain sales and/or income from a machinery auction.  Also, it may be worthwhile to try to cause a farm client’s farm income to spike periodically (every three to four years) to avoid self-employment tax, while simultaneously lowering income tax costs by an election.  Also, look to utilize the election on behalf of maximum tax bracket taxpayers.  In addition, keep an eye on future tax legislation.  A change in tax rates and/or brackets can make an income averaging election important.  Of course, the present uncertainty in farm markets will influence farm income with swings from year-to-year, making a farm income averaging election a potentially useful tool. 

July 8, 2022 in Income Tax | Permalink | Comments (0)

Wednesday, July 6, 2022

Deductible Start-Up Costs and Web-Based Businesses

Overview

It’s costly to start a business – especially a farming or ranching business.  From a tax standpoint are the start-up costs deductible?  As with many tax questions, that answer is that it “depends.”  One item that the answer depends upon is when the business begins.  That’s a key determination in properly deducting business-related expenses. 

Recently the Tax Court applied the start-up expense rules to a web-based business.  When does a web-based business begin?  Does the business start when the website is brought online?  When sales are generated?  Some other time?  What costs are deductible?  These are all interesting and important questions – many businesses, including those that are ag -related are conducted online or conduct some of the business transactions online.

Deducting costs associated with starting a business – that’s the topic of today’s post.

Categorization – In General

The Code allows deductions for various expenses that are related to a taxpayer’s investments that don’t amount to a business if the expenses are ordinary and necessary for the production or collection of income or are for the management, conservation or maintenance of property held for the production of incomeI.R.C. §212.

Once the business begins, all of the ordinary and necessary expenses of operating the business (on a basis that is regular, continuous and substantial) that are paid or incurred during the tax year are deductible. I.R.C. §162.  But business start-up costs are handled differently I.R.C. §195.

Start-Up Costs

I.R.C. §195(a) generally precludes taxpayers from deducting startup expenditures.  However, by election, a taxpayer can deduct business start-up expenses on the return for the year that the business begins. I.R.C. §195(b).  The election is irrevocable.  Treas. Reg. §1.195-1(b).  The deduction is the lesser of the amount of start-up expenses for the active trade or business, or $5,000 reduced (but not below zero) by the amount by which the start-up expenses exceed $50,000.  I.R.C. §195(b)(1)(A); I.R.C. §195(b)(1)(A)(i).  Once the election is made, the balance of start-up expenses are deducted ratably over 180 months beginning with the month in which the active trade or business begins.   I.R.C. §195(b)(1)(B); Treas. Reg. §1.195-1(a).  This all means that in the tax year in which the taxpayer’s active trade or business begins, the taxpayer can deduct the $5,000 amount (if that’s the lesser of, etc.) and the ratable portion of any excess start-up costs. 

The election is normally made on a timely filed return for the tax year in which the active trade or business begins.  However, if the return that year was timely filed without the election, the election can be made on an amended return that is filed within six months of the due date for the return (excluding extensions).  The amended return should clearly indicate that the election is being made and should state, “Filed pursuant to section 301.9100-2” at the top of the amended return.  Without the election, the start-up costs should be capitalized. 

What are start-up expenses?  Amounts paid or incurred in connection with creating an active trade or business are startup expenditures. I.R.C. §195(c). More specifically, start-up costs are amounts that the taxpayer pays or incurs for: investigating the creation or acquisition of an active trade or business; creating an active trade or business; or activities that the taxpayer engages in for profit and for the production of income before that day on which the active trade or business begins, in anticipation of the activities becoming an active trade or business, and which would be deductible in the year paid or incurred if in connection with an active trade or business.  I.R.C. §§195(c)(1)(A)(i-iii); 195(c)(1)(B).  Common types of start-up expenses include advertising costs; salaries and wages; and expenses related to travel.  See, e.g., IRS Field Service Advice 789 (1993).  But, interest expense, state and local taxes, and research and experimental expenses are not start-up expenses.  I.R.C. §195(c)(1). 

Start-up expenses are limited to expenses that are capital in nature rather than ordinary.  That’s an important point because it means that I.R.C. §195 does not bar the deductibility of ordinary and necessary expenses a taxpayer incurs in an ongoing activity for the production of income under I.R.C. §212.  In addition, it makes no difference that the activity is later transformed into a trade or business activity under I.R.C. §162.  For example, in Toth v. Comr., 128 T.C. 1 (2007), the taxpayer started operating a horse boarding and training facility for profit in 1998.  The activity showed modest profit the first few years but had really taken off by 2004.  For 1998 and 2001, the taxpayer claimed expenses from the activity on Schedule C as ordinary and necessary business expenses deductible in accordance with I.R.C. §162, but she later determined that the expenses should be deducted in accordance with I.R.C. §212 as miscellaneous itemized deduction on Schedule A (which are presently suspended through 2025).  However, the IRS took the position that the taxpayer anticipated that the horse activity would become an active trade or business and, as such, her expenses had to be capitalized under I.R.C. §195.  The Tax Court agreed with the taxpayer.  Start-up expenses, the Tax Court said, were capital in nature rather than ordinary.  Thus, once her income producing activity began her expense deductions were not barred by I.R.C. §195.  It didn’t matter that the activity later became a trade or business activity under I.R.C. §162

When Does the Business Begin? 

A taxpayer cannot deduct or amortize startup expenditures if the activities to which the expenditures relate fail to become an “active trade or business.”  See I.R.C. §§195(a), (c).  There are no regulations that help define when a trade or business begins, so the question is answered based on the facts and circumstances of a particular situation.   To be engaged in a trade or business, a taxpayer must: (1) undertake an activity intending to make a profit, (2) be regularly and actively involved in the activity, and (3) actually have commenced business operations.  See, e.g., McManus v. Comr., T.C. Memo. 1987-457, aff’d., 865 F.2d 255 (4th Cir. 1988).  In addition, the courts have held that a taxpayer is not engaged in a trade or business “until such time as the business has begun to function as a going concern and performed those activities for which it was organized.” Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965). Likewise, an activity doesn’t have to generate sales or other revenue for the business to be deemed to have begun.  Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 620 (7th Cir. 1995), aff’g., in part, rev’g. in part, and remanding T.C. Memo. 1994-316; Jackson v. Commissioner, 864 F.2d 1521, 1526 (10th Cir. 1989), aff’g., 86 T.C. 492 (1986). However, merely researching or investigating a potential business is not enough.  Dean v. Commissioner, 56 T.C. 895, 902-903 (1971).

In Smith v. Comr., T.C. Sum. Op 2019-12, the Tax Court was convinced that the taxpayer had started his vegan food exporting business.  The Tax Court noted that the taxpayer had been peddling his vegan food products in Jamaica, the Dominican Republic, Brazil, Argentina and Columbia.  However, he was having trouble getting shelf space.  Thus, for the tax year at issue, he showed expenses associated with the activity of about $41,000 and gross sales of slightly over $2,000.   The IRS largely disallowed the Schedule C expenses due to lack of documentation and tacked on an accuracy-related penalty.  After issuing the statutory notice of deficiency, the IRS said the expenses were not deductible because they were start-up expenditures.  Because IRS raised the I.R.C. §195 issue at trial, the IRS bore the burden of proof on the issue.  The Tax Court determined that the taxpayer was, based on the facts, engaged in a trade or business.  He had secured products to sell, actively marketed those products, attended food shows and other meetings around the Caribbean and South America and had established a network to find potential customers.  Thus, I.R.C. §195 did not apply to limit the deduction of the expenses – they would be deductible under I.R.C. §162.  Or would they?

Note:  To be deductible under I.R.C. §162 as an ordinary and necessary business expense on Schedule C (or Schedule F), the taxpayer must substantiate the expenses.  Here’s where the IRS largely prevailed in Smith.  The Tax Court determined that the taxpayer had not substantiated his expenses.  Thus, the expenses were not deductible beyond (with a small exception) what the IRS allowed.  The Tax Court also upheld the accuracy-related penalty.

When Does a Web-Based Business Begin?

When does a business begin when the business is web-based?  The Tax Court had not previously addressed the  application of the start-up expense rules and the active conduct of a trade or business test in the context of a web-based business until it’s decision in  Kellett v. Comr., T.C. Memo. 2022-62.  In Kellett, the petitioner launched a retail website in 2002, which he operated until 2007. He then accepted a couple of jobs with internet research firms. While working full-time, the taxpayer began work on a website that collated demographic, social and economic data that would be useful to any number of companies. He hired remote engineers to develop the website and develop user interfaces using open code software. The website was functional by March of 2015, the bugs were worked out, and the website launched in September of 2015, but no revenue was generated until 2019.  The petitioner claimed deductions for the amount paid to the software engineers, to marketing companies, and for home internet access and other miscellaneous expenses on his 2015 Schedule C as trade or business expenses. The IRS claimed that the expenses were start-up expenses under I.R.C. §195 to be amortized ratably over 180 months beginning in September of 2015.

The Tax Court recognized that the receipt of revenue is not a pre-requisite for a venture to establish that it is a trade or business. But, the Tax Court noted, a venture must at least try to sell goods or services. Here, the website did not even try to sell anything until after 2015.  The petitioner claimed that he could not successfully sell access to his website until a significant number of users actively used the website.  Thus, he didn’t charge a user fee and marketed the site to institutional users to build up an active user base.  The Tax Court accepted the petitioner’s argument and held that the 2015 activity from and after September 30, 2015, when the website launched, would be treated as trade or business activity for federal income tax purposes. Accordingly, the Tax Court allowed the petitioner to deduct all engineering expenses paid after September 30, 2015 and treated all engineering expenses paid on or before September 30, 2015, as start-up expenses. 

On other issues, the Tax Court reduced the petitioner’s claimed business use of the internet by one-half due to lack of evidence and denied a deduction for research and development expenses because the petitioner was not developing a new product, but merely using existing software to display and analyze date.  The Tax Court also held that the IRS had no statutory authority for its position taken in Rev. Proc. 2000-50, 2000-2 CB 601 that it would not challenge a taxpayer’s deduction for the costs of developing computer software even if the costs did not qualify as research and development expenses.

Conclusion

When a business is in its early phase, it’s important to determine the proper tax treatment of expenses.  It’s also important to determine if and when the business begins.  The Tax Cuts and Jobs Act makes this determination even more important.  Once these hurdles are cleared, the Smith case illustrates the importance of substantiating expenses to preserve their deductibility, and Kellett applies the start-up expense deductibility principles in the context of a web-based business.

July 6, 2022 in Income Tax | Permalink | Comments (0)

Tuesday, July 5, 2022

What is the Character of Land Sale Gain?

Overview

When land is sold, is the gain on sale taxed as capital gain (preferential rate) or as ordinary income?  As with most answers to tax questions, the answer is that “it depends.”  Most of the time, when a farmer or ranchers sells land, the gain will be a capital gain.  But, there can be situations where the gain will be ordinary in nature – particularly when farmland is subdivided or sold off in smaller tracts.  That’s a technique, by the way of some farm real estate sellers, especially in the eastern third of the United States.   It's also becoming a more popular technique for farmland to be strategically purchased as an investment asset given the economic downturn and poorer returns from stock market investments.  Does selling the land in smaller tracts, or subdividing it create ordinary gain rather than capital gain?  What about buying a tract in the path of future urban development and holding it for purposes of later sale at an appreciated price?

A couple of recent cases illustrate the issue of what a capital asset is and the safe harbor that can apply when land is sold that has been subdivided or sold off in smaller tracts.

The character of gain on sale of land and a possible “safe harbor” – that’s the topic of today’s post. 

What Is A Capital Asset?

I.R.C.§1221(a) broadly defines the term “capital asset” as all property held by the taxpayer.  Eight exceptions from that broad definition are provided.  The first exception, I.R.C. §1221(a)(1), states that property that is either inventory or like inventory cannot qualify as a “capital asset.” In particular, I.R.C. §1221(a)(1) says a capital asset does not include “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”  Whether a landowner is holding land primarily for sale to customers depends on the facts. As the U.S. Circuit Court of Appeals for the Tenth Circuit put in in the classic case of Mauldin v. Commissioner195 F.2d 714 (10th Cir. 1952), “There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. Each case must, in the last analysis, rest upon its own facts.”  The Fifth Circuit has said essentially the same thing in Suburban Realty Co., v. United States, 615 F.2d 171 (5th Cir. 1980)

Subdividing Real Estate

When property is subdivided and then sold, the IRS may assert that the property was being held for sale to customers in the ordinary course of the taxpayer’s trade or business.  If that argument holds, the gain will generate ordinary income rather than capital gain.  However, there is a Code provision that can come into play.  I.R.C. §1237 provides (at least) a partial safe harbor that allows a taxpayer “who is not otherwise a dealer”… to dispose of a tract of real property, held for investment purposes, by subdividing it without necessarily being treated as a real estate dealer.”  If the provision applies, the taxpayer is not treated as a “dealer” just simply because the property was subdivided in an attempt to sell all or a part of it.  But, the safe harbor only applies if there is a question of whether capital gain treatment applies.  If capital gain treatment undoubtedly applies, I.R.C. §1237 does not apply.  See, e.g., Gordy v. Comr., 36 T.C. 855 (1961). 

What is a “dealer”?  It’s not just subdividing land that can cause a taxpayer to be a “dealer” in real estate with gains on sale taxes as ordinary income.  That’s the result if the taxpayer is engaged in the business of selling real estate; holds property for the purpose of selling it and has sold other parcels of land from the property over a period of years; or the gain is realized from a sale in the ordinary operation of the taxpayer’s business.  In addition, it’s possible that a real estate dealer may be classified as an investor with respect to some properties sold and capital gains treatment on investment properties.  But, as to other tracts, the dealer could be determined to be in the business of selling real estate with the sale proceeds taxed as ordinary income.  See, e.g., Murray v. Comr., 370 F.2d 568 (4th Cir. 1967). 

The “Safe Harbor”

I.R.C. §1237 specifies that gain from the sale or exchange of up to five lots sold from a tract of land can be eligible for capital gain treatment.  Sale or exchange of additional lots will result in some ordinary income.  To qualify for the safe harbor, both the taxpayer and the property must meet the requirements of I.R.C. §1237 and make an election to have the safe harbor apply.  For the taxpayer to qualify for the election, the taxpayer cannot be a C corporation.  Presumably, an LLC taxed as a partnership would qualify.  For property to qualify, it must have not previously been held by the taxpayer primarily for sale to customers in the ordinary course of business; in the year of sale, the taxpayer must not hold other real estate for sale as ordinary income property; no substantial improvement that considerably enhances the property value has been made to the property (see I.R.C. §1237(b(3); Treas. Reg. §1.1237-1(c)); and the taxpayer must have held the property for at least five years.  I.R.C. §1237(a).

If the requirements are satisfied, the taxpayer can elect to have the safe harbor apply by submitting a plat of the subdivision, listing all of the improvements and providing an election statement with the return for the year in which the lots covered by the election were sold.     

Recent Cases

Sugar Land Ranch Development, LLC v. Comr., T.C. Memo. 2018-21.  In Sugar Land, the taxpayers formed a partnership in 1998 to buy and develop land outside of Houston for the purpose of turning that land into housing developments and commercial developments. The partnership acquired various parcels of land totaling about 950 acres. The land had been a former oil field and so over the years the partnership cleaned up the land, built a levee, and entered into a development contract with the city of Sugar Land, Texas to set up the rules for developing the lots.  All of this sounds like the characteristics of a “developer” doesn’t it?

By 2008, the partnership had done a lot of work developing the land.  But, then the downturn in the real estate market hit and the partnership stopped doing any more work.  It wasn’t until 2012 that the partnership sold any significant part of the land. In that year it sold two parcels (about 530 acres) to a homebuilding company.  The homebuilding company paid a lump sum for each parcel, and also agreed to make future payments relating to the expected development.  A flat fee was paid for each plat recorded, and the homebuilding company paid two percent of the final sales price of each house developed on one of the parcels.

The partners entered into a “Unanimous Consent” dated December 16, 2008, declaring that the partnership would no longer attempt to develop the land but would instead hold the land until the real estate market recovered enough to sell at a profit.

The partnership reported an $11 million gain from the sale of one parcel and a $1.6 million loss on the other parcel. It took the position that the land sold was a “capital asset” and so the gains and losses were capital gains and losses.  The IRS disagreed.  After all, it pointed out that the partnership acquired the property to develop it and merely delayed doing so because of the economic downturn.

Ultimately, the Tax Court agreed that the partnership had successfully changed its operations after 2008 from “developer” to “investor” such that the land it sold in 2012 was a capital asset and the gain was a capital gain.  That made a big bottom-line tax difference.

Observation:  The partnership in Sugar Land Ranch Development, LLC never actually subdivided the property at issue into separate lots, and the IRS still claimed it was acquired and held for development purposes.  While capital gain classification is based on a facts and circumstances test, subdividing land for sale doesn’t necessarily mean that it’s no longer a capital asset.  That’s the point of I.R.C. §1237 and the safe harbor.  In addition, the facts can cause the reason for holding property to change over time.  That, in turn, can change the tax result. 

Musselwhite v Comr., T.C. Memo. 2022-57.  In Musselwhite, the petitioner had been involved in real estate ventures since the mid-1980’s.  In 2005, the petitioner and his business partner formed an LLC.  In 2006, the LLC bought four unimproved lots for $1 million and re-platted them into nine lots.  The terms of the sale agreement included certain guarantees-of-resale-within-one-year, allocation of ownership of the nine lots between the parties with the seller allocated five lots.  The sales agreement also included buy-back provisions and other conditions related to development and sale of the lots.  The seller was to complete improvements on some of the lots. The petitioner financed the purchase of the lots via a loan from a bank. 

In 2007, the real estate market collapsed.  Because the seller didn’t make promised improvements and also because of the lack of sales, the LLC sued the seller.  To settle the suit, the seller transferred his partially improved lots to the petitioner.  The LLC made no further improvement to those lots.  The bank’s later appraisals indicated that the lots were not known to be for sale.  The LLC divided up the lots and the existing debt and distributed four of the lots to the petitioner.  Within four months, the petitioner sold the lots at a loss of $1,022,726 and reported a Schedule C deduction of $1,022,726 as cost of goods sold.  The IRS disagreed, characterizing the loss as a capital loss because the lots were, in the IRS view, capital assets. 

The Tax Court agreed with the IRS that the lots were capital assets and did not meet the definition of stock in trade under I.R.C. §1221(a)(1) that would either be held in inventory or held primarily for sale to customers in the ordinary course of business.  The Tax Court noted that the distinction between a capital asset and one held for sale to customers in the ordinary course of business is a fact question.  Those factors in the Fourth Circuit (the Circuit to which the case would be appealable) include: 1) the purpose for which the property was acquired; 2) the purpose for which the property was held; 3) improvements, and their extent, that the taxpayer made to the property; 4) the frequency, number and continuity of sales; 5) the extent and substantiality of the transaction; 6) the nature and extent of the taxpayer’s business; 7) the extent of advertising of lack thereof; and 8) the listing of the property for sale directly through a broker.  The Tax Court noted that no single factor is determinative, but that the factors overwhelmingly favored the IRS. 

Observation:  In Musselwhite, the Tax Court also noted that the reason a taxpayer holds real estate can change if, for example, the taxpayer develops investment property to prepare it for sale.  Also, the Tax Court pointed out that I.R.C. §735(a)(2) provides that gain or loss on the sale or exchange by a partner of inventory items distributed to the partner by the partnership is ordinary income/loss if the items are sold or exchanged within five years from the date of distribution. 

Conclusion

In the vast majority of situations when a farmer or rancher sells farmland, the sale will qualify for capital gain treatment.  However, there can be situations where ordinary income treatment can be the result.  In difficult economic times such as the present, farm and ranch land might be a decent investment hedge against inflation.  Investment in land that isn’t really used in the farming or ranching business might raise IRS “eyebrows” upon sale with an assertion that the gain on sale is ordinary in nature.

July 5, 2022 in Income Tax | Permalink | Comments (0)

Sunday, July 3, 2022

Farm/Ranch Tax, Estate and Business Planning Conference August 1-2 – Durango, Colorado (and Online)

Details

This summer’s second premier national ag income tax and estate/business planning conference will be in Durango, Colorado on August 1 and 2 at Fort Lewis College.  The first conference was held at the Wisconsin Dells in mid-June.  If you aren’t able to attend in-person, the conference will be live-cast on the web. 

Day 1 Itinerary

  • I will start off Monday August 1 with a tax update covering key rulings and cases of recent vintage. This session will keep you updated on what the tax issues are in the courts and with the IRS. 
  • Paul Neiffer with CliftonLarsonAllen will take us through the tax reporting issues with various federal farm programs and the options for deferring crop insurance.
  • I will then have a session on correcting depreciation errors. When can an amended return be filed and when is Form 3115 required?
  • Paul will then cover research and development credits and how to claim them on an amended return. He will follow this session with another session on farm net operating losses – a tax technique that has been modified several times in recent years.  Making and revoking elections will be addressed.
  • During the last morning session, I will cover taxation of retailer reward programs from the perspective of both the retailer and the customer. These programs are popular among many ag retailers.  I will also address the proper tax treatment of demolishing structures on the farm.
  • After the luncheon, Tiffany Robinson of the Criminal Investigation Division of IRS will provide insight from the Division’s perspective on how a business can identify data breaches, how the “Dark Web” is utilized for cyber-crimes, and crypto crimes.
  • The afternoon session involves myself and Paul covering numerous farm tax topics from machinery trades to inventory accounting, to early termination of CRP contracts, weather-related livestock sales and contribution margin analysis.

Day 2 Itinerary

  • Tuesday August 2 opens with my update of cases and rulings pertaining to farm business structures and estate planning.
  • I will follow my opening session with a discussion of succession planning strategies with intentionally defective grantor trusts and grantor-retained annuity trusts.
  • After the morning break, Tim O’Sullivan of the Foulston firm in Wichita, Kansas, will address income and estate planning techniques for estates of all sizes and how to fit those techniques with your client’s particular goals and objectives.
  • The final morning session will involve Mary Ellen Denomy, a nationally known speaker on oil and gas issues and CPA addressing how to report oil and gas royalties and working interest payments on the tax return; estate plans for clients with oil and gas interests; whether clients are being paid according to their agreements; and the role of the CPA in these situations.
  • After the luncheon, Mark Dikeman of the Kansas State University Farm Management Association will provide a session on farm economics and how to analyze the economic health of a client’s farming/ranching business. What is the true financial health of the business as opposed to what the tax return might say?
  • The next session is an absolute must if you represent clients with water rights. This panel session will involve three practitioners (one from Kansas (Mike Ramsey) and two from Colorado (Andy Morehead and John Howe) that will cover water rights in the context of income tax and estate/business planning.  How do water rights impact sale and transition transactions? 
  • Shawn Leisinger and I will close out the day with an hour of ethics focusing on asset protection planning - the right way to do it and the potential ethical violations if it is not done properly. This will be an eye-opening session.

Attend Online

If you can’t attend in person, attendance may be virtually. 

Accreditation

Washburn Law School is an NASBA certified CPE provider. For accountants, the conference qualifies as GIB, but is also offered in GL format.  The conference also qualifies for CLE credit for attorneys. 

Additional Information

More information about the conference and how to register can be found at this link:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html

Conclusion

If you have a rural practice or represent farm and ranch clients on their tax or estate/business planning issues, this conference is a “must attend” conference.  I hope to see you there or online.

July 3, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, June 29, 2022

S Corporation Dissolution – Part Two; Divisive Reorganization Alternative

Overview

In Part One earlier this week, the focus was on the tax issues associated with liquidating an S corporation.  In Part One, I noted that the same general liquidation rules apply to an S corporation as to a C corporation.  However, the tax cost is significantly smaller unless the S corporation is subject to built-in gains taxation.  One other point to note is that an S corporation must be liquidated in the same tax year as the sale/distribution of assets to produce the desired tax result.  If a sale/distribution of assets is accomplished in one tax year and the liquidation of the corporation in the following year, the capital loss produced upon liquidation would not offset the capital gain generated by the sale of assets.  In such a case, the capital loss produced upon liquidation would only offset other long-term capital gains for the tax year of the liquidation, plus $3,000 of ordinary income.  The remaining long-term capital loss would be carried forward to subsequent tax years.

An alternative to liquidating an S corporation is a divisive reorganization – and it’s the topic of today’s post.

Alternative to Liquidation – Divisive Reorganization

An alternative to liquidating an S corporation at the death of the surviving spouse is a divisive reorganization under I.R.C. §355.  This can be an option where heirs exist that are interested in continuing the farming/ranching business.  In a divisive reorganization, part of the assets of a parent corporation are split-off to one or more (former) shareholders through a new corporation.  A divisive reorganization typically involves three major steps:

  • Formation of a new subsidiary corporation;
  • Transfer of part of the parent corporation’s assets to the subsidiary (usually tax-free); and
  • Distribution of the stock in the subsidiary to some of the parent corporation’s shareholders in exchange for their stock in the parent corporation.

A divisive reorganization can be used to divide a single, functionally integrated business (e.g. farming operation) into two separate businesses and will allow surviving shareholders to postpone income recognition that would otherwise occur through corporate liquidation at the death of the first generation shareholders.  Treas. Regs. §§1.355-1(b) & 1.355-3(c), Examples 4 & 5.  See also, Rev. Rul. 75-160, 1975-1 CB 112; Coady v. Com’r., 33 T.C. 771 (1960), acq., 1965-2 C.B. 4, non. acq., 1960-2 C.B. 8 (withdrawn), aff’d., 289 F.2d 490 (6th Cir. 1961); United States v. Marett, 325 F.2d 28 (5th Cir. 1963).

For a divisive reorganization to be tax-free, five tests under IRC §355 must be met:

  • Control test;
  • Active conduct of a business” test;
  • Distribution of “solely stock or securities”;
  • Parent corporation must distribute all of the stock in the subsidiary (or enough for control); and
  • Reorganization must not be used “primarily as a device for distribution of earnings and profits.”

While, technically, these five tests must be satisfied for a divisive reorganization to be tax-free, in reality, only two of the tests generally create issues that could prevent a reorganization from being utilized.  The two problematic requisites/tests are the active conduct of trade or business requirement and the trade or business requirement. 

Active conduct of trade or business.  For purposes of I.R.C. §355, a trade or business must have been actively conducted by the distributing parent corporation throughout the five-year period ending on the date of distribution.  The regulations under I.R.C. §355 expand this requirement and require continued operation of the business or businesses existing before the implementation of the divisive reorganization. Accordingly, a transitory continuation of one of the active businesses would not satisfy the active trade or business test provided by these regulations.  I.R.C. §355(b)(1)(A); Treas. Reg. §1.355-3(a)(1).

Guidance on the active trade or business requirement:

  • The holding of stock and securities for investment purposes will not constitute the active conduct of a trade or business. Also, the ownership and rental of real or personal property (e.g., farm real estate) will not constitute the active conduct of a trade or business unless the owner performs significant services with respect to the operation and management of the property. Treas. Reg. §1.355-3(b)(2)(iv).
  • Rul. 73-234, 1973-1 CB 180 involved a corporate farming operation where the active conduct of a trade or business test was satisfied. The facts involved a livestock share lease with active involvement.  The IRS states, “the fact that a portion of a corporation’s business activities is performed by independent contractors will not preclude the corporation from being engaged in the active conduct of a trade or business if the corporation itself directly performs active and substantial management and operational functions.” 
  • The active conduct of a trade or business test was not met in Rev. Rul. 86-126,1896-2 CB 158. The facts involved a corporation that cash rented farmland.  There was a sharing of expenses.  The tenant planted, raised, harvested and sold the crops using the tenant’s equipment.  The activities of the corporate officers in leasing the land, providing advice and reviewing accounts were determined to not be substantial enough to meet the active trade or business requirement. 

Note.  It does not appear that the use of a farm manager (agent) to perform these services for the corporation necessarily impairs the active conduct of a trade or business requirement.  Webster Corp. v. Comr., 25 T.C. 55 (1955), acq. 1960-2 C.B. 4,.7, aff’d., Comr. v. Webster Corp., 240 F 2d 164 (2d Cir. 1957).  However, the officers and directors must be active in directing the activities of the agent, not mere spectators.

Caution - Tax Planning:  The corporation’s officers and directors’ activities for the pre-distribution (5 yr.) and post-distribution (suggested as 2 years or more) time frames should be well documented before a divisive reorganization is undertaken.  Also, payment of at least nominal officer/director salaries for services performed should be considered.

Trade or business purpose.  Treas. Reg. §1.355-2(b)(2) provides that a corporate business purpose must be a real and substantial non-federal tax purpose germane to the business of the distributing corporation, as well as the controlled corporation.  A shareholder purpose (e.g. accomplishing personal estate planning objectives) by itself, is not a corporate business purpose.  However, the regulations go on to explain that a shareholder purpose may be so nearly co-extensive with a corporate business purpose as to preclude any distinction between them, in which case the transaction meets the corporate business purpose requirement.  A transaction motivated in substantial part by a corporate business purpose will not fail the business purpose requirement merely because it is motivated in part by non-federal tax shareholder purposes.

Note.  According to the Treasury Regulation, the whether the business purpose test has been satisfied is generally readily ascertainable (e.g. shareholder disputes or potential therefore, etc.). 

Examples.  Rev. Rul. 2003-52, 2003-1 C.B. 960 involved a family farming corporation that the parents and their two adult children owned.  The children provided active management.  One child intended to focus on the livestock side of the business while the other child preferred to operate the grain farming operation.  The corporation reorganized into two corporations, with one child receiving the stock of the livestock business and the other child receiving the stock of the grain enterprise.  The IRS approved the reorganization on the basis that it was motivated by a substantial non-tax business purpose even though the reorganization advanced the personal estate planning goals of the parents and promoted family harmony. 

Private Letter Ruling 200323041 (Mar. 11, 2003) involved the separation of a grain farming business between siblings after their father’s death.  The IRS concluded that a corporate split-off that is undertaken to avoid shareholder disputes in a family-owned grain farming corporation (engaged in a single line of business) will constitute a divisive reorganization under I.R.C. §368(a)(1)(D) and the stockholders of the split-off corporation would not recognize gain or loss under I.R.C. §355.  See also Priv. Ltr. Rul. 200425033 (Mar. 4, 2004) and Priv. Ltr. Rul. 200422040 (Feb. 13, 2004)(same).  

Note.  The IRS has ruled that the post-distribution business purpose requirement of I.R.C. Reg. §1.355-2(b) remained satisfied even though the business purpose could not be achieved due to an unexpected change in circumstances following the divisive reorganization. In so ruling, the IRS noted that the “regulations do not require that the corporation in fact succeed in meeting its corporate business purpose, as long as, at the time of the distribution, such a purpose exists and motivates, in whole or substantial part, the distribution.”  Rev. Rul. 2003-55, 2003-1 C.B. 961.

Other considerations.  While I.R.C. §355 requires that the corporation seeking a divisive reorganization be engaged in the active conduct of a trade or business it does not require that all of the assets of the corporation be devoted to or used in an active trade or business.  The corporation may hold non-qualifying assets (generally less than 5% of total) as long as it is engaged in the active conduct of a trade or business. Treas. Reg. §1.355-(3)(a)(ii).

Planning recommendation.  It may be advisable to have all shareholders enter into an agreement providing that any shareholder who violates the post-distribution active trade or business rule agrees to pay all taxes incurred by all shareholders if the divisive reorganization fails to pass IRS scrutiny. 

Note:  In Rev. Proc. 2003-48, 2003-2 C.B. 86, the IRS stated that, for ruling requests after August 8, 2003, it would no longer rule on whether (1) a distribution of stock of a controlled corporation is carried out for business purposes, (2) the transaction is used principally as a device, or (3) a distribution and an acquisition are part of a plan under IRS §355(e).  Rather, taxpayers seeking a ruling under IRS §355 must submit representations on these issues for review and determination by IRS.

Conclusion

Tax issues do arise when an S Corporation is dissolved.  Fortunately, certain planning steps can be taken to avoid the heirs being denied the benefit of a basis increase in the corporate assets to fair market value at death.  A reorganization is one possible tax-efficient planning step that could be utilized.  Other planning options (not discussed in this two-part series) include liquidating the S corporation via a merger, and conversion of the S corporation to a partnership. 

June 29, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, June 27, 2022

S Corporation Dissolution – Part 1

Overview

The S corporation as an entity choice for the operating part of a farming or ranching business has waned over the years in favor of the general partnership (for larger operations) or the limited liability company (LLC).  While it can provide self-employment tax savings, those savings may also be achieved by using a different entity form.  Also, an S corporation requires a lot of administrative “maintenance” that some might find too cumbersome.  But, an S corporation does avoid the corporate level tax as a “flow-through” entity and is generally easy to switch to a different entity form (depending on the facts). 

While an S corporation might be an acceptable entity choice for professional service businesses such as law firms and accounting firms, it tends not to work as well as the operating entity for a farm or ranch.  The S corporation can also present some tricky issues upon liquidation.

Part one of a two-part series – tax (and income tax basis) issues upon liquidation of an S corporation.  It’s the topic of today’s post. 

For farm businesses large enough to qualify for more than one government farm program payment limit, a partnership will allow qualification.  An S corporation will be limited to a single payment limit. Another drawback of the S corporation is the adverse impact upon death of a shareholder.  That adverse impact is shown in the fact that the heirs of the deceased shareholder do not get the benefit of a step-up in basis in the underlying corporate assets to fair market value as of the date of the shareholder’s death.  Unlike a partnership where the heirs receive a full income tax basis increase for all of the underlying partnership assets, an heir of an S corporation shareholder only receives a basis increase in the corporate stock equal to the fair market value of the S corporation at death. 

Shareholder Death and Corporate Liquidation

Upon the death of an S corporation shareholder, the decedent’s stock ownership interest receives a step-up in basis to fair market value.  This basis adjustment coupled with the basis increase that results from gain recognition inside the corporation upon liquidation of corporate assets (e.g. sale/distribution of assets, real estate, etc.) and the pass-through of the taxation of this gain to the shareholder (on Schedule K-1), results in only one level of taxation being incurred on liquidation, and that is at the shareholder level. 

Since stock basis has been increased by death and pass-through of income, no gain recognition results when cash or property is distributed to the decedent’s estate/heirs (in exchange for stock) to complete the liquidation, since the pass-through gain (Schedule K-1) to the estate/heirs will be offset by a matching loss from liquidation of the stock.

Property Distributions

Distributions of property (other than cash) are treated as though the corporation sold the property to the shareholder for its fair market value, pursuant to I.R.C. §311(b).  The corporation recognizes gain to the extent the property’s fair market value exceeds its adjusted basis.  When appreciated property is distributed to an “S” corporate shareholder in exchange for stock, the gain recognized at the corporate level passes through to all shareholders (via Schedule K-1) based on their percentage ownership in the corporation. 

If the “S” corporation only had one shareholder whose interest is liquidated at death, gain recognition does not cause taxation problems due to a matching loss offset resulting from the stock basis adjustments discussed above.  In other words, when the S corporation recognizes table gain, that gain increases the estate’s basis in the stock in an amount equal to the taxable gain that the S corporation recognizes.  This taxable gain is reported to the estate on the corporation’s final Schedule K-1 (Form 1120S).  The estate’s tax basis in its S corporation stock is increased to the fair market value of the S corporation’s stock upon the shareholder’s death and is further increased as a result of the deemed sale of the S corporation stock upon liquidation.  Simultaneously, the estate recognizes a taxable loss equal to the gain reported to the estate on the corporation’s final Schedule K-1.  The loss on the deemed sale of the S corporation stock in the liquidation is reported on the estate’s or heir’s Schedule D (Form 1040 or Form 1041).  Typically, the S corporation gain on the Schedule K-1 (Form 1120S) reported on Schedule E (Form 1040 or Form 1041) and the loss on the Schedule D will net out with no tax due by the estate or the heirs for the S corporation gain on liquidation. 

Caution.  In some instances, a farming S corporation may have one spouse as a shareholder and own ordinary income assets such as grain and equipment.  Upon the shareholder’s death with the corporate stock passing to the surviving spouse, the sale of those assets by the surviving spouse will trigger ordinary income to the surviving spouse that will be taxed at the highest rate.  If the surviving spouse then liquidates the S corporation, a capital loss will be triggered in a like amount that will be reported at $3,000 per year (or offset against other capital gains). 

Note.  The business will now have a new step-up in basis in all of its asset which the heirs can contribute tax-free to a new partnership. 

However, if the “S” corporation has more than one shareholder, a distribution of property to a single shareholder (deceased or otherwise) in liquidation of their stock interest will result in a taxation event for all corporate shareholders.

Example:  Assume that Farm Corp. has four equal shareholders.  Mary, a shareholder who owns 25 percent of the S corporation’s stock dies.  The corporation distributes farm real estate to Mary’s estate in liquidation of her stock interest.  Mary’s estate would report 25 percent of any gain at distribution and would be able to offset this taxable gain through a matching capital loss created by the liquidation of her stock in Farm Corp.  Unfortunately, the other shareholders would be responsible for paying tax on the remaining 75 percent of any gain.

Note:  An alternative to avoid this taxation problem when there are multiple shareholders in an S corporation is to simply have the remaining shareholders purchase the stock of the deceased shareholder.  Implementing a corporate buy-sell agreement among the shareholders might be advantageous to accomplish the desired result.

A shareholder’s income tax basis in distributed property distributed by the corporation is the property’s fair market value at the date of distribution.  But the distributee shareholder’s holding period begins when the shareholder actually or constructively receives the property, because the distribution is treated as if the property were sold to the shareholder at its fair market value on that date.  Since the shareholder’s basis in the property is its fair market value (rather than a carryover of the corporation’s basis), the corporation’s holding period does not tack on to the shareholder’s holding period.  Thus, the redeeming shareholder would need to hold distributed property for one year after distribution prior to sale to achieve capital gain income tax treatment on a subsequent sale.

Conclusion

In Part Two, I will take a look at some alternatives for avoiding the negative tax consequences associated with liquidating an S corporation.

June 27, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Saturday, June 25, 2022

Tax Issues with Customer Loyalty Reward Programs

Overview

Many companies, including agribusiness retailers, utilize customer loyalty programs as a means of attracting and keeping customers.  Under the typical program, each time a customer or “member” buys a product or service, the customer earns “reward points.”  The reward points accumulate and are computed as a percentage of the customer’s purchases.  When accumulated points reach a designated threshold, they can then be used to buy an item from the retailer or can be used as a discount on a subsequent purchase (e.g., cents per gallon of off a fuel purchase).  Some programs may be structured such that a reward card is given to the customer after purchases have reached the threshold amount.  The reward card typically has no cash value and expires within a year of being issued. 

A “loyalty rewards” program is a cost to the retailer and a benefit to the customer, triggering tax issues for both. 

Tax issues associated with customer “loyalty” programs – it’s the topic of today’s post.

Treasury Regulations – Impact on Retailers

When is economic performance?  Treasury Regulation §1.461-4(g)(3) addresses the treatment of rebates and refunds and specifies that economic performance occurs when payment is made to the person to whom the liability is owed.  The IRS position is that a retailer cannot claim a deduction until the points are actually redeemed because the event fixing the retailer’s liability occurs when a member reaches the minimum number of points for redemption and actually redeems the points. Internal Revenue Manual 4.43.1.12.6.5(5); Priv. Ltr. Rul. 200849015 (Dec. 5, 2008).   But, for an accrual basis taxpayer, the taxpayer’s liability becomes fixed (and, hence, a deduction can be claimed) when the customers earn the rewards.  Giant Eagle, Inc. v. Comr., 822 F.3d 666 (3d Cir. 2016), rev’g., T.C. Memo. 2014-146. A deduction is not deferred until the customer redeems the rewards. 

Note:   The IRS does not agree on this point and follows the Third Circuit’s decision only in cases appealable to the Third Circuit that cannot be distinguished.  A.O.D. 2016-03 (Oct. 3, 2016).

Two requirements.  Treasury Regulation §1.451-4 addresses trading stamps and premium coupons that are issued with sales and are redeemable in cash, merchandise or “other property.”  Most retailer customer loyalty programs likely satisfy both tests. The National Office of IRS, in a matter involving an accrual basis supermarket chain that had a rewards program that allowed customers to get a certain amount of gas for free depending on purchases of products, said that the supermarket could take a current deduction for the value of the gas rewards. F.S.A. 20180101F (Nov. 7, 2017).   The IRS reached that result by concluding that the gas rewards were being redeemed for “other property.” Treas. Reg. §1,451-4(a)(1).  Clearly, the rewards were issued on the basis of purchases.

Loyalty reward programs that might not satisfy the “redeemable in cash, merchandise or other property test” might be programs that provide customers with cents-off coupons.  With these programs, the IRS could argue that a customer’s right to redeem the coupon is conditioned on a future purchase and, as a result, the coupon liability should be matched to the later sale when the liability becomes fixed and determinable and economic performance occurs.  I.R.C. §461.

Timing of deduction.  The regulation provides that the estimated redemption costs of premium coupons issued in connection with the sale of merchandise is deductible in the year of the merchandise sale, even though the reserves for future estimated redemption costs are not fixed and determinable and don’t otherwise meet the economic performance rules of the all-events test.  Internal Revenue Manual 4.43.1.12.6.5(4).

Retailers with loyalty programs that satisfy the two tests of Treas. Reg. §1.451-4 may find the use of this method preferential from a tax standpoint.  For retailers that can qualify but are not presently using the Treas. Reg. §1.451-4 approach, a method change is required. The method change is achieved by using the advance consent procedures of Rev. Proc. 97-27. 1997-1 C.B. 680. If a loyalty program does not meet the requirements to use Treas. Reg. §451-4, the redemption liability is treated as a deduction and not as an exclusion from income.  Thus, the redemption liability is taken into account in the tax year in which the liability becomes fixed and determinable and economic performance occurs under I.R.C. §461.  That will, in general, be the year in which the customer redeems the loyalty rewards. 

Tax Issues for Customers – The Anikeev case

A recent Tax Court opinion provides guidance on how a taxpayer, as a user of a rewards program, is to report the transactions on the taxpayer’s return, and whether the IRS “rebate rule” is applicable.  In Anikeev, et ux. v. Comr., T.C. Memo. 2021-23.   the petitioners, husband and wife, spent over $6 million on their credit card between 2013 and 2014. Nearly all of these purchases were for Visa gift cards, money orders or prepaid debit card reloads that the couple later used to pay the credit card bill.  The credit card earned them five percent cash back on certain purchases after they spent $6,500 in a single calendar year. Before purchases were sufficient for them to reach the five percent level, the card earned one percent cash back on certain purchases.

Rewards were issued in the form of “rewards dollars” that could be redeemed for gift cards and statement credits.  In 2013, the petitioners redeemed $36,200 in rewards dollars from the card as statement credits in 2013 and $277,275 in 2014.  The petitioners did not report these amounts as income for either year.  The IRS audited and took the position that the earnings should have been reported as “other income” as an exception to the IRS “rebate rule.”  Under the rule, when a seller makes a payment to a customer, it’s generally seen as a “price adjustment to the basis of the property.”  It’s a purchase incentive that is not treated as income.  Instead, the incentive is treated as a reduction of the purchase price of what is purchased with the rewards or points. Thus, points and cashback earned on spending are viewed as a non-taxable purchase price adjustment.  The petitioners cited this rule, pointing out that the “manner of purchase of something…does not constitute an accession of wealth.  The IRS, however, claimed that the rewards were taxable upon receipt irrespective of how the gift cards were later used. 

The Tax Court noted that the gift cards were a “product.”  Thus, the portion of their reward dollars associated with gift card purchases weren't taxable.  However, the Tax Court held that the petitioners’ direct purchases of money orders and reloads of cash into the debit cards using their credit card was different in that the petitioners were buying “cash equivalents” rather than a rebate on a purchase.  Thus, the transaction did not involve the purchase of a product subject to a price adjustment.  The purchase of a cash equivalent was different than obtaining a product or service.  Because there was no product or service obtained in connection with direct money order purchases and cash reloads, the reward dollars associated with those purchases were for taxable cash infusions. 

The Tax Court also noted that the petitioners’ practice would most often have been ignored if it had not been for the petitioners’ “manipulation” of the rewards program using cash equivalents.  Thus, the longstanding IRS rule of not taxing credit card points did not apply.  Importantly, the Tax Court held that reward points become taxable when massive amounts of cash equivalents are purchased to generate wealth.  The petitioners did this by buying money orders and funding prepaid debit cards with a credit card for cash back, and then immediately paying the credit card bill. 

Note:  The Tax Court stated that it would like to see some reform in this area that provides guidance on the issue of credit card rewards and the profiting from buying cash equivalents with a credit card. 

June 25, 2022 in Income Tax | Permalink | Comments (0)

Monday, June 6, 2022

Wisconsin Seminar and…ERP (not Wyatt) and ELRP

Overview

Next week is the first of two summer ag tax and estate/business planning conferences that Washburn Law School is putting on.  Next week’s event on June 13 and 14 will be at the Chula Vista Resort, near the Wisconsin Dells.  One of the matters addressed on Day 1 will be issues that have arisen concerning the USDA’s Emergency Relief Program (ERP).  I have received numerous questions over the past few weeks concerning the program and we will be addressing them at the conference.

Issues with the ERP – it’s the topic of today’s post.

In General

I won’t go into too much detail about the ERP here because Paul Neiffer and I will do that at the Wisconsin conference.  What follows are comments that Paul and I have been providing to those raising questions of us in recent days.  Paul has also recently blogged on the issue and with today’s post I will largely summarize and reiterate what he has commented on for the readers of this blog.  In addition, there are additional meetings occurring in D.C. this week with IRS which will hopefully result in greater clarification on some presently unclear issues (not covered in this post).  If there are additional clarifications, we will discuss those at next week’s event in Wisconsin. 

The Extending Government Funding and Delivering Emergency Assistance Act (P.L. 117-43) (Act) was signed into law on September 30, 2021.  The Act includes $10 billion for farmers impacted by weather disasters during calendar years 2020 and 2021.  $750 million is to be directed to provide assistance to livestock producers for losses incurred due to drought or wildfires in calendar year 2021 (the Emergency Livestock Relief Program – (ELRP)).

Livestock provisions. 

To receive a Phase 1 payment, a livestock producer must have suffered grazing losses in a county rated by the U.S. Drought Monitor as having a severe drought) for eight consecutive weeks or at least extreme drought during the 2021 calendar year been approved for the 2021 Livestock Forage Relief Program (LFP). Those who would have normally grazed on federal but couldn’t be due to drought are eligible for a Phase 1 payment if they were approved for a 2021 LFP.  Various FSA Forms will need to be submitted. 

ELRP Payment Calculation – Phase One

Payments are based on livestock inventories and drought-affected forage acreage or restricted animal units and grazing days due to wildfire reported on Form 2021 CCC-853.  A payment will equal the producer’s gross 2021 LFP calculated payment multiplied by 75%, and will be subject to the $125,000 payment limitation. 

Crop insurance (or NAP) requirement.  In late 2021, the USDA provided some guidance to producers impacted by various weather-related events.  The former Wildfire and Hurricane Indemnity Program (WHIP+) was retooled and renamed as the ERP.  ERP will have two payments – two phases.  Phase 1 is presently underway, and Phase 2 may not happen until 2023.  ERP payments may be made to a producer with a crop eligible for crop insurance or noninsurance crop disaster assistance (NAP) that is subject to a qualifying disaster (which is defined broadly) and received a payment.  Droughts (a type of qualifying disaster) are rated in accordance with the U.S. Drought Monitor, where the qualifying counties can be found.

To reiterate, an ERP payment will not be made to any producer that didn’t receive a crop insurance or NAP payment in 2020 or 2021.  Because of this requirement, crop insurance premiums that an ERP recipient has paid will be reimbursed by recalculating the ERP payment based on the ERP payment rate of 85 percent and then backing out the crop insurance payment based on coverage level.     

In addition, the ERP requires that the producer receiving a payment obtain either NAP or crop insurance for the next crop years.  Also, a producer that received prevented planting payments can qualify for Phase 1 payments based on elected coverage. 

Note:  ERP payments are for damages occurring in 2020 and 2021 – so they are not deferable. 

Computation of payment and limits.  Once a producer submits their data to the FSA, an ERP application will be sent out for the producer to verify.  Applications started going out to producers in late May.  An ERP payment replaces the producer’s elected crop insurance coverage.  It’s based on a percentage with the total indemnity paid using the recalculated ERP percentage with any crop insurance or NAP payment subtracted. 

The ERP payment limit is $125,000 for specialty crops.  For all other crops, its $125,000 combined.  But, for an applicant with average adjusted gross income (AGI) (based on the immediate three prior years but skipping the first year back) that is comprised of more than 75 percent from farming activities, the normally applicable $900,000 AGI limit is dropped, and the payment limit goes to $900,000 for specialty crops and $250,000 for all other crops.  There is separate payment limit for each of 2020 and 2021. 

Note:  If the three-year computation of average AGI shows a loss, the enhanced payment limit is not available even if more than 75 percent of AGI is from farming activities.  In addition, the three-year computation is simply the applicant’s net income from farming compared with all of the applicant’s other sources of income as reported on the tax return. 

Definition of farm income.  Farm income for ERP purposes includes net Schedule F income; pass-through income from farming activities; farm equipment sale gains (if farm income exceeds two-thirds of overall AGI); wages from a farming entity; IC-DISC income from an entity that materially participates in farming (has a majority of gross receipts from farming).  Also counting as farm income for ERP purposes is income from packing, storing, processing, transporting and shedding of farm products. 

Certification.  To get the enhanced payment limit, a CPA or attorney must prepare a letter to be submitted with Form FSA-510 certifying that the applicant’s AGI is over the 75 percent threshold.  The FSA has a Form letter than can be used for this that is contained in its Handbook.  The FSA 6-PL, Apr. 29, 2022, Para. 489 discusses the 75 percent test and pages 8-73 through 8-74 is where the sample letter is located.  The “certification” may allow married farmers to eliminate the off-farm income of a spouse and make it possible to meet the 75 percent test if it otherwise would not be met.

 Conclusion

There are many finer details to the ERP as well as the ELRP that I haven’t covered in this post.  As I noted above, Paul Neiffer and I will be covering all of your questions at the conference next week in Wisconsin.  Also addressed at the conference will be a discussion of what's going on in the economy and U.S. and worldwide markets that are impacting agriculture.   If you haven’t registered, the conference is also broadcast live online and there’s still time to register.  Here’s the registration link:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html

June 6, 2022 in Business Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Monday, May 30, 2022

Recent Court Decisions Involving Taxes and Real Estate

The courts are constantly deciding tax issues.  Two recurring themes in numerous cases involve timing of asset sales and recordkeeping/substantiation.  Those two issues are on display in court opinions that I summarize.  On the real estate side of the ledger fence issues loom large (and always have) as do partition actions (don’t leave property at death to your children in co-equal undivided interests – just don’t) and warrantless searches of farmland. 

Recent court opinions involving taxes and real estate – it’s the topic of today’s post.

Recent Tax Cases of Interest

Questions Remain on “Unforeseen Circumstances” Exception Under I.R.C. §121

Webert v. Comm’r, T.C. Memo. 2022-32

The petitioners, a married couple, bought a home in 2005.  The wife was diagnosed with cancer later that year and underwent costly treatments.  They resided in the home until 2009 and then rented out the home and resided in another home the husband owned.  The sold the first home in 2015.  They filed joint returns for tax years 2010 through 2015.  During those years, they reported income from the lease of the first home on Schedule E.  They reported that they used the home for personal purposes for 14 days in 2010 and zero days in 2011 through 2015. Their depreciation schedules mirrored the number of fair rental days reported for the property on their Schedule E. On their 2015 return, they reported the sale of the first home but excluded the gain from gross income.  The IRS audited and asserted that the income from the sale of the home should have been reported and moved for summary judgment.  The Tax Court granted summary judgment to the IRS on the issue of whether the petitioners used the home as their principal residence for at least two of the last five years immediately preceding the sale as I.R.C. §121 requires.  They did not.  However, the Tax Court determined that issues of material fact remained on whether the wife’s health problems were the primary reason for the sale such that the gain might be excludible because the sale was on account of health or other unforeseen circumstance in accordance with I.R.C. §121(c)(2)((B).  

Jewelry Gift Not Properly Substantiated – Charitable Deduction Denied

Albrecht v. Commissioner, T.C. Memo. 2022-53

 In 2014, the petitioner donated approximately 120 pieces of Native American jewelry to a museum, a qualified charity.  The museum executed a “Deed of Gift” which specified, in part, that “all rights, titles, and interests” in the jewelry were transferred from the donor to the donee upon donation unless otherwise stated in the Gift Agreement.  The petitioner claimed a charitable deduction for the donation on her 2014 return and supported the claimed deduction by submitting the “Deed of Gift” documentation.  The IRS denied the deduction on the basis that the “Deed of Gift” documentation did not meet the substantiation requirements of I.R.C. §170(f)(8)(B) that require a description of the donated item(s), whether the donee provided any form of consideration in exchange for the donation, and a good faith estimate of the value of the donation. The IRS pointed out that the “Deed of Gift” documentation from the museum did not state whether the museum provided any goods or services in return for the donation. In addition, the terms of the “Deed of Gift” documentation with the museum referred to a superseding agreement, “the Gift Agreement,” which left open the question of whether the donor retained some title or rights to the donation, and also indicated that the petitioner’s documentation did not include the entire agreement with the done.  The Tax Court agreed with the IRS and held that the petitioner did not comply with the substantiation requirements of I.R.C. §170(f)(8)(B) and denied the charitable deduction. 

Legal Issues Related to Real Estate

Court Construes State Fence Law 

Yin v. Aguiar, 146 Haw. 254, 463 P.3d 911 (2020)

The plaintiff leased property from a third party for growing sweet potatoes. Under the lease, the plaintiff was responsible for keeping cattle from damaging his crop. The plaintiff filed a complaint against a neighboring cattle owner claiming that the cattle damaged over 13 acres of the plaintiff’s sweet potato crop and the landowner’s fence in the amount of $190,000. The cattle owner claimed he was not liable because the fence between the properties was not a legal fence.  The fence was less than 4 and ½ feet tall and was made from hog wire, which did not meet the state law requirements for a legal fence.  The cattle owner further pointed to the plaintiff’s lease, which stated the plaintiff was responsible for keeping cattle off the leased property. The state Supreme Court determined that that it was inappropriate to interpret state fence law to hold cattle owners solely responsible for properly fenced or entirely unfenced property (including property enclosed with improper fencing) because that did not comport with  the legislative intent of the fence laws.  But, the Supreme Court also concluded that to hold the plaintiff liable for the damage due to a clause in his lease agreement would be against public policy because upholding the clause would be contrary to state fence law that holds livestock owners responsible for escaped livestock in certain situations. The state Supreme Court remanded the case to the circuit court for further proceedings consistent with its opinion.

“Improvements” Valued in Partition Action

Claeys v. Claeys, No. 124,032, 2022 Kan. App. LEXIS 16 (Kan. Ct. App. May 6, 2022)

Two brothers each inherited an undivided one-third interest in farmland, and the wife of a deceased brother owned the other one-third interest via a trust created for her benefit.  She filed a partition action seeking to sever the co-ownership. The brothers counterclaimed, asserting they improved the value of the land and that her share should be offset to account for the improvements. The brothers obtained a water permit, installed an $83,000 ten-tower irrigation system to convert the dry land to irrigation crop farming, and spent over $10,000 on piping and a water meter.  The irrigation system was one brother’s personal property.  The sister in-law did not contribute to the cost of these improvements. Three commissioners were appointed to appraise the land and they valued the dryland at $390,000 and the irrigated land at $2,065,000.  She elected to take the smaller tract that was not worth as much. The commissioners determined that because her tract was less valuable, the brothers owed her $428,333 to account for her one-third interest. The trial court ultimately ordered the brothers to pay her the $428,333 for her one-third interest in the higher-valued land based on a finding that improvements were limited to physical structures and equipment.  $50,000 of the $428,333 was placed in escrow and the brothers filed a counterclaim that the $50,000 represented her one-third interest in the increased value from irrigation and should be credited against what they owed her.  The trial court ruled for the sister-in-law on the counterclaim, finding that the increase in value was attributable solely to the pivot irrigation system.  As personal property of one of the brothers, the irrigation system was not an “improvement.”  The trial court awarded the $50,000 to the sister-in-law.  On appeal, the appellate court held the trial court erred when it found the brothers did not improve the land.  The appellate court determined that Kansas law requires a broader inquiry into possible improvements to the land other than just physical structures and equipment.  The appellate court held that the improvements enhanced the property’s condition by increasing productivity and were not mere repairs or replacements.  Changing the land’s status from dry to irrigated and obtaining a water right improved the value of the land.  Accordingly, the appellate court held that such “improvements” should be considered to offset the sister-in-law’s share in the property and remanded the case to the trial court.

State Law Allowing Warrantless Searches Unconstitutional

Rainwaters, et al. v. Tennessee Wildlife Resources Agency, No. 20-CV-6 (Benton Co. Ten. Dist. Ct. Mar. 22, 2022)

The plaintiffs owned farmland on which they hunted or fished.  They marked fenced portions of their respective tracts where they hunted and posted the tracts as “No Trespassing.”  Tennessee Wildlife Resources Agency (TWRA) officers entered onto both tracts on several occasions and took photos of the plaintiffs and their guests without permission or a warrant. Tennessee law (Tenn. Code Ann. §70-1-305(1) and (7)) allows TWRA officers to enter onto private property, except buildings, without a warrant “to perform executive duties.”  The TWRA officers installed U.S. Fish & Wildlife Service surveillance cameras on the plaintiffs’ property without first obtaining a warrant to gather information regarding potential violations of state hunting laws.  The plaintiffs challenged the constitutionality of the Tennessee law and sought injunctive and declaratory relief as well as nominal damages. The defendants moved for summary judgment arguing that the plaintiffs lacked standing and that there was no controversy to be adjudicated. The trial court found the Tennessee law to be facially unconstitutional.  The trial court noted that the statute at issue reached to “any property, outside of buildings” which unconstitutionally allowed for warrantless searches of a home’s curtilage.  The trial court also determined that the officers’ information gathering intrusions were unconstitutional searches rather than reasonable regulations and restrictions, and that the statute was comparable to a constitutionally prohibited general warrant.  It was unreasonable for the TWRA officers to enter onto occupied, fenced, private property without first obtaining consent or a search warrant. The trial court also held the plaintiffs had standing to sue because they experienced multiple unauthorized entries onto their private property, and that declaratory relief was an adequate remedy.  The trial court awarded nominal damages of one dollar.  The defendant has appealed, and the case is ongoing.  

Conclusion

The cases summarized in this post point out several important things:  1) for purposes of the gain exclusion rule of I.R.C. §121, usage of the principal residence as a “principal residence” is critical, as is the timing of the sale; 2) the substantiation rules for charitable deductions must be closely followed; 3) fence law statutes tend to be old and can be complex and somewhat difficult and confusing to apply; 4) leaving land at death to children in co-equal undivided interests often creates issues, including partition actions and difficulties in equating each separate tract; and 5) the warrantless search of farmland is a continuing issue in agriculture. 

May 30, 2022 in Income Tax, Real Property | Permalink | Comments (0)

Wednesday, May 25, 2022

When Can Business Deductions First Be Claimed?

Overview

When beginning a business, at what point in time do business-related expenses become deductible?  That’s an interesting question not unlike the “chicken and the egg” dilemma.  Which came first – the business or the expense?  To have deductible business expenses, there must be a business.  When did the business begin?  That’s a key determination in properly deducting business-related expenses. 

Deducting costs associated with starting a business – it’s the topic of today’s post.

Categorization – In General

The Code allows deductions for various expenses that are related to a taxpayer’s investments that don’t amount to a business if the expenses are ordinary and necessary for the production or collection of income or are for the management, conservation or maintenance of property held for the production of income. I.R.C. §212.

Once the business begins, all of the ordinary and necessary expenses of operating the business (on a basis that is regular, continuous and substantial) that are paid or incurred during the tax year are deductible. I.R.C. §162.  But, business start-up costs are handled differently.  I.R.C. §195.

Start-Up Costs

I.R.C. §195(a) generally precludes taxpayers from deducting startup expenditures.  However, by election, a taxpayer can deduct business start-up expenses on the return for the year that the business begins. I.R.C. §195(b).  The election is irrevocable.  Treas. Reg. §1.195-1(b).  The deduction is the lesser of the amount of start-up expenses for the active trade or business, or $5,000 reduced (but not below zero) by the amount by which the start-up expenses exceed $50,000.  I.R.C. §195(b)(1)(A); I.R.C. §195(b)(1)(A)(i).  Once the election is made, the balance of start-up expenses is deducted ratably over 180 months beginning with the month in which the active trade or business begins.   I.R.C. §195(b)(1)(B); Treas. Reg. §1.195-1(a).  This all means that in the tax year in which the taxpayer’s active trade or business begins, the taxpayer can deduct the $5,000 amount (if that’s the lesser of, etc.) and the ratable portion of any excess start-up costs. 

The election is normally made on a timely filed return for the tax year in which the active trade or business begins.  However, if the return that year was timely filed without the election, the election can be made on an amended return that is filed within six months of the due date for the return (excluding extensions).  The amended return should clearly indicate that the election is being made and should state, “Filed pursuant to section 301.9100-2” at the top of the amended return.  Without the election, the start-up costs should be capitalized. 

What are start-up expenses?  Amounts paid or incurred in connection with creating an active trade or business are startup expenditures. I.R.C. §195(c). More specifically, start-up costs are amounts that the taxpayer pays or incurs for: investigating the creation or acquisition of an active trade or business; creating an active trade or business; or activities that the taxpayer engages in for profit and for the production of income before that day on which the active trade or business begins, in anticipation of the activities becoming an active trade or business, and which would be deductible in the year paid or incurred if in connection with an active trade or business.  I.R.C. §§195(c)(1)(A)(i-iii); 195(c)(1)(B).  Common types of start-up expenses include advertising costs; salaries and wages; and expenses related to travel.  See, e.g., IRS Field Service Advice 789 (1993).  But, interest expense, state and local taxes, and research and experimental expenses are not start-up expenses.  I.R.C. §195(c)(1). 

Start-up expenses are limited to expenses that are capital in nature rather than ordinary.  That’s an important point because it means that I.R.C. §195 does not bar the deductibility of ordinary and necessary expenses a taxpayer incurs in an ongoing activity for the production of income under I.R.C. §212.  In addition, it makes no difference that the activity is later transformed into a trade or business activity under I.R.C. §162.  For example, in Toth v. Comr., 128 T.C. 1 (2007), the taxpayer started operating a horse boarding and training facility for profit in 1998.  The activity showed modest profit the first few years, but had really taken off by 2004.  For 1998 and 2001, the taxpayer claimed expenses from the activity on Schedule C as ordinary and necessary business expenses deductible in accordance with I.R.C. §162, but she later determined that the expenses should be deducted in accordance with I.R.C. §212 as miscellaneous itemized deduction on Schedule A (which are presently suspended through 2025).  However, the IRS took the position that the taxpayer anticipated that the horse activity would become an active trade or business and, as such, her expenses had to be capitalized under I.R.C. §195.  The Tax Court agreed with the taxpayer.  Start-up expenses, the Tax Court said, were capital in nature rather than ordinary.  Thus, once her income producing activity began her expense deductions were not barred by I.R.C. §195.  It didn’t matter that the activity later became a trade or business activity under I.R.C. §162. 

When does the business begin?  A taxpayer cannot deduct or amortize startup expenditures if the activities to which the expenditures relate fail to become an “active trade or business.”  See I.R.C. §§195(a), (c).  There are no regulations that help define when a trade or business begins, so the question is answered based on the facts and circumstances of a particular situation.   To be engaged in a trade or business, a taxpayer must: (1) undertake an activity intending to make a profit, (2) be regularly and actively involved in the activity, and (3) actually have commenced business operations.  See, e.g., McManus v. Comr., T.C. Memo. 1987-457, aff’d., 865 F.2d 255 (4th Cir. 1988).  In addition, the courts have held that a taxpayer is not engaged in a trade or business “until such time as the business has begun to function as a going concern and performed those activities for which it was organized.” Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965). Likewise, an activity doesn’t have to generate sales or other revenue for the business to be deemed to have begun.  Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 620 (7th Cir. 1995), aff’g., in part, rev’g. in part, and remanding T.C. Memo. 1994-316; Jackson v. Commissioner, 864 F.2d 1521, 1526 (10th Cir. 1989), aff’g., 86 T.C. 492 (1986). However, merely researching or investigating a potential business is not enough.  Dean v. Commissioner, 56 T.C. 895, 902-903 (1971).

Recent Tax Court Cases

Business Had Begun, but Lack of Substantiation Dooms Deductions

Smith v. Comr., T.C. Sum. Op 2019-12

In this case, the Tax Court was convinced that the petitioner had started his vegan food exporting business, noting that the petitioner had been peddling his vegan food products in Jamaica, the Dominican Republic, Brazil, Argentina and Columbia.  However, he was having trouble getting shelf space.  Thus, for the tax year at issue, he showed expenses associated with the activity of about $41,000 and gross sales of slightly over $2,000.   The IRS largely disallowed the Schedule C expenses due to lack of documentation and tacked on an accuracy-related penalty.  After issuing the statutory notice of deficiency, the IRS said the expenses were not deductible because they were start-up expenditures.  Because IRS raised the I.R.C. §195 issue at trial, the IRS bore the burden of proof on the issue.  The Tax Court determined that the taxpayer was, based on the facts, engaged in a trade or business.  He had secured products to sell, actively marketed those products, attended food shows and other meetings around the Caribbean and South America and had established a network to find potential customers.  Thus, I.R.C. §195 did not apply to limit the deduction of the expenses – they would be deductible under I.R.C. §162.  Or would they?

To be deductible under I.R.C. §162 as an ordinary and necessary business expense on Schedule C (or Schedule F), the taxpayer must substantiate the expenses.  Here’s where the IRS largely prevailed in Smith.  The Tax Court determined that the taxpayer had not substantiated his expenses.  Thus, the expenses were not deductible beyond (with a small exception) what the IRS allowed.  The Tax Court also upheld the accuracy-related penalty.

Lack of Trade/Business Eliminates Farm-Related Deductions

Costello v. Comr., T.C. Memo. 2021-9

Here, the Tax Court addressed the deductibility of start-up costs associated with associated farming activities.  In the case, the petitioners, a married couple, were residents of California but the wife conducted a farming operation in Mexico for which she reported a net loss on Schedule F for every year from 2007 to 2014.  She began raising chickens to sell for meat in 2007, but couldn’t recall selling any of the chickens through 2011 and only had one sale of anything during that timeframe – a $264 loss on the resale of livestock.  She then switched to raising chickens for egg production, but soon determined that the venture wouldn’t be profitable due to an increased cost of feed.  She then sold what eggs had been produced for $1,068 and switched back to selling chickens for meat in 2012.  She didn’t sell any chickens in 2012 or 2013 and her plan to begin selling chickens in 2014 was thwarted when the flock was destroyed by wild dogs. Also, during 2007-2011, she attempted to grow various fruits and vegetables, but the activity was discontinued because the soil was not capable of production due to a nearby salt flat.  As a result, she had no sales revenue, only expenses that she deducted.  She then tried to grow peppers in 2012, but insects destroyed the crop and there was no marketable production.  Later that year, she acquired three cows and three calves in hopes to “make the calves big, sell them, impregnate the mothers…repeat.”  She had to sell the cows in 2013 for $4,800 because there was insufficient forage on the 6,500-acre tract.  The $4,800 was the only farm activity income reported for 2013. In 2012 and 2013, the taxpayers reported deductible business expenses on their Schedules C and Schedule F, later reaching an agreement with the IRS that the Schedule C expenses should have been reported on Schedule F. 

The IRS disallowed the deductions, determining that the wife didn’t conduct a trade or business activity for profit and because the business had not yet started during either 2012 or 2013. The Tax Court agreed with the IRS, concluding that the farming activities never moved beyond experimentation and investigation into an operating business. Although the Tax Court reasoned that some of the wife’s farming activities could have constituted an active trade or business, costs were not segregated by activity. In addition, income from the sale of eggs, the Tax Court noted, was an incidental receipt that was only realized after the wife had abandoned that venture.  Also, the there was no itemization of costs or basis in the cattle activity to allow for an estimation of any deductible loss.  

No Trade or Business Means No Business-Related Deductions 

Antonyan v. Comr., 2021-138 

The petitioner bought 10 acres in the Mojave Desert in 2012/2013, about a mile away from any road.  He intended to develop the property’s natural resources and then rent the parcels to farmers for organic farming.  He devised a business plan under which he would build a barn-like structure; obtain USDA certification that the property complied with organic farming standards; install an irrigation system on the property; and build an access road to the property.  By 2015, the petitioner had partially installed a water tank and rainwater collection system on the property, explored and mapped the property, and experimented with growing certain plants on the property. He also used the property for recreational activities.  The petitioner started the construction of a barn-like structure in 2015.  He purchased building materials, rented a commercial truck and tractor-trailer to transport materials to the property, created an unpaved road to access the property, and hired workers to assist in building the structure. The petitioner accomplished this work on weekends. 

The petitioner was a full-time engineer.  On his 2015 return, the petitioner’s Schedule C reported no gross income and claimed deductions for car and truck expense, travel expense, start-up costs and amortization.  The IRS disallowed the deductions.   The Tax Court agreed with the IRS on the basis that the petitioner was not engaged in a trade or business in 2015 but was merely in the stage of setting up a trade or business and didn’t produce any evidence that he was actively engaging with potential customer to rent the property during 2015.   The Tax Court also denied any deductions for start-up costs and amortization expenses because there was no active trade or business in 2015.  

Conclusion

When a business is in its early phase, it’s important to determine the proper tax treatment of expenses.  It’s also important to determine if and when the business begins.  The Tax Cuts and Jobs Act makes this determination even more important.  As the recent Tax Court cases indicate, proper documentation and substantiation of expenses is critical to preserve deductibility. 

May 25, 2022 in Income Tax | Permalink | Comments (0)