Wednesday, August 12, 2020
The acquisition of a farm or changes in the farming business may lead to the need demolish existing buildings and structures. Also, the recent major wind and rainstorm that stretched from Nebraska to Indiana damaged many farm buildings and structures that may now be irreparable and require demolition. Is there any tax benefit associated with demolishing buildings and structures? If not, perhaps it’s most economical to leave unused buildings and other improvements standing.
Tax issues associated with demolishing farm buildings and structures – it’s the topic of today’s post.
Capitalize into land basis. I.R.C. §280B provides that “in the case of the demolition of any structure…no deduction otherwise allowable under this chapter shall be allowed to the owner or lessee of such structure for any amount expended for such demolition, or any loss sustained on account of such demolition.” Instead such amounts “shall be treated as properly chargeable to capital account with respect to the land on which the demolished structure was located.” Thus, the amounts must be capitalized and added to the income tax basis of the land on which the building or structure was located. Likewise, effective for tax years beginning after 1985, it became no longer possible to receive a tax deduction for the removal of trees, stumps and brush and for other expenses associated with the clearing of land to make it suitable for use in farming. I.R.C. §182, repealed by Pub. L. 99-514, Sec. 402(a), 100 Stat. 2221 (1986). Accordingly, the cost of removing trees and brush, capping wells and grading the land to make it suitable for farming cannot be presently deducted. Instead, such costs are treated as development expenses (capital investment) that are added to the basis of the land.
Use before demolishing. If a farm building or structure is used in the taxpayer’s trade or business of farming for a period of time before being demolished, depreciation can be claimed for the period of business use. Treas. Reg. §1.165-3. Upon demolition, the remaining undepreciated basis of the building or structure would be added to the basis of the land along with the demolition costs. In situations where the taxpayer purchased the property with the intent of demolishing the buildings and/or structures after using them in the taxpayer’s trade or business for a period of time, the fact that the taxpayer ultimately intended to demolish the buildings is taken into account in making an apportionment of basis between the land and the buildings under Treas. Reg. §1.167(a)-5. Treas. Reg. §1.165-3. In this situation, the amount allocated to the buildings/structures cannot exceed the present value of the right to receive rentals from the buildings/structures over the period of their intended use. Id.
Abandonment. If the buildings and structures are simply abandoned, any remaining basis is treated as a disposition or a sale at a zero price. That means that the remaining income tax basis becomes an ordinary loss that is reported on Form 4797. If the abandoned buildings and structures are eventually demolished at least one year after the taxpayer ceased using them in the farm business, they have no remaining basis and only the cost of demolition would be added to the land’s basis.
Demolition After Casualty
As noted above, the inland hurricane that pelted parts of Iowa and Illinois with sustained winds near 100 miles-per-hour that ultimately traveled nearly 800 miles in 14 hours, created significant damage to farm structures. When a casualty event such as this occurs, the normal capitalization rule of I.R.C. §280B does not apply when a structure that is damaged by the casualty is demolished. In Notice 90-21, 1990-1 C.B. 332, the IRS said that the capitalization rule does not apply to “amounts expended for the demolition of a structure damaged or destroyed by casualty, and to any loss sustained on account of such demolition.” Instead, the income tax basis of the structure is reduced by the deductible casualty loss before the “loss sustained on account of” the demolition is determined. That means for a farm building or structure destroyed in the recent inland hurricane, for example, the income tax basis in the building or structure at the time of the casualty would be deductible as a casualty loss but the cost of cleaning up the mess left behind would be capitalized into the land’s basis. In essence, the loss sustained before demolition is not treated as being sustained “on account of” the demolition with the result that the loss isn’t disallowed by I.R.C. §280B. It’s an “abnormal” retirement caused by the “unexpected and extraordinary obsolescence of the building.” See, e.g., DeCou v. Comr., 103 T.C. 80 (1994); FSA 200029054 (May 23, 2000); Treas. Reg. §1.167(a)-8(a). Conversely, if a taxpayer incurs a loss to a building or structure and decides to withdraw a building or structure from use in the trade or business and then demolish it in a later year with no tax event occurring in the interim, the demolition costs are subject to the disallowance rule of I.R.C. §280B. See, e.g., Gates v. United States, 168 F.3d 478 (3d Cir. 19998), aff’g., 81 AFTR 2d 98-1622 (M.D. Pa. 1998). In that situation, the taxpayer might be able to claim a casualty loss for the year in which the loss occurred (consistent with the casualty loss rules in place at the time), and if the structure is later demolished the structure’s basis must be reduced by the casualty loss that was allowed by I.R.C. §165 before the nondeductible loss sustained on account of the demolition can be determined. Notice 90-21, 1990-1 C.B. 332.
Tangible Property Regulations
In late 2013, the IRS released final regulations providing rules regarding the treatment of materials and supplies and the capitalization of expenditures for acquiring, maintaining, or improving tangible property (the final repair regulations). T.D. 9636 (Sept. 13, 2013). About a year later, the IRS issued final regulations on dispositions of tangible property, including rules for general asset accounts (GAAs) (the final disposition regulations). T.D. 9689 (Aug. 14, 2014). These regulations are generally effective for tax years beginning on or after Jan. 1, 2014. Under the regulations, a taxpayer generally must capitalize amounts paid to acquire, produce, or improve tangible property, but can expense items with a small dollar cost or short useful life. The regulations also provide a de minimis safe harbor that can be elected on a yearly basis to expense all items under a certain dollar cost. The repair regulations also contain specific rules for determining whether an expenditure qualifies as an improvement or a betterment (essentially following established caselaw) and provide a safe harbor for amounts paid for routine property maintenance. There is also an election that can be made to capitalize certain otherwise deductible expenses for tax purposes if they are capitalized for book purposes.
The repair/disposition regulations provide a potential opportunity for a taxpayer to continue depreciating a building/structure after demolition has occurred. Under the regulations, a taxpayer doesn’t have to terminate a GAA upon the disposition of a building/structure. Thus, the taxpayer that has included buildings and structures in a GAA may choose whether to continue to depreciate them when they are disposed of (e.g., demolished) or capitalize the adjusted basis into the land under I.R.C. §280B.
The adjusted basis of any asset in a GAA that is disposed of is zero immediately before its disposition. The basis associated with such an asset remains in the GAA where it will continue to depreciate. See Treas. Reg. §§1.168(i)-1(e)(2)(i) and (iii). Consequently, the basis of a demolished building/structure where the cost of the demolition would be subject to capitalization under I.R.C. §280B is zero and the taxpayer can continue to depreciate the basis in the GAA. But, if only one demolished building/structure is in a GAA and the taxpayer elects to terminate the GAA, the adjusted basis of the building/structure would, in effect, be capitalized in under I.R.C. §280B. Likewise, the strategy doesn’t apply if the building or structure is acquired in the same year that it is demolished or if the taxpayer intended to demolish the building/structure at the time it was acquired. See Treas. Reg. §§1.168(i)-(c)(1)(i); 1.168(i)-1(e)(3)(vii).
The opportunity to use the technique is further limited by a requirement that the taxpayer must have elected to include the building in a General Asset Account (GAA) in the year the taxpayer placed the building/structure in service and is in compliance with the GAA rules. The election must have been made on an original return.
The inland hurricane of August 10 wreaked havoc on a great deal of agricultural assets that were in its path. The tax rules surrounding the disposition of disaffected assets is important to understand.
Monday, August 10, 2020
Wild game “farms” are big business in the United States. In Texas alone, in excess of four million acres are devoted to wild game farming activities. Interest continues to grow in such activities such as the raising of captive deer, for example, often as a result of the possibility of greater profitability on fewer acres than is presently possible with raising cattle. But, how does the IRS view such activities? Is it a “farm” for purposes of tax Code provisions that provide special tax status to “farm” businesses?
The tax treatment of wild game activities – it’s the topic of today’s post.
Definition of “Farming”
I.R.C. § 464(e) broadly defines “farming” to include the feeding, caring for and management of animals. In addition, Treas. Reg. §1.61–4(d) defines “farm” as including stock farms and ranches owned and operated by a corporation. For purposes of the deduction for soil and water conservation expenses, I.R.C. §175(c)(2) defines “land used in farming” to include land used for the sustenance of livestock. Under the uniform capitalization rules, the term “farming business” includes a trade or business involving the raising, feeding, caring for, and management of animals. Treas. Reg. §1.263A–4T(c)(4)(i)(A). For purposes of ag labor I.R.C. §3121(g)(1) includes within the meaning of “agricultural labor,” service connected with raising wildlife. Taken together, these provisions are broad enough to classify the raising of exotic and wild game as a farm. Likewise, the tax Code defines an exotic game rancher as a “farmer.” Work on an exotic game ranch meets the definition as agricultural labor.
1996 IRS Technical Advice
In Tech. Adv. Memo. 9615001 (Oct. 17, 1995) involved a taxpayer (an S corporation) that maintained a hunting property where deer were raised and managed for ultimate “harvest” by hunters who paid to come onto the property to hunt. It was a “trophy deer” operation. The taxpayer operated the activity such that each animal attained a body weight and antler size far exceeding that occurring naturally among deer of the same species. The deer were enclosed behind a game fence and all native deer on the enclosed property were then hunted and killed. The taxpayer bought whitetail deer from various locations in the United States, and brought them to the property where they were tagged, medically examined and treated as necessary. The deer were then released into the enclosed property. The taxpayer hired a genetic and nutritional consultant to help assure the economic success of the activity and to structure it as a research project to that it was in compliance with state law. The state exercised substantial control over the activity, deeming the deer to be the state’s natural resources that could only be harvested by hunting. The taxpayer culled the deer herd with hunts by paying hunters. The taxpayer sought a private letter ruling which addressed the question of whether the taxpayer was a “farmer” operating a “farm for profit.”
The IRS, in answering that question, noted that Treas. Reg. §1.162-12 does not define the terms “farmer,” “farms” or the “business of farming.” But, the IRS referenced the Code sections discussed above and that I.R.C. §1231 property (characterizing gain or loss realized on the disposition of certain business property) includes livestock held by the taxpayer for draft, dairy or sporting purposes. I.R.C. §1231(b)(3). That’s virtually any mammal held for breeding or sporting purposes.
Also, the IRS noted that Treas. Reg. §1.1231-2(a)(3) provides that for purposes of I.R.C. §1231, the term “livestock” is given a broad, rather than a narrow, interpretation and includes cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals. It does not include poultry, chickens, turkeys, geese, pigeons, other birds, fish, frogs, reptiles, etc. When defining the term “gross income of farmers” the term “farm” includes stock, dairy, poultry, fruit and truck farms, as well as plantations, ranches and all other land used for farming operations. Treas. Reg. 1.61-4(d). The IRS also pointed out that “agricultural labor” includes services in connection with raising wildlife. I.R.C. §3121(g)(1).
Thus, the Code and Regulations broadly classified deer as “livestock,” a deer ranch as a “farm,” a deer rancher as a “farmer” and work on a deer ranch as agricultural labor. Likewise, the taxpayer’s activities involving the importing, breeding, raising, feeding, protecting and harvesting the captive deer involved the operation of a farm by a farmer similar to the production of more conventional livestock such as cattle and hogs. The Code makes no distinction as to the type of livestock or the method of harvest. What is key are the activities the taxpayer engaged in to produce stock of marketable size and quantity.
Thus, the IRS concluded that the taxpayer was engaged in the business of farming for purposes of Treas. Reg. §1.162-12 (deducting from gross income all amounts expended in carrying on the business of farming) if the activities were engaged in for profit.
What is the appropriate depreciable recovery period of exotic game animals, including domesticated deer under the Modified Accelerated Cost Recovery System (MACRS)? Under MACRS, cattle, sheep and goats have a five-year recovery period. Rev. Proc. 87-56, 1987-2 C.B. 647. Breeding hogs are three-year property. Id. Under Rev. Proc. 87-56, 1987-2 C.B. 647, any property that is not described in an asset class or used in a described activity defaults to the seven-year classification under MACRS (12 years for alternative MACRS). Rev. Proc. 87-56, 1987-2 C.B. 647 does not mention exotic game animals, thus the animals would be classified as seven-year property. But, as “farm animals” and, thus, a depreciable asset used in farming, a plausible argument can be made that while they would have a recovery period of seven years, their alternative live would be ten years (rather than twelve). Also, because there is no requirement for depreciation purposes that animals be domesticated, an argument could also be made that a five-year recovery period applies for certain types of exotic sheep and goats. Indeed, perhaps all ruminant exotic game animals could be classified as five-year MACRS property on the basis that the livestock species in the five-year category are ruminant animals – cattle, sheep and goats. Hogs and horses, non-ruminant animals, have different recovery periods than cattle, sheep and goats.
Because the activity is classified as a farming activity, the fencing used in exotic game (including captive deer) activities would be an agricultural asset and classified as seven-year MACRS property. In addition, as livestock that are tangible personal property, the game animals would qualify for expense method depreciation. I.R.C. §179. The same is true for qualifying costs of game fences and catch pens.
A question that the TAM lest unanswered is whether the hunters’ activity would meet the definition of “hunting” for tax purposes. That could have implications for the meal and entertainment rules as well as deducting travel and lodging costs.
With the increase in non-traditional uses of agricultural land, the questions of whether the use of the land is a “farming activity” and the assets involved are “farming” assets has become an important question.
Sunday, July 12, 2020
The tax Code often requires a taxpayer to materially participate in a farm business activity as a pre-requisite to receiving a tax benefit. This is not an issue if the taxpayer is directly involved in the farming activity. However, many farming activities are conducted by a tenant. In those situations, can the landlord receive the tax benefit or benefits that might be available? The answer is that it “depends.” What it depends upon is the particular Code section involved and whether the conduct of the tenant can be imputed to the landlord for tax purposes.
The issue of imputation and the tax Code – it’s the topic of today’s post.
A Bit of History
In Hoffman v. Gardner, 369 F.2d 837 (8th Cir. 1966), the court acknowledged the role of an agent in meeting the material participation requirement. The plaintiff grew up on a farm in south-central Iowa. After graduating college in 1913, he got married in 1914 and took a teaching job in Iowa almost two hours from where he grew up. That same year he bought two farms in the Iowa county where he was from. Two years later he moved to the St. Louis area where he continued to teach school for the next 40 years. He and his brother-in-law managed the farms by keeping in touch with the tenants. The brother-in-law lived near the farms. He compensated his brother-in-law with a percentage of the farms’ income. In 1957, a year after retiring from school teaching, the plaintiff entered into agreements with the tenants that gave him complete managerial control, subject only to the right of the tenants to make suggestions. The agreements specified that the plaintiff would pay for all grass seed, one-half of the corn seed, one-half of the baling expense and all of the fertilizer expense. The straw, threshed hay and stalks were to be fed to livestock on the farms. The plaintiff was not required to pay for the oats seed or the expense of threshing. The agreements further provided that he controlled the place and time of crop planting and crop cultivation and harvesting. He also retained decisionmaking control over the crops to be sprayed and how they were to be tended to. The plaintiff kept charts on his farms that detailed all types of crop and soil information, and he annually sent this information to the tenants along with information on fencing and terracing. He consulted periodically with his brother-in-law and the tenants by telephone and letter, and occasionally spent time on the farms with his daughter during which times he would inspect the crops and walk the fields and provide crop growing advice to his brother-in-law and the tenants. His brother-in-law inspected the farms several times monthly during the growing season and often served as a middleman between the tenants and the plaintiff in terms of conveying information about the farms.
Also in 1957, at the age of 71, the plaintiff applied for Social Security benefits based on his self-employment earnings by virtue of his management of the farms and the conduct of his brother-in-law and the tenants. In other words, the plaintiff claimed that he had been material participating in the operation of the farms that would entitle him to Social Security benefits. The local Social Security Office denied the claim as did the Hearing Examiner on appeal. The plaintiff’s request for formal review was denied, and the federal trial court also ruled against the plaintiff. On further review, the U.S. Court of Appeals noted that the facts showed that the plaintiff was the one that made the key decisions involving the production activities on the farms. The evidence also revealed that the plaintiff kept informed of issues that arose on the farms and educated himself by reading farm production literature and by seeking input from experts at agricultural colleges. He also made decisions to start new farming practices and establish longer term farming practices and techniques to improve the farms’ profitability. The appellate court also noted that the plaintiff kept close track of any new production technique or crop that was tried on the farms.
Based on the evidence, the appellate court reversed the trial court and held that the plaintiff had materially participated in crop production and in the management of crop production on the farms. Importantly, the appellate court determined that the plaintiff qualified for Social Security benefits based on his own material participation in the farming activities and the activities of his brother-in-law as his agent. In other words, the brother-in-law’s activities were imputed to the plaintiff for purposes of the material participation test.
In 1974, the Congress amended the material participation statute to provide that the activities of an agent were thereafter to be irrelevant in determining whether the material participation requirement has been met. Currently, I.R.C. §1402(a)(1) reads as follows:
“(a)Net earnings from self-employment. The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member; except that in computing such gross income and deductions and such distributive share of partnership ordinary income or loss—
(1) there shall be excluded rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares, and including payments under section 1233(a)(2) of the Food Security Act of 1985 (16 U.S.C. 3833(a)(2)) to individuals receiving benefits under section 202 or 223 of the Social Security Act) together with the deductions attributable thereto, unless such rentals are received in the course of a trade or business as a real estate dealer; except that the preceding provisions of this paragraph shall not apply to any income derived by the owner or tenant of land if (A) such income is derived under an arrangement, between the owner or tenant and another individual, which provides that such other individual shall produce agricultural or horticultural commodities (including livestock, bees, poultry, and fur-bearing animals and wildlife) on such land, and that there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) in the production or the management of the production of such agricultural or horticultural commodities, and (B) there is material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticultural commodity;…”
For purposes of imputation, the key is the parenthetical language contained in §1402(a)(1)(A) – “…there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant).” In addition, when read as a whole, the bar on imputation only applies when the production of agricultural or horticultural commodities is involved.
Satisfying Material Participation
For purposes of Social Security and “net earnings from self-employment” material participation must be achieved personally when agricultural or horticultural crop production is involved. How is that accomplished? The IRS has offered three safe harbors and one catchall for determining whether the material participation test has been satisfied. See Farmers Tax Guide, IRS Pub. 225, page 75 (2019). The first test requires the landlord to satisfy any three of the following: (1) advance, pay, or stand good for at least half of the direct costs of producing the crop; (2) furnish half of the tools, equipment and livestock used in producing the crop; (3) advise and consult with the tenant periodically; or (4) inspect production activities periodically. The second test requires the landlord to regularly and frequently make, or take an important part in making, management decisions substantially contributing to the success of the enterprise. Under this test, it appears that decisions should be made throughout the year, such as when to plant, cultivate, dust, spray, or harvest; what items to buy, sell or rent; what records to keep; what reports to make; and what bills to pay and when. Establishing a lease arrangement at the beginning of the season probably will not be regarded as making management decisions. The third test requires the landlord to work 100 hours or more over a period of five weeks or more in activities connected with producing the crop. The fourth test requires the landlord to do things which, in total affect, show that the landlord is materially and significantly involved in the production of farm commodities. This fourth test is the catchall that a landlord can attempt to utilize if the landlord is not able to satisfy any of the first three tests. The litigated cases on the material participation issue have arisen primarily from this catchall provision.
Other Code Provisions
“Material participation” is required by other tax provisions which are not subject to the 1974 amendment. In other words, when the issue of material participation does not route through I.R.C. §1402, imputation is not blocked. For example, the qualified business income deduction of I.R.C. §199A does not bar the imputation of an agent’s activity to the principal for purposes of the principal claiming the 20 percent deduction. There is also no specific statutory bar of imputing an agent’s activity to the principal for purposes of the passive loss rules of I.R.C. §469 (although Committee Report language seems to indicate that there is a bar).
Whether the landlord materially participates in the tenant’s farming business is irrelevant for farm income averaging purposes. I.R.C. §1301. Thus, non-materially participating landlords are eligible for income averaging if the landlord’s share of a tenant’s production is set in a written rental agreement before the tenant begins significant activities on the land. That places a premium on written leases.
There are other sections of the Code where the imputation issue also matters.
The Type of Lease Matters
If a landowner is in the business of farming, the landowner's expenses and income are reported on Schedule F where the net income is subject to self-employment tax. Income and expenses associated with a material participation crop share lease are reported on Schedule F. The rental income is subject to self-employment tax and the owner is able to deduct soil and water conservation expenses attributable to the real estate, as well as qualify for the exclusion of cost-sharing payments associated with the rented real estate. Similarly, the landlord could qualify for expense method depreciation under I.R.C. §179. In addition, CRP payments received by a materially participating landlord are subject to self-employment tax only if there is a nexus between the CRP land and the materially participating landlord’s farming operation. The IRS continues to deliberately misstate this point in IRS Publication 225.
A landlord who is not materially participating under a crop share lease receives the income from the lease not subject to self-employment tax. While the landlord still qualifies for special treatment of soil and water conservation expenses and is eligible for exclusion of cost-sharing payments, and may, as noted below, be eligible for expense method depreciation, the income is to be reported on IRS Form 4835 rather than the Schedule F.
Income under a cash rent lease is income from a passive rental arrangement and is not subject to self-employment tax. Cash rent landlords do not qualify for special treatment of soil and water conservation expenses but apparently qualify for the exclusion of cost sharing payments received from the USDA. At least that the conclusion to be drawn from an IRS Private Letter Ruling from 1990. See, e.g., Priv. Ltr. Rul. 9014041 (Jan. 5, 1990). In the ruling, there was no mention of the type of lease involved.
As for expense method depreciation, the landlord must be “meaningfully participating” in the management or operations of the trade or business, (Treas. Reg. §1.179-2(c)(6)(ii)) and avoid the “noncorporate lessor” rules. I.R.C. §179(d)(5). Income from a cash rent lease is to be reported on the Schedule E -Supplemental Income and Loss.
Imputation is a key concept in several areas of farm income taxation. It’s made trickier because sometimes it applies and sometimes it does not. It’s all a matter of which Code section applies and how the material participation requirement is routed through the Code.
Wednesday, July 8, 2020
The U.S. Tax Court continues to issue decisions involving conservation easements. The IRS has many of these cases in the pipeline which means that the decisions will keep on coming. This is definitely one area of tax that has been audited heavily and it can be anticipated that the audits will continue. I have written prior posts on the issues surrounding conservation easements. They can be beneficial for rural landowners from a tax perspective, but the deeds granting the easement must be drafted very carefully and attention to detail is a must.
In today’s post, I look at a few recent cases and an important IRS development concerning conservation easements.
Extinguishment Regulation Upheld.
Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020); Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54
In 2008, the petitioner donated a permanent conservation easement to a qualified organization and claimed a charitable deduction. The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution. That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement. The IRS denied the charitable deduction because (inter alia) the deed language violated the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6).
The full Tax Court, agreeing with the IRS, upheld the validity of the regulation on the basis that the extinguishment regulation had been properly promulgated and did not violate the Administrative Procedure Act. The full Tax Court also determined that the construction of I.R.C.§170(h)(5) (e.g., that the donated easement be exclusively for conservation purposes), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
In a related memorandum opinion, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made. It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed. However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable.
Charitable Deduction Denied – Bad Deed Language and Overvaluation
Plateau Holdings LLC, et al. v. Comr., T.C. Memo. 2020-93.
The petitioner, an entity, owned two parcels of rural land and donated two open-space conservation easements on the parcels to a land trust. The deeds were recorded the next day, and included language expressing an intent to ensure that the land “be retained forever in its current natural, scenic, forested and open land condition” and language preventing any use of the conserved area inconsistent with the conservation purpose. The petitioner claimed a $25.5 million charitable deduction for the donation. Eight days before the donation, an investor acquired nearly 99 percent ownership in the petitioner for less than $6 million.
The Tax Court determined that the deed language was similar to that deemed invalid in Coal Property Holdings LLC v. Comr., 153 T.C. 126 (2019) because the grantee wouldn’t receive a proportionate amount of the full sale proceeds. The Tax Court also upheld a 40 percent penalty under I.R.C. §6662(e) and I.R.C. §6662(h) for a gross misstatement of the value of the contribution. The Tax Court noted that the petitioner valued both properties well above 200 percent of market value, the cut-line for the gross misstatement penalty. One parcel was valued a$10.9 million, or 852 percent of its correct value. The other easement was valued at $14.5 million, or 1,031 percent of its proper value.
Conservation Easement Not Protected In Perpetuity – The Extinguishment Issue
Hewitt v. Comr., T.C. Memo. 2020-89.
The petitioner owned farmland and deeded a conservation easement on a portion of the property to a qualified charity as defined in I.R.C. §170(h)(3). The petitioner continued to own a large amount of agricultural land that was contiguous with the easement property, and he continued to live on the land and use it for cattle ranching. The petitioner claimed a charitable contribution deduction for the donation of $2,788,000 (the difference in the before and after easement value of the property) which was limited to $57,738 for the tax year 2012 – the year of donation. The petitioner claimed carryover deductions of $1,868,782 in 2013 and $861,480 in 2014.
The petitioner could not determine his basis in the property and, upon the advice of a CPA firm, attached a statement to Form 8283 explaining his lack of basis information. The deed stated that its purpose was to preserve and protect the scenic enjoyment of the land and that the easement would maintain the amount and diversity of natural habitats, protect scenic views from the roads, and restrict the construction of buildings and other structures as well as native vegetation, changes to the habitat and the exploration of minerals, oil, gas or other materials. The petitioner reserved the right to locate five one-acre homesites with one dwelling on each homesite. The deed did not designate the locations of the homesites but required the petitioner to notify the charity when he desired to designate a homesite. The charity could withhold building approval if it determined that the proposed location was inconsistent with or impaired the easement’s purposes.
The deed provided for the allocation of proceeds from an involuntary extinguishment by valuing the easement at that time by multiplying the then fair market value of the property unencumbered by the easement (less any increase in value after the date of the grant attributable to improvements) by the ratio of the value of the easement at the time of the grant to the value of the property, without deduction for the value of the easement at the time of the grant. The deed also stated that the ratio of the value of the easement to the value of the property unencumbered by the easement was to remain constant. The charity drafted the deed and a CPA firm reviewed it and advised the petitioner that it complied with the applicable law and regulations, and that he would be entitled to a substantial tax deduction.
The IRS denied the carryover deductions for lack of substantiation and assessed a 40 percent penalty under I.R.C. §6662(h) for gross valuation misstatement and, alternatively, a 20 percent penalty for negligence or disregard of the regulations or substantial understatement of tax. The petitioner bought additional land that he held through pass-through entities that would then grant easements. The petitioner recognized gain of over $3.5 million on the sale of interests in the entities to investors who then claimed shares in the easement deductions. The IRS claimed that these entities overvalued the easements for purposes of the deductions. Individuals in the CPA firm invested in the entities and claimed easement deductions. The Tax Court determined that the deed language violated the perpetuity requirement of I.R.C. §170 because of the stipulation that the charity’s share of proceeds on extinguishment would be reduced by improvements made to the land after the easement grant. The Tax Court did not uphold the penalties.
Conservation Easement Doomed by Bad Deed Language
Woodland Property Holdings, LLC v. Comr., T.C. Memo. 2020-55
The petitioner donated a conservation easement to a qualified charity. The deed conveying the property contained a judicial extinguishment provision stating that the easement gave rise to a vested property right in the donee, the value of which "shall remain constant." The value of the donee's property right was defined as the difference between (a) the fair market value (FMV) of the conservation area as if unburdened by the easement and (b) the FMV of the conservation area as burdened by the easement, with both values being "determined as of the date of this Conservation Easement." The IRS took the position that the language failed to satisfy the "in perpetuity" requirement for such gifts. The petitioner pointed to the following deed language for support of the his position that the perpetuity requirement was satisfied: "If any provision of this Conservation Easement is found to be ambiguous, an interpretation consistent with its purposes that would render the provision valid should be favored over any interpretation that would render it invalid."
The Tax Court, however, held that the provision did not help the taxpayer because it was a cure only for ambiguous provisions and the deed was unambiguous in limiting the donee's vested property right. In addition, the Tax Court noted that a statement from the donee organization that the easement be in full compliance with the tax law was immaterial.
Conservation Easement Deduction Allowed At Reduced Amount.
Johnson v. Comr., T.C. Memo. 2020-79
The petitioner is the president of a west-central Colorado company that manufactures and sells disposable ink pans for printing presses. He purchased a ranch in 2002 for 200,000 and carved out a permanent conservation easement that he donated to the Colorado Open Lands, a qualified charity. He made the donation in 2007. The easement encumbered 116.14 acres along with the water rights, leaving the remaining five acres unencumbered. The easement restricted the encumbered area from being subdivided, used as a feedlot, or used for commercial activities. It also restricted all construction within the encumbered area except for five acres that was designated a “building envelope”. The deed limited constructed floor space inside the building envelope to 6,000 square feet for single residential improvements and a cumulative maximum of 30,000 square feet for all improvements.
On his return for 2007, the petitioner claimed a $610,000 charitable contribution deduction for the donated easement, with carryover amounts deducted in future years. He also claimed certain farm-related expenses. The IRS denied the carryover charitable deductions in three carryover years on the basis that he had already deducted more than the easement’s value for previous tax years. The petitioner and the IRS agreed that the property’s highest and best use was for farming and a residence. The petitioner’s valuation expert used a quantitative approach by taking comparable sales adjusted by time between the time of those easement donations and when the petitioner donated his easement. The petitioner’s expert then adjusted for nearness of the encumbered property to town and size. He then factored in irrigation, topography and improvements to arrive at the value of the property before the easement. The expert did not have many post-donation comparable sales to work with in arriving at the value of the petitioner’s property after the easement donation.
The valuation expert for the IRS used the qualitative approach. By comparing several characteristics for each comparable, including market conditions at the time of sale, location/access, size, aesthetic appeal, zoning, and available utilities, to evaluate the relative superiority, inferiority, or similarity of each comparable to the ranch. The expert then evaluated the overall comparability of each property to the ranch.
The Tax Court preferred the approach of the petitioner’s expert, due to the IRS’s expert ignoring the quantitative factors. However, the Tax Court adjusted the value arrived at by the petitioner’s expert. Post-encumbrance nearby comparable sales were lacking, the Tax Court rejected both experts’ post-encumbrance direct comparable sales analyses. By ignoring an outlier from both of the experts, the parties were only two percent apart on value. The Tax Court split the difference between the parties and added it to the pre-easement value as adjusted to arrive at the easement’s value. Thus, the Tax Court allowed a $373,000 deduction for the easement. The Tax Court also disallowed various farming expense deductions including travel-related expenses due to the lack of substantiation.
The saga of claimed charitable deductions for donated conservation easements will continue. It seems that nothing generates more Tax Court litigation than a Code provision that the IRS despises.
Monday, July 6, 2020
Experiencing a tax audit can be a traumatic experience. Often, the level of trauma depends on the examining agent(s). It can also depend on how aggressive the IRS National Office is on the issue under examination. But, once an audit is completed can the IRS return to the same issue involving the same tax year and with the same taxpayer and get a “do-over”? In other words, how many times can the IRS audit the same issue?
The ability of IRS to re-audit issues that have been examined and resolved – it’s the topic of today’s post.
Applicable Code Section
In 1921, the Congress enacted I.R.C. 7605(b) as a reaction to constituent complaints that the IRS was abusing its power by subjecting taxpayers to unnecessary audits. See H.R. Rep. No. 67-350, at 16 (1921). Based on the recorded legislative history, the purpose of the new Code section was to relieve taxpayers from “unnecessary annoyance” by the IRS. See statement of Sen. Penrose at 61 Cong. Rec. 5855 (Sept. 28, 1921).
I.R.C. §7605(b) states as follows:
“No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.”
Thus, the provision bars the IRS from conducting “unnecessary examination or investigations” and conducting more than a single investigation of a taxpayer’s “books of account” for a tax year. But, if any investigation is legitimate, the courts generally don’t get in the way of the IRS. Instead, the courts have tended to focus on the “unnecessary” language in the statute rather than the “single investigation” part of the provision. See, e.g, United States v. Schwartz, 469 F.2d 977 (5th Cir. 1972); United States v. Kendrick, 518 F.2d 842 (7th Cir. 1975). In addition, the provision has been interpreted so as to not prevent an IRS agent from “diligently exercising his statutory duty of collecting the revenues.” Benjamin v. Comr., 66 T.C. 1084 (1976). The public purpose of collecting revenues duly owed is of utmost importance to the courts, and the statutory provision is not to be read in such a broad manner as to defeat that purpose. At least that’s how the U.S. Court of Appeals construed the statute in a 1963 case. DeMasters v. Arend, 313 F.2d 79 (9th Cir. 1963).
Earlier this year, the U.S. Tax Court addressed the application of I.R.C. §7605(b) in a case involving a surgeon (the petitioner) that inherited his mother’s IRA upon her death in 2013 – one that she had received upon her husband’s (the petitioner’s father) death. In Essner v. Comr., T.C. Memo. 2020-23, the petitioner then took distributions from the IRA in 2014 and 2015. He didn’t tell his return preparer that he had taken sizable distributions in either 2014 or 2015, and didn’t ask for guidance from the preparer on how to treat the distributions for tax purposes. Even though he received a Form 1099-R for the distributions received in 2014 and 2015, he didn’t report them in income for either year. The IRS Automated Underreporting (AUR) program, caught the discrepancy on the returns and generated a notice to the petitioner seeking more information and substantiation. After a second notice, the petitioner responded in handwriting that he disagreed with having the distributions included in income. While the AUR review was ongoing, the IRS sent the petitioner a letter in late 2016 informing him that his 2014 return had been selected for audit and requesting copies of his 2013 through 2015 returns. The audit focused on various claimed expenses, but did not focus on the IRA distributions. The examining agent was unaware of the AUR’s actions concerning the 2014 and 2015 returns. The examining agent sent the petitioner a letter in early 2017 with proposed adjustments, later revising it upon receipt of additional information. Neither letter mentioned the issue with the IRA distributions, and the petitioner sent a letter to the IRS agent requesting confirmation that his IRA distribution received in 2014 was not taxable. 17 days later, the petitioner filed a Tax Court petitioner challenging a notice of deficiency that the AUR had generated seven days before the examining agent’s original letter proposing adjustments to the 2014 return. About seven months later the IRS issued a notice of deficiency to the petitioner asserting a $101,750 tax deficiency for the 2015 tax year and an accuracy-related penalty. The petitioner filed another Tax Court petition concerning the 2015 tax year.
At trial, the petitioner couldn’t establish that any portion of the distributions he received represented a return of his father’s original investment and the Tax Court sustained the IRS position that the distributions were fully taxable. The petitioner also claimed that I.R.C. §7605(b) barred the IRS from assessing the proposed deficiency for 2014 because the concurrent review of the 2014 return by the AUR and the agent constituted a “second inspection” of his books and records for 2014. The Tax Court, based on its prior decision in Digby v. Comr., 103 T.C. 441 (1994), framed the issue of whether the examination was unnecessary or unauthorized, and noted that the U.S. Supreme Court has explained that I.R.C. §7605 imposes “no severe restriction” on the power of the IRS to investigate taxpayers. United States v. Powell, 379 U.S. 48 (1964). The Tax Court noted that the AUR didn’t inspect the petitioner’s books, but merely based its review on third-party information returns – there was no “examination” of the 2014 return. Accordingly, the Tax Court concluded that the AUR program’s matching of third-party-reported payment information against his already-filed 2014 return was not an “examination” of his records. There was no violation of I.R.C. §7605(b). The Tax Court also upheld the accuracy-related penalty.
Recent Chief Counsel Legal Advice
Just a few weeks ago the IRS Chief Counsel’s Office addressed the I.R.C. §7605(b) issue with respect to net operating loss (NOL) carrybacks. This time the outcome was favorable for the taxpayer. Under the facts of CCM 20202501F (May 7, 2020), the taxpayer was a hedge fund operator and a former investment banker that bought a vineyard. The vineyard also included a house, guesthouse, caretaker’s house, and olive grove. The IRS conducted an audit resulting in the issuance of a Notice of Proposed Adjustment disallowing all expenses and depreciation deductions related to the vineyard for the prior tax years under audit. The IRS took the position that the vineyard was a hobby activity under I.R.C. §183 for those years.
On further review, the IRS Appeals Office determined that the taxpayer’s vineyard activity was not a hobby for those tax years based on its conclusion that all of the nine-factors contained in Treas. Reg. §1.183-2(b) were in the taxpayer’s favor and, as a result, the deductions and expenses claimed in those years were allowable which resulted in a net operating loss (NOL). The IRS again audited the taxpayer in a later year on the hobby activity issue. Also at issue was whether the taxpayer could deduct an NOL carryforward originating from the tax years that had previously been audited and for which IRS Appeals had determined that the vineyard activity was not a hobby The taxpayer asserted that the second audit stemmed from previously audited tax years and violation I.R.C. §7605(b) as a repetitive audit. The IRS sought guidance from the IRS Chief Counsel’s Office (CCO).
The CCO noted that I.R.C. §7605 bars the IRS from conducting more than a single inspection of a taxpayer’s books of account for a tax year to prevent an “unnecessary” examination or “unnecessary annoyance.” As noted above, existing caselaw does not prevent the IRS from auditing a later year based on a taxpayer’s transactions that originated from records that had been part of a prior audit. However, the CCO concluded the taxpayer’s situation was different. Here, the CCO noted, the taxpayer had been previously examined and prevailed at the IRS Appeals Office level. The losses allowed in the prior years under examination were properly carried forward, and IRS was disallowing the NOL carryforward on the second audit for the same reason that the IRS Appeals Office had previously considered and ruled in the petitioner’s favor. The CCO determined that this amounted to a “second examination” or “repetitive audit” that I.R.C. §7605 barred. Had the NOL carryforward been disallowed for a different reason, the CCO noted, a second examination would have been proper.
Almost 100 years ago, the Congress determined that taxpayers needed protection against abuses from the IRS. That determination manifested itself in I.R.C. §7605(b) which was enacted within the first ten years of the creation of the tax Code. But, whether or not the IRS can get a “second-bite” at the audit apple is highly fact-dependent. However, it is probably a decent bet that audit activity will be extremely low in the coming months due to circumstances beyond the control of the IRS.
Tuesday, June 30, 2020
The Paycheck Protection Program (PPP) was enacted into law in late March and has now been statutorily modified by the Paycheck Protection Program Flexibility Act (PPFA). It is designed to provide short-term financial relief to qualified businesses that have been negatively impacted by the action of state Governors in response to the virus. The Small Business Administration (SBA) administers the law.
The Premium Assistance Tax Credit (PATC) is a refundable credit designed to offset the higher cost of health insurance triggered by Obamacare for eligible individuals and families that acquire health insurance purchased through the Health Insurance Marketplace. In recent days important developments have involved the PATC.
Prior posts have discussed various aspect of the PPP, particularly as applied to farm and ranch businesses. In today’s post I take a brief look at a couple of PPP court developments and key information involving the PATC. Recent developments of the PPP and the PATC – it’s the topic of today’s post.
PPP Court Developments
Maine case. The SBA has promulgated a rule taking the position that an individual PPP applicant that is in bankruptcy is ineligible for PPP funds. Also, if the applicant is an entity and a majority owner is in bankruptcy, the SBA also denies PPP eligibility to the entity. In recent days, two more courts have addressed various aspects of the SBA position.
In a recent case from Maine, the plaintiff had filed Chapter 11 and sought approval of a disclosure describing its Chapter 11 plan. The statement acknowledged the problems the virus presented to its business, but assured creditors that the plan was feasible. The plaintiff continued to project that its business would be viable and would continue in business and meet plan obligations. The statement also described a general effort to get assistance, but did not suggest any likelihood of suffering immediate and irreparable harm in the form of ceasing business if access to the PPP were denied. The plaintiff’s statement also pointed to a forecasted ability to weather the current economic problems after July 2020 and into 2022, even without receipt of funds under the PPP.
The court noted the devoid record of any showing of projected receipts and disbursements and determined that it didn’t have enough information to determine if the state Governor’s conduct seriously impaired the plaintiff’s financial projections. The court denied the temporary restraining order (TRO). In re Breda, No. 20-1008, 2020 Bankr. LEXIS 1246 (Bankr. D. Me. May 11, 2020). In a later proceeding the plaintiff claimed that the defendant violated the anti-discrimination provisions of 11 U.S.C. §525. The court granted the defendant’s motion to dismiss. In re Breda, No. 18-10140, 2020 Bankr. LEXIS 1626 (Bankr. D. Me. Jun. 22, 2020).
Fifth Circuit case. As noted above, the SBA created a regulation with respect to eligibility for the PPP that makes an applicant ineligible to receive program funds if the applicant is a debtor in a bankruptcy proceeding. 85 Fed. Reg. 23, 450 (Apr. 28, 2020). In In re Hidalgo County Emergency Service Foundation v. Carranza, No. 20-40368, 2020 U.S. App. LEXIS 19400 (5th Cir. Jun. 22, 2020), the debtor was in Chapter 11 bankruptcy and was denied PPP funds. The debtor claimed that such denial violated the anti-discrimination provisions of 11 U.S.C. §525(a) which bars discrimination based on bankruptcy status in certain situations. The debtor also claimed that the regulation was arbitrary and capricious and an abuse of the SBA’s discretion.
The bankruptcy court agreed and issued a preliminary injunction mandating that the SBA handle the debtor’s PPP application without considering that the debtor was in bankruptcy. The district court stayed the injunction and certified the case for direct appeal to the appellate court. On further review, the appellate court vacated the preliminary injunction noting that federal law prohibits injunctive relief against the SBA.
Premium Assistance Tax Credit
The IRS recently proposed regulations clarify that the reduction of the personal exemption deduction to zero for tax years beginning after 2017 and before 2026 does not affect an individual taxpayer’s ability to claim the PATC. The regulations essentially adopt the guidance set forth in Notice 2018-84. The proposed regulations apply to tax years ending after the date the regulations are finalized as published in the Federal Register. Taxpayers can rely on the proposed regulations for tax years beginning after 2017 and before 2026 that end on or before the date the Treasury decision adopting the regulations as final regulations is published in the Federal Register. Prop. Treas. Reg. 124810-19.
On another angle, the self-employed health insurance deduction may allow for a PATC. In Abrego, et ux. v. Comr., T.C. Memo. 2020-87, the petitioners, a married couple, received an advance premium assistance tax credit under I.R.C. §36B to help offset the higher cost of health insurance acquired through the Health Insurance Marketplace as a result of Obamacare. The advance credit was received for a tax year during which the wife worked as a housekeeper and the husband worked as a driver for a transport company. The husband also operated his own tax return preparation business. The IRS determined that the entire advanced credit had to be paid back based on the petitioners’ actual income for the year as reported on the tax return.
The Tax Court held that the repayment amount was capped under I.R.C. §36B(f)(2) when taking into account the partial self-employment health insurance deduction that lowered the petitioners’ “household income” to just under 400 percent of the federal poverty line. Thus, the petitioners were eligible for some advance credit amount under I.R.C. §36B(b)(2) rather than being completely ineligible.
These are just a small sample of what’s been happening in the courts that might impact a client’s return. Unfortunately, it’s still tax season. Fortunately, the IRS has announced that the end of tax season won’t be postponed again. You can sign up for two days of continuing education on these and other topics at the National Farm Income Tax & Estate and Business Planning Conference in Deadwood, SD on July 20-21. You may either attend in-person or online. For more information click here: https://washburnlaw.edu/employers/cle/farmandranchtax.html
Saturday, June 27, 2020
Either as part of an estate plan or for purposes of setting up another person in business or for other reasons, a gift might be made. But when is a transfer of funds really a gift? Why does it matter? The recipient doesn’t have to report into income gifted amounts. If the amount transferred is not really a gift, then it’s income to the recipient. When large amounts are involved, the distinction is of utmost importance.
When is a transfer of funds a gift? It’s the topic of today’s blog article
Definition of a “Gift”
Under the Internal Revenue Code (“Code”), gross income is income from whatever source derived unless otherwise excluded. I.R.C. §61(a). However, gross income does not include the value of property that is acquired by gift. I.R.C. §102(a). In Comr. v. Duberstein, 363 U.S. 278 (1960), the U.S. Supreme Court defined a gift under I.R.C. §102 as a transfer that proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses. As a result, the Supreme Court concluded that the most important consideration in determining whether a gift has been made is the donor’s intent. That’s a broader inquiry than simply looking at how the donor characterizes a particular transaction. A court will examine objectively whether a gift occurs based on the facts and if those facts support a donor that intended a transfer based on affection, etc. Detached and disinterested generosity is the key. If the transfer was made out of a moral duty or some sort of expectation on the recipient’s part, it is not a gift under I.R.C. §102 because it did not arise out of a detached and disinterred generosity. Similarly, when the recipient has rendered services to a donor, a payment for services is not a gift even if the transferor had no legal obligation to pay the remuneration for the services.
Apart from the Court’s analysis in Duberstein, a particular transaction may amount to a “common law” gift. A common law gift requires only a voluntary transfer without consideration. If the donor had no legal obligation to make the payment, the transfer is a gift under the common law standard. That’s an easier standard to satisfy than the Code definition set forth in Duberstein.
The recent Tax Court case of Kroner v. Comr., T.C. Memo. 2020-73 illustrates how the courts examine whether a particular transfer constitutes a gift and the consequences of misreporting the transaction(s) for tax purposes. The petitioner was the CEO of a business that bought and sold structured settlement payments and lottery winnings. The company would buy structured payments from lottery winners and resell the payments to investors. The petitioner had historically worked in the discounted cashflow industry and, as a result, met a Mr. Haring, a wealthy British citizen, sometime in the 1990s. Their business relationship lasted until 2007.
In 2003 and 2004, the petitioner was interested in protecting his assets and an attorney recommended the use of an “offshore” trust to hold the petitioner’s assets. An offshore trust is often associated with tax scams, but I reserve that discussion for another post in the future. In any event, the petitioner established the “Kroner Family Trust” in a small island in the Caribbean. The petitioner was the beneficiary of the trust along with his son. In 2007, the petitioner established another trust in the Bahamas to hold business assets. From 2005-2007, the petitioner received wire transfers from Mr. Haring totaling $24,775,000. Some of the transferred funds went directly to the petitioner, but others went to the trust in the Caribbean island and still others went to the petitioner’s business. The lawyer that set up the offshore trusts “advised” the petitioner that the transfers were gifts that the petitioner didn’t have to report as taxable income. The attorney’s legal “analysis” which led him to this conclusion was a conversation he had with the petitioner and a note that he drafted for Mr. Haring stating that the transfers were gifts. The attorney also advised the petitioner of the requirements to file Form 3520 every year that he received a transfer from Mr. Haring to report the gifts from a foreign person. A CPA prepared the Form 3520 for the necessary years. The petitioner never reported any of the transfers from Mr. Haring as taxable income.
The petitioner was audited for tax years 2005-2007. The IRS took the position that the transfers were not gifts, should have been reported as taxable income, and assessed accuracy-related penalties on top of the tax deficiency.
The Tax Court agreed that the transfers should have been included in the petitioner’s taxable income. They were not gifts. The Tax Court noted that Mr. Haring’s intention was the most critical factor in determining the status of the transfers. The petitioner bore the burden to establish Mr. Haring’s intent by a preponderance of the evidence. However, Mr. Haring never appeared at trial and didn’t provide testimony. Instead, the petitioner tried to establish the gift nature of the transfers by his own testimony. The petitioner and Mr. Haring had operated some business interests together in the 1990s, and the petitioner acted as a nominee for Mr. Haring for certain of Mr. Haring financial interests. He even formed a trust in Liechtenstein for Mr. Haring in 2000. Mr. Haring also provided a loan for the petitioner’s credit counseling business in 2000. That loan was paid off in 2007. Mr. Haring also held about a 70 percent equity interest in the petitioner’s cashflow industry business in exchange for providing funding and loan guarantees. He later liquidated his interest for $255 million.
The petitioner last saw Mr. Haring in 2002 and testified at trial that he didn’t know where he lived and that he didn’t know his telephone number. He did, however, receive a telephone call from Mr. Haring in 2005 that lasted no more than three minutes. The petitioner claimed that Mr. Haring told him during the call that Mr. Haring had a “surprise” for the petitioner. The petitioner later met with Mr. Haring’s associate and they set up the ability to receive wire transfers from Mr. Haring into the petitioner’s bank account. That’s when the attorney drafted a note to the petitioner from Mr. Haring stating that the transfers would be gifts.
The Tax Court didn’t buy the petitioner’s story, finding that neither the petitioner nor the attorney were credible witnesses. The Tax Court stated that the petitioner’s testimony was self-serving and that the attorney’s testimony was “simply not credible.” There was no supporting documentary evidence. In addition, the attorney represented both Mr. Haring and the petitioner. The Tax Court also noted that the attorney was “evasive in his answers and in his selective invocation of the attorney-client privilege with regard to the legal advice provided to Mr. Haring about the transfers.” The Tax Court also doubted the authenticity and credibility of the 2005 note allegedly from Mr. Haring but drafted by the attorney regarding his desire to gift funds to the petitioner. Thus, the note carried little weight in determining whether the transfers were gifts.
The Tax Court also determined that the petitioner failed to prove that the transfers were made with disinterested generosity. The record was simply devoid of any credible evidence to prove that Mr. Haring transferred the funds to the petitioner with detached and disinterested generosity. The Tax Court noted that timing of some of the transfers with liquidity events of the petitioner’s business of which Mr. Haring was an investor. That raised a question as to whether Mr. Haring was acting as the petitioner’s nominee.
The Tax Court determined that the petitioner need not pay the 20 percent accuracy-related penalty because the IRS failed to satisfy its burden of production under I.R.C. §6751(b).
The Kroner case is a textbook lesson on what constitutes a gift – detached and disinterested generosity. The burden of establishing that a transfer is a nontaxable gift is on the party asserting that the transfer amounted to a gift. The case is also a lesson into the messes that sloppiness and questionable lawyering can get a client into. When the amount of the gift (or gifts) is as large as that involved in the Kroner case, attention to detail is a must. The income tax consequences from being wrong are enormous.
Wednesday, June 17, 2020
As part of an estate plan, an heir may be given an option to buy certain assets of the decedent at a specified price. In agricultural estates, such an option is typically associated with farmland of the decedent, and often gives the optionee (the person named in the will with the right to exercise the option) a very good deal for the property upon exercise of the option.
Often the question arises as to the basis of the property in the hands of the optionee when the option is exercised and the resulting tax consequences when the property is later sold.
Tax issues associated with the exercise of an option – it’s the topic of today’s post.
Options – The Basics
There is no question that an option can be included in a will. A testator has the right to dispose of their property as desired. The only significant limitation on testamentary freedom involves the inability to completely disinherit a spouse. Even if the will leaves nothing for the surviving spouse, under state law the surviving spouse has a right to an elective share entitling the surviving spouse to “elect” to take a portion of the estate regardless of what the deceased spouse’s will says (except, of course, if a valid prenuptial agreement was executed). Under most state laws, a surviving spouse’s elective share comprises anywhere from between one-third to one-half of the decedent’s estate. In addition, in some states, the spousal elective share can include retirement assets or life insurance.
What are the tax consequences when an optionee exercises an option? Does the exercise result in tax consequences to the decedent’s estate? What are the tax consequences if the optionee later sells the property that was acquired by the exercise of the option?
Decedent’s estate. The exercise of an option results in no tax consequence to the decedent’s estate. The exercise of the option, followed by the sale of the property by the estate to the holder of the option does not result in gain or loss to the estate. In Priv. Ltr. Rul. 8210074, Dec. 10, 1981, the decedent's son was given an option under the terms of the parent’s will to purchase some of the parent’s farmland at $350/acre. The son exercised the option and paid the estate $26,668 for the land. At the time the option was exercised, the farmland was worth $114,293 (as valued on the parent’s estate tax return). The IRS determined that the combined basis of the option and the real estate subject to the option was $114,293 with $26,668 of that allocable to the land. Thus, when the real estate was sold to the son for $26,668, it equaled the basis in the land in the hands of the estate resulting in neither gain nor loss to the estate.
When the optionee exercises the option in a will or trust, the primary question is what the income tax basis of the property received under the option is in the optionee’s hands. I.R.C. §1014 is the applicable basis provision for property acquired from a decedent. The provision states in pertinent part, “(a)In general Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be— (1) the fair market value of the property at the date of the decedent’s death,… (b)Property acquired from the decedent For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (1) Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent….
This ‘”stepped-up” basis rule applies to property required to be included in the decedent’s gross estate, including property that is subject to an option in a will (or trust) that grants the beneficiary an option to purchase the property at a beneficial price from the estate. The option is treated as property acquired from the decedent and receives an income tax basis equal to its fair market value as of the date of the decedent’s death. Its basis is the estate tax value of the property subject to the option less the price the beneficiary must pay to exercise the option. A beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the optionee’s basis in the property.
In Cadby v. Comr., 24 T.C. 899 (1955), acq., 1956-2 C.B. 5, the decedent died in 1942. His will included a provision directing the executor and trustee to sell some of the decedent’s stock to a family member and another person for $25,000 upon proof that the family member had purchased from the decedent’s surviving spouse preferred stock in the same company for $6,000 if payment were made within two years of the decedent’s death. If payment wasn’t made within the specified timeframe, disposition of the stock was left to the discretion of the executor and trustee. Shortly after the decedent’s death, the family member sold his rights under the will to a third party for $13,000.
In determining the tax consequence of the transaction to the family member, the Tax Court noted that the fair market value of the decedent’s stock interest subject to the option was $55,243 as of the date of death as denoted on the decedent’s federal estate tax return. In addition, the family member paid $6,000 for the stock he purchased from the decedent’s surviving spouse. Thus, the family member’s income tax basis in the stock was $61,243.40. From that amount, the Tax Court subtracted the option price of $25,000 and the payment to the surviving spouse of $6,000. The result, $30,243.40, was the option price. Because the family member held a one-half interest in the option, that one-half interest was worth $15,121.70. Thus, the sale for $13,000 did not trigger any taxable income to the family member.
Twelve years after the Tax Court’s ruling in Cadby, the IRS issued a Revenue Ruling formally stating its position that a beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the beneficiary’s basis in the property. Rev. Rul. 67-96, 1967-1 C.B. 195. In 2003, the IRS issued a private letter ruling again confirming the Tax Court’s approach in Cadby. Priv. Ltr. Rul. 200340019 (Jun. 25, 2003). Under the facts of the ruling, under the terms of Mother's will, the taxpayer was given the right to purchase the Mother’s home upon the Mother’s death at an amount less than fair market value. The basis in the option and in the home upon exercise of the option was determined in accordance with Rev. Rul. 67-96. Thus, the basis in the option upon its exercise was measured by the difference between the value of the home for federal estate tax purposes and the option price. In addition, as a result of exercising the option, the taxpayer’s basis in the home was the sum of the basis of the option and the actual option price paid.
Options can play an important role in transitioning a farming or ranching business to the next generation. Not only must thought be given to the financial ability of the optionee to exercise the option, the income tax issues triggered upon exercise of the option and, when applicable, the subsequent sale of the property acquired by exercising the option must also be considered.
Wednesday, May 27, 2020
During the last couple of months while various state governors have issued edicts randomly declaring some businesses essential and other non-essential, the ag industry has continued unabated. The same is true for the courts – the ag-related cases and tax developments keep on coming in addition to all of the virus-related developments.
As I periodically do, I provide updates of ag law and tax issues of importance to agricultural producers and others in the ag industry, as well as rural landowners in general.
That the topic of today’s post – a few recent developments in ag law and taxation.
FSA Not Entitled To Set-Off Subsidy Payments
In Re Roberts, No. 18-11927-t12, 2020 Bankr. LEXIS 1338 (Bankr. D. N.M. May 19, 2020)
Bankruptcy issues are big in agriculture at the present time. Several recent blog articles have touched on some of those issues, including bankruptcy tax issues. This case dealt with the ability of a creditor to offset a debt owed to it by the debtor with payments it owed to the debtor. The debtors (husband and wife) borrowed $300,000 from the Farm Service Agency (FSA) in late 2010. The debtors enrolled in the Price Loss Coverage program and the Market Facilitation Program administered by the FSA. The debtors filed Chapter 11 bankruptcy in mid-2018 and converted it to a Chapter 12 bankruptcy in late 2019. The debtors defaulted on the FSA loan after converting their case to Chapter 12.
The debtors were entitled to receive approximately $40,000 of total MFP and PLC payments post-petition. The FSA sought a set-off of the pre-petition debt with the post-petition subsidy payments. The court refused to the set-off under 11 U.S.C. §553 noting that the offsetting obligations did not both arise prepetition and were not mutual as required by 11 U.S.C. §553(a). There was no question, the court opined, that the FSA’s obligation to pay subsidy payments arose post-petition and that the debtors’ obligation to FSA arose pre-petition. Thus, set-off was not permissible.
HSA Inflation-Adjusted Amounts for 2021
Rev. Proc. 2020-32, 2020-24 I.R.B.
Persons that are covered under a high deductible health plan (HDHP) that are not covered under any other plan that is not an HDHP, are eligible to make contributions to a health savings account (HSA) subject to certain limits. For calendar year 2021, an HDHP is a health plan with an annual deductible of at least $1,400 for individual coverage or $2,800 for family coverage, and maximum out-of-pocket expenses of $7,000 for individual coverage or $14,000 for family coverage. For 2021, the maximum annual contribution to an HSA is $3,600 for self-only coverage and $7,200 for family coverage.
Charitable Deduction Allowed for Donated Conservation Easement
Champions Retreat Golf Founders, LLC v. Comr., No. 18-14817, 2020 U.S. App. LEXIS 15237 (11th Cir. May 13, 2020), rev’g., T.C. Memo. 2018-146
The vast majority of the permanent conservation easement cases are losers for the taxpayer. This one was such a taxpayer loser at the Tax Court level, but not at the appellate level. Under the facts of the case, the petitioner claimed a $10.4 million charitable deduction related to the donation of a permanent conservation easement on a golf course. The IRS denied the deduction on the basis that the easement was not exclusively for conservation purposes because it didn’t protect a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem as required by I.R.C. §170(h)(4)(A)(ii). The IRS also asserted that the donation did not preserve open space for the scenic enjoyment of the general public or in accordance with a governmental conservation policy for the public’s benefit under I.R.C. §170(h)(4)(A)(iii). The Tax Court agreed with the IRS and denied the deduction. The Tax Court determined that the “natural habitat” requirement was not met – there was only one rare, endangered or threatened species with a habitat of only 7.5 percent of the easement area. In addition, the Tax Court noted that part of the golf course was designed to drain into this habitat area which would introduce chemicals into it. Thus, the easement’s preservation of open space was not for public enjoyment nor in accordance with a governmental policy of conservation.
On further review, the appellate court reversed. The appellate court found that the deduction was proper if the donation was made for the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem or was made for the preservation of open space for the scenic enjoyment of the general public. The appellate court noted that without the golf course, the easement would satisfy the requirements and an easement deduction is not denied simply because a golf course is included. The appellate court remanded the case for a determination of the proper amount of the deduction.
Residence Built on Farm Was “Farm Residence” For Zoning Purposes
Hochstein v. Cedar County. Board. of Adjustment, 305 Neb. 321, 940 N.W.2d 251 (2020)
Many cases involve the issue of what is “agricultural” for purposes of state or county zoning and related property tax issues. In this case, Nebraska law provided for the creation of an “ag intensive district.” In such designated areas, any “non-farm” residence cannot be constructed closer than one mile from a livestock facility. The plaintiff operated a 4,500-head livestock feedlot (livestock feeding operation (LFO)) and an adjoining landowner operates a farm on their adjacent property. The adjoining landowner applied to the defendant for a zoning permit to construct a new house on their property that was slightly over one-half mile from the plaintiff’s LFO. The defendant (the county board of adjustment) approved the permit and the plaintiff challenged the issuance of the permit on the basis that the adjoining landowner was constructing a “non-farm” residence. The defendant affirmed the permit’s issuance on the basis that the residence was to be constructed on a farm. The plaintiff appealed and the trial court affirmed. On further review, the appellate court affirmed. On still further review by the state Supreme Court, the appellate court’s opinion was affirmed. The Supreme Court noted that the applicable regulations did not define the terms “non-farm residence” or “farm residence.” As such, the defendant had discretion to reasonably interpret the term “farm residence” as including a residence constructed on a farm.
Ag Cooperative Fails To Secure Warehouse Lien; Loses on Conversion Claim.
I dealt with the issue in this case in my blog article of March 27. You may read it here: https://lawprofessors.typepad.com/agriculturallaw/2020/03/conflicting-interests-in-stored-grain.html In the article, I detail many of the matters that arose in this case.
The facts of the case revealed that a grain farmer routinely delivered and sold grain to the defendant, an operator of a grain warehouse and handling facility. The contract between the parties contemplated the sale, drying and storage of the grain. The farmer also borrowed money from the plaintiff to finance the farming operation and granted the plaintiff a security interest in the farmer’s grain and sale proceeds. The plaintiff filed a financing statement with the Secretary of State’s office on Feb. 29, 2012 which described the secured collateral as “all farm products” and the “proceeds of any of the property [or] goods.” The financing statement was amended in late 2016 and continued. The underlying security agreement required the farmer to inform the plaintiff as to the location of the collateral and barred the farmer from removing it from its location without the plaintiff’s consent unless done so in the ordinary course of business. It also barred the farmer from subjecting the collateral to any lien without the plaintiff’s prior written consent. However, the security agreement also required the farmer to maintain the collateral in good condition at all time and did not require the plaintiff’s prior written consent to do so.
The plaintiff complied with the 1985 farm products rule and the farmer gave the plaintiff a schedule of buyers of the grain which identified the defendant. From 2014 through 2017, the farmer sold grain to the defendant, and the defendant remitted the net proceeds of sale via joint check to the farmer and the plaintiff after deducting the defendant’s costs for drying and storage – a longstanding industry practice. The plaintiff, an ag lender in an ag state, claimed that it had no knowledge of such deductions until 2017 whereupon the plaintiff sued for conversion. The defendant did not properly perfect a warehouse lien and the lien claim was rejected by the trial court, but asserted priority on a theory of unjust enrichment. The trial court rejected the unjust enrichment claim.
The state Supreme Court agreed, refusing to apply unjust enrichment principles in the context of Article 9 of the Uniform Commercial Code (UCC). The court did so without any mention of UCC §1-103 (b) which states that, "Unless displaced by the particular provisions of the Uniform Commercial Code, the principles of law and equity” including the law merchant [undefined] and the law relative to capacity to contract; duress; coercion; mistake; principal and agency relationships; estoppel, fraud and misrepresentation; bankruptcy, and other validating or invalidating cause [undefined] supplement its provisions.” This section has been characterized as the "most important single provision in the Code." 1 J. White & R. Summers, Uniform Commercial Code § 5. “As such, the UCC was enacted to displace prior legal principles, not prior equitable principles.” However, the Supreme Court completely ignored this “most important single provision in the Code.” The Court also ignored longstanding industry practice and believed an established ag lender in an ag state that it didn’t know the warehouse was deducting its drying and storage costs before issuing the joint check.
The developments keep rolling in. More will be covered in future articles.
Monday, May 25, 2020
A taxpayer that donates a “qualified real property interest” to a “qualified organization” can receive a charitable contribution deduction upon satisfying numerous technical requirements. A primary requirement is that the easement donation be exclusively for conservation purposes. That requirement, however, can only be satisfied if the conservation purposes are protected in perpetuity. I.R.C. §§170(h)(2)(C); (h)(5)(A). Essentially, that means that legally enforceable restrictions must be in place that will bar the use of the portion of the property that the taxpayer retains from being used in a manner that is inconsistent with the conservation purposes of the donated easement.
But, can anything here on earth really last forever? What if the easement is extinguished by court action? There’s a rule for that contingency and it requires careful drafting of the easement deed. Numerous court opinions have dealt with the issue, including a couple in recent weeks.
Dealing with potential extinguishment of a perpetual conservation easement donation – it’s the topic of today’s post.
The Issue of Extinguishment – Treasury Regulation
While the law generally disfavors perpetual control of interests in land, for a taxpayer to claim a tax deduction for a donated conservation easement, the easement must be granted in perpetuity. But if the conditions surrounding the property subject to a perpetual conservation easement make impossible or impractical the continued use of the property for conservation purposes, a Treasury Regulation details the requirements to be satisfied to protect the perpetual nature of the easement if a judicial proceeding extinguishes the easement restrictions. Treas. Reg. §1.170A-14(g)(6)(i)-(ii).
The regulation requires that, at the time of the donation, the donor must agree that the donation gives rise to a property right that is immediately vested in the donee. Treas. Reg. §1.170A-14(g)(6)(ii). The value of the gift must be the fair market value of the easement restriction that is at least equal to the proportionate value that the easement restriction, at the time of the donation, bears to the entire property value at that time. See Treas. Reg. §1.170A-14(h)(3)(iii) relating to the allocation of basis. The proportionate value of the donee’s property rights must remain constant such that if the conservation restriction is extinguished and the property is sold, exchanged or involuntarily converted, the done is entitled to a portion of the proceeds that is at least equal to that proportionate value of the restriction. The only exception is if state law overrides the terms of the conservation restriction and specifies that the donor is entitled to the full proceeds from the conversion restriction. Treas. Reg. §1.170A-14(g)(6)(ii).
Extinguishment – Cases
The formula language necessary to comply with the regulation must be precisely drafted. The IRS has aggressively audited perpetual easement restrictive agreements for compliance. Consider the following:
- In Carroll, et al. v. Comr., 146 T.C. 196 (2016), the petitioner contributed a conservation easement on a tract of land to two qualified organizations. The easement provided that if the conservation purpose was extinguished because of changed circumstances surrounding the donated property, the donees were entitled to a proportionate share of extinguishment proceeds not to be less than the amount allowed as a deduction to the donor for federal income tax purposes over the fair market value of the property at the time of the contribution. The plaintiff claimed a charitable contribution for the year of the contribution and carried forward the remaining balance to tax years 2006-2008.
Because the easement at issue provided that the value of the contribution for purposes of the donees’ right to extinguishment proceeds was tied to the amount of the petitioner’s allowable deductions rather than the fair market value of the easement, the court determined that the easement violated the Regulation and was not protected in perpetuity under I.R.C. §170(h)(5)(A). The court also imposed an accuracy-related penalty.
- In Palmolive Building Investors, LLC v. Comr., 149 T.C. No. 18 (2017), the petitioner acquired a building in 2001 for $58.5 million. In 2004, the petitioner transferred a façade easement on the building via deed to a qualified charity (a preservation council) to preserve the exterior building perimeter. The easement deed placed restrictions on the petitioner and its successors with respect to the façade easement and the building – the petitioner and any subsequent owner couldn’t demolish or alter the protected elements without the charity’s permission. The building was subject to two mortgages, but before executing the easement deed, the petitioner obtained mortgage subordination agreements from its mortgagee banks. However, the easement deed provided that in the event the façade easement was extinguished through a judicial proceeding, the mortgagee banks will have claims before that of the donee charity to any proceeds received from the condemnation proceedings until the mortgage is satisfied.
By the time of the easement donation, the value of the building had increased to $257 million, of which $33.4 million was attributable to the easement. The petitioner claimed a $33.4 million charitable contribution deduction for the tax year of the easement contribution. The IRS disallowed the deduction, claiming that the easement deed failed to satisfy the perpetuity requirements of I.R.C. §170 and Treas. Reg. §1.170A-14(g)(6)(ii) because it provided the mortgagees with prior claims to the extinguishment proceeds in preference to the donee. Specifically, the lender had agreed to subordinate the debt to the charity's claims, but the easement deed said that the lender would have priority access to any insurance proceeds on the property if the donor had insurance on the property. The easement deed also said that the lender would have priority to any condemnation proceeds.
The petitioner claimed that the First Circuit's decision in Kaufman v. Comr., 687 F.3d 21 (1st Cir. 2012) applied. In that case, the First Circuit rejected the view that a subordination must remove any preferential treatment of the lender in all situations, creating an exception for unusual situations that could possibly occur at some point in the future. The First Circuit determined that the Tax Court's reading of what is necessary to grant a perpetual easement would eliminate easement donations because an easement represented only a partial interest in property. In addition, the First Circuit reasoned that a broad reading was improper because, for example, a tax lien could arise if the donor failed to pay property tax when they became due which could result in the loss of the property without the charity receiving a pro rata portion of the property value.
In the present case, the Tax Court rejected the view of the First Circuit, noting that its decision would be appealable to the Seventh Circuit and, thus, the Tax Court was not bound by the First Circuit's decision. The Tax Court reasoned that because the lender had superior rights in certain situations, the mortgages did not meet the subordination requirement of Treas. Reg. §1.170A-14(g). Thus, the donated easement did not meet the perpetuity requirement of I.R.C. §170(h)(5). The Tax court also pointed out that other Circuits had agreed with the Tax Court's interpretation of the subordination rule since Kaufman was decided. The Tax Court also noted a difference concerning what must be done to subordinate an existing liability at the time of the donation (such as a mortgage) as opposed to a possible future liability that was not yet in existence. The Tax Court also noted that the Treasury Regulations specifically mentioned mortgages in the list of requirements necessary to satisfy the perpetuity requirement, but made no mention of a need to have taxing agencies to agree to give up rights to a priority interest that might arise in the future for delinquent taxes when the taxes were not delinquent.
The IRS assessed a gross valuation misstatement penalty in 2008 and additional accuracy-related and negligence penalties in 2014. The petitioner contested the penalties, but the Tax Court, in a later proceeding, determined that there is no requirement that IRS determine the penalties at the same time or by the same IRS agent. The only requirement, the Tax Court held, was that each penalty, at the time of initial determination, was approved in writing by a supervisor before being communicated to the petitioner. That requirement was satisfied. That later proceeding on the penalty issue is at 152 T.C. No. 4 (2019).
- In Salt Point Timber, LLC, et al. v. Comr., T.C. Memo. 2017-245, the petitioner was a timber company that granted a perpetual conservation easement on a 1,032-acre property for which the petitioner claimed a $2.13 million deduction on its 2009 return. The easement preserved the view of natural, environmentally significant habitat on the Cooper River by barring development. The petitioner received $400,000 for the donated easement, and the done satisfied the definition of a “qualified organization” under I.R.C. §170(h)(1)(B). The appraised value of the easement was $2,530,000. The IRS disallowed the deduction on the basis that the easement grant allowed the original easement to be replaced by an easement held by a disqualified entity. In addition, the IRS claimed that the grant allowed the property to be released from the original easement without the extinguishment regulation being satisfied. The petitioner claimed that there was a negligible possibility that the easement could be held by a non-qualified party. The court agreed with the IRS, noting that the grant did not define the term “comparable conservation easement” or what type of organization could hold it, just that an “eligible donee” could hold it. The court noted that an assignment of the easement is different from a replacement of the easement. As such, the grant did not restrict that the holder of the easement had to be a “qualified organization.” The court also determined that the chance that the easement could be replaced was other than negligible as Treas. Reg. §1.170A-14(g)(3) required.
- In PBBM-Rose Hill, Ltd., v. Comr., 900 F.3d 193 (5th Cir. 2018), the petitioner owned a tract of land subject to a use restriction requiring it to only be used for recreational facilities open space for 30 years. At the time of the petitioner’s ownership, the property was a golf course with a clubhouse. The petitioner wanted to sell the property, but before doing so wanted to remove the use restriction. A local buyer expressed interest, but also wanted to block any removal of the use restriction. The sale went through after the buyer agree to allow the removal of the use restriction. However, before the sale closed, the petitioner conveyed a conservation easement of the property to a land trust. The terms of the easement stated that the property was to remain open for public use for outdoor recreation and that fees for such use could be charged. Upon extinguishment of the easement, the land trust would be entitled to a portion of the sale proceeds equal to the greater of the fair market value of the easement at the time of the donation or a share of the proceeds after expenses of sale and an amount attributable to improvements constructed on the property. The IRS denied the charitable deduction.
The Tax Court agreed with the IRS position based on its findings that the easement did not protect the conservation purpose under I.R.C. §170(h)(4)(A) and didn’t satisfy the perpetuity requirement of I.R.C. §170(h)(5)(A) because the easement deed’s extinguishment provision did not comply with Treas. Reg. §1.170A-14(g)(6). As such, the easement donation was not “exclusively for conservation purposes as required by I.R.C. §170(h)(1)(C). The Tax Court held that the easement value was $100,000 rather than the $15.2 million that the petitioner claimed. The Tax Court also upheld the gross valuation misstatement penalty that the IRS had imposed. On appeal, the appellate court affirmed that the petitioner was not entitled to any charitable deduction and upheld the penalty. The appellate court held that when determining whether the public access requirement for a recreation easement is fulfilled, the focus is to be on the terms of the deed and not the actual use of the land post-donation. The appellate court determined that the terms of the easement satisfied the public-access requirement of Treas. Reg. §1.170A-14(d)(5)(iv)(C). However, the appellate court concluded that the contribution was not exclusively for conservation purposes because the requirements of Treas. Reg. §1.170A-14(g)(6)(ii) were not satisfied. The deed, the appellate court noted, allowed the value of improvements to be subtracted from the proceeds before the donee took its share, and that Priv. Ltr. Rul. 200836014 no longer represented the current position of the IRS and could not be used to alter the plain meaning of the regulation which mandates that the donee receive at least the proportionate value of the “proceeds.” The appellate court also agreed with the Tax Court that the gross valuation misstatement penalty applied to the difference between the amount the petitioner deducted on its return ($15 million) and the $100,000 deduction allowed by the Tax Court.
- In Coal Property Holdings, LLC v. Comr., 153 T.C. No. 7 (2019), the petitioner donated to a qualified charity an open space conservation easement over property which was previously subjected to surface coal mining and which was also subject to oil and gas leases and certain improvements. The IRS denied a charitable deduction because the easement wasn’t protected in perpetuity, and the Tax Court agreed. The conservation purpose of allowing the land subject to the easement to continue to recover from and provide scientific insight into the long-term effects of mining didn’t entitle the charity to a proportionate part of the proceeds if the subject property were sold upon a judicial extinguishment of the easement. As such, the easement wasn’t perpetual in nature as required by I.R.C. §170(h)(5)(A) and I.R.C. §1.170A-14(g)(6). While the petitioner claimed that the deed language contained a “regulation override” mandating that the deed be interpreted to satisfy the perpetuity requirements of the Code and Regulations, the Tax Court rejected that argument because it was a condition subsequent constituting a savings clause that the court would not enforce.
On this issue, the IRS also argues that when an easement deed’s proceeds allocation formula deducts (from the proceeds allocable to the done) an amount attributable to “improvements” made by the owner after the donation, no charitable deduction is allowed. The IRS position is that the deduction violates the extinguishment regulation (Treas. Reg. 1.170A-14(g)(6)(ii)), making the charitable deduction unavailable. See, e.g., Priv. Ltr. Rul. 200836014 (Sept. 5, 2008).
- In Railroad Holdings, LLC, et al. v. Comr., T.C. Memo. 2020-22, the petitioner donated a permanent conservation easement to a qualified entity and claimed a $16 million charitable deduction. The deed granting the easement contained a clause specifying the result if the easement were extinguished as the result of a court order. The IRS pointed out that in the event of a forced judicial sale, Treas. Reg. §1.170A-14(g)(6)(ii) requires the charity to receive an equal proportionate value of the sale proceeds that extinguishes the interest to the value of the easement as compared to the value of the property at the date of the donation. The language of the deed at issue held the charity’s payment constant, equal to the value as of the date of the contribution. It did not tie the charity’s payment to a percentage of the value of the property at the time of the forced sale equal to the percentage of value the easement was to the property at the time of the donation. The IRS denied the entire $16 million donation and the Tax Court agreed.
The Tax Court noted that the deed language did not create a proportion or fraction representing the donee’s share of the property right and a corresponding fraction of the proceeds to which the donee was entitled in perpetuity. Rather, the Tax Court noted, the language gave the charity a “proportionate value…at the time of the gift” which guaranteed only that a fixed dollar amount would go to the charity. The Tax Court also held as irrelevant a declaration of intent executed by an officer of the charity that the deed language reflected the charity’s intent to be in full compliance with the Code. What mattered was the donor’s intent, not the charity’s intent. Even so, the deed language failed to conform to the Code. The Tax Court also determined that the deed language was not ambiguous. Thus, the easement was not protected in perpetuity and the full deduction was disallowed.
Challenge to the Validity of the Regulation
In Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020), the petitioner challenged the validity of the extinguishment regulation. In 2008, the petitioner donated a permanent conservation easement to a qualified organization and claimed a charitable deduction. The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution. That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement. The IRS denied the charitable deduction because (inter alia) violated the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6).
The Tax Court, agreeing with the IRS, upheld the validity of the regulation. The full Tax Court held that the extinguishment regulation (Treas. Reg. §1.170A-14(g)(6)) had been properly promulgated and did not violate the Administrative Procedure Act. The full Tax Court also determined that the construction of I.R.C.§170(h)(5), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
In a related memorandum opinion, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made. Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54. It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed. However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable.
The extinguishment regulation is, perhaps, the most common audit issue for IRS when examining permanent conservation easement donations. The clause specifying how proceeds are to be split when a donated conservation easement is extinguished is routinely included in easement deeds. The cases point out that the clause must be drafted precisely to fit the confines of the regulation. A regulation that now has survived an attack on its validity. Many perpetual easement donations will potentially be affected.
Thursday, May 21, 2020
The TCJA eliminated tax-deferred like-kind exchanges of personal property for exchanges completed after 2017. However, exchanges of real estate can still qualify for tax-deferred treatment if the exchange involves real estate that is “like-kind.” But, what if the exchange involves non-like-kind cash “boot” or otherwise fails the requirements of the Code? Is there a way to still achieve tax deferral?
“Fixing” a tax-deferred exchange that has failed – it’s the topic of today’s post.
The tax deferral of an IRC §1031 exchange is only achieved if the requirements of IRC §1031 are satisfied. If the requirements are not satisfied, the exchange is taxable as a sale or exchange under the general rules of IRC §1001.
There are four basic requirements to achieving tax-deferred treatment under IRC §1031:
- There is an exchange of property rather than a sale; IRC §1031(a)(1).
- The property exchanged and the property received must be like-kind real estate;
- The property exchanged and the property received must both be held for the productive use in a trade or business or for investment; and
- The exchange of properties must be simultaneous, or the replacement property must be identified within 45 days of the exchange and the identified property must be received within 180 days of the identification or the due date of the return (including extensions), if shorter. IRC §§1031(a)(3)(A)-(B)((ii).
If an exchange satisfies the requirements of IRC §1031, but property is received that is not like-kind (such as money or other non-like kind property, the recipient of the property recognizes gain to the extent of the sum of the money and the fair market value of the non-like-kind property received. I.R.C. §1031(b). That means that tax deferral is not achieved with respect to the non-like-kind property (or “boot”) received in the exchange. But a taxpayer may elect to recognize the gain on the boot under the installment method of I.R.C. §453. Similarly, a taxpayer that fails to satisfy the requirements of IRC §1031 may be able to defer gain on the transaction under IRC §453 by properly structuring the sale.
Treasury Regulation Example
Treasury Regulation §1.1031(k)-(1)(j)(2)(vi), Example 4, indicates that a buyer’s installment note issued to a seller qualifies for installment treatment under IRC §453. In the Example, the buyer offers to buy the seller’s real property, but doesn’t want to have the transaction structured as a like-kind exchange. As a result, the seller enters into an exchange agreement with a qualified intermediary to facilitate the exchange. Under the agreement, the seller transfers the real property to the qualified intermediary who then transfers the property to the buyer. The buyer pays $80,000 cash and issues a 10-year installment note for $20,000. The Example specifies that the seller has a bona fide intent to enter into a deferred exchange, and the exchange agreement specifies that the seller cannot receive, pledge, borrow or otherwise obtain the benefits of the money or other property that the qualified intermediary held until the earlier of the date the replacement property is delivered to the seller or the end of the exchange period. The Example also points out that the buyer’s obligation bears adequate stated interest and is not payable on demand or readily tradable. The qualified intermediary acquires replacement property having a fair market value of $80,000 and delivers it, along with the $20,000 installment obligation, to the seller.
While the $20,000 of the seller’s gain does not qualify for deferral under IRC §1031(a), the seller’s receipt of the buyer’s obligation is treated as the receipt of an obligation of the person acquiring the property for purposes of installment reporting of gain under IRC §453. Thus, the Example concludes that the seller may report the $20,000 gain on the installment method on receiving payments from the buyer on the obligation
A safe harbor exists that provides protection against an IRS assertion that a taxpayer is in actual or constructive receipt of money or other property held in a qualified escrow account, qualified trust, or by a qualified intermediary. Treas. Regs. §§1.1031(k)-1(g)(3)-(4); T.D. 8535 (Jan. 1994). With respect to a qualified intermediary, the determination of whether a taxpayer has received payment for purposes of IRC §453 is made as if the qualified intermediary is not the taxpayer’s agent. Treas. Regs. §§1.1031(k)-1(j)(2)(ii); (g)(4). Thus, when a taxpayer transfers property under such an arrangement and receives like-kind property in return, the transaction is an exchange rather than a sale, and the qualified intermediary is not deemed to be the taxpayer’s agent. See Priv. Ltr. Rul. 200327039 (Mar. 27, 2003). Similarly, when a buyer places money in an escrow account or with the qualified intermediary, the seller is not in constructive receipt of the funds if the seller’s right to receive the funds is subject to substantial restriction. See, e.g., Stiles v. Commissioner, 69 T.C. 558 (1978). The Treasury Regulations state that any agency relationship between the seller and the qualified intermediary is disregarded for purposes of IRC §453 and Treas. Reg. §15a.453-1(b)(3)(i) in determining whether the seller has constructively received payment. Treas. Reg. §1.1031(k)-1(j)(2)(vi), Example 2.
Exchange Transaction Example
Assume that Molly Cule owns a tract of farmland that she uses in her farming business and would like to exchange it for other farmland in an I.R.C. §1031 transaction. Bill Bored and Molly enter into a purchase contract, calling for Bill to buy Molly’s farmland. The purchase contract clearly states that Bill must accommodate Molly’s desire to complete an IRC §1031 exchange and states that Molly desires to enter into an IRC §1031 exchange. Molly and a qualified intermediary then enter into an exchange agreement specifying that the qualified intermediary agrees to acquire Molly’s farmland and transfer it to Bill. The agreement also states that the qualified intermediary will acquire like-kind farmland and transfer it to Molly. Molly assigns her rights in and to the farmland she gave up to the qualified intermediary. She also assigns her rights to the qualified intermediary in all contracts she enters into with the owner who holds title to the replacement farmland.
The exchange agreement requires Molly to identify replacement farmland within 45 days of the initial exchange and to notify the qualified intermediary of the identified parcel within that 45-day period. The exchange agreement allows Molly 180 days from the date of the first exchange to receive the identified property.
The exchange agreement specifies that the qualified intermediary will sell Molly’s farmland and hold the sales proceeds until the qualified intermediary buys replacement farmland. When the replacement farmland is purchased, it will then be transferred to Molly.
Structured sale aspect. The exchange agreement says that if the transaction qualifies under I.R.C. §1031, but Molly receives “boot,” the qualified intermediary and Molly must engage in a structured sale for the boot. This is to bar Molly from having any right to receive cash from the exchange. Similarly, the exchange agreement contains additional language stating that if the transaction fails to qualify for I.R.C. §1031 treatment for any reason, the qualified intermediary and Molly must engage in a structured sale. The structured sale involves the qualified intermediary making specified periodic payments to Molly pursuant to an installment sale agreement (based on the consideration the qualified intermediary holds) coupled with a note for a set number of years. Thus, the exchange agreement is drafted to specify that if an installment sale results, Molly will report each payment received into income in the year she receives it.
The assignment agreement. If the installment sale language is triggered, the exchange agreement specifies that the qualified intermediary will assign its obligations to make the periodic payments under the installment note to an assignment company pursuant to a separate assignment agreement between the qualified intermediary and the assignment company. Molly is not a party to this agreement. The assignment agreement requires the qualified intermediary to transfer a lump sum to the assignment company. The lump sum amount equals the discounted present value of the stream of payments that the qualified intermediary must make under the installment note and exchange agreement. In return, the assignment company assumes the qualified intermediary’s obligation to pay Molly. Thus, the assignment company becomes an obligor under the installment note.
As discussed above, Example 4 of Treas. Reg. §1.1031(k)-1(j)(vi), involves an installment note that the buyer issues to the seller of the property. That note qualifies for installment treatment under I.R.C. §453. In the example involving Molly, it is the qualified intermediary that issues the note. While the regulation states that the qualified intermediary is not the agent of the Molly for purposes of IRC §453, that is only the case until the earlier of the identification (or replacement) period, or the time that Molly has the unrestricted right to receive, pledge, borrow or otherwise benefit from the money or other property that the qualified intermediary holds. Treas. Reg. §1.1031(k)-1(j)(2)(ii). But, the risk of Molly being in constructive receipt of the buyer’s funds is eliminated if the exchange agreement is drafted carefully to fit within the safe harbor.
As an alternative to the approach of the example involving Molly, what if a different taxpayer, Millie, engaged in a similar transaction and used installment reporting but received all of the cash up front via a loan. Will an arrangement structured in this manner achieve tax deferral?
Facts of the example. Millie sells an asset to Howard’s Exchange Service (HSE) and HSE resells the asset to Andy. Millie receives a loan from Usurious Bank, an independent lender shortly after selling the asset to HSE for an amount equating the selling price to HSE. The repayment of the loan is funded by installment payments over a period of time that HSE makes to Usurious Bank. Three escrow accounts are established with an escrow company affiliated with Usurious Bank. The escrow company, on a monthly basis, takes funds from HSE and moves it into Escrow Account No. 1 as an interest payment on the loan; then to Escrow Account No. 2 (which is designated as Millie’s account); and then to Escrow Account No. 3 to pay interest on the loan. The transactions are conducted as automatic debit/credit transactions that occur on a monthly basis over the length of the installment period.
Analysis. IRC §453 requires that the initial debt obligation be that of the buyer of the property for the seller to receive installment treatment on the proceeds of sale. If the obligor is someone other than the buyer, the debt is treated as payment on the sale. Treas. Reg. §15a.453-1(b)(3)(i). Thus, for installment sale treatment to result, HSE must be both the buyer of the asset and the obligor on the installment note rather than only being the obligor. This means that the transaction must be structured such that the obligation is due to Millie from Andy, followed by a substitution of the obligor via an independent transaction in which Andy assigns the obligation. In Rev. Rul. 82-122, 1982-1 C.B. 80, amplifying Rev. Rul. 75-457, 1974-1 C.B. 115, the substitution of a new obligor on the note and an increase in the interest rate, together with an increase in the amount paid monthly to reflect the higher interest rate, was not considered to be a satisfaction or disposition of an installment obligation within the meaning of I.R.C. §453B(a).
As for the escrow accounts, generally an installment note of the buyer cannot be used as security or pledged to support any other debt that benefits the seller. If that happens, the net proceeds of the debt are treated as a payment received on the installment sale. See IRC §453A(d)(1); Treas. Reg. §15A.453-1(b)(3)(i); Rev. Rul. 79-91, 1979-1, C.B. 179; Rev. Rul. 77-294, 1977-2, C.B. 173; Rev. Rul. 73-451, 1973-2, C.B. 158. However, there is an exception to this “pledge rule” that triggers gain recognition if the seller uses an installment obligation to secure a loan. Property that is used or produced in the trade or business of farming is not subject to the rule. I.R.C. §453A(b)(3)(b). Thus, a taxpayer who sells farmland (or other farm property) in an installment sale may use that installment receivable as security, or in a pledged manner, to borrow funds from a third party. The third party should collateralize the payments and file a UCC-1 to formally pledge and secure the installment payments
Tax-deferred exchanges post-2017 are limited to real estate exchanges. Normally, only the like-kind portion of the exchange qualifies for deferral. However, if an exchange involving farm property is structured properly, tax deferral can be achieved for the entire transaction. Careful drafting of the contracts involved is critical.
Friday, May 15, 2020
The interest among some farmers and ranchers in converting some of their land into a “solar farm” is growing. The opportunity for additional cash in tough economic times is driving the interest. Is it a good investment? Of course, the boondoggles of Solyndra, LLC in California and Crescent Dunes in Nevada are a reminder that such ventures can turn up dry. In addition, the federal government encourages ventures into solar energy production with the use of taxpayer dollars.
Solar energy production and the tax credit for producing electricity from the sun – it’s the topic of today’s post.
Residential Energy Credit
Currently, a taxpayer may claim a residential energy efficient property credit of 26 percent credit for the costs of the solar panels and related equipment and material installed to generate electricity for use by a residential or commercial building. I.R.C. §25D. A taxpayer is “allowed as a credit against the tax imposed…for the taxable year, an amount equal to the sum [of] the qualified solar electric property expenditures” – expenditures “for property which uses solar energy to generate electricity for use in a dwelling unit located in the United States and used as a residence by the taxpayer.” I.R.C. §25D(2). The credit is computed by taking into account the cost of solar panels as well as piping or wiring to connect the property to the dwelling unit plus labor costs. For a newly constructed home, the taxpayer may request that the homebuilder make a reasonable allocation, or the taxpayer may use any other reasonable method to determine the cost of the property that is eligible for the credit. IRS Notice 2013-70, 2013-47 IRB 528, Q&A No. 21.
A taxpayer that claims the credit for solar energy property installed in the taxpayer’s principal residence or vacation home must reduce the taxpayer’s income tax basis in the property by the amount of the credit. A “home” includes a house, houseboat, mobile home, cooperative apartment, condominium, and a manufactured home. See Instructions to Form 5695, Residential Energy Credits.
Commercial (Business) Energy Credit
I.R.C. §48 provides a credit for “energy property placed in service during [the] taxable year.” I.R.C. §48(a)(1). The amount of the credit is a percentage of energy based on each energy property placed in service during the taxable year. The energy percentage is 26 percent for solar energy property that is under construction on or before December 31, 2020 and placed in service before January 1, 2024. The credit belongs to the owner of the solar energy property. The credit is claimed on Form 5695 with the amount of the credit carried to Form 1040.
IRS Notice 2013-70 provides taxpayers with two methods to establish the beginning of construction – either by starting physical work of a significant nature (the “Physical Work” test) or by satisfying a safe harbor (the “Five Percent Safe Harbor” test). Under the safe harbor, construction is deemed to begin when the taxpayer pays or incurs five percent or more of the total cost of the energy property and thereafter makes continuous efforts to advance towards completion of the energy property. While either method may be used, construction is deemed to have begun on the date the taxpayer first satisfies one of the two methods.
Energy property is defined as any “equipment which uses solar energy to generate electricity to…a structure” and “equipment which uses solar energy to illuminate the inside of a structure.” I.R.C. §48(a)(3). The regulations provide additional guidance. Treas. Reg. §1.48-9(d)(1) provides that “solar energy property’ includes equipment and materials (and parts related to the functioning of such equipment) that use solar energy directly to (i) generate electricity (ii) heat or cool a building or structure, or (iii) provide hot water for use within a building or structure.” Treas. Reg. §1.48-9(d)(3) defines electric generation equipment as follows:
“Solar energy property includes equipment that uses solar energy to generate electricity, and includes storage devices, power conditioning equipment, transfer equipment, and parts related to the functioning of those items. In general, this process involves the transformation of sunlight into electricity through the use of such devices as solar cells or other collectors. However, solar energy property used to generate electricity includes only equipment up to (but not including) the stage that transmits or uses electricity.”
In addition, Treas. Reg. §1.48-9(d)(4) specifies that “[p]ipes and ducts that are used exclusively to carry energy derived from solar energy are solar energy property.” Because the credit is part of the general business credit under I.R.C. §38. Property that is eligible for the general business credit is tangible property for which depreciation is allowable.
The solar energy credit is part of the investment credit under I.R.C. §46(2) which means that it is subject to the rules that apply to unused general business credits under I.R.C. §38(a). Unused credit amounts are carried back one year and then to each of the 20 years following the unused credit year. The credit is nonrefundable and may only be used against the taxpayer’s actual tax liability. The entire amount of the unused credit must be carried back one year before it may be carried over to the next 20 years. I.R.C. §39(a)(2)(A).
The solar equipment can be owned by one party and used on another person’s property. In that situation, the owner/lessor may claim the energy credit provided that the solar property is placed in service and meets the other requirements of I.R.C. §48. Rev. Rul. 79-264, 1979-2 C.B. 92.
As noted, the owner of the solar energy property is entitled to the energy credit. If IRS challenges the ownership issue in lessor/lessee situations, the most important factor in determining ownership is the source of capital for the solar energy property. The party that is exposed to the risk of loss from supplying the necessary capital for the asset and retaining an actual and legal proprietary interest in the asset is the owner of the property that is entitled to the credit.
A lessor of new solar energy property may elect to pass the credit to the lessee if the transaction involves a profit intent and the and the lease is a bona fide lease. The property is deemed to be place in service when it is first held out for leasing to others in a profit-motivated leasing venture. See, e.g., Cooper v. Commissioner, 88 T.C. 84 (1987). A sale/leaseback is also possible which allows the lessee to claim the credit or would permit the lessor to pass-through its credit to a lessee.
A recent U.S. Tax Court case, Golan v. Comr., T.C. Memo. 2018-76, involved the solar energy credit as well as associated income tax basis, depreciation, at-risk and passive loss issues. The case is a good illustration of the issues that can arise when a farmer or rancher (or other taxpayer) gets involved with a “solar farm” project.
Fact of the case. In 2010, the petitioners (a married couple), sought an income-producing investment and thought they would do so by purchasing solar equipment from a seller of such equipment. The seller identifies property owners and offers them discounted electricity in exchange for permission to install solar panels and related equipment on their properties (known as “host properties”) The seller remains the owner of the solar equipment and temporarily retains the burdens and benefits of ownership (including all resulting tax credits and rebates). Then, the seller sells the solar equipment (and the associated rights and obligations) to a buyer such as the petitioners. An owner of a host property filed an application with the local utility company for an interconnection agreement (for net energy metering), and the seller entered into a power purchase agreement (PPA) with the owner of the host property. The seller, as noted, temporarily retained ownership of the solar equipment and was responsible for any servicing or repairs. The PPA barred the owner of the host property from assigning the PPA to another party without the seller’s consent, but the seller could assign it interest in the PPA to another party with 30 days’ notice to the host. Once the solar panels were installed, the utility company informed the host property owner of eligible rebates, which the host property owner assigned to the seller.
The sale of the solar equipment to the petitioners was accomplished in 2010 under a solar project purchase agreement coupled with a promissory note and guarantee that the petitioner’s signed. It was completed with a bill of sale and conveyance. The solar equipment was installed on the host properties in 2010, but under the purchase agreement, the “original use” of the solar equipment “shall commence on or after the Closing Date.” The purchase price was set at $300,000, consisting of a $90,000 down payment due on closing in early 2011; a $57,750 credit for the rebates the seller received from the utility company before the sale; and the petitioners’ promissory note in the principal amount of $152,250 with interest at 2 percent. The solar equipment secured the note and all monthly revenue generated from the solar equipment was to be applied to the note. If accrued interest exceeded monthly receipts for any particular month, the difference was to be carried forward and the petitioners would owe it in future months. If monthly receipts exceeded accrued interest and amortized principal, the excess would accelerate the loan’s repayment. Upon default, the seller would seek recourse against the solar equipment before exercising any remedies against the petitioners, and the petitioners were liable to pay any deficiencies owed to the seller if sale of the collateral upon foreclosure didn’t pay outstanding amounts owed to the seller. The petitioners also signed a guarantee for the note.
Ultimately, the petitioners failed to pay the down payment in 2011 but did make partial payment in 2012 and 2013. In addition, the petitioners directed the owners of the host properties to make direct payment of electricity bills to the seller who then credited the payments toward the note. The seller continued to honor the purchase agreement.
On their 2011 return, the petitioners Schedule C reported no income, but claimed various deductions including depreciation of $255,000. The petitioners stated that the Schedule C business was as a “consultant” for the seller’s business. The petitioners were also on the cash method of accounting. The $255,000 figure was arrived at as the difference between their claimed $300,000 basis in the solar equipment and $45,000. The $45,000 was one-half of the $90,000 energy credit claimed reduced by one-half in accordance with IRC §§50(c)(1) and (3)(A). On their associated Form 4562, the petitioners stated that the $255,000 deduction was a “[s]pecial depreciation allowance for qualified property.” Also attached to the 2011 return was Form 3468 on which they claimed a $90,000 energy credit (30 percent of $300,000).
The IRS disallowed the depreciation deduction on the basis that the solar equipment did not qualify for “bonus” depreciation because it was neither acquired after September 8, 2010 nor placed in service before January 1, 2012. The IRS also disallowed the energy credit claiming that the petitioners did not have a basis in the energy property because no funds changed hands. In addition, the IRS asserted that the petitioners were not at-risk with respect to the promissory note and, as a result, could not claim any basis in the note. The IRS based its position that the seller had a prohibited continuing interest in the solar equipment activity. See I.R.C. 465(b)(3). The IRS also took the position that the passive loss rules applied to the petitioners’ Schedule C loss and claimed solar energy credit. An accuracy-related penalty was also applied.
The Tax Court’s holdings:
- Income tax basis. Because the down payment of $90,000 payment was not paid in 2011, that amount could not be applied to the petitioners’ basis in the solar property for 2011, citing Treas. Reg. §1.1012-1(a). As for the $57,750 credit for the rebates assigned to the utility company by the owners of the host properties, the petitioners neither received them nor reported them as income. This amount could also not be applied to the petitioners’ basis in the solar equipment. It was not part of the petitioners’ cost of the solar equipment. The $152,250 promissory note was a recourse obligation that was issued in exchange for the solar equipment. As such, the face amount of the note could be included in the petitioners’ basis in the solar equipment.
The result was that the petitioners’ income tax basis in the solar equipment was $152,250.
- Bonus depreciation. The Tax Court determined that the solar equipment (which has a recovery period of 20 years) did qualify for bonus depreciation because the petitioners acquired it (as the original user) in January of 2011 and placed it in service that year. While the solar property was installed on the host properties in 2010, the IRS failed to prove that the property was connected to the grid in before 2011. As such, the solar property was not ready and available for its intended use until it was connected to the electric grid, and that was in 2011 rather than 2010.
- At-risk rules. The Tax Court disagreed with the IRS claim that the seller had a prohibited continuing interest in the solar equipment activity under I.R.C. §465(b)(3). The IRS failed to identify any provision of the purchase agreement entitling the seller to the solar equipment upon liquidation. Similarly, the seller was not shown to have an interest in the net profits of the petitioners’ solar energy venture. The right to have monthly revenue applied to the note was a permitted gross receipts interest. It was immaterial that the seller was also a promoter of the transaction.
- Passive loss rules. The petitioners claimed that the husband participated in the solar energy venture for at least 100 hours in 2011 and that his participation was not less than that of any other individual, thus satisfying the material participation test of Temp. Treas. Reg. §1.469-5T(a)(3). The Tax Court viewed the husband’s testimony as credible and that the IRS failed to establish otherwise.
- The Tax Court did not uphold the accuracy-related penalty, finding that the petitioners made a good faith effort to determine their tax liability and reasonably relied on the advice of their tax preparer.
The tax credit for solar energy electricity production is designed to incentivize solar energy production. But, there are other considerations besides tax in determining whether a “solar farm” investment is a good one for any particular farmer or rancher. Each situation is dependent on the facts. For those interested in a “solar farm” investment, seek good legal and tax counsel.
Wednesday, May 6, 2020
On April 1, https://lawprofessors.typepad.com/agriculturallaw/2020/04/disasteremergency-legislation-summary-of-provisions-related-to-loan-relief-small-business-and-bankruptcy.htmlI published a detailed article on this blog concerning the CARES Act and, in particular, the Paycheck Protection Program (PPP). The PPP is an extension of the existing Small Business Administration (SBA) 7(a) loan program for a “qualified small business” with many of the existing restrictions on 7(a) loans waived for a set timeframe including guarantee and collateral requirements and the requirement that the borrower cannot find credit elsewhere. The purpose of the program is to support small businesses and help support their payroll during the coronavirus situation. In addition, a small business loan borrower is eligible for loan forgiveness on existing SBA 7(a) loans.
Over the past six weeks, the U.S. Treasury Department and the SBA have been issuing guidance concerning various aspects of the CARES Act, including the PPP. In spite of all of the guidance, questions remain for farmers and ranchers.
Lingering questions and issues surrounding the PPP – it’s the topic of today’s post.
Is Ag Eligible?
After some initial questions concerning whether farming and ranching businesses qualified for the PPP, the SBA issued an Interim Final Rule and an FAQ clarifying that ag businesses are eligible upon satisfying certain requirements. Unfortunately, while ag businesses are eligible apparently some lenders were apparently advising farmers that participation in the PPP would either reduce their USDA farm subsidies or eliminate their eligibility for them. That is not true. There is no basis for reaching that conclusion based on the statutory language. Some lenders were also apparently informing farmers that they wouldn’t be eligible for the ag part of the CARES Act Food Assistance Program. Again, there is no basis for that conclusion.
Other Areas of Concern
Loss on Schedule F? While the SBA has clarified that Schedule F income can be used for computing loan eligibility, the SBA has taken the position that a loss on line 34 of Schedule F disqualifies the farm/ranch taxpayer from loan eligibility based on earnings. Thus, such a farmer can only qualify for a PPP loan based on employee payroll costs (if any). That’s a harsh rule as applied to farmers and ranchers – particularly smaller operations that don’t have employees. Income that shows up on a form other than Schedule F doesn’t count toward for purposes of loan computation. While this could be changed in the future, the present position of the SBA is that eligible income is only that subject to self-employment tax.
Passive rental income. As noted above, the SBA position is that loan eligibility is tied to self-employment earnings. Apparently, that position means that rental income that is not reported on Schedule F fails to qualify (such as that reported on either Schedule E or on Form 4835).
Partnerships. For a partnership, PPP loan filing is at the partnership level. Thus, a partner is precluded receiving a loan at the partner level. A partnership can count all employee payroll costs for loan computational purposes and all self-employment income of partners reported on line 14a of Schedule K/K-1. That amount is then reduced by any I.R.C. §179 expense deduction claimed; unreimbursed partnership expenses claimed, and depletion claimed on oil and gas properties. The result is then multiplied by 92.35% to arrive at net self-employment earnings. If the final amount exceeds $100,000, it is to be reduced to $100,000. Whether that same computational approach applies to a Schedule F farmer (or Schedule C filer) is unclear. Relatedly, it’s unclear whether the ordinary income of manager-managed LLCs where self-employment tax is reduced counts toward the PPP loan computations purposes. Likewise, if a taxpayer has an interest in more than one partnership that are treated as self-employed entities, a question remains as to whether each entity can qualify for a loan or whether the $100,000 compensation limit must be allocated among the partnerships. The same lack of clarity applies to LLCs taxed as a partnership.
Commodity wages. In computing eligible wages, S or C corporations are only allowed to use taxable Medicare wages & tips from line 5c of Form 941 (Employer’s Quarterly Federal Tax Return). These wages are subject to FICA and Medicare taxes. If eligible wages must be subject to FICA and Medicare tax, agricultural commodity wages will not be eligible. Thus, the question is whether Form 943 (Employer’s Annual Federal Tax Return for Agricultural Employees) filers are to be treated as Form 941 filers.
Payroll costs. Certain sectors of the agricultural economy hire a significant amount of H2A workers. Recent guidance of the SBA and the Treasury indicate that wages paid to an H2A worker can count as eligible “payroll costs” if the worker satisfies the “principle place of residence” test under the Internal Revenue Code – at least 183 days present in the U.S. during the year. That would seem to mean that H2A workers in the U.S. year-round will also qualify. What’s not clear is whether wages paid to H2A workers count even if ultimately the worker is to return to the worker’s home country.
Loan forgiveness. As I noted in my article of April 1, https://lawprofessors.typepad.com/agriculturallaw/2020/04/disasteremergency-legislation-summary-of-provisions-related-to-loan-relief-small-business-and-bankruptcy.html loan proceeds that are forgiven and are not included in the recipient’s income do not give rise to deductible expenses by virtue of I.R.C. §265. On April 30, the IRS agreed. I.R.S. Notice 2020-32. Now certain members of the Congress are putting pressure on the I.R.S. to change its position. Another area needing clarification is how the amount of the loan that is forgiven is to be computed for a sole proprietor or self-employed taxpayer – is it based on eight weeks of self-employment income in 2019 plus qualified expenses, or is it simply limited to eight weeks of self-employment income? Is employer compensation counted as “wages”?
Bankruptcy. Can a debtor in reorganization bankruptcy apply for a PPP loan and receive funds upon satisfying the requirements for a loan? The answer, at least according to one bankruptcy court, is “yes.” In re Springfield Hospital, Inc., No. 19-10283, 2020 Bankr. LEXIS 1205 (Bankr. D. Vt. May 4, 2020). This is an important development for small businesses and farming operations.
The uncertainties surrounding the PPP are largely a result of the legislation being crafted in a rush without numerous hearings and vetting of the statutory language and thought being given to related impacts of the statutory provisions. Since enactment of the CARES Act in late March, guidance from the SBA and the Treasury/IRS has largely been of the non-substantial authority type. It’s not binding on the IRS or taxpayers. Unless the unclear aspects of the PPP are clarified substantially, it could mean that litigation could arise and be ongoing into the future.
Friday, April 24, 2020
This coming July, Washburn Law School will be conducting a national conference on farm income tax and farm estate and business planning in Deadwood South Dakota. Also occurring nearly simultaneously will be the law school’s first “CLE Excursion.” In today’s post I provide a preview of the conference and the excursion.
Farm Income Tax/Estate and Business Planning Conference
If you represent ag clients in handling tax issues and or work with them on estate and business plans, this conference is a focused event on issues tailored to the farm clientele that will be useful to your business. Numerous tax rules as well as the rules surrounding estate and business planning for the ag client are unique. The unique rules and the planning challenges and opportunities they present will be discussed.
The conference will be held at the Lodge at Deadwood, a premier conference facility just outside Deadwood, South Dakota in the beautiful Black Hills with proximity to Mount Rushmore, Devils Tower, Spearfish Canyon and other beautiful locations.
Day 1 (July 20) – Farm Income Tax
On Monday, July 20, the discussion will focus on various farm income tax topics. Speakers for the day include myself, Paul Neiffer, and U.S. Tax Court Judge Elizabeth Crewson Paris The topics for the day include:
- Caselaw and IRS update
- GAAP Accounting Update
- Restructuring Credit Lines
- Deducting Bad Debts
- Forgiving Installment Sale Obligations
- Passive Losses
- R.C. §199A Advanced Planning
- Practicing Before the U.S. Tax Court
- NOLs and EBLs
- FSA Advanced Planning
- Like-Kind Exchanged and I.R.C. §1245 property
Day 2 (July 21) – Farm Estate and Business Planning
On Tuesday, July 21, the focus will shift to farm estate and business planning. Speakers for the day along with myself will be Prof. Jeff Jackson, Brandon Ruopp, Marc Vianello and Prof. Shawn Leisinger
- Caselaw and IRS update
- Incorporating a Gun Trust Into an Estate Plan
- Retirement Planning
- Common Estate Planning Mistakes of Farmers and Ranchers
- Post-Death Management of the Family Farm and Ranch Business
- Estate and Gift Tax Discounts for Lack of Marketability
- Valuation of Farm Chattels and Marketing Rights
- Ethical Issues Related to Risk
You can learn more about the conference and find registration information here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
Corresponding with the farm income tax and estate/business planning conference will be Washburn Law School’s “CLE Excursion. While this event is primarily for Washburn Law Alumni, others are welcome to register. An informal gathering will be on Friday evening, July 17. On Saturday, July 18, with two hours of CLE that day. A day of sightseeing is planned for Sunday, July 19 and a couple of hours of CLE are also available that day as well as a reception that evening preceding the two-day tax and estate/business planning conference that begins the next day. All of the CLE events and the reception will be held at the Lodge at Deadwood. Additional CLE topics for this July 20 event will be:
- Gun Trusts
- Law and Technology
Also on July 20 an excursion will also take place to Mount Rushmore and Crazy Horse mountain. You can learn more about this event and register here: http://washburnlaw.edu/employers/cle/deadwoodcle.html
This conference will take place shortly after the end of the filing season at a time when many will also be ready for a nice place to vacation at and also take in a continuing education conference. It is also possible to register for both events and pick and choose the topics you would like to attend. In addition, the farm income tax/farm estate and business planning conference can also be attended online as it will be broadcast live online. A room block has been established for the tax/planning conference. When you call the Lodge at Deadwood, just mention that you will be attending Washburn Law School’s summer conference. A special rate has been negotiated for the room block.
I hope to see you in Deadwood this summer. If you can’t be there, I hope you can attend online.
Friday, April 10, 2020
In recent days, the Congress has enacted and the President has signed into law various pieces of legislation to provide economic relief to individuals and businesses as a result of the economic devastation as a result of government’s reaction to a novel viral strain of influenza originating in China that spread to the United States. On March 27, the President signed H.R. 748 into law. That bill, known as the Coronavirus Aid, Relief and Economic Security Act (CARES Act), contains multiple parts. Last week I addressed the bankruptcy and loan/grant provisions of the law. Earlier this week I covered the retirement related provisions. Today’s discussion focusses on the provisions related to income tax.
Separately, the IRS provided broad filing-related relief on April 9 via Notice 2020-23 that applies to all taxpayers that have a filing or payment deadline falling on or after April 1, 2020, and before July 15, 2020, including individuals, trusts, estates, corporations, and other noncorporate tax filers. The IRS also stated that it will disregard this timeframe in calculating any interest, penalty, or addition to tax for failure to file the forms specified in the Notice. Notice 2020-23 grants automatic relief to affected taxpayers which means that there is no need to file extensions or send documents to the IRS to obtain relief. The relief applies to Forms and their related schedules and attachments and applies to time-sensitive acts listed in Treas. Reg. §§301.7508A-1(c)(1)(iv) through (vi) and Rev. Proc. 2018-58. However, the Notice does not grant filing or payment relief for federal estate tax returns (Form 706) while it does offer relief for federal gift taxes and the generation skipping transfer tax.
The Notice also postpones the June 15, 2020 deadline for estimated tax payments to July 15.
Via Notice 2020-23, the IRS allows partnerships subject to the centralized audit provisions in the Bipartisan Budget Act of 2015 (BBA), to file an amended partnership return for 2018 or 2019 to take advantage of beneficial tax provisions in the CARES Act.
Income tax provisions of CARES Act – it’s the topic of today’s post.
Credits for leave. Under prior emergency legislation enacted on March 18 (the Families First Coronavirus Response Act – P.L. 116-127), an employer with 500 or fewer employees whose employees receive paid sick leave or family leave required by that law are entitled to credits. The CARES Act provides that those credits can be advance refunded (including any refundable portion). CARES Act, §3606(a-(b). Any penalty triggered under I.R.C. §6656 for failure to deposit tax imposed by I.R.C. §§3111(a) or 3221(a) is waived if the penalty was triggered because the taxpayer anticipated the allowed credit. CARES Act, §§3606(a)(3); 3606(c). The provision is effective for qualified sick leave or family leave wages paid for a period beginning on or before April 2, 2020 (at IRS discretion) through 2020.
Medical expenses. I.R.C. §223(d)(2) “qualified medical expenses” that can be paid from a health savings account on a tax-favored basis. Payment for medicine or drugs that are not prescribed do not meet the definition. Likewise, I.R.C. §106(f) specifies that reimbursement for qualified medical expenses from a taxpayer’s HSA doesn’t include medicine or drugs that are not prescribed. The CARES Act eliminates the requirement of a prescription and also specifies that qualified medical expenses include menstrual care products (defined as a tampon, pad, liner, cup, sponge or similar product used by women with respect to menstruation or other genital-tract secretions. In addition, expenses for such products are treated as incurred for medical care purposes under I.R.C. §106. CARES Act, §§3702(a)(1)-(2); 3702(a)(1)-(2); (b) and (c), effective for expenses incurred after 2019.
Individual Income Tax Provisions
Economic impact payment. The legislation provides a rebate (Economic Impact Payment) of advance refunds via check or direct deposit up to $1,200 for single persons and heads of households and up to $2,400 for married couples that have filed a joint return. The rebate is paid based on a taxpayer’s filed 2019 return (or 2018, if 2019 has not yet been filed). If a return has not been filed for either 2018 or 2019, then the IRS “may” use information from Form SSA-1099 (Social Security Benefit Statement), or Form RRB-1099 (the equivalent for railroad workers). Non-filers must file a return to claim a payment. Also provided is $500 for each qualifying child of the taxpayer that is also the taxpayer’s dependent (as defined by the Child Tax Credit rules).
The payment phases out at a five percent rate above adjusted gross income (AGI) of $75,000 (single); $122,500 (HoH); and $150,000 (MFJ). Thus, the payment is phased out if AGI exceeds $99,000 (single) or $198,000 (MFJ) for taxpayer’s without dependent children. There is no income floor or phase in. Tax filers must provide their Social Security number for each family member claiming a rebate other than active duty military. The rebates are also available to residents of U.S. Territories. CARES Act, §2201.
Note: On March 30, 2020, the IRS issued IR 2020-61 in which it set forth the rules for the Economic Impact Payment. Under the rules, the IRS stated that all older clients on Social Security who did not file a tax return for either 2018 or 2019 due to income limits may be required to file some type of simple tax return with the IRS to receive payment. However, the IRS reversed course two days later. On April 1, 2020, the IRS indicated that it would simply rely on Social Security numbers to make payments to individuals that otherwise do not have an income tax filing obligation.
Charitable contributions. The new law makes two modifications to existing law impacting charitable contributions. The CARES Act provides for a $300 above-the-line deduction for cash contributions to public charities during 2020. The legislation also increases the 60 percent limitation on charitable deductions to 100 percent of modified adjusted gross income for cash contributions to public charities during 2020. Thus, 100 percent of cash contributions to charity can be deducted against MAGI for 2020. Corporations, for 2020, will be able to deduct charitable donations up to 25 percent of MAGI rather than being limited to 10 percent. In addition, the legislation increases the limitation on food inventory contributed by a corporation to charity from 15 percent to 25 percent for 2020. CARES Act, §2205.
Student Loans. Present law allows an employee to exclude up to $5,250 from income for an employer-sponsored educational assistance program. The CARES Act includes in the definition of qualified expenses for this purpose an employer’s payment of student loan debt. CARES Act, §2206, effective for student loan payments made after March 27, 2020 before January 1, 2021.
Payroll tax credit. Through 2020, the CARES Act provides a refundable payroll tax credit for 50 percent of wages paid by an employer (including non-profit organizations) that has had operations fully or partially suspended due to governmental actions as a result of the virus. The credit is in lieu of participation in the payroll protection loan program. The credit also is available to an employer that has suffered a decline in quarterly revenues by more than 50 percent compared to the same quarter a year earlier.
Note: Farming and ranching businesses are deemed “essential” and, thus, can only qualify if quarterly revenues decline by more than 50 percent compared to the same quarter last year. Revenues could be shown to decline by the necessary amount, for example, by a farmer taking out a CCC loan on a crop (or crops) and then selling the grain under loan after the end of the second quarter (June 30, 2020). Alternatively, a deferred payment contract could be entered into that defers payment after June 30, 2020.
For employers with more than 100 employees, wages of employees that have been furloughed or had work hours reduced are also eligible. All employee wages of employers with an average number of full-time employees in 2019 of 100 or fewer full-time employees are eligible. The credit applies to the first $10,000 in wages and compensation (including health benefits) the employer pays to an eligible employee. Disqualified wages are those taken into account for purposes of payroll credits and for required sick or family leave. Also disqualified are wages taken into account for the employer credit for paid family and medical leave, as well as wages taken into account for the I.R.C. §45S employer credit for paid family and medical leave. The credit is not available to employers receiving Small Business Interruption Loans under CARES Act §1102 - I.R.C. §2301(c)(2). CARES Act, §2301, effective for wages paid after March 12, 2020 and before January 1, 2021.
Note: The eligibility requirement of having revenues decline by more than 50 percent from the same quarter a year earlier does not allow the deferment of payment of the employer share of FICA tax to the end of 2021 and 2022.
Deferral of payroll taxes. The legislation allows a taxpayer to defer payment of the employer portion of some payroll taxes (employer portion of FICA and the employer and employee representative portion of Railroad Retirement taxes that are attributable to the employer FICA rate, and one-half of SECA tax liability) through 2020. Then, deferred amounts will be due in two equal installments – at the end of 2021 and the end of 2022. Deferral is unavailable if the employer has obtained a Small Business Administration 7(a) loan designated for payroll under §1106 of the CARES Act. CARES Act, §2302, establishing a payroll tax deferral period beginning March 27, 2020 and continuing through 2020.
Net operating losses. The legislation provides for a carryback of any NOL arising in a tax year beginning after Dec. 31, 2017, and before Jan. 1, 2021, to each of the five tax years preceding the tax year in which the loss arises. For tax years beginning before 2021 and after 2017, a five-year carryback of NOLs is allowed for all taxpayers, farm and non-farm. This has the result of delaying the 80 percent taxable income limitation of present law until 2021. C corporations can elect to file for an accelerated refund to claim the carryback benefit. Also, for tax years beginning before 2021, a taxpayer may fully deduct an NOL. For tax years beginning after 2021, a taxpayer is eligible for full NOL deduction attributable to tax years before 2018, and an 80 percent of modified taxable income for NOLs arising in tax years after 2017. CARES Act, §2303(b).
Note: In Rev. Proc. 2020-24 issued on April 9, 2020, the IRS provided guidance on the treatment of NOLs under the provision, and extended the deadline for filing an application for a tentative carryback adjustment under I.R.C. §6411 to carryback an NOL that arose in any tax year that began during calendar year 2018 and that ended on or before June 30, 2019. Under the guidance, an election to waive the I.R.C. §172(b)(3) carryback for NOLs arising in tax years beginning in 2018 or 2019 must be made no later than the due date, including extensions, for filing the taxpayer's federal income tax return for the first tax year ending after March 27, 2020. A taxpayer makes the election by attaching to its federal income tax return filed for the first tax year ending after March 27, 2020, a separate statement for each of the tax years 2018 or 2019 for which the taxpayer intends to make the election. The election statement must state that the taxpayer is electing to apply I.R.C. §172(b)(3) under Rev. Proc. 2020-24 and the tax year for which the statement applies. The election for an NOL arising in a tax year beginning in 2018 or 2019 must be made no later than the due date, including extensions, for filing the taxpayer's federal income tax return for the first tax year ending after March 27, 2020. For an NOL arising in a tax year beginning after Dec. 31, 2019, and before Jan. 1, 2021, an election must be made by no later than the due date, including extensions, for filing the taxpayer's federal income tax return for the tax year in which the NOL arises. The election is made by attaching a statement to the return.
Also, in Notice 2020-26, the IRS extended the deadline for filing an application for a tentative carryback adjustment under I.R.C. §6411 to carry back an NOL that arose in a tax year beginning during 2018 and ending on or before June 30, 2019. The legislation did not provide additional time to file tentative carryback adjustment applications for NOLs arising in a tax year beginning on or after Jan. 1, 2018 and ending before March 27, 2019. Taxpayers with losses during this timeframe can carry them back to an earlier tax year by filing amended returns. Also, the IRS granted affected taxpayers a six-month extension of time to file Form 1045 (for individuals) or Form 1139 (for corporations) (if the NOL arose in a tax year beginning in 2018 and ending on or before June 30, 2019). The Forms can be faxed to the IRS at 844-249-6237 (Form 1045) or 844-249-6236 (Form 1139). For 2018 returns, the deadline is June 30, 2020 to prepare either Form. If the deadline is missed, an amended tax return will need to be filed.
The time extension is only for requesting a tentative refund to carry back an NOL. It does not extend the time to carry back any other item. To use the extension, a taxpayer must file the form no later than 18 months after the close of the tax year in which the NOL arose (i.e., no later than June 30, 2020, for a tax year ending Dec. 31, 2018); and include on the top of the form "Notice 2020-26, Extension of Time to File Application for Tentative Carryback Adjustment."
Excess business loss limitation. The excess business loss limitation of $250,000 (single) and $500,000 (MFJ) is eliminated for tax years 2018-2025. Thus, a taxpayer may deduct business losses without limit for 2018-2025 and carry the losses back for up to five years. In addition, the provision specifies that excess business losses do not include any deduction under I.R.C. §172 or I.R.C. §199A, or any deductions related to performing services as an employee. Also, capital loss deductions are not taken into account in computing the I.R.C. §461(l) limitation, and the amount of capital gain taken into account in calculating the I.R.C. §461(l) limitation cannot exceed the lesser of capital gain net income from a trade or business or capital gain net income. CARES Act, §2304, effective for tax years beginning after 2017.
Note: Effective for tax years beginning after 2020, business income cannot be offset by wage income, include wages paid from the business. This could present enhanced audit activity concerning reasonable compensation in the S corporation context.
Corporate AMT. The legislation allows corporations to claim 100 percent of AMT credits in 2019 as fully refundable and provides an election to accelerate claims to 2018, with eligibility for accelerated refunds. CARES Act, §2305, effective for tax years after 2017.
Business interest. The legislation allows a business with gross receipts over $26 million to elect to increase the limitation on the deduction of interest from 30 percent of adjusted taxable income to 50 percent of adjusted taxable income for tax years beginning in 2019 and 2020. A business may elect to use 2019 adjusted taxable income (ATI) in calculating the 2020 limitation. If an election is made to compute the limitation using 2019 ATI for a tax year that is a short tax year, the ATI for the taxpayer’s last tax year beginning in 2019 which is substituted under the election will be equal to the amount which bears the same ratio to the ATI as the number of months in the short taxable year bears to 12. A taxpayer may elect out of the increase for any tax year beginning in 2019 or 2020. It is an irrevocable election unless IRS consents to a revocation.
Note: In Rev. Proc. 2020-22, issued on April 10, 2020, the IRS set forth the rules for making a late election or withdrawing an election for real property trades or businesses and farming businesses. The IRS, in the Rev. Proc, also provided guidance concerning the time and manner for electing out of the 50 percent ATI limitation for tax years beginning in 2019 and 2020; using the taxpayer’s ATI for the last tax year beginning in 2019 to calculate the taxpayer’s limitation for tax year 2020; and electing out of deducting 50 percent of excess business interest expense for tax years beginning in 2020 without limitation.
Note: For farming businesses that previously elected not to have the interest limitation apply, can either make a late election or elect out of the election that was previously made. This provides flexibility, and may allow the use of bonus depreciation on assets with a 10-year on longer life and MACRS depreciation.
The 50 percent ATI limitation does not apply to partnerships for taxable years beginning in 2019. Rather, a partner treats 50 percent of the partner’s allocable share of the partnership’s excess business interest expense for 2019 as an interest deduction in the partner’s first taxable year beginning in 2020 without limitation. The remaining 50 percent of excess business interest from 2019 is subject to the ATI limitation as it is carried forward at the partner level. A partner may elect out of the 50 percent limitation. CARES Act, §2306, effective for tax years beginning after 2018.
Note: Businesses entitled to use cash accounting (i.e., those with average revenue not exceeding $26 million for 2020) are not subject to the limitation on deducting business interest. I.R.C. §163(j)(5) defines the term “business interest” as any interest expense properly allocable to a trade or business. “Trade or business” for this purpose does not include an “electing farming business.”
Qualified improvement property. The legislation makes a technical correction to the Tax Cuts and Jobs Act to allow qualified improvements to business real estate (i.e., interior improvements of buildings) to be classified as 15-year MACRS property rather than 39-year property. The 15-year classification allows such property to be immediately expensed via 100 percent first-year bonus depreciation or, in the alternative, depreciated over 20 years (in the case of a real property trade or business). CARES Act, §2307, effective for property placed in service after 2017.
Note: An affected taxpayer may find it worthwhile to amend the 2018 return or file Form 3115 for the 2019 return. Doing so could also create an NOL that could be carried back five years.
The CARES Act is massive economic aid legislation as an attempt to provide relief to individuals and businesses harmed by the governmental reaction to a virus that has spread to various degrees throughout the U.S. Many tax provisions are included for individuals and businesses primarily on a temporary basis.
Wednesday, April 8, 2020
The 2018 Farm Bill legitimized the commercial production of hemp by removing it from being a “controlled substance” under federal law. As a result, it becomes another possible crop for commercial production. But, many questions abound surrounding hemp production. What must a producer know to engage in the commercial production of hemp? Will there be a market for hemp that is produced? Are any special loans available to help start up the hemp growing operation? What about labeling and licensing requirements? How can risk best be managed? How should contracts for the production of hemp be structured?
As part of the requirements for my agricultural law course at the law school, Emily J. Young, devoted her research paper to the topic of hemp production. Emily will be graduating from Washburn Law School next month. Today’s post is the result of her research into the matter.
Questions surrounding hemp production - it’s the topic of today’s post.
2018 Farm Bill
Historically, federal law made no distinction between hemp and other cannabis plants. They were considered to be a Schedule I drug – a controlled substance under federal law. However, the Agriculture Improvement Act of 2018, P.L. 115-334 (also known as the 2018 Farm Bill), removed hemp from the Controlled Substances Act. 21 U.S.C. §§801 et seq. While hemp is a plant from the cannabis family, the 2018 Farm Bill excludes hemp from the statutory definition of marijuana under the Controlled Substance Act if it contains a delta-9 tetrahydrocannabinol (THC, marijuana’s primary psychoactive chemical) concentration of not more than 0.3% on a dry weight basis. 7 USC § 1639o(1).
In addition, the 2018 Farm Bill establishes a framework where the states and the federal government share regulatory authority over hemp production. See generally 7 U.S.C § 5940; 7 CFR Part 990. Section 10111 of the 2018 Farm Bill requires each state department of agriculture to consult with the state’s governor and attorney general to develop a plan for hemp licensing and regulation. The plan must be submitted to the United States Department of Agriculture (USDA). A state’s plan cannot be implemented until the USDA approves it. If a state does not develop its own regulatory program for hemp, the USDA will develop a system regulating hemp growers in that state.
Kansas enacted industrial hemp legislation in 2018 (K.S.A. 2018 Supp. 2-3901 et seq.) and experienced its first harvest in 2019. The Industrial Hemp Research Program is administered through the Kansas Department of Agriculture (KDA). The KDA anticipates making a Commercial Industrial Hemp Program available for the 2020 growing season, but the timeline and transition to a commercial program is presently unknown. The KDA submitted the state plan on January 23, 2020 for inclusion into the U.S. Domestic Hemp Production Program and is awaiting a response. Currently, the KDA lists 24 active processor licenses that may accept hemp during the 2020 growing season.
The 2018 Farm Bill also provides that farmers growing industrial hemp can receive banking services in the same manner available to farmers of other commodities. Indeed, the Board of Governors of the Federal Reserve System along with the Federal Deposit Insurance Corporation, Financial Crimes Enforcement Network, Office of the Comptroller of the Currency, and the Conference of State Bank Supervisors issued a joint press release on December 3, 2019 emphasizing that banks are no longer required to file a Suspicious Activity Report (SAR) for customers solely because they are engaged in the growth or cultivation of hemp in accordance with applicable laws and regulations. However, for hemp-related customers, the Board of Governors indicated that banks are expected to follow standard SAR procedures and file a SAR if indicia of suspicious activity is present.
While the 2018 Farm Bill legalizes hemp, the production of hemp is more heavily regulated than is the production of other crops due to the effect of the presence of Cannabidiol (CBD), the natural compound in the flower of the female cannabis plant, which is contained in both the hemp and marijuana varieties. While the CBD derived from hemp does not contain THC at illegal levels, the present uncertainty concerning hemp varieties and growing methods could, at least theoretically, potentially cause illegal levels of THC to be present in a harvested hemp crop. In addition, hemp has a similar appearance to marijuana that can make it more difficult for law enforcement officials to enforce drug laws governing marijuana.
Thus, while marijuana remains a Schedule I controlled substance (making illegal its cultivation and sale) CBD can legally be produced from hemp if it is produced by a licensed grower in accordance with federal and state regulations. In 2018, there were approximately 75,000 acres of hemp grown via permit in the U.S. It is estimated that permitted U.S. acres of hemp grown in 2019 was between 100,000 and 200,000.
Production Methods and Economics
Farmers grow hemp for grain, fiber, and floral material. Hemp is usually planted between May and June and harvested in September or October. It is either cultivated as a row crop or via a horticultural method. Row crop cultivation is generally cheaper and less risky compared to horticultural cultivation and is typically used to grow grain and fiber. The horticultural method involves hemp growing in a manner similar to marijuana. The grower typically uses clone plants (cuts from the mother plant) instead of seeds to have a more uniform crop and higher CBD content. January 2020 pricing indicates that a prospective grower would pay an average of $4.25/plant for clone plants. Plant spacing under the horticultural method is approximately of 1,000 to 2,200 plants per acre. If the crop is grown for CBD extraction, the current market price is anywhere between $63 and $675 per pound for the hemp flower and approximately $1.00 per percent of CBD per pound for biomass (the organic material of the hemp plant remaining after the flower is harvested and processed). Each plant yield approximately one pound of flower. CBD content varies based on the variety planted and the growing conditions.
The January 2020 industrial seed price average ranged from $3.72 to $8.00 per pound, with an average price of $4.57. Viable seeding density is 25 to 35 pounds per acre. Hemp grain can sell for an amount between $0.60 to $1.70 per pound, and on average, a farmer can harvest 1,100 pounds of grain per acre. This “traditional” hemp is grown for the manufacture of such items as textiles and bioplastics, and is drilled in a manner comparable to wheat at an approximate rate of 100 plants per square yard. The plant grows tall with the tops harvested for seed production. It is the stalks that are used for industrial purposes.
After input and harvest costs, farmers can net approximately $250-300 per acre on grain (traditional hemp). Hemp fiber is presently selling for approximately $275 per ton, and crops can yield between 4 and 5 tons of hemp fiber per acre. These returns are presently higher than returns on corn, soybeans and wheat. According to data from the Department of Agricultural Economics at Kansas State University, a Kansas farmer in the North Central region of the state can expect net revenue of $46.20 per acre on corn; $48.12 per acre on soybeans and a net loss of $62.93 per acre on wheat. https://agmanager.info/farm-mgmt-guides/2020-farm-management-guides-non-irrigated-crops.
Funding the operation
The 2020 growing season is the first-time hemp producers are eligible to apply for operating, ownership, beginning farmer, and farm storage facility loans through the Farm Service Agency (FSA). A complete loan application requires proof of crop insurance (unless ineligible); a farm operating plan with income history; and a contract for the sale of the crop. New growers are likely unable to secure a purchase contract before the season starts. As a result, most hemp producers in Kansas are either using private funding or local credit unions.
Initial license requirements
As of March 2020, the Industrial Hemp Research Program is the only program available to growers in Kansas. Anyone interested in a license for 2021 growing season should review the application checklists to determine the requirements and fees associated with the type of license being sought. See https://agriculture.ks.gov/divisions-programs/plant-protect-weed-control/industrial-hemp/industrial-hemp-applications.
A license is required for the listing and use of an approved variety of industrial hemp. K.A.R. 4-34-5(e)(1) https://agriculture.ks.gov/docs/default-source/pp-industrial-hemp/approved-varieties-final.pdf?sfvrsn=9faf85c1_4. Only authorized seeds or clone plants are permitted to be grown at this time unless otherwise approved by the KDA during the application process. K.A.R. 4-34-2; 2018 Supp. K.S.A. 2-3901(b)(11). Authorized seeds include properly imported seeds or clones from another state and accompanied with a proper certification label or seeds from local Kansas distributers that have been tested and the certificate of analysis (COA) meets KDA standards. 2018 Supp. K.S.A. §2-3901(b)(11). These labels will need to be retained until the pre-harvest inspection (and for 5 years after) to prove that the hemp inspected was grown from the seeds or clones as shown on the label. §§K.A.R. 4-34-17; K.A.R. 4-34-21.
Several private insurance companies offer small hail policies and limited coverage for hemp growers. The USDA presently offers two programs to help with loss of a hemp crop. Producers may apply now through their local FSA office, and the deadline to sign up for both programs was March 16, 2020. However, these programs do not cover loss of ‘hot’ crops (THC in excess of 0.3%).
Multi-Peril Crop Insurance Pilot Insurance Program. This program provides coverage against loss of yield because of insurable causes (natural causes such as weather, insects and disease) of loss for hemp grown for fiber, grain or Cannabidiol (CBD) oil. There are minimum acreage requirements - 5 acres for CBD and 20 acres for grain and fiber. To be eligible for MPCI, a hemp producer must also have at least a one-year history of production and have a contract for the sale of the insured hemp. The program is available in 21 states, including Kansas.
Noninsured Crop Disaster Assistance Program. This program protects against losses associated with lower yields, destroyed crops or prevented planting where no permanent federal crop insurance program is available. In general, assistance is available for losses that exceed 50 percent of the crop or for prevented plantings that exceed 35 percent of the intended crop acres. The amount paid is 55 percent of the average market price for crop losses.
Types of contracts. A purchase contract is typically entered into after a grower has completed harvest or immediately before harvest once quantity and grade of the crop is known. The buyer then makes a purchase offer for the crop with the price reflecting market demands and crop quality.
A production contract is an agreement entered into between the grower and buyer for the crop before planting. The contract denotes the obligations of the parties and specifies the quantity, quality, and price or a method to determine price of the crop. Under a production contract, a processor usually supplies the seed and inputs and the grower provides the labor and the land. The harvested crop is then delivered to the processor who pays the agreed upon price adjusted for certain contract specifications. Typically, under a production contract, the grower has no ownership rights in the seed or the harvested crop. As such, the grower cannot legally sell the crop to a third party or pledge it as collateral.
Under a split processing agreement, the processor extracts the CBD and returns a portion of the finished product to the grower. Under a typical agreement, the processor retains 40 percent of the extract as the processing fee and returns 60 percent to the grower either in kind or in accordance with market value.
Quantity. A contract may require production from a set number of acres or the delivery of pounds of biomass. If production from an acreage is specified, the grower is obligated to deliver all the crop produced on the identified acres in accordance with a “best efforts” or “best farming practices” measure of performance. Thus, if there is complete crop failure and the grower has utilized “best efforts” or utilized “best farming practices,” the grower is not liable for the shortfall and the buyer is not obligated to pay. Currently, litigation in Oregon involves claims surrounding a “best farming practices” clause. See https://hempindustrydaily.com/oregon-hemp-production-lawsuits-may-offer-lessons-for-farmers/.
Alternatively, a contract may contain a “passed acreage clause.” This clause allows the buyer to refuse acceptance of the entire crop produced from the designated acreage. This clause is common in vegetable contracts and may could be utilized in hemp contracts.
A contract could also be structured as an output contract where no quantity is specified, and the grower sells the entire output to the buyer.
Quality and crop conditions. A contract will likely set forth quality standards for the crop and how those quality standards are to be established. Related provisions will denote acts that can give rise to contract termination, the grower’s right to cure and whether the grower retains the right to sell the crop if a processor (buyer) rejects it.
A contract will likely contain language specifying the condition of the crop on delivery and the buyer’s right of inspection. A processor may require a sample from each load a grower brings in before accepting the crop. They may also want to specify the timeframe they have to inspect the crop to account for changes in the crop. For example, contract language may address the issue of crop rejection as well as applicable discounts if a delivered crop’s CBD content falls below the contract-specified percentage after delivery but before processing. This clause could also address any related pricing issues associated with the change in CBD or THC content from time of delivery to time of processing.
Force majeure events/cancellation provision. A force majeure provision allows a party to suspend or terminate its obligations when certain events happen beyond their control. Such a clause may be present in a contract involving hemp production with thought given to triggering events.
Other provisions. Additional contract clauses may address such matters as choice of law and dispute resolution.
I.R.C. §280E limits income tax deductions for businesses that traffic in controlled substances to cost-of-goods-sold (COGS) as an adjustment to gross receipts. See also C.C.A. 201504011 (Dec. 12, 2014). Because hemp is no longer a Schedule I controlled substance, the I.R.C. §280E limitations don’t apply. While hemp producers and resellers must follow the inventory costing methods of Treas. Reg. §1.471, they are not subject to the uniform capitalization rules if average gross receipts are $25 million or less (inflation-adjusted for years beginning after 2017) for the three preceding tax years and the business does not fall within the definition of a “tax shelter.” Likewise, if these tests are met, the business need not calculate an I.R.C. §263A adjustment.
The removal of hemp as a federally controlled substance provides another crop growing option for growers to consider. However, the regulatory system governing hemp production is complex and involves both state and federal regulatory bodies. Contracts for hemp production also present unique issues. Economically, hemp production can be an addition to a farmer’s common crop production routine or may serve as an alternative depending on anticipated net revenues. Is hemp the present-day equivalent of the Jerusalem Artichoke of the 1980s? Only time will tell.
Monday, April 6, 2020
The government’s response to the virus that originated in China and has spread to the United States has, in turn, precipitated Congressional legislation designed to provide economic relief from that government response. Last week, I devoted a blog article to the small business and bankruptcy provisions. In today’s post, I examine the retirement-related provisions. Later this week, I will provide a run-down of the individual and business income tax-related provisions.
Retirement-related provisions of recent legislation – it’s the topic of today’s post.
Change In Early Distribution Penalty Rule
I.R.C. §72(t) provides for a 10 percent additional tax on an early distribution from a qualified retirement plan as defined in I.R.C. §4974(c). I.R.C. §72(t)(1). The penalty tax does not apply if the distribution is made on or after the date the taxpayer turns age 59 and ½. I.R.C. §72(t)(2). It also doesn’t apply to post-death distributions and distributions made on account of disability, among other things. See I.R.C. §72(t)(2)(A)(i)-(viii).
Section 2202 of H.R. 748, the Coronavirus Aid Relief and Economic Security (CARES) Act (Act), Pub. L. No. 116-136, amends I.R.C. §72(t) such that the 10 percent penalty does not apply to any coronavirus-related distribution of $100,000 or less during the tax year from an eligible retirement plan. Act, §2202(a)(1)-(2). An “eligible retirement plan” is one listed in I.R.C. §402(c)(8)(B). That means that IRAs, individual retirement annuities, qualified trusts, annuity plans, governmental deferred compensation plans, qualified pension, profit sharing or stock bonus plans (including I.R.C. §401(k) plans), annuity plans and contracts, as well as custodial accounts.
The distribution must occur on or after January 1, 2020 and before December 31, 2020. Act, §2202(a)(4)(A)(i). It is not available for distributions made on December 31, 2020. Id. The distribution must also be made to a “qualified person” – a person or the person’s spouse or dependent (as defined in I.R.C. §152) that is diagnosed with the virus SARS-CoV-2 or with coronavirus disease 2019 (COVID-19) by a test that the Centers for Disease Control and Prevention has approved. Act, §2202(a)(4)(A)(ii)(I)-II). A qualified person is also one who experiences adverse financial consequences as a result of being quarantined, furloughed or laid off or as a result of reduced work hours due to the virus or disease. Act, §2202(4)(A)(III). A qualified person is also one who is unable to work due to lack of child-care due to the virus or disease, as well as an owner (undefined) of a business (undefined) who either closed the business or reduced business hours due to the virus or disease. Id. The Act also gives the Secretary of the Treasury the ability to determine other factors via regulation. Id.
The administrator of an eligible retirement plan (as defined by I.R.C. §402(c)(8)(B)) can rely on an employee’s certification that the employee is a qualified individual when determining whether a distribution is a qualified distribution. Act, §2202(a)(4)(B).
The amount distributed may be repaid at any time during the three-year period beginning on the day after the date on which the distribution was received via one or more contributions to an eligible retirement plan of which the taxpayer is a beneficiary and to which a rollover contribution could be made. Act §2202(3)(A). If the amount repaid is attributable to a distribution from an eligible retirement plan other than an IRA, the taxpayer is treated as having received the distribution in an eligible rollover distribution (as defined by I.R.C. §402(c)(4)) and as having transferred the amount to the eligible retirement plan in a direct trustee to trustee transfer within 60 days of the distribution. Act, §2202(3)(B). The same result is obtained if the amount repaid traces to a distribution from an IRA. Act, §2202(3)(C).
While the 10 percent penalty is waived for such virus or disease-related early distributions, the amount withdrawn must still be included in income. However, the Act provides that distributed amounts are to be included in income ratably over the three-year period beginning with 2020. Act, §2202(a)(5)(A). An election out of the three-year rule can be made. Id. Qualified distributions are also exempt from the normal trustee to trustee and withholding rules. In other words, virus/disease-related distributions are not treated as eligible rollover distributions. Act, §2202(a)(6)(A). But, the distributions are treated as satisfying plan distribution requirements. Act, §2202(a)(6)(B).
Loans from a qualified employer plan can be made up to $100,000 (up from $50,000) for the first 180 days of the Act (180 days from March 27, 2020). The loan is capped at 100 percent of the vested account balance and must be to a qualified individual. Act, §2202(b)(1)A). If repayment of the loan occurs in 2020, the due date is delayed for one year. Act, §2202(b)(2). In other words, for an outstanding loan or after March 27, 2020 from an eligible retirement plan that must be repaid between March 27 and the end of 2020, the due date is extended for one year.
Modified Required Minimum Distribution Rule
In late December of 2019, the Congress passed Omnibus spending bills containing multiple parts that impact retirement provisions and disaster relief tax rules. One of those bills, the “Setting Every Community Up for Retirement Enhancement Act” (SECURE Act), increased the required minimum distribution (RMD) age for distributions from a traditional IRA from the year in which an individual turns 70.5 to the year the individual turns 72. This provision matches the existing rules for 401(k)s and Roth IRAs. The provision is applicable to persons that did not reach age 70.5 by the end of 2019. SECURE Act §114(a), amending I.R.C. §401(a)(9(C)(i)(I).
The Act amends I.R.C. §401(a)(9) to waive the required minimum distribution rule for calendar year 2020 for an IRA, I.R.C. §401(k) plan I.R.C. §403(b) plan or other defined contribution plan, that is in effect by the end of 2020. Act, §2203(a). The waiver applies to any distribution required to be made in 2020 due to a required beginning date occurring in 2020 as well as because of the distribution not having been made by the end of 2019. Id.
The virus has generated a great deal of activity on Capitol Hill, some of which applies to retirement plans. The big changes apply to the possibility of having the early withdrawal penalty eliminated, plan loans and a change to the required minimum distribution rule.
Wednesday, April 1, 2020
Disaster/Emergency Legislation – Summary of Provisions Related to Loan Relief; Small Business and Bankruptcy
The disaster/emergency legislation enacted in late March is wide-ranging and far-sweeping in its attempt to provide economic relief to the damage caused by various federal and state “shut-downs” brought on by a widespread viral infection that originated in China in late 2019 and has spread to the United States. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) provides relief to small businesses and their employees, including farmers and ranchers, as well as to certain students. Some states have also acted to temporarily stop mortgage foreclosures.
I am grateful to Joe Peiffer of Ag and Business Legal Strategies located in Hiawatha, Iowa, for his input on some of the topics discussed below.
Recent disaster/emergency legislation related to loan relief, small business and bankruptcy – it’s the topic of today’s post.
Deferral of Student Loan Payments
The CARES Act provides temporary relief for federal student loan borrowers by requiring the Secretary of Education to defer student loan payments, principal, and interest for six months, pthrough September 30, 2020, without penalty to the borrower for all federally owned loans. This provides relief for over 95 percent of student loan borrowers.
The CARES Act makes the following changes to the bankruptcy Code:
- A one-year increase in the debt limit to $7.5 million (from $2.73 million) for small businesses that file Chapter 11 bankruptcy. For one year after date of enactment, following the bill’s enactment, the measure temporarily excludes federal payments related to COVID-19 from income calculations under Chapter 11 bankruptcy proceedings. It would also allow debtors experiencing hardship because of COVID-19 to modify existing bankruptcy reorganization plans. CARES Act, §1113.
- Individuals and families currently undergoing Chapter 13 bankruptcy may seek payment plan modifications if they are experiencing a material financial hardship due to the virus, including extending payments for up to seven years after the due date of the initial plan payment. This provision expires one year after date of enactment.
- “Income” for Chapter 7 and Chapter 13 debtors does not include virus-related payments from the federal government. This provision expires one year after date of enactment.
- For Chapter 13 debtors, “disposable income” for purposes of plan confirmation does not include virus-related payments. This is also a one-year provision.
“Small Employer” Relief
The CARES Act provides qualified small businesses various options.
- Immediate SBA Emergency Economic Injury Disaster Grants. These $10,000 grants (advances) are to be used for authorized costs such as providing paid sick leave; maintaining payroll to retain employees; meeting increased material costs; making rent or mortgage payments; and repaying obligations which cannot be met on account of revenue losses. The grants are processed directly through the Small Business Association (SBA), but the SBA may utilize lenders (that are an SBA authorized lender) for the processing and making of the grants. A grant applicant may request an expedited disbursement. If such a request is made, the funds are to be disbursed within three days of the request. The CARES Act also removes standard program requirements including that the borrower not be able to secure credit elsewhere or that the borrower has been in business for at least a year, as long as the business was in operation as of January 31, 2020. CARES Act, §1110.
- Traditional SBA Economic Injury Disaster Loans (EIDL). The CARES Act expands this existing program such that the SBA can provide up to $2 million in loans to meet financial obligations and operating expenses that couldn’t be met due to the virus such as fixed debts, payroll, accounts payable and other bills attributable to actual economic injury. The loans are available to businesses and organizations with less than 500 employees. The interest rate is presently 3.75 percent and cannot exceed 4 percent for small businesses that can receive credit elsewhere. Businesses with credit available elsewhere are ineligible. The interest rate for non-profits is 2.75%. The length of the loan can be for up to 30 years with loan terms determined on a case-by-case basis, based on the borrower’s repayment ability. Applications will be accepted through December of this year.
- Forgivable SBA 7(a) Loan Program Paycheck Protection Loans. The Paycheck Protection Loan Program (PPP) is an extension of the existing SBA 7(a) loan program with many of the existing restrictions on 7(a) loans waived for a set timeframe including guarantee and collateral requirements and the requirements that the borrower cannot find credit elsewhere. In addition, a small business loan borrower is eligible for loan forgiveness on existing SBA 7(a) loans. The 7(a) loan program is the SBA's primary program for providing financial assistance to small businesses. For borrowers with an existing 7(a) loan, the SBA will pay principal, interest, and any associated loan fees for a six-month period starting on the loan’s next payment due date. Payment on deferred loans start with the first payment after the deferment period. However, this relief does not apply to loans made under the PPP.
- For purposes of the PPP, a “qualified small business” is defined as a business in existence as of February 15, 2020 paying employees or independent contractors that does not have more than 500 employees or the maximum number of employees specified in the current SBA size standards, whichever is greater; or if the business has more than one location and has more than 500 employees, does not have more than 500 employees (those employed full-time, part-time or on another basis) at any one location and the business' primary NAICS code starts with "72" (Accommodation and Food Service – e.g., hotels, motels, restaurants, etc.); or is a franchisee holding a franchise listed on the SBA's registry of approved franchise agreements; or has received financing from a Small Business Investment Corporation.
Farmers and ranchers are eligible for PPP loans if the business has 500 or fewer employees; or the business has average annual gross receipts of $1 million or less. If neither of those tests can be satisfied, the ag business can still qualify if the net worth of the business does not exceed $15 million and the average net income after federal income taxes (excluding carry over losses) for the two full fiscal years before the date of the PPP application does not exceed $5 million. Affiliation rules are used, when applicable, in determining qualification under the tests.
Sole proprietorships and self-employed individuals (i.e., independent contractors) may qualify under this program if the sole proprietor/self-employed person has a principal residence in the United States, and the individual filed or will file a Schedule C for 2019.
Note: While the SBA guidance on the issue only refers to Schedule C businesses, it seemed that “Schedule F” should be able to be substituted. Further guidance, discussed below, has added some clarity to the issue.
Additionally, certain I.R.C. §501(c)(3) organizations; qualified veterans’ organizations; employee stock ownership plans; and certain Tribal businesses are also eligible. Ineligible businesses are those that have engaged in any illegal activity at the federal or state level; household employers; any business with a 20 percent or more owner that has a criminal history; any business with a presently delinquent SBA loan; banks; real estate landlords and developers; life insurance companies; and businesses located in foreign countries.
The terms and conditions, like the guaranty percentage and loan amount, may vary by the type of loan. The lender must be SBA-approved. The loan proceeds can be used for payroll costs (up to a per-employee cap of $100,000 of cash wages (as prorated for the covered period)); a mortgage or rent obligation; payment of utilities; and any other debt obligation incurred before the “covered period” (February 15, 2020 – June 30, 2020) – however, amounts incurred on this expense is not eligible for forgiveness) plus compensation paid to an independent contractor of up to $100,000 per year. Included in the definition of “payroll costs” are salary, wages, commissions, or similar compensation; guaranteed payments of a partner in a partnership and a partner’s share of income that is subject to self-employment tax (subject to a per-partner cap of $100,000); cash tips; payment for vacation, parental, family, medical or sick leave; an allowance for dismissal or separation; payments for providing group health care benefits, including insurance premiums; payment of retirement benefits; payment of state or local tax assessed on the compensation of employees; and agricultural commodity wages. Not included in the computation of payroll costs are Federal FICA and Medicare taxes and Federal income tax withholding (but, SBA has subsequently taken the position that this is to be ignored such that the computation should be based on gross payroll); any compensation paid to an employee whose principal place of residence is outside the United States (e.g., H-2A workers); qualified sick leave and family leave wages that receive a credit under the Families First Coronavirus Response Act.
Note: Wages for an H-2A worker employed under an H-2A contract for over 180 days can establish their U.S. address as their principal residence and include their wages in average payroll. Once, associated utility costs should also count as eligible expenses.
Under the PPP, the bank can lend up to 250 percent of the lesser of the borrower’s average monthly payroll costs (before the virus outbreak) or $10,000,000 (with some exclusions including compensation over $100,000). For example, if the prior year’s payroll was $300,000, the maximum loan would be $62,500 (total payroll of $300,000 divided by 12 months = 25,000 x 2.5 = $62,500). The SBA guarantee is 100 percent.
Note: For farm borrowers, some lenders have been reported as claiming that the receipt of a PPP loan makes the farmer ineligible for the ag part of the CARES Act Food Assistance Program. That is incorrect. It is also incorrect that the receipt of a PPP loan by a farmer impacts the farmer’s USDA subsidies. The is no statutory support for either of those propositions.
Self-employed taxpayers became eligible for loans on April 10, 2020. For a self-employed taxpayer, the loan amount is based on the taxpayer’s net self-employment earnings, limited to $100,000 of net self-employment income. The maximum loan to a self-employed taxpayer is set at 20.8333 percent of self-employment earnings (plus other payroll costs). For a Schedule C taxpayer, that amount can be determined from line 31 (net profit). If that amount is over $100,000, the loan is limited to $100,000. If line 31 is a loss, the loan amount would normally be zero, but one-half of employee payroll costs can be added in. For a 2019 Schedule F, the applicable line is line 34. A copy of the taxpayer’s 2019 Schedule C (or Schedule F) must be provided to SBA.
Note: The SBA has taken the position that a loss is shown on line 34 of Schedule F that the taxpayer does not qualify for any loan based on earnings and could only qualify for a loan based on employee payroll costs.Thus, the income of a farmer reported on Form 4797 (as the result of an equipment trade, for example, will not qualify. Thus, while a farmer’s Schedule F income might be a loss, but significant income may be present on Form 4797 (which is not subject to self-employment tax), such a farmer will not be able to reconcile the Schedule F to include all equipment gains. Likewise, gains attributable to farmland and buildings are also excluded. Presently, it is unknown whether rental income that is not reported Schedule F qualifies (such as that reported on either Schedule E or on Form 4835).
The amount of loan forgiveness for a self-employed taxpayer equals 2/13 of the 2019 line 31 income. Thus, for a loan that is limited to $20,833, the amount forgiven would be $15,384 ($100,000/52 x 2.5).
For partnerships, filing is at the partnership level. This precludes each partner from receiving a loan. The law is unclear, however, whether income is based on guaranteed payments to partners or partnership gross receipts. According to the SBA’s interpretation, a partnership is allowed to count all employee payroll costs. In addition, the partnership can count all self-employment income of partners computed as the total self-employment income reported on line 14a of Schedule K/K-1. That amount is then reduced by any I.R.C. §179 expense deduction claimed; unreimbursed partnership expenses claimed, and depletion claimed on oil and gas properties. That result is then multiplied by 92.35% to arrive at net self-employment earnings. If the final amount exceeds $100,000, it is to be reduced to $100,000.
Note. Multiplying by 92.35% for Schedule F farmers appears not to be required but may be required in a future announcement since the same calculations usually apply to Schedule C and Schedule F filers on Schedule SE.
Note: Many farm partnerships have a manager managed LLC structure that allows for a reduction in self-employment tax. Even though this income is considered to be ordinary income, it appears that none of that income will qualify for a PPP loan.
Note: S or C corporations are only allowed to use taxable Medicare wages & tips from line 5c of Form 941. These wages are subject to FICA and Medicare taxes.
Based on the SBA position, if it is determined to apply to Form 943 filers, commodity wages will not be allowed for calculating total employee payroll costs. Thus, it is possible that if a farmer received an original PPP loan using commodity wages, the loan may need to be revised.
Likewise, if a taxpayer has an interest in more than one partnership that are treated as self-employed entities, a question remains as to whether each entity can qualify for a loan. For instance, if a farmer is a partner in three partnerships and earns at least $100,000 of net self-employment earnings in each partnership, can each partnership use the farmer’s full $100,000 compensation limit or must it be allocated among each partnership?
For an LLC that is taxed as a partnership, only the amount a partner receives as a guaranteed payment is taxed as self-employment income. For taxpayer’s with interests in multiple single-member LLCs, a holding company can file for the entities under its ownership or each entity can file for a loan. What is not known is whether if only one entity is profitable whether a loan can be filed only for the profitable entity. Similarly, it is not known whether a taxpayer’s compensation from each entity is allowed in full (if it is doesn’t exceed $100,000/entity) even though total earnings exceeds $100,000, or whether the taxpayer’s compensation is limited to $100,000.
The interest rate is set at one percent and cannot exceed 4 percent. Payments, including principal, interest and fees can be deferred anywhere from six to 12 months, and the SBA will reimburse lenders for loan original origination fees. A borrower can then apply for loan forgiveness to the extent the loan proceeds were used to cover payroll costs (at least 75 percent), mortgage interest, rent and utility payments during the eight-week period following loan disbursement.
Note: According to the SBA, the forgivable portion of the non-payroll costs is limited to 25 percent.
The borrower must have been in business as of February 15, 2020 and employed employees and paid salaries and taxes or had independent contractors and filed Form 1099-MISC for them. Guarantee fees are waived, and the loans are non-recourse to the borrower, shareholders, members and partners of the borrower. There is no collateral that is required, and the borrower need not show an inability to secure financing elsewhere before qualifying for financing from the SBA.
The SBA will pay lenders for processing loans under the Payroll Protection Program in an amount of 5 percent of the loan up to $350,000; 3 percent of the loan from $350,000 to $2 million; and 1 percent of loans of $2 million or more. Lender fees are payable within five days of disbursement of the loan.
A borrower under the PPP can apply for loan forgiveness on amounts the borrower incurs after February 14, 2020, in the eight-week period immediately following the loan origination date (e.g., the receipt of the funds) on the following items (not to exceed the original principal amount of the loan): gross payroll costs (not to exceed $100,000 of annualized compensation per employee); payments of accrued interest on any mortgage loan incurred prior to February 15, 2020; payment of rent on any lease in force prior to February 15, 2020 (no differentiation is made between payments made to unrelated third parties and related entities (self-rents)); fuel for business vehicles and, payment on any utilities, including payment for the distribution of electricity, gas, water, transportation, telephone or internet access for which service began before February 15, 2020. The amount forgiven is not considered taxable income to the borrower. Documentation of all payment received under the PPP is necessary to receive forgiveness. Any amount that remains outstanding after the amount forgiven is to be repaid over two years, after a six-moth deferral, at a one percent interest rate.
Note: For a sole proprietorship or self-employed individual, it is unclear whether the loan forgiveness amount is based on eight weeks of self-employment income in 2019 plus amounts spent on qualified amounts, or whether the amount forgiven is limited to eight weeks of self-employment income.
The amount forgiven will be reduced proportionally by any reduction in the number of full-time equivalent employees retained as compared to the prior year. The proportional reduction in loan forgiveness also applies to reductions in the pay of any employee. The reduction if loan forgiveness applies when the reduction of employees or an employee’s prior year’s compensation exceeds 25 percent. It is increased for wages paid to employees that are paid tips. A borrower will not be penalized by a reduction in the amount forgiven for termination of an employee made between February 15, 2020 and April 26, 2020, as long as the employee is rehired by June 30, 2020.
Note: For both the loan calculation and the amount of forgiveness a taxpayer cannot include any owner’s health insurance or retirement payments. Reference is to simply be made to Schedule C or Schedule F net income.
Note: As for loan forgiveness for the self-employed owner compensation, apparently Schedule C (of Schedule F) compensation shown on the 2019 return is used. This amount is then divided by 52 (weeks in the year) and multiplied by eight. The resulting amount is (apparently) forgiven.
The SBA “audits” the requirements that taxpayers certify both that there was economic uncertainty and that the funds were actually needed in order to keep employees on the payroll and paid during the period February 15, 2020 through June 30, 2020. For farmers, with sufficient liquidity that not poised to shut-down, being able to establish that that the funds were needed for payroll purposes could be difficult to establish. This could be particularly true for grain farmers and others that are currently planting crops, have sufficient liquidity or lines-of-credit available, and have an adequate percent of their crop insured and have the ability to pay their employees. For dairy, livestock and produce operations, it will likely be much easier to satisfy the payroll requirement. Clearly, documentation as to the need for the loan is critical to maintain, as is documentation after the end of the eight-week loan forgiveness period.
Note: A taxpayer that receives a PPP loan is ineligible for the Employee Retention Tax Credit. (discussed next), and is barred from applying for unemployment.
Certain qualified small businesses are eligible for loan forgiveness of certain SBA loans. A “covered loan” is a loan added under new §7(a)(36) of the Small Business Act (15 U.S.C. §636(a)). The amount forgiven is equal to the sum of costs incurred and payment made during the eight-week period beginning on the covered loan’s origination date. Forgiven amounts are excluded from gross income up to the principal amount of the loan. To be forgiven, loan proceeds must be used to cover rent paid under a lease agreement in force before February 15, 2020; a mortgage that was entered into in the ordinary course of business that is the borrower’s liability, and is a mortgage on real or personal property incurred before February 15, 2020; or utilities (electricity, gas, water transportation, telephone or internet access) for which service began before February 15, 2020. The borrower must verify that the amount for which forgiveness is requested was used for the permissible purposes. The amount of loan forgiveness is subject to a reduction formula tied to employee layoffs. The numerator of the formula it the average number of full-time employees per month. The denominator is, at the borrower’s election, the average number of full-time employees per month employed from Feb. 15, 2019 to Jun. 30, 2019 or the average number of full-time employees per month employed from Jan. 1, 2020 to Feb. 29, 2020.
Note: Expenses attributable to loan forgiveness (rent, mortgage, utilities, etc.) are not deductible. See I.R.C. §265.
Employers with seasonal employees use a different formula to calculate payroll costs. A seasonal employer uses the average total monthly payments for payroll for the twelve-week period beginning Feb. 15, 2019; or, by election, Mar. 1, 2019 through Jun. 1, 2019. As an alternative, the employer may choose to use any consecutive 12-week period between May 1, 2019 and September 15, 2019. Thus, if payroll costs are much higher in the summer time to harvest crops, the employer will qualify for a larger PPP loan.
To receive any loan forgiveness, the employer must spend at least 75 percent of the loan proceeds on labor costs. There is also a reduction formula for employee salaries and wages, with the amount forgiven reduced by the amount of any reduction in salary or wages of any employee during the covered period. That is the excess of 25 percent of total salary and wages for the most recent quarter for that employee. For purposes of this formula, employees earning over $100,000 are excluded. If an employer rehires the employees or raises salaries and wages back to their prior level by Jun. 30, 2020, the rehire is not considered for purposes of the formula. CARES Act, §1106.
- Employee Retention Credit. If a government order requires an employer to partially or fully suspend operations due to the virus (there is no statutory definition of “partially” or “fully”), or if business gross receipts have declined by more than 50 percent as compared to the same quarter in the immediately prior year, the employer can receive a payroll tax credit equal to 50 percent of employee compensation (“qualified wages”) up to $10,000 (per employee) paid or incurred from March 13, 2020 and January 1, 2021. For employers with greater than 100 full-time employees, qualified wages are wages paid to employees when they are not providing services (“services” is undefined) due to the coronavirus-related circumstances described above. For eligible employers with 100 or fewer full-time employees, all employee wages qualify for the credit, whether the employer is open for business or subject to a shut-down order. Qualified wages must not “exceed the amount such employee would have been paid for working an equivalent duration during the 30 days immediately preceding such period.” As noted, the credit applies to the first $10,000 of compensation, including health benefits, paid to an eligible employee. The credit is provided for wages paid or incurred from March 13, 2020 through December 31, 2020.
- The credit is allowed in each calendar quarter against Medicare tax or the I.R.C. §3221(a) tax imposed on employers at the rate of 50 percent of wages paid to employees during the timeframe of the virus limited to the applicable employment taxes as reduced by any credits allowed under I.R.C. §§3111(e) and (f) as well as the tax credit against amounts for qualified sick leave wages and qualified family leave wages an employer pays for a calendar quarter to eligible employees under the FFCRA. Thus, “applicable employment taxes” are reduced by the I.R.C. §§3111(e)-(f) credits and those available under the FFCRA. Then, the resulting amount is reduced by the Employee Retention Credit. If a negative amount results, the negative amount is treated as an overpayment that will be refunded pursuant to I.R.C. §6402(a) and I.R.C. §6413(b). CARES Act, §2301.
- Express Loan Program. The SBA’s Express Loan Program loan limit is increased to $1 million (from $350,000) until December 31, 2020. This program features an accelerated turnaround time for SBA review, with a response to applications within 36 hours. CARES Act, §1102(c).
- Tax Credit to Fund Paid Sick Leave. An employer with an employee that is paid sick-leave on account of the virus receives a FICA tax credit (employer share only) equal to the lesser of wages plus health care costs or $511 per day for up to 10 days. An employer providing sick leave to an employee with a sick family member, the credit is $200 per day, up to a maximum of $10,000.
Planning strategies. For businesses with immediate cashflow needs, a $10,000 EIDL grant can be applied for. Simultaneously, application can be made for PPL program loan. But, as noted, the basis for the separate loans and the costs being paid with each loan are different. An application can then be made seeking loan forgiveness. If this approach is inadequate, a traditional EIDL loan can be applied for. Also, if the business has sufficient cashflow, one of the FICA/Medicare tax credit options can be considered. Also, for employers with employees impacted by the virus or are caring for affected family members, the sick leave credit or the employee retention credit can be utilized if business operations were suspended or if gross receipts declined substantially.
The CARES Act contains many provisions that small employers can utilize to bridge the economic divide created by the government reaction to the virus. As the new programs are implemented rules will be developed that should address presently unanswered questions. The SBA has up to 30 days following the enactment of the CARES Act to issue regulations implementing and providing guidance on certain CARES Act provisions. In addition, the Treasury Department is required to issue regulations implementing and providing guidance under many CARES Act provisions. Issuance of regulations and guidance could delay loan approval and disbursement or modify/waive certain loan requirements.
The disaster/emergency legislation also made numerous tax changes. Those will be addressed in a future post.
Thursday, March 19, 2020
In the event that a farmer or rancher is confronted with the situation where expenses exceed income from the business, an operating loss may result. Losses incurred in the operation of farms and ranches as business enterprises as well as losses resulting from transactions entered into for profit are deductible from gross income. A net operating loss (NOL) may be claimed as a deduction for individuals and is entered as a negative figure on Form 1040.
Special rules apply to farm NOLs. Today’s post examines the proper way to handle a farm NOL and also discusses the changes to NOLs contained in the recently enacted Tax Cuts and Jobs Act (TCJA).
Farm NOLs – The Basics
Carryback rule. Until the TCJA changes, a farm NOL could be carried back five years or, by making in irrevocable election, a farmer could forego the five-year carryback and carry the loss back two years (or three years for a loss attributable to a federally declared disaster). I.R.C. §§172(b)(1)(F) and (h). An election to waive the five-year carryback resulted in a 2-year carryback. A “farming NOL” is defined as a the lesser of the NOL applicable for the tax year considering only income and deductions attributable to the farming business, or the NOL for the tax year.
Those were the rules in place through 2017. A beneficial aspect of the loss carryback rule is that a loss that is carried back to a prior year will offset the income in the highest income tax bracket first, and then the next highest, etc., until it is used up. Determining whether a loss should be carried back two years instead of five depended on the farmer’s level of income in those carryback years and the applicable tax bracket.
Another beneficial rule can apply when an NOL is carried back to a prior year. Because two years back (as opposed to five years under pre-TCJA rules) involves an open tax year, any I.R.C. §179 election that has been made can be revoked if the loss carry back eliminates the need (from a tax standpoint) for the election. By revoking the I.R.C. §179 election, the taxpayer will get the income tax basis back (to the extent of the election) in the item(s) on which the I.R.C. §179 election was made. That will allow the taxpayer to claim future depreciation deductions. This is the case, at least, on the taxpayer’s federal return. Some states don’t “couple” with the federal I.R.C. §179 provision.
Under the pre-2018 rules, taxpayers could elect to forego an NOL carryback in favor of a carryforward (for 20 years). However, if a taxpayer elected not to carry a NOL back to offset income in prior years, the taxpayer was limited to carrying forward the NOL.
Impact of receiving farm subsidies. For tax years beginning before 2018, in which an individual taxpayer receives farm subsidies (essentially limited to CCC loans), farming losses were limited to the greater of $300,000 (married filing jointly) or the taxpayer’s total net farm income for the prior five taxable years.
Excess business loss. An excess business loss (EBL) for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The NOL carried over from other years may not be used in calculating the NOL for the year in question. In addition, capital losses may not exceed capital gains. Non-business capital losses may not exceed non-business capital gains, even though there may be an excess of business capital gains over business capital losses. In addition, no deduction may be claimed for a personal exemption or exemption for dependents, and non-business deductions (either itemized deductions or the zero-bracket amount) may not exceed non-business income. Deductions may be lost for the office in the home, IRA contribution and health insurance costs.
Post-2017 Tax Years
The TCJA made changes to how farmers can treat NOLs. For tax years beginning after 2017 and before 2026), a farm taxpayer is limited to carrying back up to $500,000 (MFJ) of NOLs. NOLs exceeding the threshold must be carried forward as part of the NOL carryover to the following year. For tax years beginning before 2018, farm losses and NOLs were unlimited unless the farmer received a loan from the CCC. In that case, as noted above, farm losses were limited to the greater of $300,000 or net profits over the immediately previous five years with any excess losses carried forward to the next year on Schedule F (or related Form).
Also, under the TCJA, for tax years beginning after December 31, 2017, NOLs can only offset 80 percent of taxable income (the former rule allowed a 100 percent offset). Technically, the NOL deduction is limited to the lesser of: (1) the aggregate of NOL carryforwards and carrybacks to the tax year, or (2) 80% of taxable income computed for the tax year without regard to the NOL deduction allowed for the tax year. I.R.C. §172(a).
Carryback issues. In addition, effective for tax years ending after December 31, 2017, NOLs can no longer be carried back five years (for farmers) or two years (for non-farmers). Instead, under the TCJA, farmer NOLs can only be carried back two years. Non-farmers cannot carryback NOLs. As noted, NOLs that are carried back can only offset 80 percent of taxable income. However, NOLs that are carried forward will not expire after 20 years (as they did under prior law). Similar to the carryback rule, NOLs that are carried forward can only offset 80 percent of taxable income.
An individual taxpayer claiming a tax refund from an NOL carryback has the option of filing either Form 1045 or Form 1040X. The IRS instructions can be helpful in determining the best approach.
When filing an NOL carryback refund claim Form 1045 or 1040X can be filed. IRS transcripts and statements of account to verify the amounts reported for previous years can be helpful when preparing either Form. The Form 1045 and 1040X instructions also contain detailed lists of attachments to be included with each Form. Also, on Schedule A, an NOL must be included with the carryback claim.
If the taxpayer has multiple carrybacks to a tax year, taxable income is reduced (without regard to the NOL deduction) in the carryback year in the order in which incurred starting with the earliest year. After deducting an NOL, the resulting taxable income is used to determine the deductibility of any remaining NOL. NOLs from years beginning before 2018 can offset 100% of taxable income (without regard to the NOL deduction) in the carryback year whereas NOLs from post-2017 years can only offset 80% of taxable income (without regard to the NOL deduction) in the carryback year.
Note: When figuring a refund claim for an NOL carryback year, the applicable law is the tax law in effect for the carryback year not the tax law in effect for the NOL year.
Once the amount of the NOL deduction after carryback has been determined for the carryback year, the AGI that results after applying the NOL deduction is then used to recompute income or deduction items that are based on, or limited to, a percentage of AGI,
Note: In the case of a partnership or S corporation, the NOL rules are applied at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder.
Carryover of unused NOL carryback. The amount of unused NOL carryback available for carryover requires determination of the taxpayer’s modified taxable income for the carryback year. Modified taxable income for this purpose is defined as the taxpayer’s taxable income with certain modifications. See Treas. Reg. §1.172-5; IRS Pub. 536, Net Operating Losses (NOLS) for Individuals, Estates, and Trusts. Any items that are affected by the taxpayer’s revised AGI after making some of the modifications must be re-figured using that revised AGI. The calculation can be accomplished via Form 1045, Schedule B.
NOL carryover. Taxpayers carrying back a farming loss, must first carry the entire farming loss to the earliest carryback year. Any unused farming loss is then carried back to the next earliest carryback year, and so on. If the carryback period is waived or the loss is not fully utilized in the carryback period, the unused NOL is carried forward indefinitely until it is fully utilized. An unused NOL is the sum of: (1) any farming loss less the amount of the farming loss that is deemed to be carried back; (2) any nonfarm NOL; and (3) any EBL for the NOL year.
Note: Procedurally, the unused NOL is carried forward to the first tax year after the NOL year. Any NOL not utilized in that year is carried forward to the next year and so on until the NOL is fully utilized.
Marital status changes. Additional rules that apply if a taxpayer’s marital status is not the same for all years involved with a NOL carryback/carryforward. In that case, only the spouse who had the loss can claim the NOL deduction. Moreover, for years when the couple file jointly, an NOL deduction is limited to the income of the spouse to whom it belongs. Therefore, a taxpayer filing a 2020 joint return with their spouse who later divorces can only carryback an NOL from a future year to offset his/her share of the taxable income reported on the 2020 joint return. Additionally, the refund for a person filing an NOL carryback claim against a joint return with a former spouse may be subject to limitations.
On a joint return, the NOL carryback deduction is limited to the income of the spouse with the loss. Also, the refund for a divorced person claiming a NOL carryback against a joint return with a former spouse cannot be more than the taxpayer’s contribution to taxes paid on the joint return. The tax Code sets forth a step-by-step procedure to be used in calculating the portion of joint liability allocated to the taxpayer with the NOL carryback.
Change in filing status. Special rules also apply in calculating NOL carrybacks/carryforwards for couples who are married to each other throughout the subject NOL years, but who use a mix of MFJ and MFS filing statuses on returns in the carryback or carryforward years. A married couple who file jointly in the NOL year and the NOL carryback or carryover year, treat the NOL deduction as a joint NOL. If instead the couple file separately, then the spouse who sustained the loss takes the NOL deduction on their separate return.
When a married couple’s filing status differs between the NOL year and the NOL carryback or carryover year, special rules apply. If the couple filed separate returns in the NOL year but jointly in the carryback or carryforward year, then a separate NOL carryback/carryover is treated as a joint carryback/carryover to the carryback/carryover year. If the couple file jointly in the NOL year but separate returns in the carryback or carryforward year, then any joint NOL carryback/carryover is apportioned between the spouses based on the NOLs that would have resulted if the couple had filed separate returns in the NOL year.
Individual taxpayers report their NOL carryover as a negative figure on the “Other income” line of Schedule 1 (Form 1040) or Form 1040NR (line 21 for 2019). Estates and trusts include an NOL deduction on Form 1041, line 15b, for 2019.
For each NOL carryover, taxpayers should attach a statement to their tax return showing how the NOL deduction was figured as well as important facts about the NOL.
NOLs and Death
A NOL that has been carried forward is deductible on a decedent’s final income tax return. It cannot be carried over to a decedent’s estate. Also, an NOL of a decedent cannot be carried over to subsequent years by a surviving spouse.
Just because the farming business loses money doesn't mean that there isn't a tax benefit that can be taken advantage of to soften the blow. That's where the NOL rules come into play…and they get complex quickly.
Friday, March 13, 2020
Periodically on this blog I write about recent caselaw and IRS developments that farmers, ranchers and others should be aware about. The courts are constantly churning out cases that are important to agriculture and tax developments are always non-stop. It’s amazing how broad the reach is of the issues the courts and IRS address that touches agriculture in one way or another. Many of these issues may not be given much thought on a daily basis, but perhaps they should.
In today’s post, I look at a few more recent developments of relevance to agriculture – it’s the focus of today’s post.
IRS Loses Valuation Case
Grieve v. Comr., T.C. Memo. 2020-28
When interests in closely-held businesses are transferred, either by death or gift, and either federal estate or gift tax is involved, the valuation issue becomes highly relevant. For farms and ranches, blocks of non-controlling stock may be involved and the IRS may seek to apply a premium to the value of the stock to increase estate or gift taxes owed. Recently, the U.S. Tax Court shot down an IRS attempt to attach a premium to a gift of non-controlling stock among family members.
In the case, after the petitioner’s wife died, he formed two LLCs (Rabbit and Angus) for financial management and estate planning purposes. He then transferred some of the Class B shares of Rabbit to a grantor-retained annuity trust (GRAT) and the Class B shares of Angus to an irrevocable trust. The petitioner filed a 2013 gift tax return (Form 709) and attached appraisal reports that reported a taxable gift of nearly $10 million. The IRS rejected that valuation, claiming that the proper valuation was $17.8 million, and issued a notice of deficiency.
The Tax Court examined both appraisal reports, noting that the petitioner’s appraisal reports included independent analysis of the LLC shares using a combination of market and income approaches to determine the total value. Conversely, the Tax Court noted that the IRS included an assumption that selling the Class B share would encourage the petitioner’s daughter (who solely owned the Class A shares) to sell her 0.2 percent interest in the entities, which would increase the petitioner’s interests. However, the daughter testified that she would not be inclined to sell her interest, and if she were to sell, would seek a much higher premium that the IRS estimated. The Tax Court also determined that the IRS appraisal also relied on additional hypothetical scenarios that were inconsistent and insufficient to consider a change to the petitioner’s appraisal and the discounts concluded in the report. In addition, the Tax Court noted that the IRS appraiser failed to provide support for the valuations, and also did not provide evidence that his appraisal methodology was subject to peer review.
The Tax Court concluded that the IRS failed to provide sufficient evident to support its expert appraiser’s conclusion that the interests of the LLCs were undervalued and that the petitioner’s gifts of the assets to the two trusts were likewise undervalued. The Tax Court rejected the IRS position that the petitioner had underreported gift tax by $4.4 million and also rejected the IRS penalties of $600,000.
IRAs and the Constitution
Conard v. Comr., 154 T.C. No. 6 (2020)
So that people are disincentivized from using their retirement savings for things other than retirement, the IRS hits withdrawals before age 59-1/2 with a 10 percent penalty. Exceptions to the penalty apply, but even if a taxpayer fits within an exception the amount withdrawn still must be reported into income. Exemptions include distributions made post-death; because the account owner is total and permanently disabled, to cover qualified post-secondary education expenses; distributions made after being called to active military duty for 180 days; or within a year of a child’s birth or adoption.
The U.S. Tax Court recently dealt with a constitutional challenge to such penalty exemptions. In the case, the petitioner had not yet reached age 59-1/2 at the time the she received a distribution from a qualified retirement plan. Consequently, the IRS assessed the 10 percent early withdrawal penalty of I.R.C. §72(t). She sought review of the asserted tax deficiency and challenged the additional tax on the basis that the application of the tax to her early distribution violated the Constitution’s Fifth Amendment Due Process Clause because exceptions exist to the penalty that are applicable to taxpayers that haven’t reached age 59-1/2, such as for disability, etc.
The Tax Court disagreed, applying the rational basis test (low-level scrutiny) to evaluate the constitutionality of the Code provision. The Tax Court determined that test applied because the provision did not invade a substantive constitutional right or freedom or involve a suspect classification. As a result, the constitutionality of the provision could only be overcome by an explicit demonstration that the statute established hostile and oppressive discrimination against particular persons and classes. The Tax Court noted that the petitioner did not claim that the penalty provision concerned a substantive constitutional right or freedom or involved a suspect classification. Age is not a suspect classification for purposes of equal protection. Thus, the provision was presumed constitutional if it had a legitimate governmental purpose. The Tax Court noted that Committee Reports concerning the provision provided that the statute aimed “to provide means for financing retirement” and that penalties for early withdrawals were “designed to insure that retirement plans will not be used for other purposes.” An exemption from the penalty for disability, for example, satisfied a legitimate objective of encouraging taxpayers to provide for times of inability to work.
Huge FBAR Penalty Imposed
In recent years, some farmers and ranchers have started operations in locations other than the United States. Others may have bank accounts in foreign jurisdictions. Still others may serve as an agent under a power of attorney for someone that has a bank account in a foreign jurisdiction. In that event, every year, under the Bank Secrecy Act, anyone that owns or has an interest in or signature authority over certain foreign accounts such as bank accounts, brokerage accounts and mutual funds, must report the account(s) by filing a Report of Foreign Bank and Financial Accounts (FBAR) on FinCEN Form 114. The proper box must also be checked on Schedule B of Form 1040. Failure to do so can trigger a penalty. Willful failure to do so can result in a monstrous penalty. A recent case points out how bad the penalty can be for misreporting.
In the case, the taxpayer had a foreign bank account with aggregate highest balance of $1.9 million, $770,000 and $1.76 million for the three tax years at issue. Form 1040, Schedule B contains a question with a box to be checked asking whether the taxpayer had a financial interest in or signature authority over a financial account located in a foreign country. The box on Schedule B was checked “No” which was the default in the software that the return preparer used. The taxpayer also did not file an FBAR Form for any of the three years. The FBAR Form is required to be filed when the aggregate account balance exceeds $10,000.
The IRS claimed that the taxpayer had constructive knowledge of his reporting requirements by signing his tax returns which included a reference to the FBAR on Schedule B, and that the naming his sister's Canadian address on the accounts was an act of concealment. The taxpayer argued that he was simply negligent and there was no will failure to file the FBARs. The Court examined the definition of willfulness for purposes of FBAR filing and concluded that the taxpayer could have easily determined the need to file the FBAR. Accordingly, the court held that the taxpayer willfully failed to file the FBAR Form and assessed penalties for the years at issue in the amount of $988,245.
Lakes Have Constitutional Rights?
Drewes Farms Partnership v. City of Toledo, No. 3:19 CV 434, 2020 WL 966628 (N.D. Ohio Feb. 27, 2020) No. 3:19 CV 434 2020 U.S. Dist. LEXIS 36427 (N.D. Ohio Feb. 27, 2020)
The genesis of this case actually began in a bar in Toledo (no word on whether the bar was across from the depot). Apparently, the inebriated were commiserating over the pollution of Lake Erie. Ultimately, the ideas of that night got formulated into a ballot question at a special election for the citizens of Toledo concerning whether Lake Erie should be granted legal rights that people have. It was the first rights-based legislation in the U.S. aimed at protecting an ecosystem – Lake Erie, its tributaries and the species that live there.
When election time came, sufficient Toledo citizens voted to add the “Lake Erie Bill of Rights” (LEBOR) to the city’s charter in early 2019. The LEBOR prohibited any infringement of the “rights” of Lake Erie to “exist, flourish, and naturally evolve” without explaining the kind of conduct that would infringe those “rights.” The plaintiff, a farming operation that grows crops in four counties near Toledo and Lake Erie, sued to invalidate the LEBOR on constitutional grounds for lack of due process as being void for vagueness. The court agreed and vacated the LEBOR in its entirety.
There are always developments involving agriculture. It’s good to stay informed.