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.
Monday, March 9, 2020
Many farming and ranching operations provide meals for employees and receive a tax-break for doing so. But, the late 2017 tax law – the Tax Cuts and Jobs act (TCJA) modified the rules. In 2018, the IRS provided guidance on changed rules and how to distinguish between deductible meals and entertainment expense which is no longer deductible under the TCJA. That guidance was issued as a precursor to formal regulations on the issue. Now the Treasury Department has issued proposed regulations addressing the TCJA changes and where the lines are to be drawn.
Meal and entertainment expense tax treatment – that’s the topic of today’s post.
Line-Drawing – The TCJA
Meals. As noted above, the TCJA changed the rules on deductible meals and entertainment. For farming and operations, the tax rules governing meals often comes into play at harvest. An example would be for part-time workers that are employed at times of planting and harvest. These part-time employees may be fed lunches on the farm. Before 2018, meals were normally deductible to an employer at 50 percent of the cost of the meals. But, where the meals are provided on the employer’s premises (i.e., at the farm) and for the convenience of the employer, the meals are 100 percent deductible by the employer and the employees do not have to report any of the amount of the meals as income. The 100 percent deduction is because farm workers generally work in remote areas where eating facilities are not near, and the farm employer finds it a more productive use of time to supply meals at the farm.
Under the TCJA, the 50 percent rule still generally applies to allow an employer to deduct 50 percent of the (non-extravagant) food and beverage expenses associated with operating the business (e.g., meals consumed by employees on work travel). I.R.C. §274(k). But, for amounts incurred and paid after Dec. 31, 2017, and until Dec. 31, 2025, the TCJA expands the 50% limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer. I.R.C. §274(n)(1). That means that the 100 percent deduction for the meals provided the part-time farm employees in the above example is reduced to 50 percent. The 50 percent limitation remains in place through 2025 for meals (food and beverages) that aren’t “lavish or extravagant” and the taxpayer or employee of the taxpayer is present when the meal is furnished. I.R.C. §274(k)(2). Of course, the 50 percent cut-down can be avoided by treating the food and beverages as compensation to the employee (i.e., wages for withholding purposes).
After 2025, none of the cost of meals is deductible.
Entertainment. Through 2017, deductions for entertainment were generally disallowed unless they were directly related to the taxpayer’s business or directly preceded or followed a substantial bona fide business discussion. In those instances, entertainment expenses were deductible at the 50 percent level. Under the TCJA, effective for tax years after 2017, no deduction is allowed for any activity that is generally considered to be entertainment, amusement, or recreation that is purchased as a business expense. Likewise, no deduction is allowed for membership dues for any club organized for business, pleasure, recreation, or other social purposes. Similarly, no deduction is allowed associated with a facility or portion thereof used in connection with the provision of entertainment, amusement or recreation.
But what if meals and entertainment are interconnected in a business context? As noted, before 2018, 50 percent of the cost of business meals and entertainment purchased for business purposes was deductible. Now, entertainment expenses are not deductible even if they are incurred in a business context, unless they can satisfy an exception contained in I.R.C. §274(e). This creates an issue of how to distinguish between deductible meals and non-deductible entertainment when they are provided together. Clearly, taxpayers have an incentive under the TCJA for categorize expenses as “meals” rather than “entertainment.”
In 2018, the IRS issued Notice 2018-76, 2018-42 IRB to assist taxpayers in determining where the line was between deductible meals and nondeductible entertainment. The guidance in the Notice can be relied on until final regulations are issued.
The notice clarifies that taxpayers may deduct 50 percent of a business meal expense that meets these five requirements:
- The expense must be an ordinary and necessary expense business expenses as defined by I.R.C. §162(a);
- The expense must not be “lavish or extravagant” based on the particular situation;
- The taxpayer, or an employee of the taxpayer, must be present at the “meal”;
- The meal must be provided to a current or potential business customer, client, consultant, or similar business contact; and
- If the meal is provided in conjunction with entertainment, the meal expenses must be “stated separately” from the entertainment expenses.
Based on the Notice, it’s clear that meals expenses should not be inflated to make up for the loss of entertainment-related deductions. Separately purchasing meals and entertainment is important. The deduction for meals can be lost if the meals and entertainment are purchased together unless the “stated separately” requirement is satisfied.
On February 21, 2020, the IRS issued proposed regulations on the deductible meal/nondeductible entertainment issue. REG-100814-19. The proposed regulations generally follow Notice 2018-76, which can be relied upon until the regulations are finalized. Under the proposed regulations, taxpayers may deduct 50% of an otherwise allowable business meal expense if:
- The expense is an ordinary and necessary business expense under Sec. 162(a) paid or incurred during the tax year when carrying on any trade or business;
- The expense is not lavish or extravagant under the circumstances;
- The taxpayer or an employee of the taxpayer is present when the food and beverages are furnished;
- The food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact; and
- For food and beverages provided during or at an entertainment activity, they are purchased separately from the entertainment, or the cost of the food and beverages is stated separately from the cost of the entertainment on one or more bills, invoices, or receipts.
“Food or beverage” expense is defined as “…all food and beverage items, regardless of whether characterized as meals, snacks or other types of food and beverages, and regardless of whether the food and beverages are treated as de minimis fringes under section 132(e). Prop. Treas. Reg. §1.274-12(b)(1). When food and beverages are provided to a potential business contact, the food and beverages must be provided to a “person with whom the taxpayer could reasonably expect to engage or deal in the active conduct of the taxpayer’s trade or business such as the taxpayer’s customer, client, supplier, employee, agent, partner, or professional adviser, whether established or prospective.” Prop. Treas. Reg. §1.274-12(b)(3). The proposed regulations also apply this standard to employer-provided meals and when meals are provided to employees and nonemployee business associates at the same event.
To provide a means for IRS to determined that food and beverage costs have not been inflated, the proposed regulations require that the venue’s typical selling cost for items the food and beverages sold must be listed if they were purchased apart from any entertainment. Prop. Treas. Reg. §1.274-11(b)(1)(ii). If the typical selling price is not listed, the reasonable approximate value must be provided. However, the proposed regulations also state that if a single invoice is used for food and beverage costs and entertainment, the amount for food and beverages must be billed separately to be eligible for any deduction. Id.
So what is nondeductible “entertainment” under the proposed regulations? It’s “any activity which is of a type generally considered to constitute entertainment, amusement, or recreation, such as entertaining at bars, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar trips, including such activity relating solely to the taxpayer or the taxpayer’s family.” Prop. Treas. Reg. §1.274-11(b)(1)(i). It doesn’t matter that expenses for such activities is associated with the taxpayer’s trade or business – it’s still “entertainment.” “Entertainment” can also include activities that fall within the definition that are engaged in to satisfy personal living needs of the taxpayer and the taxpayer’s family. Thus, for example, the expenses associated with the spring fishing trip on Lake Michigan to provide salmon for the family for the next year could now be nondeductible entertainment expenses. But what about the cost of the two-week pack trip into the Teton Wilderness Area with clients and potential clients? Is that cost now fully nondeductible?
TCJA changed the rules for deducting meals and entertainment. Of course, substantiating meal expenses is key, and some meals remain 100 percent deductible under specific exceptions contained in I.R.C. §274(e). See I.R.C. §274(d). The proposed regulations are voluminous, contain many examples and are now subject to a public comment period. The IRS will hold a public hearing on comments received on April 7, 2020 in Washington, D.C. After the hearing, the proposed rules could become finalized. The proposed regulations apply to tax years beginning on or after the date they are published in the Federal Register as final regulations. Before that time, however, they can be relied on for expenses incurred after 2017. Also, taxpayers can continue to rely on Notice 2018-76 until the proposed regulations are finalized.
Thursday, March 5, 2020
Registration is now open for this summer’s national ag tax and estate/business planning conference in Deadwood, South Dakota. The conference is set for July 20-21 at The Lodge at Deadwood. In today’s post I briefly summarize the conference, the featured speakers and registration.
Deadwood, South Dakota - July 20-21, 2020
The conference will be in Deadwood, South Dakota on July 20 and 21. The event is sponsored by the Washburn University School of Law. The Kansas State University Department of Agricultural Economics is a co-sponsor. Some of the morning and afternoon breaks are sponsored by SkySon Financial and Safe Harbour Exchange, LLC. The location is The Lodge at Deadwood. The Lodge is relatively new, opening in 2009. It is located just west of Deadwood on a bluff that overlooks the town. You can learn more about The Lodge here: https://www.deadwoodlodge.com/hotel. The Lodge has great conference facilities and also contains the Deadwood Grille featuring Western dining. For families with children, The Lodge contains an indoor water playland. There is also transportation from The Lodge to Main street in Deadwood where the shops and local attractions are located. Deadwood is in the Black Hills area of western South Dakota. Nearby is Mt. Rushmore, Crazy Horse, Custer State Park, Devil’s Tower and Rapid City. The closest flight connection is via Rapid City. The Deadwood area is a beautiful area, and the weather in late July should be fabulous.
On Day 1, July 20, joining me on the program will be Paul Neiffer. Paul has been doing the summer seminars with me for several years now and is affiliated with CliftonLarsonAllen, LLP. We enjoy working together to provide the best in ag tax education that you can find. We will discuss new cases and IRS developments; GAAP Accounting; restructuring credit lines; deducting bad debts; forgiving installment sale debt and some passive loss issues. We will also get into advanced tax planning issues associated with the qualified business income deduction of I.R.C. Sec. 199A as well as net operating loss issues under the new rules; FSA advanced planning and like-kind exchanges when I.R.C. §1245 property is involved.
Also with us as a Day 1 speaker is the honorable Judge Elizabeth Paris of the U.S. Tax Court. She will provide an informative session on litigating a case before the U.S. Tax Court and the special rules and procedures of the court – what you need to know before filing a case with the Tax Court. Judge Paris has issued opinions in several important ag cases during her tenure on the court, including Martin v. Comr., 149 T.C. 293 (2017), and is a great speaker. You won’t want to miss her session.
I will lead off Day 2, July 21, with coverage of the most recent ag-related cases and rulings impacted farm and ranch estate and business planning. Also joining me on Day 2 will be Prof. Jeffrey Jackson, a colleague of mine at Washburn University School of Law. He will present a session on gun trusts for holding firearms and the unique issues that passing firearms at death can present. Prof. Jackson will discuss what a gun trust is and how it works, what it cannot do, and client counseling with respect to passage of firearms by gift or at death. Prof. Jackson's presentation will be followed by a session involving a comprehensive review of the new rules surrounding retirement planning after the SECURE act by Brandon Ruopp, an attorney from Marshalltown, Iowa.
Also making a presentation on Day 2 will be Marc Vianello. Marc is a CPA and the managing member of Vianello Forensic Consulting, LLC. He is an experienced financial professional with and intensive 30-year history as a forensic accountant and expert witness regarding damages in highly complex litigation, including breach of contract, intellectual property (patent, Lanham, trade secret, copyright), business valuation, franchise, agriculture, Qui Tam and class action, personal injury, employment, casualties, financial crimes, and all other types of income and valuation damages. Marc also has an extensive background regarding the computation of estate and gift tax discounts for lack of marketability. Marc’s presentation will focus on how practitioners can utilize forensic accounting techniques and expert testimony to bolster a client’s position against the IRS on audit as well as in court.
Other topics that I will address on Day 2 include the common estate planning mistakes of farmers and ranchers; post-death management of the farm or ranch business; and the valuation of farm chattels and marketing rights.
Day 2 will conclude with an hour session on ethics. Prof. Shawn Leisinger of Washburn School of Law will present a session on the ethical issues related to risk I the legal context and how to ethically advise clients concerning risk decisions.
If you are unable to join us in-person for the two-day event in Deadwood, the conference will be broadcast live over the web. The webcast will be handled by Glen McBeth. Glen handles Instructional Technology at the law library at the law school. Glen has broadcast the last few summer seminars and does a tremendous job producing a high-quality webcast.
A room block has been established at The Lodge for conference attendees under Washburn University School of Law. The rate is $169 per night and is valid from July 17 through July 22. The room block will release on June 19. The Lodge does not have an online link for reservations, but you may call the front desk at (877) 393-5634 and tell them they need to make reservations under the Washburn University Law School room block. As noted, the room block begins the weekend before the seminar begins so that you can arrive early and enjoy the weekend in Deadwood and the Black Hills area before conference if you’d like.
Washburn’s law school will also be holding an alumni event at The Lodge that corresponds with the summer seminar. There will be a social event for law school alumni and registrants of the summer seminar on Sunday evening, July 19. That event will be followed the next day with a CLE seminar focusing on law and technology. This CLE event will also be at The Lodge and will run simultaneously with Day 1 of the two-day summer seminar on July 20. The summer seminar will continue on July 21.
If your business is interested in sponsoring a breakfast, break or lunch, and having vending space at the conference, please let me know. It’s a great event to interact with practitioners that represent the legal and tax needs of farmers and ranchers from across the country that are involved in many aspects of agriculture.
If you have farm or ranch clients that you work with on tax, estate or business planning, this conference is an outstanding opportunity to receive specialized training in ag tax in these areas and interact with others. The conference is also appropriate for agribusiness professionals, rural landowners and agricultural producers.
More detailed information about the conference and registration information is available here: http://washburnlaw.edu/employers/cle/farmandranchtax.html. I look forward to seeing you in Deadwood or having you participate via the web.
Friday, February 28, 2020
Just over a year ago, the Treasury issued corrected Final Regulations concerning the Qualified Business Income Deduction (QBID) of I.R.C. §199A. Those final regulations were intended to clear up some of the then-existing confusion over certain aspects of the QBID. One thing that the Final Regulations did not do, however, was provide a precise definition of what constitutes a “trade or business” for QBID purposes. The 20 percent QBID applies to ordinary income from a qualifying “trade or business” that is not conducted by a C corporation. But what qualifies as a trade or business? It’s a trade or business defined as such under I.R.C. §162 (except for the trade or business of performing services as an employee). This question keeps coming up in emails and calls that I receive. It seems as if the factual scenarios are endless.
“Trade or business for QBID purposes – it’s the topic of today’s post.
The term “trade or business” in the Code ranges from “no involvement” for purposes of farm income averaging in I.R.C. §1301 to material participation on a regular, continuous and substantial basis for purposes of the passive activity loss rules of I.R.C. §469. But, the definitional standard for the QBID is I.R.C. §162. I.R.C. §162 states, “There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business…”. I.R.C. §162. In an early case attempting to define a trade or business activity, the U.S. Supreme Court distinguished between a trade or business and an investment activity and concluded that engaging in an activity merely for pecuniary gain or to increase personal holdings without devoting a major portion of time to the activity did not amount to a trade or business activity. Snyder v. Comr., 295 U.S. 134 (1935). In addition, the taxpayer in Snyder was not truly engaged in buying and selling securities for a living.
Snyder indicates that merely engaging in an activity with intent to make a profit is not a trade or business without the presence of other factors. This remains an argument that the IRS incorrectly asserts with respect to Conservation Reserve Program (CRP) rental income where IRS has attempted to claim since 2003 that a landowners signature on a CRP contract is sufficient to constitute a trade or business resulting in the CRP payments being subject to self-employment tax in the landowner’s hands. CCM 200325002 (Jun. 20, 2003). It lost that argument in Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014), rev’g., 140 T.C. 350 (2013), but issued a non-acquiescence (A.O.D. 2015-002, I.R.B. 2015-41 (Oct. 13, 2015)) and incorrectly states the status of the law in Publication 225 where it claims that CRP rents must always be reported on Schedule F and be subjected to self-employment tax (except for taxpayers that are also receiving Social Security retirement or disability payments).
Simply stated, more than a signature on a contract is required for an activity to rise to the level of a trade or business. The U.S. Supreme Court has consistently held for many years that the determination of whether a taxpayer is carrying on a trade or business “requires an examination of the facts of each case.” In Higgins v. Comr., 312 U.S. 212 (1941), the Court held that managing and preserving one’s personal estate was not a business activity. The Court reached the same result in City Bank Farmers Trust v. Helvering, 313 U.S. 121 (1941) when it held that simply collecting interest and clipping coupons coupled with very few reinvestments did not constitute a trade or business. More recently, the Court said that a full-time gambler who wagered for himself personally was engaged in a trade or business for purposes of self-employment tax based on the entire facts of the taxpayer’s situation. Comr. v. Groetzinger, 480 U.S. 23 (1987). In Groetzinger, the court said that the presence of a trade or business activity was to be determined based on the facts of each case and that its presence was to be determined based on whether the taxpayer’s involvement in the activity is regular and continuous, and whether the primary purpose of the activity is for income or profit. Both of those factors must be present for a trade or business to exist. Importantly, the Final QBID regulations cite to these two tests of Groetzinger. See also S.C.A. Memo. 200120037 (Mar. 30, 2001).
In 1988 (the year after the Supreme Court decided Groetzinger), the Tax Court elaborated on Groetzinger in a hobby loss case involving an Illinois horse breeding activity and pointed out (for purposes of deducting expenses under I.R.C. §162) that the taxpayer must be engaged in the activity with the primary purpose and intent of making a profit. Seebold v. Comr., T.C. Memo. 1988-183. Whether a taxpayer has a profit intent, the Tax Court said, is to be determined based on an objective analysis of the factors of the situation and not on the taxpayer’s personal statement(s) of intent.
What About Land Leases?
For farmers and ranchers, a primary question is whether a land rental arrangement will generate a QBID. While the answer to the question is fact-based, the Final Regulations contain four factors designed to guide taxpayers and courts on whether a real estate activity rises to the level of a trade or business. The first factor focuses on the type of real estate involved – whether it is commercial, residential, condominium or personal. The second factor addresses the number of properties (or tracts) the taxpayer leases out. The third factor looks at the degree of daily involvement of the landlord in the rental activity. That involvement can be either personally or via an agent. Because the trade or business standard for I.R.C. §199A routes through I.R.C. §162 rather than I.R.C. §1402, imputation of an agent’s activity is not blocked as it is under I.R.C. §1402. The fourth factor concerns the type of the lease – the length of the lease and whether it is a triple-net lease, etc.
Planning points. Simply renting land out under a cash lease with the landlord doing nothing more than collecting the rent is not enough to qualify the rental income as qualified business income (QBI). While a single rental can qualify as a trade or business (see Hazard v. Comr., 7 T.C. 372 (1946), the landlord must do more than collect the rent check. See, e.g., Neill v. Comr., 46 B.T.A. 197 (1942). The same is true for passive investments in oil and gas interests – merely collecting the royalty income from the investment is not a trade or business activity. While a triple-net lease would normally not result in the landlord being engaged in a trade or business activity with respect to the rental activity under the Groetzinger test of the QBID regulations (for lack of satisfying the regularity and continuity requirement), such a lease is not automatically disqualified from generating QBI. But, a triple-net lease will likely have to be modified or aggregated with other qualifying activities to qualify the income for the QBID In addition, under Notice 2019-7, 2019-09 I.R.B. 740 and associated Rev. Proc. 2019-38, 2019-42 I.R.B. 942 the IRS created a safe harbor for rental real estate activities on an annual basis. Treas. Reg. §1.199A-1 through Treas. Reg. §1.199A-6. The final rental safe harbor was issued in September of 2019. A triple net lease is not disqualified from using the optional safe harbor. Failure to satisfy the safe harbor requirements is not fatal to a determination that the rental activity fails the trade or business standard.
The rub for many farm landlords is to create QBI from rental income without triggering self-employment tax. On this point, it is important to note that the requirement for self-employment tax is material participation under the lease. That’s a different standard than the trade or business standard for QBI which is profit intent along with regularity and continuity. Another way of stating this is that a rental activity can produce QBI without triggering self-employment tax. That’s a key point. Some minimal involvement in the rental activity is required to convert cash rent into QBI. Entering into a written lease with the tenant that details the minimal involvement (such as consultation on cropping decisions; mowing of lanes; fence maintenance; inspecting the property, etc.) by the landlord is important. Maintaining a calendar of activities and involvement of the landlord (even via an agent) concerning the rental is also key.
I.R.C. §162 establishes a test for the existence of a trade or business that is a lower hurdle than that applicable for self-employment tax. Most farm/ranch land rental income will likely be deemed to be a trade or business under the I.R.C. §162 standard and qualify as QBI. However, existing lease agreements may need to be modified and put in writing if presently an oral. Documenting landlord involvement is critical. At the same time, making sure a landlord’s involvement is not significant enough to trigger self-employment tax is also essential to many farm landlords.
Wednesday, February 26, 2020
The economic loss of livestock for an agricultural producer is difficult. In a prior post I discussed the USDA’s livestock indemnity program. https://lawprofessors.typepad.com/agriculturallaw/2017/03/livestock-indemnity-payments-what-they-are-and-tax-reporting-options.html. That program can provide some financial relief when livestock die because of adverse weather conditions or attacks by animals that the Federal Government has reintroduced into the wild. But a significant concern is the tax treatment of livestock death losses. Can a loss deduction be claimed? If so, what is the character of the loss? How is the loss reported on the tax return?
The tax rules surrounding death of livestock – that’s the focus of today’s post.
Required Holding Period
The tax consequences of dead livestock are tied to how long the taxpayer “held” the livestock. The tax consequences upon death of livestock that are held for draft, dairy, breeding or sporting purposes differ depending on whether the taxpayer held the animals for 12 months or more (24 months or more for cattle and horses) that if they were not held for that requisite time period. If they have been held for the required holding period, they are “I.R.C. §1231 property.” Why is being I.R.C. §1231 property beneficial? It allows a taxpayer to receive tax-favored treatment for I.R.C. §1231 property gains that exceed I.R.C. §1231 property losses. Thus, if an I.R.C. §1231 asset can be sold for a value greater than its original cost basis, it can be taxed at a favorable capital gains rate. But, if a loss results, it is a fully deductible ordinary loss rather than a capital loss capped at $3,000 against ordinary income with any excess carried over to the following year.
I.R.C. §1231 property includes depreciable property and real property (e.g. buildings and equipment) used in a trade or business and generally held for more than one year. As noted, some types of livestock, coal, timber and domestic iron ore are also included in the definition of I.R.C. §1231 property. But, the category of I.R.C. §1231 property does not include inventory; property held for sale in the ordinary course of business; artistic creations held by their creator; or, government publications.
Gains and losses under I.R.C. §1231 due to casualty or theft are excluded from the netting process unless the gains exceed the losses. In that situation, both the gain and loss are calculated with any other I.R.C. §1231 gains and losses. If casualty losses exceed gains, the excess is treated as an ordinary loss. This all means that gain or loss that is triggered upon death may be included in the I.R.C. §1231 netting process.
If draft, dairy, breeding or sporting purpose livestock has been held for less than 12 months (24 months for cattle and horses) as of the time of the animal’s death, the gain or loss is not an I.R.C. §1231 gain or loss. It is reported on Part II of Form 4797. In this instance, it makes no difference whether the animal’s death was caused by casualty or disease.
Death Due to Casualty
Losses resulting from casualty-caused deaths are netted with the taxpayer’s other business casualty gains and losses to determine whether they will be included in the I.R.C. §1231 netting process. If the casualty gains exceed the casualty losses, the net gain is included with other I.R.C. §1231 gains and is netted against I.R.C. §1231 losses for the year. If the casualty losses exceed the casualty gains, the net loss is not included in the I.R.C. §1231 netting process. Rather, it’s allowed as an ordinary deduction for income tax purposes but not for self-employment tax purposes.
(Facts): In the spring of 2019, a “bomb cyclone” completely destroyed Slim’s barn and killed the 25 dairy cows that were in the barn. At the time of the weather event, assume that Slim’s income tax basis in the barn was $50,000 and its fair market value was $100,000. Slim received a $90,000 insurance payment for the destroyed barn. Thus, Slim has $40,000 gain as a result. As for the cows in the barn at the time of the casualty, assume that they were worth $20,000 immediately before the casualty and that Slim’s basis in the cows was $8,000. He didn’t receive any insurance proceeds attributable to the cows. Thus, Slim sustained an $8,000 loss on the cows.
(Result): Slim will report the loss of his barn and cows and the insurance payment for the barn on Form 4684. Neither his barn nor the cows will be subject to depreciation recapture because Slim claimed straight-line depreciation on the barn and there is no gain on the cows. Slim will report the net casualty gain on Form 4797, Part I, line 3. There it is netted with any other I.R.C. §1231 gains and losses that Slim incurred during the tax year.
Tax planning opportunities. If Slim has a net I.R.C. §1231 gain for the tax year, his loss on the cows will reduce the gain that would be taxed as capital gain. If he has a net I.R.C. §1231 loss for the year, his loss on the cows will increase the net I.R.C. §1231 loss, which is fully deductible as an ordinary loss. Under another rule, gain that is realized from casualty to business property can be rolled into replacement property. I.R.C. §1033. The replacement property must be purchased within two years of the end of the tax year of the involuntary conversion. I.R.C. §1033(a)(2)(B)(i). Thus, if Slim replaces the barn, he can roll the gain into the new barn and the loss from the cows would not be netted against the gain from the barn. The loss would avoid the I.R.C. §1231 netting process and be deducted against ordinary income. If Slim had a net loss on the barn (perhaps because the insurance pay-out was less), he would report the net loss from the casualty on Form 4684 but would not net it with his I.R.C. §1231 gains and losses for the tax year. Rather, it is reported on Part II of Form 4797 (or directly on Form 1040 if Form 4797 is not otherwise needed) where it will reduce ordinary income not subject to self-employment tax.
If Slim had triggered gain on the loss of the livestock, he could have elected to postpone gain recognition by under the involuntary conversion rule by investing the proceeds in livestock that are similar in service or use to the livestock that died. I.R.C. §1033(a). Normally, the livestock must be purchased by the end of the second tax year after the year the livestock died. If Slim makes the election to postpone the gain, but then does not purchase replacement livestock within the required timeframe, he will have to amend his return for the year of death to report the gain. The definition of “livestock” for purposes of I.R.C. §1231 applies for purposes of the involuntary conversion rule. Treas. Reg. §1.1231-2(a)(2).
If the cows had died as the result of a presidentially declared disaster, Slim could elect to deduct the loss for the year preceding the year of the loss. I.R.C. §165(i). Slim would accomplish this by amending the prior year’s return. Claiming the loss in the prior year could reduce the net I.R.C. §1231 gain for the current year which is taxed as capital gain. That could allow the loss to be deducted from ordinary income if Slim didn’t have any casualty or theft gains on that prior year’s return.
While the above example indicated that depreciation recapture was not triggered, what if a casualty does trigger depreciation recapture? If that happens, the recaptured depreciation is reported as ordinary income on Part III of Form 4797. It does not become part of the I.R.C. §1231 netting process.
Death Due to Disease
Disease is not a casualty. To be treated for tax purposes as a casualty, the loss must be “sudden, unexpected and unusual.” See, e.g., Rev. Rul. 72-592, 1972-2 C.B. 101. Disease is too gradual in nature to be treated as a casualty. Instead, it is an involuntary conversion and if the diseased livestock qualify as I.R.C. §1231 property, the gain or loss from the death is netted with other I.R.C. §1231 transactions for the tax year. The tax reporting of the livestock death would be in Part I of Form 4797 (unless depreciation recapture is present).
Livestock deaths can be economically devastating for a agricultural operation. However, understanding the associated tax rules and the related planning opportunities can help soften the blow.
Monday, February 24, 2020
For medium-sized and larger farming operations that grow crops covered by federal farm programs, a general partnership is often the entity of choice for the operational part of the business because it can aid in maximizing federal farm program benefits for the farming operation. I have discussed this issue in prior posts – how to maximize farm program benefits in light of the overall planning goals and objectives of the family farming operation.
Partnerships, however, can present rather unique and complex tax issues. The “flow-through” feature of partnership taxation and tax basis of a partnership interest – these are the topics of today’s post.
Partnerships are not subject to federal income tax. I.R.C. §701. The partnership’s income and expense is determined at the entity (partnership) level. Then, each partner takes into account separately on the partner’s individual return the partner’s distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit. I.R.C. §702. This sounds simple enough, but the facts of a particular situation can make the application of the rule something other than straightforward.
For example, in Lipnick v. Comr., 153 T.C. No. 1 (2019), the petitioner’s father owned interests in partnerships that owned and operated rental real estate. In 2009, the partnerships borrowed money (in the millions of dollars) and distributed the proceeds to the partners. The loans had a 5.88 percent interest rate and a note secured by the partnership’s assets, but no partner was personally liable on the notes. The father deposited the proceeds of the distributions in his personal account, and he later invested the funds in money market and other investment assets which he also held in his personal accounts until his death in late 2013. The partnerships incurred interest expense on the loans from 2009-2011, and the father treated his distributive share of the interest on the loans that the partnerships paid that passed through to him as “investment interest” on Schedule A of his individual return. By doing so, he deducted the investment interest to the extent of his net investment income. See I.R.C. §163(d)(1).
In mid-2011, the father transferred his partnership interests to the petitioner with the petitioner agreeing to be bound by the operating agreement of each partnership. However, the petitioner did not become personally liable on any of the partnership loans. The gifts relieved the father of his shares of the partnership liabilities and he reported substantial taxable capital gain as a result.
The father also owned minority interests in another partnership that owned and operated rental real estate. In early 2012, this partnership borrowed $20 million at a 4.19 percent interest rate and distributed the proceeds to the partners. Partnership assets secured the associated note, but no partner was personally liable on the note. Again, the father deposited the funds in his personal account and then invested the money in money market funds and other investment assets that he held in his personal accounts until death. Under the terms of his will, he bequeathed his partnership interest to the petitioner.
The loans remained outstanding during 2013 and 2014, and the partnerships continued to pay interest on them with a proportionate part passed through to the petitioner. The petitioner treated the debts as allocable to the partnerships’ real estate assets and reported the interest expense on his 2013 and 2014 individual returns (Schedule E) as regular business interest that offset the passed-through real estate income from the partnerships. On Schedule E, the interest expense was netted against the income from each partnership with the resulting net income reported on Forms 1040, line 17. The IRS disagreed, construing the interest as investment interest (“once investment interest, always investment interest”) reportable on Schedule A with the effect of denying any deduction because the petitioner didn’t have any investment income.
The Tax Court disagreed with the IRS position. The Tax Court noted that the partnership debt was a bona fide obligation of the partnership and the petitioner’s partnership interest was encumbered at the time it was gifted to him. The Tax Court also pointed out that the petitioner did not receive any distributions of loan proceeds to him and he didn’t use any partnership distributions to make investment-related expenditures. The Tax Court determined that the proper treatment of the petitioner was that he made a debt-financed acquisition of the partnership interests that he acquired from his father. Under I.R.C. §163(d) the debt proceeds were to be allocated among all of the partnerships’ real estate assets using a reasonable method, and the interest was to be allocated in the same fashion. Treas. Reg. §1.163-8T(c)(1).
Under the tracing rule of the regulation, debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. While the tracing rule is silent concerning its application to partnerships and their partners, the IRS has provided guidance. Notice 89-35, 1989-1 C.B. 675. In that guidance, the IRS provided that if a partner uses the proceeds of a debt-financed distribution to acquire property held for investment, the corresponding interest expense that the partnership incurs and is passed on to the partner will be treated as investment interest. But, the Tax Court held that the petitioner was not bound to treat the interest expense passed through to him in the same manner as his father. The Tax Court noted that the petitioner, instead of receiving debt-financed distributions, was properly treated as having made a debt-financed acquisition of his partnership interests for purposes of I.R.C. §163(d). He also made no investment expenditures from distributions that he received. See Treas. Reg. §1.163-8T(a)(4)(i)(C). Furthermore, because the partnerships’ real estate assets were actively managed in the operation of the partnerships, they didn’t constitute investment property. The Tax Court also held as irrelevant the fact that the petitioner was not personally liable on the debts. That fact did not mean that his partnership interest was not “subject to a debt” for purposes of Subchapter K. It was enough that he had acquired his partnership interests subject to the partnership debts.
A taxpayer’s income tax basis in an asset is important to know. Basis is necessary to compute gain on sale, transfer or other disposition of the asset. The starting point for computing basis is tied to how the taxpayer acquired the asset. In general, for purchased assets, the purchase price establishes the taxpayer’s basis. If the property is received by gift, the donor’s basis becomes the donee’s basis. For property that is acquired by inheritance, the value of the inherited property as of the date of the decedent’s death pegs the basis of the asset in the recipient’s hands. The same general rules apply with respect to a partnership interest when establishing the starting point for computing basis. But, as with other assets, the basis in a partnership interest adjusts over the time of the taxpayer’s ownership of the interest. For example, the basis in a partnership interest is increased by contributions to the partnership as well as taxable and tax-exempt income. It is decreased by distributions, nondeductible expenses and deductible losses. I.R.C. §705. But, the deductibility of a partner’s distributive share of losses is limited to the extent that the partner has insufficient basis in the partner’s partnership interest. I.R.C. §704(d).
Sec. 754 election
When a partnership distributes property or transfers the partner’s partnership interest (such as when a partner dies), the partnership can elect under I.R.C. §754 to adjust the basis of partnership property. See, e.g., Priv. Ltr. Ruls. 201909004 (Dec. 3, 2018); 201919009 (Aug. 9, 2018); and 201934002 (May 16, 2019). This election allows a step-up or step-down in basis under either I.R.C. §734(b) or I.R.C. §743(b) to reflect the FMV at the time of the exchange. This election has the advantage of not taxing the new partner on gains or losses already reflected in the purchase price of his or her partnership interest. The partnership must file the election by the due date of the return for the year the election is effective, normally with the return. In late 2017, the IRS proposed to amend Treas. Reg. §1.754-1(b)(1) to eliminate the requirement that an I.R.C. §754 election be signed by a partner of the electing partnership. REG-116256-17, 82 Fed. Reg. 47408 (Oct. 12, 2017).
I.R.C. §743 requires a partnership with an I.R.C. §754 election in place or with a substantial built-in loss to adjust the basis of its property when a partnership interest is transferred. I.R.C. §743(d). A partnership has a substantial built-in loss if the partnership's basis in its property exceeds the fair market value by more than $250,000. Id. But, do contingent liabilities count as “property” for purposes of I.R.C. §743? The answer is not clear. Treas. Reg. §1.752-7 treats contingent liabilities as I.R.C. §704(c) property, but the I.R.C. §743 regulations do not come right out and say that contingent liabilities are “property” for purposes of I.R.C. §743.
The IRS addressed the lack of clarity in 2019. In Tech. Adv. Memo. 201929019 (Apr. 4, 2019), two partnerships with the same majority owner merged. The merging partnership was deemed to have contributed all of its assets and liabilities in exchange for an interest in the resulting partnership. Then the interest in the resulting partnership was distributed to the partners in complete liquidation. The resulting partnership had a substantial built-in loss – the result when either the adjusted basis in the partnership property exceeds its fair market value by more than $250,000 or the transferee partner is allocated a loss of more than $250,000 if the partnership sells its assets for fair market value immediately after the merger.
I.R.C. §743(b) requires a mandatory downward inside-basis adjustment in this situation, but the question presented was whether it applies to a deemed distribution of an interest. The IRS determined that it did, taking the position that a deemed distribution of an interest of the resulting partnership was to be treated as a sale or exchange of the interest of the resulting partnership. See I.R.C. §§761(e) and 743.
As for the adjusted basis computation in the transferred partnership interest for the transferee partner, the IRS said that the resulting partnership’s liabilities (including contingent ones) must be included in the transferee partner’s basis in the partnership interest. They are also to be included in the transferee partner’s basis in the transferred partnership interest. Likewise, they are to be included in the transferee partner’s share of the resulting partnership’s liabilities to the extent of the amount of the I.R.C. §731(a) gain that the transferee partner would recognize absent the netting rule of Treas. Reg. §1.752-1(f). But, deferred cancellation-of-debt income (under I.R.C. §108(i)) is not to be included in calculating the transferee partner's share of previously taxed capital because this type of income is not taxable gain for purposes of I.R.C. §743.
General partnerships can be a very useful entity for the operational entity of a farm. Liability protection can be achieved by holding the partnership interests in some form of entity that limits liability – such as a limited liability company. But, with partnerships comes tax complexity. When a partnership interest is transferred (by sale, gift or upon death) the tax consequences can become complicated quickly. The same is true when partnerships are merged. Understanding how the flow-through nature of a partnership works, and how basis is computed and adjusted in a partnership is important when such events occur.
Tuesday, February 18, 2020
The law impacts agricultural operations, rural landowners and agribusinesses in many ways. On a daily basis, the courts address these issues. Periodically, I devote a post to a “snippet” of some of the important developments. Today, is one of those days.
More recent developments in agricultural law and taxation – it’s the topic of today’s post.
IRS Rulings on Portability.
Priv. Ltr. Ruls. 201850015 (Sept. 5, 2018); 20152016 (Sept. 21, 2018); 201852018 (Sept. 18, 2018); 201902027 (Sept. 24, 2018); 201921008 (Dec. 19, 2018); 201923001 (Feb. 28, 2019); 201923014 (Feb. 19, 2019); 201929013 (Apr. 4, 2019).
Portability of the federal estate tax exemption between married couples comes into play when the first spouse dies and the taxable value of the estate is insufficient to require the use of all of the deceased spouse's federal exemption (presently $11.58 million) from the federal estate tax. Portability allows the amount of the exemption that was not used for the deceased spouse's estate to be transferred to the surviving spouse's exemption so that the surviving spouse can use the deceased spouse's unused exemption plus the surviving spouse’s own exemption when the surviving spouse later dies. Portability is accomplished by filing Form 706 in the deceased spouse’s and is for federal estate tax purposes only. Some states that have a state estate tax also provide for portability at the state level. That’s an important feature for those states – it’s often the case that a state’s estate tax exemption is much lower than the federal exemption.
Sometimes a tax election is not made on a timely basis. Over the past year, the IRS issued numerous rulings on portability of the federal estate tax exemption and the election that must be made to port the unused portion of the exemption at the death of the first spouse over to the surviving spouse. In general, each of the rulings involved a decedent that was survived by a spouse, and the estate did not file a timely return to make the portability election. The estate found out its failure to elect portability after the due date for making the election. The IRS determined that where the value of the decedent's gross estate was less than the basic exclusion amount in the year of decedent's death (including taxable gifts made during the decedent’s lifetime), “section 9100 relief” was allowed. Treas. Reg. §§301.9100-1; 301.9100-3
The rulings did not permit a late portability election and section 9100 relief when the estate was over the filing threshold, even if no estate tax was owed because of the marital, charitable, or other deductions. In addition, it’s important to remember that there is a 2-year rule under Rev. Proc. 2017-34, 2017-26 I.R.B. 1282 making it possible to file Form 706 for portability purposes without section 9100 relief
Not Establishing a Lawyer Trust Account Properly Results in Taxable Income.
Isaacson v. Comr., T.C. Memo. 2020-17.
Attorney trust accounts are critical to making sure that money given to lawyers by clients or third-parties is kept safe and isn’t comingled with law firm funds or used incorrectly. But most people (even some new lawyers) don’t fully understand attorney trust accounts. An attorney trust account is basically a special bank account where client funds are stored for safekeeping until time for withdrawal. The funds function to keep client funds separate from the funds of the lawyer or law firm. For example, a trust account bars the lawyer from using a client’s retainer fee from being used to cover law firm operating costs unless the funds have been “earned.” But, whether funds have been “earned” has special meaning when tax rules come into play – think constructive receipt here. This was at issue in a recent Tax Court case.
In the case, a lawyer received a contingency fee upon settling a case. He deposited the funds in his lawyer trust account but did not report the deposited amount in his income for the tax year of the deposit claiming that his fee was in dispute and, thus, subject to a substantial limitation on his rights to the funds. The IRS disagreed and claimed that the account was not properly established as a lawyer trust account under state (CA) law. The IRS also pointed out that the petitioner commingled his funds with his clients’ funds which gave him access to the funds. The IRS also asserted that the petitioner should have reported the amount in income even if he later had to repay some of the amount. The Tax Court agreed with the IRS on the basis that the lawyer failed to properly establish and use the trust account and because the he had taken the opposite position with respect to the fee dispute in another court action. The income was taxable in the year the IRS claimed.
Semi-Trailer in Farm Field Near Roadway With Advertising Subject to Permit Requirement.
Counties, towns, municipalities and villages all have various rules when it comes to billboard and similar advertising. Sometimes those rules can intersect with agriculture, farming activities and rural land. That intersection was displayed in a recent case.
In the case, the defendant owned farm ground along the interstate and parked his semi-trailer within view from the interstate that had a vinyl banner tied to it that advertised a quilt shop on his property. The plaintiff (State Transportation Department) issued the defendant a letter telling him to remove the advertising material. The defendant requested an administrative hearing. The sign was within 660 feet of the interstate and was clearly visible from the interstate. The defendant collected monthly rent of $300 from the owner of the quilt shop for the advertisement. The defendant never applied for a permit to display the banner. The defendant uses the trailer for farm storage and periodically moves it around his property. The administrative hearing resulted in a finding that the trailer was being used for advertising material and an order was adopted stating the vinyl sign had to be removed. The defendant did not appeal this order, but did not remove the banner. The plaintiff sued to enforce the order. After the filing of the suit, the defendant removed the vinyl sign only to reveal a nearly identical painted-on sign beneath it with the same advertising. The plaintiffs amended their complaint alleging that the painted-on sign was the equivalent of the vinyl sign ordered to be removed and requesting that the trial court order its removal. The trial court found that the trailer with the painted-on sign was not advertising material as the semi-trailer was being used for agricultural purposes and was not an advertisement. The court did concede that the semi-trailer was within 660 feet of the right-of-way of the interstate; was clearly visible to travelers on the highway; had the purpose of attracting the attention of travelers; defendant received a monthly payment for maintaining the sign. On further review, the appellate court reversed and remanded. The appellate court concluded that the trailer served a dual purpose of agricultural use and advertising and that there was no blanket exemption for agricultural use. The trailer otherwise satisfied the statutory definition as an advertisement because of its location, visibility, and collection of rental income. The appellate court concluded that the defendant could use the trailer for agricultural purposes in its current location, but that advertising on it was subject to a permit requirement.
Lack of Basis Information in Appraisal Summary Dooms Charitable Deduction for Conservation Easement Donation.
Oakhill Woods, LLC v. Comr., T.C. Memo. 2020-24.
The tax Code allows an income tax deduction for owners of property who relinquish certain ownership rights via the grant of a permanent conservation easement to a qualified charity (e.g., to preserve the eased property for future generations). I.R.C. §170(h). But, abuses of the provision are not uncommon, and the IRS has developed detailed rules that must be followed for the charitable deduction to be claimed. The IRS audits such transactions and has a high rate of success challenging the claimed tax benefits.
In this case, the petitioner executed a deed of conservation easement on 379 acres to a qualified land trust in 2010. The deed recited the conservation purpose of the easement. The petitioner claimed a $7,949,000 charitable deduction for the donation. Included with the petitioner’s return was an appraisal and Form 8283 which requires, among other things, basis information concerning the gifted property or an attached reasonable cause explanation of why the information was not included with the return. Basis information was not included on Form 8283, and the petitioner attached a statement taking the position that such information was not necessary. The IRS denied the deduction for noncompliance with Treas. Reg. §1.170A-13(c)(2). The Tax Court agreed with the IRS, noting that the lack of cost basis information was fatal to the deduction as being more than a minor and unimportant departure from the requirements of the regulation. The Tax Court cited its prior opinion in Belair Woods, LLC v. Comr., T.C. Memo. 2018-159. The Tax Court also rejected the petitioner’s argument that Treas. Reg. §1.170A-13(c)(4)(i)(D) and (E) was invalid. The petitioner claimed that the basis information was required with the return and not the appraisal summary, but the Tax Court rejected this argument because a “return” includes all IRS forms and schedules that are required to be a part of the return. As such, Form 8283 was an essential part of the return. In addition, the Tax Court noted that the underlying statute absolutely required basis information to be included with the appraisal summary and, in any event, the IRS’ interpretation of the statute via the regulation was reasonable.
Cram-Down Interest Rate Determined.
In re Country Morning Farms, Inc., No. 19-00478-FPC11, 2020 Bankr. LEXIS 307 (E.D. Wash. Feb. 4, 2020).
A "cramdown" in a reorganization bankruptcy allows the debtor to reduce the principal balance of a debt to the value of the property securing it. The creditor is entitled to receive the value, as of the effective date of the plan, equal to the allowed amount of the claim. Thus, after a secured debt is written down to the fair market value of the collateral, with the amount of the debt in excess of the collateral value treated as unsecured debt which is generally discharged if not paid during the term of the plan, the creditor is entitled to the present value of the amount of the secured claim if the payments are stretched over a period of years. 11 U.S.C. §1129(b)(2)(A). But, how is present value determined? The U.S. Supreme Court offered clarity in 2004. The matter of determining an appropriate discount rate was involved in a recent bankruptcy case involving a Washington dairy operation.
The debtor filed Chapter 11 bankruptcy and couldn’t agree with a creditor (a bank) on the appropriate interest rate to be used in the debtor’s reorganization plan. The parties agreed that the “Prime Plus” method set forth in Till v. SCS Credit Corp., 541 U.S. 465 (2004) was the appropriate method to determine the “cram down” interest rate.” The parties agreed that the prime rate was presently 4.75 percent and that an additional amount as a “risk factor” should be added to the prime rate. The debtor proposed a 6 percent interest rate, based on the risk associated with the dairy business. The bank claimed that the appropriate interest rate was 7.75 percent – the highest rate factor under the Till analysis. The bank cited the length of the plan, the volatility of dairy market, the debtor’s capital structure, and conflicting projections from an expert when determining the appropriate risk factor. The court determined that the appropriate interest rate was 7 percent which raised the interest rate on some of the debtor’s loans and lowering it on others.
There’s never a dull moment in the world of ag law and ag tax. These are just a few developments in recent weeks.
Friday, February 14, 2020
Washburn University School of Law in conjunction with the Department of Agricultural Economics at Kansas State University is sponsoring a farm income tax and farm estate/business planning seminar in Deadwood, South Dakota on July 20 and 21. This is a premier event for practitioners with an agricultural clientele base, agribusiness professionals, farmers and ranchers, rural landowners and others with an interest in tax and planning issues affecting farm and ranch families.
For today’s post I detail the agenda for the event.
Monday July 20
The first day of the conference begins with my annual update of developments in farm income tax from the courts and the IRS. I will address the big ag tax issues over the past year. That session will be followed up with a session on GAAP accounting and the changes that will affect farmer’s financial statements. Topics that Paul Neiffer of CliftonLarsonAllen discuss will include revenue recognition and lease accounting changes.
After the morning break, I will examine several farm tax topics that are of current high importance – tax issues associated with restructuring credit lines; deducting bad debts; forgiving installment sale debt; and selected passive loss issues. Paul will follow up my session with an hour of I.R.C. §199A advanced planning that can maximize the qualified business income deduction for clients.
After the luncheon, U.S. Tax Court Judge Elizabeth Paris will speak for 90 minutes on practicing before the U.S. Tax Court. She will present information all attorneys and CPAs need to consider if they are interested in representing clients in the U.S. Tax Court. She will cover topics including the successful satisfaction of Tax Court notice pleading requirements; multiple exclusive jurisdictions of the Tax Court; troubleshooting potential conflicts and innocent spouse issues; utilizing S-Case procedures to a client’s advantage; and available Tax Court website resources.
I will follow the afternoon break with a discussion of issues associated with net operating losses and excess business losses. I will take a look at how the late 2017 tax legislation changed the rules for net operating losses and excess business losses – how the modified rules work; carrybacks and carryforwards; limitations; relevant guidance; business and non-business income; and entity sales. After my session, Paul will be back to discuss Farm Service Agency Advanced Planning and how to maximize a farm client’s receipt of ag program payments without sacrificing them at the altar of self-employment tax savings.
For the final session of the day I will discuss I will discuss real estate trades when I.R.C. §1245 property (such as grain bins and hog confinement buildings and other structures) is involved in the exchange. address the rules to know, how to identify and avoid the traps and the necessary forms to be filed
Tuesday July 21
I will begin the second day of the conference by providing an update of key developments in the courts and the IRS over the past year that impact estate, business and succession planning for farmers and ranchers. It will be a fast-paced survey of cases and rulings that practitioners must be aware of when planning farm and ranch estates and succession plans. My opening session will be followed by a an hour session on how to incorporate a gun trust into an estate plan. Prof. Jeff Jackson of Washburn Law School will lead the discussion and explore the basic operation of a gun trust to hold firearms and the mechanics of such a trust’s operation. Jeff will discuss the reasons to create a gun trust; their effectiveness as an estate planning tool to hold firearms; common myths and understandings about what a gun trust can do; special rules associated with gun trusts; and client counseling issues associated with gun trusts.
After the morning break, Brandon Ruopp, a private practitioner from Marshalltown, Iowa, will provide a comprehensive review of the rules concerning contributions, rollovers, and required minimum distributions for IRA's and qualified retirement plans following the passage of the SECURE Act in late 2019. I will follow Brandon’s session with a brief session on the common estate planning mistakes that farm and ranch families make that can be easily avoided if they are spotted soon enough. With the many technical rules that govern estate and business planning, sometimes the “little things” loom large. This session addresses these common issues that must be addressed with clients.
After the luncheon, I will provide a brief session on the post-death management of the family farm or ranch business. I will discuss the issues that must be dealt with after the death of family member of the family business. This session will also examine probate administration issues that commonly arise with respect to a farm or ranch estate, including the application of Farm Service Agency rules and requirements. Also addressed will be distributional and tax issues; issues associated with partitioning property; handling marital property and disclaimers; potential CERCLA liability; and issues associated with estate tax audits.
Next up will be Marc Vianello, a CPA in the Kansas City area who is well-renown in the area of valuation discounting. Marc’s session will provide a summary of Marc’s research into the market evidence of discounts for lack of marketability. The presentation will challenge broadly used methodologies for determining discounts for lack of marketability, and illustrate why such discounts should be supported by probability-based option modeling.
Following the afternoon break, I will discuss the valuation of farm chattels and marketing rights and the basic guidelines for determining the estate tax value of this type of farm property.
The final session of the day will be devoted to ethics. Prof. Shawn Leisinger at Washburn Law School will present an interesting session on ethical issues related to risk in a legal context and how to understand and advise clients. Shawn’s presentation will look at how different people, and different attorneys, approach risk taking through a live exercise and application of academic risk approaches to the outcomes. Then, the discussion looks at how an attorney can get competent and ethically advise clients concerning risk decisions in practice. Participants will be challenged to contemplate how their personal approach to risk may impact, or fail to impact, client decisions and choices.
Law School Alumni Reception and CLE
On Sunday evening, July 19, Washburn Law School, in conjunction with the conference will be holding a law school alumni function. Conference attendees are welcome to attend the reception. On Monday, July 20, a separate CLE event will be held for law school alumni at the same venue of the conference. Details on the alumni reception and the CLE topics will be forthcoming.
Registration for the conference will be available soon. Be watching my website – www.washburnlaw.edu/waltr for details as well as this blog. The conference will be held at the Lodge at Deadwood. https://www.deadwoodlodge.com/ A room block has been established for the weekend before the conference and for at least a day after the conference ends.
I hope to see you at Deadwood in July. If you’re looking for high quality CPE/CLE for farm and ranch clients, this conference will be worth your time.
Monday, February 10, 2020
I have done prior posts on conservation easements. In one post I dealt with the perpetuity requirement that must be satisfied for the donor to obtain a tax deduction for the easement that is donated to a qualified charity. In that post, I discussed perpetuity in the context of subordination agreements and deed recordation. But what if the easement is extinguished by a court or there are conditions on the grant or there is a merger of property interests involving the easement. All of these can impact the perpetuity requirement and cause the donor to lose out on the anticipated tax deduction.
Conservation easements are clearly in the “bulls-eye” of IRS scrutiny and the perpetuity requirement is causing practitioners and donors trouble.
Drilling down deeper on the perpetuity requirement associated with the donation of a permanent conservation easement – it’s the topic of today’s post.
The Perpetuity Requirement
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)(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.
The “dirt” is in the details concerning the technical requirements that must be satisfied for the easement donation to meet the perpetuity requirement and generate a charitable contribution deduction for the donor. What are some of those details?
Mortgage. If the donated easement is subject to a mortgage, the mortgagee must subordinate its rights in the property to the rights of the easement holder. In Palmolive Bldg. Investors, LLC v. Comr., 149 T.C. 380 (2017), the IRS disallowed a $33.41 million charitable deduction attributable to the donation of a façade easement over a historic building in Chicago because the mortgage holders were entitled to insurance proceeds in preference to the land trust. The Tax Court agreed, holding that the preference given to the motgagees on the insurance proceeds violated the perpetuity requirement. See Treas. Reg. §§1.170A-14(g)(2); (g)(6)(ii).
Changes and court orders. If some future unanticipated change in the conditions surrounding the easement makes the conservation use of the property impossible or impractical, a court may extinguish the conservation purposes and require the property to be sold. In that event, to preserve the tax deduction for the donor, the donee organization must receive a certain part of the sale proceeds as established by a formula. This requirement is to ensure that the donation is “perpetual” even in the event the easement is extinguished.
For example, 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. Under Treas. Reg. §1.170A(g)(6)(i)-(ii), when a change in conditions extinguishes a perpetual conservation restriction, the donee, on later sale, exchange or conversion of the property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction. 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.
More recently, the Tax Court decided Railroad Holdings, LLC, et al. v. Comr., T.C. Memo. 2020-22. In the case, 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. §1,70A-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.
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 Treas. Reg. 1.170A-14(g)(6)(ii), making the charitable deduction unavailable. See, e.g., Priv. Ltr. Rul. 200836014 (Sept. 5, 2008); PBBM-Rose Hill, Ltd. v. Comr., 900 F.3d 193 (5th Cir. 2018). This is perhaps the most common audit issue for IRS when examining permanent conservation easement donations.
Amendments. A very common clause in deeds granting permanent conservation easements is one that allows the parties to agree to amend the deed at some point in the future. However, the IRS position is that such deed language violates the perpetuity requirement, even if the right to amend is designed to protect the conservation purposes and ensure that they remain perpetual by making the donated easement flexible to respond to changed circumstances.
Merger. A dominant estate can merge with a lesser estate if the two estates become commonly owned. When that happens, the lesser estate is extinguished. Thus, for example, if a land trust acquires the fee simple interest in conservation easement property, the easement is extinguished. The IRS views the possibility of merger as allowing the parties to extinguish the easement without a judicial proceeding if permitted under state law. In the IRS view, that is a violation of the perpetuity requirement, and raises a question whether contractually prohibiting the dominant and lesser estates to merge is permissible under state property law. The IRS position raises a question as to the possibility of drafting deed language that avoids problems with the IRS on this issue.
Miscellaneous. Recent court decisions and IRS rulings have also touched on other aspects of the perpetuity requirement. For example, in C.C.A. 202002011 (Nov. 26, 2019), the IRS stated that a conservation easement deed may contain a clause specifying that if the easement holder fails to respond within a certain time to a request by the property owner regarding a proposed use that the request is considered to be denied. The IRS noted that because a constructive denial is not a decision by the easement holder based on the merits of the property owner’s request, it is not final or binding on the easement holder, and the property owner can resubmit the same or a similar request for approval. The IRS determined that such clause language does not violate the perpetuity requirements of I.R.C. §170(h).
In TOT Property Holdings, LLC v. Comr., Docket No. 005600-17 (U.S. Tax Ct. Dec. 13, 2019), the petitioner engaged in a syndicated easement transaction whereby it claimed a $6.9 million charitable contribution deduction for an easement on 637 acres of a 652-acre parcel donated to a land conservancy. The IRS denied a charitable deduction due to the easement deed not satisfying the perpetuity requirement and imposed a 40 percent gross valuation misstatement and negligence penalties. The Tax Court agreed, determined that the actual value of the easement donation was less than 10 percent of what was originally reported on the petitioner’s return. In the process, the Tax Court gave more credibility to the approach of the appraiser for the IRS.
The IRS takes a close look at donated conservation easements. It simply does not like the granting of a significant tax deduction while the donor continues to use the underlying property in largely the same manner as before the easement on the property was donated. Thus, all of the requirements necessary to obtain the deduction must be followed. That includes satisfying the perpetuity requirement. IRS is definitely is on the look-out for what it believes are abusive transactions involving charitable contributions of easements.
The IRS has also produced an audit technique guide concerning the donation of permanent conservation easements. That guide should be reviewed by parties interested in donating permanent easements. It is accessible here: https://www.irs.gov/pub/irs-utl/conservation_easement.pdf
Wednesday, January 29, 2020
It’s not unusual for a taxpayer to present the tax preparer with unique factual situations that aren’t commonplace and have very unique rules. Today’s post digs into three of those areas that often generate many questions from practitioners, and also aren’t handled easily by tax software.
Unique, but important tax issues - the topic of today’s post.
“Claim of Right” Doctrine Denies Remedy for Stock Sale
In 1932, the U.S. Supreme Court created the “claim of right” doctrine. American Oil Consolidated v. Burnet, 286 U.S. 417 (1932). It applies when a taxpayer receives income, but the income is subject to a contingency or other significant restriction that might remove it from the taxpayer. In that situation, the taxpayer need not recognize the income. In essence, the doctrine applies when the taxpayer doesn’t have a fixed right to the income. If the taxpayer ultimately has to return the income that has been recognized, the taxpayer might be entitled to receive an offsetting deduction or a tax credit. I.R.C. §1341.
The “claim of right” doctrine arose in a recent Wisconsin federal court case in a rather unique situation. Under the facts of the case, the plaintiffs, a married couple, created a revocable living trust in 2004 and amended it in 2012. The trust was created under Wisconsin law and named a bank as trustee with a different bank as successor trustee. The trust language gave the trustee broad discretion to invest, reinvest, or retain trust assets. However, the trust barred the trustee from doing anything with the stock of two companies that the trust held. The trustee apparently did not know of the prohibition and sold all of the stock of both companies in late 2015, triggering a taxable gain of $5,643,067.50. The sale proceeds remained in the trust. Approximately three months later, in early 2016, the trustee learned of the trust provision barring the stock sale and repurchased the stock with the trust’s assets. The grantors then revoked the trust later in 2016.
On their 2015 return, the plaintiffs reported the gain on the stock sale and paid the resulting tax. On their 2016 return, the plaintiffs claimed a deduction under I.R.C. 1341 for the tax paid on the stock sale gain the prior year. The IRS denied the deduction and the plaintiffs challenged the denial. The IRS motioned to dismiss the case. The plaintiffs relied on the “claim of right” doctrine of I.R.C. §1341– they reported the income and paid the tax. Under I.R.C. §1341, the plaintiffs had to: (1) establish that they included the income from the stock sale in a prior tax year; (2) show that they were entitled to a deduction because they did not have an unrestricted right to the income as of the close of the earlier tax year; and (3) show that the amount of the deduction exceeds $3,000. If the requirements are satisfied, a taxpayer can claim the deduction in the current tax year or claim a credit for the taxes paid in the prior year.
The IRS claimed that the plaintiffs could not satisfy the second element because the plaintiffs were not actually required to relinquish the proceeds of the stock sale. The court agreed, noting that once the stocks were sold the plaintiffs had the unrestricted right to the proceeds as part of the revocable trust, as further evidenced by them revoking the trust in 2016. The court noted that neither the trustee nor the plaintiffs had any obligation to repurchase the stock. The court also noted that under Wisconsin trust law, the plaintiffs could have instructed the trustee to do anything with the proceeds of the stock sale, and that they had the power to consent to the trustee’s action of selling the stock. In other words, they were not duty-bound to require the trustee to buy the stock back. Accordingly, the court determined that I.R.C. §1341 did not provide a remedy to the plaintiffs, and that any remedy, if there was one, would be against the trustee.
Grouping and the Passive Loss Rules
Eger v. United States, 405 F. Supp. 3d 850 (N.D. Cal. 2019)
Under I.R.C. §469, the deduction of losses from a “passive activity” is limited to the amount of passive income from all passive activities of the taxpayer. Stated another way, a passive activity loss is the excess of the aggregate losses from all passive activities for the year over the aggregate income from all passive activities for that particular year. For taxpayers with multiple activities, Treas. Reg. §1.469-4(c)(1) provides for a grouping of legal entities if the activities constitute an appropriate economic unit for the measurement of gain or loss. Also, rental activities can generally be grouped together. Grouping can be helpful to satisfy the material participation tests of I.R.C. §469 to avoid the application of the passive loss rules. This grouping issue came up in a recent federal case in Oklahoma involving rental activities.
In the case, the plaintiff was a real estate professional within the meaning of I.R.C. §469(c)(7) that owned three properties (vacation properties) in different states that he offered for rent via management companies at various times during the year in issue. The plaintiff reserved the right for days of personal use of each rental property. The plaintiff sought to group the vacation rental properties with his other rental activities as a single activity for purposes of the material participation rules of I.R.C. §469. The IRS denied the grouping on the basis that the vacation rental properties were not rental properties on the basis that the average period of customer use for the vacation rentals was seven days or less as set forth in Treas. Reg. §1.469-1T(e)(3)(ii)(A), and that the petitioner was the “customer” rather than the management companies.
The court agreed with the IRS position on the basis that the plaintiff’s retained right to use each vacation property eliminated the management companies from having a continuous or recurring right to use the property when applying the test of Treas. Reg. §1.469-1(e)(3)(iii)(D) providing for measuring the period of customer use. As such, the facts of the case differed substantially from the contracts at issue in White v. Comr., T.C. Sum. Op. 2004-139 and Hairston v. Comr., T.C. Memo. 2000-386. Thus, the management companies were not customers with a continuous right to use the properties, but merely provided marketing and rental services for the petitioner to rent out the properties.
Prior Bankruptcy Filings Extends Non-Dischargeability Period
In re Nachimson v. United States, 606 B.R. 899 (Bankr. W.D. Okla. 2019)
The creation of the bankruptcy estate as a new taxpayer, separate from the debtor, highlights the five categories of taxes in a Chapter 7 or 11 case. Category 1 taxes are taxes where the tax return was due more than three years before filing. These taxes are dischargeable unless the debtor failed to file a return or filed a fraudulent return. Category 2 taxes are the taxes due within the last three years. These taxes are not dischargeable but are entitled to an eighth priority claim in the bankruptcy estate, ahead of the unsecured creditors. Category 3 taxes are the taxes for the portion of the year of bankruptcy filing up to the day before the day of bankruptcy filing. If the debtor's year is closed as of the date of filing, the taxes for the first year, while not dischargeable, are also entitled to an eighth priority claim in the bankruptcy estate. If the debtor's year is not closed, the entire amount of taxes for the year of filing are the debtor's responsibility. Category 4 taxes are the taxes triggered on or after the date of filing and are the responsibility of the bankruptcy estate. Taxes due are paid by the bankruptcy estate as an administrative expense. If the taxes exceed the available funds, the tax obligation remains against the bankruptcy estate but does not return to the debtor. Category 5 taxes are for the portion of the year beginning with the date of bankruptcy filing (or for the entire year if the debtor's year is not closed) and are the responsibility of the debtor.
In a recent Oklahoma case, the debtor filed Chapter 7 in late 2018 after not filing his 2013 and 2014 returns. The 2013 return was due on October 15, 2014, and the 2014 return was due April 15, 2015. The debtor had previously filed bankruptcy in late 2014 (Chapter 13). That prior case was dismissed in early 2015. The debtor filed another bankruptcy petition in late 2015 (Chapter 11). Based on the facts, the debtor had been in bankruptcy proceedings during the relevant time period, (October 15, 2014, through October 25, 2018) for a total of 311 days. 11 U.S.C. § 523(a)(1)(A) provides, in general, that a discharge of debt in bankruptcy does not discharge an individual debtor from any debt for an income tax for the periods specified in 11 U.S.C. § 507(a)(8). One of the periods provided under 11 U.S.C. § 507(a)(8), contained in 11 U.S.C. § 507(a)(8)(A)(i), is the three years before filing a bankruptcy petition. Also, 11 U.S.C. § 507(a)(8) specifies that an otherwise applicable time period specified in 11 U.S.C. § 507(a)(8) is suspended for any time during which the stay of proceedings was in effect in a prior bankruptcy case or during which collection was precluded by the existence of one or more confirmed bankruptcy plans, plus 90 days. When a debtor files multiple, successive bankruptcy cases, the ordinary operation of the automatic stay 11 U.S.C. § 507(a)(8) is altered by 11 U.S.C. § 362(c)(3)(A) which specifies that if a debtor had a case pending within the preceding one-year period that was dismissed, then the automatic stay with respect to any action taken with respect to a debt or property securing that debt terminates with respect to the debtor on the 30th day after the filing of the later case.
The debtor sought to have his 2013 and 2014 tax liabilities discharged in the present bankruptcy case under 11 U.S.C. §523(a)(1)(A) on the basis that the filing dates for those returns were outside the three-year look-back period. The IRS took the position that the three-year “look-back” period was extended due to the debtor's bankruptcy filings. The court agreed with the IRS, noting that the three-year look-back period began on October 25, 2015. However, the court concluded that an issue remained as to whether the look-back period extended back 401 days, or only for the first 30 days following each bankruptcy filing as provided by 11 U.S.C. § 362(c)(3)(A). Based on a review of applicable bankruptcy case law, the court concluded that the tolling provision of 11 U.S.C. § 507(a)(8) was not impacted by the automatic nature of 11 U.S.C. § 362(c)(3)(A). Instead, for purposes of the tolling provision, the stay of proceedings was in effect in each of debtor's three previous cases until each was dismissed. Therefore, the court found that the look-back period extended back three years plus 401 days. Since the debtor filed the bankruptcy petition in the present case on October 25, 2018, the three-year plus 401-day look-back period reached back to September 19, 2014. Because the debtor's 2013 and 2014 tax liabilities were due after that date (including the extension for the 2013 liability), neither was dischargeable in the current bankruptcy case.
Some clients have standard, straightforward returns. Others have very complicated returns that present very unique issues. The cases discussed today point out just three of the ways that tax issues can be very unique and difficult to sort out.