Saturday, April 9, 2022

Farm Economic Issues and Implications

Overview

A firm understanding of the economic context within which the farmers and ranchers operate is necessary for both tax planning and financial planning.  The creation and dissolution of legal entities, the restructuring of debt, and the use of various legal devices for the protection of assets from creditors and preserving inheritances cannot successfully be accomplished without knowledge of agriculture that transcends the applicable legal rules. 

Crop production, energy issues, monetary policy, issues in the meat sector and unanticipated outside shocks have farm-level impacts that professional advisors and counselors need to account for when representing farm and ranch clients.

Current economic issues impacting ag – it’s the topic of today’s post.

Projected Plantings (and Implications)

On March 31, the USDA released its “prospective plantings” report for the 2022 crops. https://www.nass.usda.gov/Publications/Todays_Reports/reports/pspl0322.pdf  The report projects farmers planting 91 million acres of soybeans and 89.5 million acres of corn.  The corn planting number is down 4 percent from last year, and is the lowest acreage estimate over the last five years.  The soybean projection is up four percent from 2021.  Total planted acres are projected to remain about the same as 2021.

Note:  The shift from corn acres to soybean acres was very predictable.  Farmers have calculators and can run the numbers with higher input costs (such as fertilizer).  Corn, as compared to soybeans, requires a greater amount of inputs which have risen in price substantially. 

Projected wheat planted acres is up one percent from 2021, but still is projected to be the fifth lowest total wheat planted acres since 1919.  Grain sorghum is projected to be down 15 percent (1.4 million acres) from 2021, with significant declines projected in Kansas and Texas.  Conversely, barley and sunflower planted acres is projected to increase 11 percent and 10 percent respectively from 2021.  With respect to sunflowers, however, the 2022 projection is still the fifth lowest planted area on record.  Cotton acreage is projected to be up about 800,000 acres.

Implication:  The projected planting numbers indicate that higher protein prices can be expected in the future.

Global Crops

The Russian war with Ukraine will have impacts on global grain trade and create additional issues for U.S. farmers and ranchers.  Russia and Ukraine are leading exporters of food grains.  But, Ukraine ports are closed and Russian imports are being avoided causing rising food prices. In the U.S., the rise is in addition to existing inflationary price increases for most good products.  Russia and Ukraine produce 19 percent of the world’s barley; 14 percent of the world’s wheat; and four percent of the world’s maize.  They also produce 29 percent of total world wheat exports and 19 percent of total world corn exports.  Those numbers are particularly important to countries that depend on imported grain from Russia and Ukraine, with a major issue being the loss of corn exports from Ukraine. 

Note:  U.S. corn exports are projected to rise, but U.S. wheat exports are not.

If the war triggers a global food crisis, the least developed countries that are also likely to be low-income or food-deficit countries are the most vulnerable to food shortages.  This would create a surge in malnutrition in these countries.  Presently, 50 countries rely on Russia and Ukraine for 30 percent of their wheat supply (combined), and 26 countries source at least 50 percent of their wheat needs from Russia/Ukraine.  Egypt and Turkey get over 70 percent of their wheat from Russia/Ukraine.  Russia supplies 90 percent of Lebanon’s wheat and cooking oil.  Grain shortages will hit the poorer African countries particularly hard.  These countries rely on imported bread to feed their expanding populations.  As a whole, in 2020, the  continent of Africa imported $4 billion worth of ag products from Russia (which supplied the majority of the continent’s wheat consumption. 

This combined data indicates an escalation of global food insecurity.  One estimate is that worldwide food and feed prices could rise by 22 percent which could, in turn, cause a surge in malnutrition in developing nations.  Since the war started, total world food output has decreased, resulting in a sharp drop in food exports from exporting countries.  Other food exporting countries have announced new limitations on food exports (or are exploring bans) to preserve domestic supplies.  This will have an impact on international grain markets and will likely have serious implications for the world’s wheat supply.  The extent of such disruptions is unknown at the present time. 

Note:  Russia is also a major fertilizer exporter, supplying 21 percent of world anhydrous exports, 16 percent of world urea exports and 19 percent of world potash exports.  Combined, Russia and Belarus provide 40 percent or world potash exports.  The Russia/Ukraine war will likely have long term impacts on fertilizer prices in the U.S. and elsewhere.  This will have impact crop planting decisions by farmers. 

Energy Policy

Incomprehensible energy policy in the U.S. since late January of 2021 and in Europe have been a financial boon to Russia.  The policy, largely couched in terms of ameliorating “climate change,” has resulted in the U.S. from being energy independent to begging foreign countries to produce more.  The restriction in U.S. production and distribution of oil has occurred at a time of increasing demand coming out of state government mandated shutdowns as a result of the China-originated virus.  The resulting higher energy prices have caused the prices of many products and commodities to increase. 

Monetary Policy

The U.S. economy is incurring the highest inflation in 40 years.  While the employment numbers are improving coming out of virus-related shutdowns, the labor force participation rate is not.  A higher rate of employment coupled with a decrease in the labor force participation rate may mean that workers are taking on multiple (lower paying) jobs in an attempt to stay even with inflation. 

The last time the government attempted to dig itself out of a severe inflationary situation the Federal Reserve raised interest rates substantially to “wring inflation out of the economy.”  The result for agriculture was traumatic, bringing on the farm debt crisis of the 1980s.  The current situation is similar with the Federal Reserve having backed itself into a corner with prolonged, historic low interest rates coupled with an outrageous increase in the money supply caused by massive government spending.  If the Federal Reserve attempts to get out of the corner by just raising interest rates, the end result will likely not be good.  The money supply must be reduced, or worker productivity gains must be substantial.  Higher interest rates are a means to reducing the money supply. 

Meat Sector

In the meat sector, the demand for beef remains strong.  Beef exports are steadily growing.  The current major issue in the sector is the disconnect between beef demand and the beef producer.  Currently, the large meat packers are enjoying record-wide margins.  Cattle producers are being signaled to decrease herd sizes because of the disconnect.  Legislation is being considered in the Congress with the intent of providing more robust and transparent marketing of live cattle.

On the pork side, demand is not as impressive but is improving.

For poultry, demand remains strong and flock sizes are decreasing largely because of the presence of Avian Flu. 

Some states have enacted labeling laws designed to protect meat consumers from deceptive and misleading advertising of “fake meat” products.  The Louisiana law has been held unconstitutional on free speech grounds. Turtle Island Foods SPC v. Strain, No. 20-00674-BAJ-EWD, 2022 U.S. Dist. LEXIS 56208 (M.D. La. Mar. 28, 2022).  Much of the advertising of “fake meat” products is couched not in terms of health benefits, but on reducing/eliminating “climate change.”  Government mandates have been imposed for the sake of “climate change” – a certain amount of ethanol blend in fuel; a certain amount of “renewable” energy to generate electricity, etc.). Could that also happen to the meat industry, but in a negative way?  A concern for the meat industry is whether the government will try to mandate that a certain percentage of meat cuts in a meat case consist of “fake meat” products based on a claim that doing so would further the “save the planet” effort. 

Water Issues

West of the Sixth Principal Meridian, access to water is critical for the success of many farming and ranching operations.  A dispute is brewing between Colorado and Nebraska over water in northeast Colorado that Nebraska lays claim to under a Compact entered into almost 100 years ago.  In the fertile Northeastern Colorado area, the State Engineer has shut-in almost 4,000 wells over the past two decades to maintain streamflow and satisfy downstream priority claims.  A similar number of wells have had their pumping rights limited in some way.  While this is a very diverse agricultural-rich area, water is essential to maintain production.  Given the rapid urban development in this area, the need for water for new subdivisions along the front range will trigger major political ramifications if there are any further reductions in agriculture’s water usage. 

The economic impact of water issues in Northeastern Colorado is already being felt.   The Colorado-Big Thompson Project collects, stores and delivers more than 200,000 acre-feet of supplemental water annually. Melting snowpack in the Colorado River headwaters on the West Slope is diverted through a tunnel beneath the Continental Divide to approximately 1,021,000 million residents and 615,000 acres of irrigated farmland in Northeastern Colorado. A unit (acre-foot) of Colorado Big Thompson water storage is presently selling for approximately $65,000.  Fifteen years ago, it was priced in the $6,000 range.  All other water shares are priced accordingly.  This dramatic increase in price has implications for the structure of farming operations, succession planning and estate valuation. 

Water access and availability will continue to be key to profitability of farms and ranches in the Plains and the West.

Tax Policy

In late March, the White House release its proposed 2023 fiscal year budget (October 1, 2022 – September 30, 2023).  At the same time, the Treasury release its “Greenbook” explanation of the tax provisions contained in the budget proposal.  Many of the proposals are the same as or similar to those included in bills in 2021 that failed to become law. 

Here’s a brief list of some of the proposals:

  • Top individual rate to 39.6 percent on income over $400,000 ($450,000 for married couples;
  • Corporate rate goes to 28 percent (87 percent increase on many farm corporations);
  • Raise capital gain rate to 39.6 percent on income over $1 million;
  • Capital gain tax on any transfer of appreciated property either during life or at death;
  • Partial elimination of stepped-up basis – if to spouse, then carryover; transfer of appreciated property to CRAT would be taxable;
  • Trust assets must be “marked-to-market” every 90 years beginning with any new trust after 1940. The rule would be the same for partnerships or any other non-corporate owned entity.  In addition, no valuation discount for partial interests, and a transfer from a trust would be a taxable event.  Exclusion of $1 million/person would apply.  Any tax on illiquid assets could be paid over 15 years or the taxpayer could elect to pay the tax when the property is sold or is no longer used as a farm (in that event, there would be no 15-year option);
  • All farm income (including self-rents) would be subject to the net investment income tax of 3.8 percent;
  • A minimum tax would apply to those with a net worth over $100 million;
  • Grantor-Retained Annuity Trusts (GRATs) must have minimum term of 10 years. This would essentially eliminate the use of a “zeroed-out” GRAT;
  • Any sale to a grantor trust is taxable and any payment of tax of the trust is a taxable gift;
  • Limitation on valuation discounts (related party rules);
  • R.C. §2032A maximum reduction would increase to $11.7 million
  • Trust reporting of assets would be required if the trust corpus is over $300,000 (or $10,000 of income);
  • Elimination of dynasty trusts;
  • Carried interest income would become ordinary income;
  • R.C. §1031 exchange tax deferral would be limited to $1 million;
  • Depreciation recapture would be triggered on the sale of real estate, which would eliminate the maximum 25% rate.

Note:  The provisions have little to no chance of becoming law, but if some or all were to become law, there would be significant implications for farm and ranch businesses.  Many of those implications would be negative for farming and ranching operations.

Conclusion

Farmland values remain strong.  Indeed, input, machinery costs and land values are outpacing inflation.  For those farmers that were able to pre-pay input expenses in 2021 for 2022 crops, the perhaps much of the price increase of inputs will be blunted until another round of inputs are needed in late 2022 for the 2023 crop.  Also, short-term loans were locked in before interest rates began rising.  That story will also likely be different in early 2023 when those loans are redone. 

The biggest risks to agriculture will continue to be from outside the sector.  Unexpected catastrophic events such as the Russian war with Ukraine, whether (or when) China will invade Taiwan, domestic monetary and fiscal policy, political developments at home and abroad, and regulation of agricultural activities remain the biggest unknown variables to the profitability of farming and ranching operations and agribusinesses. 

An awareness of the economic atmosphere in which farmers and ranchers operate is important to understand for practitioners to provide fully competent advice and counsel with respect to income tax, estate, business and succession planning for farmers and ranchers.

April 9, 2022 in Business Planning, Environmental Law, Estate Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Tuesday, April 5, 2022

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

Overview

Last week, there were two court major court developments of importance to agriculture.  In one, the U.S. Supreme court agreed to hear a case from the U.S. Court of Appeals for the Ninth Circuit involving California’s Proposition 12.  That law sets rules for pork production that must be satisfied for the resulting pork products to be sold in California.  In another development, a federal court in Louisiana held that state’s law designed to protect consumers from misleading and false advertising concerning meat products. 

The Supreme Court and Pork Production Regulations

National Pork Producers Council, et al. v. Ross, 6 F.4th 1021 (9th Cir. 2021), cert. granted, No. 21-468, 2022 U.S. LEXIS 1742 (U.S. Mar. 28, 2022) 

Background.  California voters approved Proposition 12 in 2018.  The new law took effect on January 1, 2022.  Proposition 12 bans the sale of whole pork meat (no matter where produced) from animals confined in a manner inconsistent with California’s regulatory standards (largely remaining to be established).  It also establishes minimum requirements on farmers to provide more space for egg-laying hens, breeding pigs, and calves raised for veal. Specifically, the law requires that covered animals be housed in confinement systems that comply with specific standards for freedom of movement, cage-free design and minimum floor space. The law identifies covered animals to include veal calves, breeding pigs and egg-laying hens.

The implementing regulations are to prohibit a farm owner or operator from knowingly causing any covered animal to be confined in a cruel manner, as specified, and prohibits a business owner or operator from knowingly engaging in the sale within the state of shell eggs, liquid eggs, whole pork meat or whole veal meat, as defined, from animals housed in a “cruel manner.”  In addition to general requirements that prohibit animals from being confined in a manner that prevents lying down, standing up, fully extending limbs or turning around freely, the measure added detailed confinement space standards for farms subject to the law. The alleged reason for the law was to protect the health and safety of California consumers and decrease the risk of foodborne illness and the negative fiscal impact on California.  Apparently, California believes that existing state and federal law regulating food products for health and safety purposes was inadequate (or the alleged reason for the law is false). 

Trial court.  In late 2019, several national farm organizations challenged Proposition 12 and sought a declaratory judgment that the law was unconstitutional under the Dormant Commerce Clause. 

Note:   The Dormant Commerce Clause bars states from passing legislation that discriminates against or excessively burdens interstate commerce.  It prevents protectionist state policies that favor state citizens or businesses at the expense of non-citizens conducting business within that state.  The clause is dormant because it is not state outright, but rather implied in the Constitution’s Commerce Clause of Article I, Section 8, Clause 3.

The plaintiffs also sought a permanent injunction preventing Proposition 12 from taking effect.  The plaintiffs claimed that Proposition 12 impermissibly regulated out-of-state conduct by compelling non-California producers to change their operations to meet California’s standards.  The plaintiffs also alleged that Proposition 12 imposed excessive burdens on interstate commerce without advancing any legitimate local interest by significantly increasing operation costs without any connection to human health or foodborne illness.  The trial court dismissed the plaintiffs’ complaint.  

Appellate court decision.  On appeal, the plaintiffs focused their argument on the allegation that Proposition 12 has an impermissible extraterritorial effect of regulating prices in other states and, as such, is per se unconstitutional.  This was a tactical mistake for the plaintiffs.  The appellate court noted that existing Supreme Court precedent on the extraterritorial principle applied only to state laws that are “price control or price affirmation statutes.”   Thus, the extraterritorial principle does not apply to a state law that does not dictate the price of a product and does not tie the price of its in-state products to out-of-state prices.  Because Proposition 12 was neither a price control nor a price-affirmation statute (it didn’t dictate the price of pork products or tie the price of pork products sold in California to out-of-state prices) the law didn’t have the extraterritorial effect of regulating prices in other states.  The appellate court likewise rejected the plaintiffs’ claim that Proposition 12 has an impermissible indirect “practical effect” on how pork is produced and sold outside California.  Upstream effects (e.g., higher production costs in other states) the appellate court concluded, do not violate the dormant Commerce Clause.   The appellate court pointed out that a state law is not impermissibly extraterritorial unless it regulates conduct that is wholly out of state.  Because Proposition 12 applied to California and non-California pork production the higher cost of production was not an impermissible effect on interstate commerce.  The appellate court also concluded that inconsistent regulation from state-to-state was permissible because the plaintiffs had failed to show a compelling need for national uniformity in regulation at the state level.  In addition, the appellate court noted that the plaintiffs had not alleged that Proposition 12 had a discriminatory effect on interstate commerce and, as such, had failed to plead a Dormant Commerce Clause violation. 

Supreme Court grants certiorari.  On March 28, 2022, the U.S. Supreme Court agreed to hear the case.  The issues before the Court are: (1) whether allegations that a state law has dramatic economic effects largely outside of the state and requires pervasive changes to an integrated nationwide industry state a violation of the Dormant Commerce clause, or whether the extraterritoriality principle is now a dead letter; and (2) whether the allegations, concerning a law that is based solely on preferences regarding out-of-state housing of farm animals, state a claim in accordance with Pike v. Bruce Church, Inc., 347 U.S. 132 (1970). In Pike, the Court said a state law that regulates fairly to effectuate a legitimate public interest will be upheld unless the burden on commerce is clearly excessive in relation to commonly accepted local benefits. 

In the current case, while California accounts for about 13 percent of U.S. pork consumption, essentially no pigs are raised there.  Thus, the costs of compliance with Proposition 12 fall almost exclusively on out-of-state hog farmers.  In addition, because a hog is processed into cuts that are sold nationwide in response to demand, those costs will be passed on to consumers everywhere, in transactions that have nothing to do with California. 

Meat Labeling Law Unconstitutional 

Turtle Island Foods SPC v. Strain, No. 20-00674-BAJ-EWD, 2022 U.S. Dist. LEXIS 56208 (M.D. La. Mar. 28, 2022)

Background.  In 2019, Louisiana enacted the Truth in Labeling of Food Products Act (“Act”), with the Act taking effect October 1, 2020.  Among other things, the Act prohibits the intentional misbranding or misrepresenting of any food product as an agricultural product via a false or misleading label; selling a product under the name of an ag product; representing food product as an meat or a meat product when the food product is not derived from a harvested beef, port, poultry, alligator, farm-raised deer, turtle, domestic rabbit, crawfish, or shrimp carcass. 

The LA Dept. of Ag and Forestry (LDAF) developed rules and regulations to enforce the Act with fines of up to $500 per violation per day but had not received any complaints nor brought any enforcement actions against anyone. Indeed, the LDAF determined that plaintiff’s product labels complied with the law. 

The plaintiff produces and packages plant-based meat products that are marketed and sold in LA and nationwide.  Plaintiff’s labels and marketing materials clearly state that its products are plant-based, meatless, vegetarian or vegan, and accurately list the products ingredients.  After the Act passed, the plaintiff refrained from using certain words and images on marketing materials and packages and removed videos from its website and social media to avoid prosecution under the Act. 

Trial court decision.  The plaintiff sued, challenging the constitutionality of the Act on the grounds that the Act violated its freedom of commercial speech.  The plaintiff claimed it would be very expensive to change its labeling and marketing nationwide.  The trial court determined that the plaintiff had standing because “chilled speech” or “self-censorship” is an injury sufficient to confer standing, and that the plaintiff had demonstrated a “serious intent” to engage in proscribed conduct and that the threat of future enforcement was substantial. 

On the merits, as noted, the plaintiff asserted that its conduct was protected commercial speech (both current and future intended) that the Act prohibited.  The trial court noted that commercial speech is not as protected as is other forms of speech.  To be constitutional, the government speech (the Act) must be a substantial governmental interest, advance the government’s asserted interest and not be any more excessive than what is necessary to further the government’s interest.  The trial court determined that the Act was more extensive than necessary to further the state’s interest.  While the interest in protecting consumers from misleading and false labeling is substantial, the defendant failed to establish that consumers were confused by the plaintiff’s labeling.  Thus, the Act failed to directly advance the State’s interest and was more extensive than necessary to further that interest.    The trial court also determined that the defendant failed to show why alternative, less-restrictive means, such as a disclaimer would not accomplish the same goal of avoiding consumer deception/confusion.  The trial court held the Act unconstitutional and enjoined its enforcement. 

“Greenbook” Released

On March 28, the White House released the details of its $6 trillion budget for the 2023 fiscal year (October 1, 2022 – September 30, 2023).  That same day, the Treasury released the Greenbook, its explanations of the revenue proposals.  Many of the provisions are those that were proposed in 2021, but did not become law.  Here’s a brief rundown of the provisions of most significance to farmers and ranchers:

  • Top individual rate to 39.6 percent on income over $400,000 ($450,000 for married couples;
  • Corporate rate goes to 28 percent (87 percent increase on many farm corporations);
  • Raise capital gain rate to 39.6 percent on income over $1 million;
  • Capital gain tax on any transfer of appreciated property either during life or at death;
  • Partial elimination of stepped-up basis – if to spouse, then carryover; transfer of appreciated property to CRAT would be taxable;
  • Transfers of property by gift or at death would be a realization event (eliminates the fair market value at death rule);
  • Trust assets must be “marked-to-market” every 90 years beginning with any new trust after 1940. The rule would be the same for partnerships or any other non-corporate owned entity.  In addition, no valuation discount for partial interests, and a transfer from a trust would be a taxable event.  Exclusion of $1 million/person would apply.  Any tax on illiquid assets could be paid over 15 years or the taxpayer could elect to pay the tax when the property is sold or is no longer used as a farm (in that event, there would be no 15-year option);
  • All farm income (including self-rents) would be subject to the net investment income tax of 3.8 percent;
  • A minimum tax would apply to those with a net worth over $100 million;
  • Long-term capital gains and qualified dividends taxed at ordinary income rates for taxpayers with taxable income exceeding $1 million;
  • Grantor-Retained Annuity Trusts (GRATs) must have minimum term of 10 years. This would eliminate the use of a “zeroed-out” GRAT; also, the remained interest in a GRAT at the time of creation must have a minimum value for gift tax purposes equal to the greater of 25 percent of the value of assets transferred to the GRAT or $500,000.  In addition, there would be limited ability to use a donor-advised fund to avoid the payout limitation of a private foundation;
  • Any sale to a grantor trust is taxable and any payment of tax of the trust is a taxable gift;
  • Limitation on valuation discounts (related party rules);
  • R.C. §2032A maximum reduction would increase to $11.7 million (from current level of $1.23 million);
  • Trust reporting of assets would be required if the trust corpus is over $300,000 (or $10,000 of income);
  • Elimination of dynasty trusts;
  • Carried interest income would become ordinary income;
  • No basis-shifting by related parties via partnerships;
  • Limitation of a partner’s deduction in certain syndicated conservation easement transactions;
  • R.C. §1031 exchange deferral would be limited to $1 million;
  • Depreciation recapture would be triggered on the sale of real estate, which would eliminate the maximum 25% rate;
  • Elimination of credit for oil and gas produced from marginal wells;
  • Repeal of expensing of intangible drilling costs;
  • Repeal of enhanced oil recovery credit;
  • Adoption credit refundable, and some guardianship arrangements qualify; and
  • Expand the definition of “executor” to apply for all tax matters.

The provisions have little to no chance of becoming law, but they are worth paying attention to. 

Conclusion

There’s never a dull moment in agricultural law and tax. 

April 5, 2022 in Business Planning, Estate Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Friday, April 1, 2022

Captive Insurance – Part Three

Overview

This week, I have been discussing captive insurance.  Part One set forth the definition of captive insurance and how a captive insurance company is treated for income tax purposes as well as how it might be used for estate planning and business succession.  Part Two examined IRS concerns with captive insurance and the results of litigation involving the concept.  Today, in Part Three, I take a look at some recent IRS administrative issues concerning captive insurance and the attempts of the IRS to “crack-down” on the use of the concept to achieve income tax savings and estate planning benefits.  On this point, the most recent developments have not gone well for the IRS.

Captive insurance and recent administrative/regulatory issues – it’s the topic of today’s post.

Administrative Issues

2015 IRS Notice.  Abusive micro-captives have been a concern to the IRS for several years. IRS initiated forensic audits of large captive insurance providers at least a decade ago which resulted in certain transactions making the “Dirty Dozen” tax scam list starting in 2014.  In 2015, the IRS issued a news release that notified taxpayers that it would be taking action against micro-captive insurance arrangements it believes are being used to evade taxes.  IR 2015-16 (Feb. 3, 2015).  Since that time, the IRS has been litigating the micro-captive insurance issue aggressively. 

2016 IRS Notice.  In 2016, the IRS issued a Notice which identified certain micro-captive transactions as having the potential for tax avoidance and evasion.  Notice 2016-66, 2016-47 IRB 745.  In the Notice, the IRS indicated that micro-captive insurance transactions that are the same as, or substantially similar to, the transactions described in the Notice would be considered “transactions of interest.”  Under the Notice, these transactions require information reporting as “reportable transactions” under Treas. Reg. §1.6011 and I.R.C. §§6011 and 6012 for taxpayers engaging in the transactions and their “material advisers.”  Thus, persons entering into micro-captive transactions were required to disclose such transactions to the IRS via Form 8886 and “material advisors” also had disclosure and maintenance obligations under I.R.C. §§6111-6112 and the associated regulations.  In addition, a “material advisor” had to file a disclosure statement (Form 8918) with the IRS Office of Tax Shelter Analysis by January 30, 2017, with respect to such transactions entered into on or after November 2, 2006.  Failure to make the required disclosures came with possible civil and/or criminal penalties.  On December 30, 2016, the IRS extended the disclosure deadline for micro-captive transactions to May 1, 2017.  Notice 2017-08.

Note:  After the issuance of the Notice, the IRS audits of micro-captive arrangements and litigation ramped up substantially.

A manger of captive insurance companies subject to the disclosure requirements challenged Notice 2016-66 in early 2017.  The Notice would have forced the manager to incur substantial compliance costs.  The manager claimed that the Notice constituted a legislative-type rule and, as such, was subject to the mandatory notice-and-comment requirements of the Administrative Procedures Act (APA).  5 U.S.C. §553, et seq.  The manager also claimed that the Notice was invalid as being arbitrary and capricious, and that the IRS failed to submit the rule contained in the Notice to Congress and the Comptroller General as the Congressional Review of Agency Rule-Making Act required.  5 U.S.C. §801.  The manager sought a declaration under the Declaratory Judgment Act (28 U.S.C. §2201) that the Notice was invalid and that an injunction barring the IRS from enforcing the disclosure requirements of the Notice should be issued. 

Note:  Since 2019, the IRS has offered a settlement framework for taxpayers under audit on micro-captive insurance arrangements.  IR 2019-157 (Sept. 16, 2019).  In 2020, the IRS made the settlement framework more restrictive and increased the number of examinations.  IR 2020-26 (Jan. 31, 2021) and IR 2020-241 (Oct. 22, 2020).  Under the 2020 framework, taxpayers are offered reduced accuracy-related penalties of 5, 10 or 15 percent (instead of 20 or 40 percent).  In exchange, a taxpayer must agree to have 90 percent of the premium deductions disallowed for all open tax years, as well as any captive-related expenses such as management fees.  The captive insurance company must also be liquidated, or else there will be a deemed distribution to the owners for the amount of premiums paid to the captive during all years. 

The trial court denied the plaintiffs’ motion for a preliminary injunction, reasoning that the plaintiffs were not likely to succeed on the merits because the claims were likely barred by the Anti-Injunction Act (AIA).  26 U.S.C. §7421. 

Note:  The AIA provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court.”  Instead, a tax can be challenged in court only after the plaintiff pays the disputed tax and files a claim for refund.

The IRS moved to dismiss the plaintiffs’ claims.  The trial court granted the motion and dismissed the case for lack of subject matter jurisdiction.  CIC Services, LLC v. Internal Revenue Service, No. 3:17-cv-110, 2017 U.S. Dist. LEXIS 181482 (E.D. Tenn. Nov. 2, 2017).  The appellate court affirmed.  CIC Services, LLC v. Internal Revenue Service, 925 F.3d 247 (6th Cir. 2019).  On further review, however, the U.S. Supreme Court reversed, vacated the appellate court’s decision, and remanded the case to the trial court.    CIC Services, LLC v. Internal Revenue Service, 141 S. Ct. 1582 (2021).  The Court unanimously held that the AIA did not bar pre-enforcement judicial review of the Notice.  The Court pointed out that while the Notice was “backed by” tax penalties, the plaintiffs’ suit challenged the Notice’s “reporting mandate separate from any tax.” On remand, the trial court set aside the Notice and ordered the IRS to return all documents that it had collected under the Notice.  The trial court stated, “While the IRS may ultimately be correct that micro-captive insurance arrangements have the potential for tax avoidance or evasion and should be classified as transactions of interest, the APA requires that the IRS examine relevant facts and data supporting that conclusion.”  CIC Services, LLC v. Internal Revenue Service, No. 3:17-cv-00110 (E.D. Tenn. Mar. 21, 2022). 

Shortly before the trial court’s remand decision in CIC Services, LLC, the U.S. Court of Appeals for the Sixth Circuit voided IRS Notice 2007-83, 2007-2 CB 960 that established reporting requirements for potentially abusive benefit trust arrangements or face the imposition of civil and/or criminal penalties for engaging in such a “listed transaction.”  Mann Construction, Inc. v. United States, No. 21-1500, 2022 U.S. App. LEXIS 5668 (6th Cir. Mar. 3, 2022), rev’g., 539 F.Supp. 3d 745 (E.D. Mich. 2021).  With Notice 2007-83, the appellate court concluded that the IRS had developed a legislative rule without going through the APA’s required notice and comment procedures.  The Congress had not created any exemption for the IRS from this rulemaking requirement.  Indeed, the appellate court pointed out in Mann Construction, Inc. that the U.S. Supreme Court had rejected the notion that tax law deserves a special “carve-out” from the APA’s notice and comment requirement.  Mayo Foundation for Medial Education & Research v. United States, 562 U.S. 44 (2011). 

Note:  Before getting pushed back by the Courts for rulemaking without following the APA’s rulemaking requirements, the IRS gave some indication that it was also looking at captive insurance company variations.  See IR-2020-226 (Oct. 1, 2020); FAA 20211701F (Feb. 5, 2021).

Filing Obligations

In the summer of 2020, the IRS issued I.R.C. §6112 letters to persons it believed to be a “material advisor” that had failed to report themselves for engaging in an “abusive” transaction.  Since the courts have now voided Notice 2016-66, the filing of Form 8918 and the associated penalties are currently not in play.  But the I.R.C. §6694 preparer penalties are still applicable for taking an unreasonable position on the return.  Also, the IRS could follow the APA’s notice-and-comment procedures and properly adopt its position taken in Notice 2016-66 in the future.  If IRS does, it appears to have attorneys trained to review captive insurance company issues.  Thus, tax practitioners would be well-advised to proceed with caution when engaging with clients interested in captive insurance and examine client files where captive insurance companies have already been established. 

Conclusion

The recent developments surrounding micro-captive arrangements have forestalled the IRS from treating them as “listed transactions” at least until the IRS complies with the APA’s notice and comment requirements.  That’s a big development on the penalty issue, but it doesn’t mean reporting requirements necessary to avoid penalties won’t come back in the future. 

In addition, the caselaw over the past few years provides helpful guidance concerning the proper structuring of captive/micro-captive insurance corporations to provide a more economical means of risk management to business such as farms and ranches.  Also, if structured properly, a micro-captive arrangement can be used to accomplish specific income tax as well as estate and business planning objectives of the owner(s). 

April 1, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, March 30, 2022

Captive Insurance – Part Two

Introduction

In Part One earlier this week, I introduced the concept of a captive insurance company. Part One can be found here: https://lawprofessors.typepad.com/agriculturallaw/2022/03/captive-insurance-part-one.html  In Part One, I looked at the income tax, estate and gift tax implications of captive companies and how they might be used as part of an overall income tax planning, estate planning and succession planning vehicle to minimize unique risks of the business.      

In Part Two today, I look at the IRS audit issues associated with captive insurance companies and how the courts have addressed the issues. 

Captive insurance companies, IRS audit issues and litigation. It’s the topic of today’s post.

IRS Scrutiny, Litigation and Other Developments

The IRS focus.  Abusive micro-captive corporations have been a concern to the IRS for several years.  The basic issue is where the line is between deductible captive insurance and non-deductible self-insurance.

Note:  The IRS focus centers on the fact that with an I.R.C. §831(b) election premiums can be deducted at ordinary income rates and can then be distributed to owners at capital gain rates.  To the extent claims are not paid, the premiums can be distributed from the captive in a manner that escapes transfer taxes.  Both of these issues, in turn, are centered on whether the captive company is insuring legitimate business risks and that “insurance” is actually involved. 

IRS audits.  IRS initiated forensic audits of large captive insurance providers at least a decade ago, and the IRS activity resulted in certain transactions making the “Dirty Dozen” tax scam list starting in 2014.  In 2015, the IRS put out a news release that notified taxpayers that it would be taking action against micro-captive insurance arrangement that it believes are being used to evade taxes.  IR 2015-16 (Feb. 3, 2015).  In 2016, the IRS issued a Notice which identified certain micro-captive transactions as having the potential for tax avoidance and evasion.  Notice 2016-66, 2016-47 IRB 745.  Since that time, the IRS has been litigating the micro-captive insurance issue aggressively. 

Court cases.  Taxpayers have won court cases involving IRS challenges to the tax treatment of and deductions associated with captive insurance companies.  The wins involved large captive insurance companies.  For instance, in Rent-A-Center v. Comr., 142 T.C. 1 (2014), the Tax Court determined that payments that a subsidiary corporation made to a captive insurance company were insurance expenses deductible under I.R.C. §162.  Likewise, in Securitas Holdings, Inc. v. Comr., T.C. Memo. 2014-225, the Tax Court determined that premiums paid to a brother-sister captive insurance company were deductible.  Also, in R.V.I. Guaranty Co. Ltd. and Subs v. Comr., 145 T.C. 209 (2015), the Tax Court held that insuring against losses in the residual value of an asset leased to third parties was insurance for federal income tax purposes. 

Note:  Importantly, in each of the cases involving taxpayer wins, the Tax Court determined that actual “insurance” was involved. 

But the IRS has won several prominent cases since ramping up its scrutiny.  In Avrahami v. Comr., 149 T.C. 144 (2017), the petitioners (a married couple) owned three shopping centers and several jewelry stores in Arizona.  Via these businesses, they deducted about $150,000 in insurance expenses in 2006.  The petitioners then formed a captive insurance company under the law of the Federation of Saint Kitts and Nevis (the birthplace of Alexander Hamilton).  After the captive insurance company was formed their deductible insurance expenses for the companies increased to over $1.1 million annually, and included coverage for terrorism risks and tax liabilities from an IRS audit. 

The Tax Court upheld the IRS determination that the expenses were non-deductible and that the elections the micro-captive company had made under I.R.C. §953(d) and 831(b) were invalid because the micro-captive company did not qualify as a legitimate insurance business.  The Tax Court noted that proper policy language, actuarial standards, and payment and processing of claims are required to operate as an insurance company. These features were lacking.  In addition, the Tax Court determined that there was inadequate risk distribution, and the actuary did not have any coherent explanation of how he priced the insurance policies.  Also, there had been no claims filed until two months after the IRS initiated an audit.  In addition, a majority of the investments of the micro-captive were in long-term illiquid and partially unsecured loans to related parties – the petitioners’ other entities.  This left little liquid fund from which to pay claims.  All of these facts indicated to the Tax Court that the captive was not a legitimate insurance company. 

Note:  It is important to establish that the captive insurance company was established to reduce or insure against risks, and not just to achieve tax benefits.  In additions, policies must be appropriately priced relative to commercial insurance.  The payment of excess premiums annually for a number of years while few or no claims are made inures against a finding of a legitimate business purpose for creating the captive. 

The next year, the Tax Court in Reserve Mechanical Corp. v. Comr., T.C. Memo. 2018-86, disallowed deductions for insurance premiums based largely on the same reasoning utilized in Avrahami.  The case involved an Idaho company engaged in manufacturing and distributing heavy machinery used for underground mining.  Its business activities were heavily regulated and subject to potential liability risk under various state and federal environmental laws.  To minimize the risk from its business operations in a more cost-effective manner, the owner(s) formed a captive insurance company under the laws of Anguilla, British West Indies to provide itself with an excess pollution policy.  The captive company also provided other policies covering business cyber risk. 

The Tax Court held that the micro-captive company was not a legitimate insurance company because its transactions were not “insurance transactions.”  The Tax Court also determined that the micro-captive didn’t qualify as a domestic corporation.  The Tax Court upheld the IRS’ determination that the company was subject to a 30 percent tax under I.R.C. §881(a) on fixed or determinable annual or periodical (FDAP) income the company received from U.S. sources.  The Tax Court determined that the income was not effectively connected with the conduct of a U.S. trade or business. 

In Syzygy Insurance Co. v. Comr., T.C. Memo. 2019-34, the petitioners had a family business that manufactured steel tanks.  Annual revenue averaged about $55 million.  The business obtained policies from a captive insurance company, but the arrangement, the Tax Court determined, did not resemble insurance transactions.  As it had in the 2018 case, the Tax Court noted that for a company to make a valid I.R.C. §831(b) election, it must transact in insurance.  As noted above, if insurance is actually involved, premiums paid are deductible. The Tax Court analyzed the policies and concluded that there was no risk distribution, the arrangement was not “insurance” in the commonly accepted sense of the term.  Thus, the premium payments were not deductible. They were neither fees or payments for insurance. The Tax Court also noted that the president of the family business had sent an email stating that one of the reasons for leaving the previous insurance arrangement was the decrease in premiums. Judge Ruwe wrote, “It is fair to assume that a purchaser of insurance would want the most coverage for the lowest premiums… The fact that [the president] sought higher premiums leads us to believe that the contracts were not arm’s-length contracts but were aimed at increasing deductions.”

Note:  To reiterate, business deductions must have a business purpose, and not be solely for the purpose of lowering income tax liability.

In early 2021, the Tax Court decided Caylor Land Development v. Comr., T.C. Memo. 2021-30.  In Caylor, the petitioner was a construction company.  The petitioner’s $60,000 annual insurance cost was deemed to be too high.  Beginning in late 2007 the company took out policies from a related micro-captive company formed under the laws of Anguilla.  Doing so caused the petitioner’s insurance bill to increase to about $1.2 million.  The petitioner paid $1.2 million to the captive insurance company on the day of formation and deducted that amount on its 2007 return.   Each year thereafter, the deducted consulting payments (legal, accounting and management fees) were about $1.2 million.  The micro-captive company did not include the $1.2 million in income.  The Tax Court held that the arrangement did not qualify as insurance for tax purposes because the micro-captive company did not provide insurance (because there was no risk distribution).  IN addition, the Tax Court concluded that the arrangement did not resemble any type of commonly accepted notion of insurance.  The Tax Court also upheld 20 percent accuracy related penalties for substantial understatement of tax and for negligence. 

Taxpayer victory – sort of.  In late 2021, the Tax Court entered an order in Puglisi et al. v. Comr, No. 13489 (Nov. 5, 2021). The IRS conceded the case before trial to avoid an adverse ruling on the merits.  The petitioners owned an egg farm in Delaware with more than 1.2 million egg-producing hens.  The farm owned a liability insurance policy but wasn’t able to buy insurance to insure against the Avian flu. 

Note:  In early 2022, reports of Avian influenza surfaced in flocks of chickens in Montana, Nebraska, South Dakota, Iowa and elsewhere.  The presence of this influenza results in the destruction of the flock at great cost to the owner(s). 

As a result, the petitioners formed a captive insurance company to provide that additional coverage.  The captive company was a Delaware corporation operaitng as a reinsurance company.  The egg farm bought insurance from a fronting company.  The fronting company then entered into a reinsurance arrangement with the captive company.  Under the reinsurance arrangement the captive insurance company reinsured 20 percent of all approved claims of the egg farm, and 80 percent of all approved claims of unrelated entities that the fronting company insured. The egg farm was organized as an LLC which resulted in deductions flowing through to the petitioners’ personal returns.  Before the IRS initiated an audit, the egg farm had submitted a total of five claims to the fronting company. 

The IRS audited and issued statutory notices of deficiency (taxes and penalties) exceeding $2.7 million (total) for 2015, 2016 and 2018.  Ultimately, the IRS conceded the deductions and sought an order from the Tax Court that the deficiency was a mere $18,587 for 2015.  The petitioners objected, wanting the Tax Court to rule on whether the fronting company was an insurance company for income tax purposes because the issue of the deductibility of premiums paid to the fronting company would be an issue that would continue to arise annually. and they wanted the issue resolved.  In addition, many other businesses paid insurance premiums to the fronting company that were reinsured, at least in part, by the petitioner’s captive insurance company.  The Tax Court refused to rule on the matter and entered a decision in line with the IRS’ concession.  Presently, it remains to be seen whether the IRS will challenge the petitioners’ captive insurance company in the future. 

Note:  It’s important to note that the IRS continued to maintain that the fronting company was not an insurance company for tax purposes, even though it conceded the tax deficiency issue. 

Conclusion

Captive insurance certainly has come under IRS scrutiny in recent years.  But, if it truly involves insurance and is providing risk-management for unique risks of the business with premiums set at reasonable rates, it is a legitimate concept.  The court cases illustrate those points and show the boundaries of what is an appropriate use of a captive insurance company and what is not.

In Part Three, I will turn my attention to IRS administrative attempts to tighten the screws on captive insurance transactions without following procedural law and the courts pushing the IRS back.  These developments have filing/disclosure implications for tax practitioners and “material advisors.”

March 30, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, March 28, 2022

Captive Insurance – Part One

Overview

Many businesses, including farming and ranching businesses, face rising insurance costs and higher self-insured risks for hazards that were not an issue in the past.  This is particularly true for many ag businesses that face ever-increasing environmental rules and regulations that can impair operational profitability, heightened cyber threats, as well as supply chain and labor issues.  As a result, some of these businesses have begun to investigate and utilize captive (and micro-captive) insurance. 

What is captive insurance and what are the benefits of it?  Where does it fit in the overall income tax and estate/business plan for a business, including farming and ranching operations?  What concerns might the IRS have with captive insurance, and what do those concerns mean for practitioners?

Utilizing captive insurance as part of an income tax and estate/business plan that also is designed to minimize business risk - it’s the topic of today’s post.  Part One of a three-part series. 

Captive Insurance Defined

A captive insurance company is an insurer that is a wholly owned subsidiary that providing risk-mitigation services for its parent company or a group of related companies.  A key to being a true captive insurance company is the provision of risk-mitigation.  Often, the reason for forming a captive insurance company is when a business (the parent company) is unable to find standard commercial insurance to cover risks that are unique to the business.  Without the creation of a captive insurance company, the business is left to self-insure against risks for which it is unable to acquire commercial insurance.  In this situation, a captive insurance company provides the ability to shift self-insured risks to the captive company with policies tailored to fit the unique parent’s unique needs.  The owners of the parent can retain control of the captive’s investments, and may also be able to achieve tax savings and wealth transfer benefits

Note:  Since 2000, the potential risks to a business from contract non-performance (business interruption), a loss of key suppliers and input supplies, cyber-attacks, labor shortages, and administrative and/or regulatory actions have increased substantially.  This is causing businesses (including farming and ranching operations) to search for cost-effective and tax efficient ways to manage these unique risks.   A captive insurance company is viewed as one approach that can satisfy an overall risk-mitigation strategy.  See, e.g., “Once Scrutinized, an Insurance Product Becomes a Crisis Lifeline,” The New York Times (Mar. 20, 2020). 

Income Tax Aspects

Insurance is a transaction that involves an actual insurance risk and involves risk-shifting and risk-distributing.  Helvering v. Le Gierse, 312 U.S. 521 (1941).  Insurance premiums are deductible as an ordinary and necessary business expense under I.R.C. §162(a) if paid or incurred in connection with the taxpayer’s trade or business.  Treas. Reg. §1.162-1(a).  However, amounts set aside in a loss reserve as a form of self-insurance are not deductible.  See, e.g., Harper Group v. Comr., 96 T.C. 45 (1991), aff’d., 979 F.2d 1341 (9th Cir. 1992).  As Judge Holmes stated in Caylor Land & Development, Inc. v. Comr., T.C. Memo. 2021-30, “the line between nondeductible self-insurance and deductible insurance is blurry, and we try to clarify it by looking to four nonexclusive but rarely supplemented criteria:

  • risk-shifting;
  • risk-distribution;
  • insurance risk; and
  • whether an arrangement looks like commonly accepted notions of insurance.”

On the other side of the equation, an insurance company includes premiums that it receives in income, and the company is generally taxed on its income just like any other corporation.  I.R.C. §831(a).  But an insurance company that receives premiums under a certain amount during a tax year can elect to be taxed only on investment income.  I.R.C. §831(b)(1)-(2). 

Note:  For premiums paid to be deductible, the captive must be respected as an insurance company for federal income tax purposes.  Otherwise, what is involved non-deductible self-insurance.  This means that qualified underwriting services must be used to determine the actual cost of similar coverage in the market or via an underwriting evaluation so that the policies are properly designed and the premiums are appropriate.  This is key to getting the desired tax treatment and withstanding an IRS attack.  Setting premiums too high coupled with claims that are less than anticipated will cause the captive’s stock value to rise. That value can be returned to shareholders in a tax-favorable manner as qualified dividends taxed at favorable capital gain rates.  Hence, the importance of the proper structuring of the captive to avoid an IRS attack and the imposition of severe penalties (explained further below).

Estate and Business Planning Aspects

Before the Congress modified I.R.C. §831, the captive or micro-captive corporation could fit rather easily into an estate or succession plan, and could be held in various types of entities depending upon the overall estate and business plan of the owner(s).  A straightforward approach, for example, was to have a parent (or parents) form a captive insurance company and name the children as the shareholders.  As the parents paid the premiums, they achieved insurance coverage for their unique need(s) and transferred wealth to the children.  Establishing the captive, however, must be justified by a legitimate business purpose of insuring risks of the business other than simply transferring wealth in a tax-efficient manner to the children.

Trust ownership.  A trust could be established to own the captive insurance company.  If the trust’s beneficiaries are the grantor’s children and/or grandchildren, it is possible to structure the trust such that the assets of the captive insurance corporation will not be included in the owner’s estate at death. 

LLC/FLP ownership.  Similarly, the captive corporation could be placed in a limited liability company (LLC) or a family limited partnership (FLP).  The ownership structure of the LLC or FLP could involve various classes of ownership held by various members of the owner(s) family.  This structure may be especially beneficial in the context of a small businesses such as a farm or ranch where the senior generation wants to maintain control over the business, investments, and distributions of the captive insurance corporation while simultaneously setting up valuation discounts for minority interest and/or lack of marketability.

Gift tax.  From a federal gift tax standpoint, income tax deductible premiums made for adequate and full consideration are not a gift from the owners of the insured to the owners of the captive insurance company.  Treas. Reg. §§25.2512-1(g)(1); 25-2512-8.  The “full and adequate consideration” test of I.R.C. §2512 applies in the estate tax context such that the premium payments are not pulled back into the decedent/transferor’s estate at death for federal estate tax purposes under I.R.C. §2036 or I.R.C. §2038.  This also means that the generation-skipping transfer tax (GSTT) would not apply.

Statutory modifications.  In late 2015, the Congress passed “extender” legislation that included new rules impacting certain captive insurance companies.  Under the new rules, effective for tax years beginning after 2016, the maximum amount of annual premiums that a captive insurance company may receive became capped (subject to an inflation adjustment).  The cap is $2.45 million for 2022.  In addition, a captive insurance company must satisfy one of two “diversification” tests that bear directly on the ability to transfer wealth to the next generation without transfer tax.  Under this requirement, the ownership of the underlying business of the captive must be within two percent of the ownership of the captive.  The new rule applies to all I.R.C. §831(b) captive insurance companies regardless of when formed. 

Under revised I.R.C. §831(b), a captive that makes an I.R.C. §831(b) election must satisfy one of the following two requirements designed to prevent it from being used as a wealth transfer tool (notice the second requirement is written in the negative – the captive must not satisfy it):

  • No more than 20 percent of the net written premiums (or, if greater, direct written premiums) of the company for the tax year is attributable to any one policyholder;

Note:  I.R.C. §831(b) was retroactively amended by the Consolidated Appropriations Act, 2018 (CAA) such that “policyholder” means “each policyholder of the underlying direct written insurance with respect to such reinsurance or arrangement.”  Thus, a risk management pool itself is not considered to be the policyholder.  Instead, each insured paying premiums into the pool is considered a policy holder.  As long as none of those insureds accounts for more than 20 percent of the total premiums paid to the captive, the 20 percent test is satisfied.  I.R.C. §831(b)(2)(D)

  • The captive company does not meet the 20 percent requirement and no person who holds (directly or indirectly) an interest in the company is a spouse or lineal descendant of a person who holds an interest (directly or indirectly) in the parent company who holds (directly or indirectly) aggregate interests in the company which constitute a percentage of the entire interests in the company which is more than a 2 percent percentage higher than the percentage interests in the parent company with respect to the captive held (directly or indirectly) by the spouse or lineal descendant.

Note:  Essentially, the second requirement means that if the spouse or lineal descendants’ ownership of the captive company is greater than 2 percent of their ownership of the parent company, the second requirement is not satisfied.

The CAA modified the second test (the ownership test) to eliminate spouses from the definition of “specified holder” unless the spouse is not a U.S. citizen.  Thus, the ownership test only applies to lineal descendants of either spouse, spouses that are not U.S. citizens, and spouses of lineal descendants.  I.R.C. §831(2)(B)(iii).  The CAA also added a new aggregation rule to apply to certain spousal interests such that any interest held, directly or indirectly, by the spouse of a specified holder is deemed to be held by the specified holder.  In addition, the CAA modified the ownership test to look at the aggregate amount of an interest in the trade, business, rights or assets insured by the captive, held by a specified holder, spouse or “specified relation.”  I.R.C. §831(b)(2)(B)(iv)(I).  The rule excludes assets that have been transferred to a spouse or other related person by bequest, devise or inheritance from a decedent during the taxable year of the insurance company or the preceding tax year.  Id.

Thus, in the estate planning/succession planning context if a parent (i.e., father or mother) or parents is (are) the sole owner of the parent company and the captive company, the captive company can make the I.R.C. §831 election.  That’s because no lineal descendant has any ownership in the captive company.  But, if a parent(s) is (are) the sole owner of the parent company and the and children own the captive company, the captive cannot make the I.R.C. §831 election (100 percent is more than 2 percent greater than zero percent).  The result is the same if the captive is held (indirectly) in a trust with the children as the beneficiaries.  But, for example, if the parent owns half of the parent company and half of the captive company with the children owning the other half of each entity, the captive company can make the I.R.C. §831 election. 

Note:  If the children meaningfully own the parent company, they can own the captive company.  The converse is also true. 

Given the modifications to I.R.C. §831(b) it remains possible to use a captive insurance company as part of an estate/business succession plan if the ownership of the parent and the captive is structured properly with the appropriate ownership percentages in both the parent and captive business entities.  For example, a captive company could be capitalized with cash from an intentionally defective grantor trust (IDGT) that has been established for the benefit of a child.  I recently posted an article on the use of an IDGT in estate planning.  You may read that article here:

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

The gift of funds to the IDGT is a completed gift for federal gift tax purposes and removes that value from the grantor’s estate at death.  The income the IDGT receives from the captive is taxed to the grantor, and the grantor deducts the premiums paid to the captive company and reports the net profits from the captive as a qualified dividend.  That is the case even though the cash flows from the parent company (the family business) to the captive insurance company and then to the IDGT and then on to the grantor’s child/children.  But, again, the ownership percentages of the parent and the captive insurance company must be carefully structured to stay within the borders of I.R.C. §831. 

As an alternative, as noted above, the captive insurance company could be held in an FLP and the parents could gift FLP interests to the children annually consistent with the present interest annual exclusion (presently $16,000 per donee per year (and, spouses can elect “split-gift” treatment)).  Each FLP interest entitles the owner a share of the captive company’s profits.  It may also be possible for the parents to claim valuation discounts on the gifts of interests in the FLP.  But, of course, the percentage ownerships of the parent company and the captive must stay within the “guardrails” of I.R.C. §831.

Conclusion

In Part Two I will examine the issues that give the IRS concern about captive insurance companies and discuss various court cases construing the IRS position.

March 28, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Friday, March 25, 2022

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

Overview

Last December, I posted a “hold-the-date” announcement for the 2022 summer national farm income tax/estate and business planning conferences that Washburn Law School will be conducting this summer. Earlier this month I devoted a blog article to the itinerary.

Registration is now open for both the Wisconsin event in mid-June and the Colorado event in early August. 

Wisconsin Dells, Wisconsin

Here’s the link to the online brochure and registration for the event at the Chula Vista Resort on June 13-14:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html

A block of rooms is available for this seminar at a rate of $139.00 per night plus taxes and fees. To make a reservation call (855) 529-7630 and reference booking ID "#i60172 Washburn Law School." Rooms can be reserved at the group rate through May 15, 2022. Reservations requested after May 15 are subject to availability at the time of reservation.

An hour of ethics is provided at the end of Day 2.

The conference will also be broadcast live online for those that cannot attend in person.  Online attendees will be able to interact with the presenters, if desired. 

Durango, Colorado

Here’s the link to the online brochure and registration for the event at Fort Lewis College on August 1-2:  https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html

An hour of ethics is also provided at the end of Day 2 at this conference.

Just like the Wisconsin conference, this conference will also be broadcast live online for those that cannot attend in person.  Online attendees will be able to interact with the presenters, if desired. 

Other Points

There are many other important details about the conferences that you can find by reviewing the online brochures. 

Looking forward to seeing you there or having you participate online.  If you do tax, estate planning or business succession planning work for clients or are involved in production agriculture in any way, this conference is for you.  Each event will also have a presentation involving the farm economy that you won’t want to miss.  Also, if you aren’t needing to claim continuing education credits, you qualify for a lower registration rate.

See you there. 

March 25, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, March 14, 2022

What if Tax Rates Rise?

Overview

Current geo-political events and domestic policies are having an impact on the United States economy.  Farmers are facing incredibly higher input costs (particularly fuel and fertilizer) associated with planting spring 2022 crops.  Higher energy costs will ripple throughout the entire economy with the burden felt primarily by the middle to lower income groups. 

During practically all of 2021, talk in the Congress focused on increasing taxes.  But Senators Manchin and Sinema put a stop to that.  However, the enormous amount of government spending hasn’t stopped.  The Senate, on March 10 approved another massive $1.5 trillion omnibus spending bill.  The legislation will be signed into law.  That spending is on top of the massive amounts of spending that has occurred since the enactment of the CARES Act in late March of 2020.  The infusion of all of these dollars into the economy has caused the money supply to quadruple and is fueling inflation. 

As problems continue to rise around the world, the temptation, of course, will be for the Congress to increase taxes to generate even more revenue for itself to fund U.S. involvement in these affairs.  Will it be able to push through a tax increase before the fall Congressional elections?  If so, what might be some good tax moves to make if rates increase?

Tax strategies in anticipation of higher tax rates – it’s the topic of today’s post.

Tax Strategies

In a stable tax environment (which hasn’t been present for some time) when tax rates are not anticipated to change, the typical strategy is to delay income recognition and accelerate deductions.  But, when tax rates are expected to rise, the opposite strategy is true – accelerate income into the current (lower tax rate) year and postpone deductions to the next (higher tax rate) year. 

So how can this technique be accomplished?  Here are some possibilities:

Income acceleration.    Numerous techniques can be available based on the facts of each particular taxpayer.  One strategy is to currently sell appreciated assets.  This will trigger capital gain in the current year, rather than waiting until a later year when rates might be higher.  Also, instead of using a like-kind exchanges for real estate consider a taxable exchange.  If cancellation of debt income needs to be recognized, it might be better to time transactions such that the income is triggered in the current year.  For installment sales, such as the tax reporting for deferred grain contracts, elect out of installment treatment by reporting the income currently.  If an investment has been made in a qualified opportunity fund, consider selling or gifting it this year. 

For farming (and other) businesses, review depreciable asset to see if any assets need to be demolished or have become obsolete or otherwise abandoned, or are no longer in service.  Is there any depreciation recapture that could be triggered in the current year?  Depreciation recapture is taxed at (higher) ordinary income tax rates.  Also, if the business is presently structured as an S corporation, consider changing to a partnership.  For a farming business, not only may this result in an increase in payment limits under the farm programs, it could trigger gain recognition on the appreciation of assets in the S corporation and result in a higher income tax basis. 

Defer deductions.  As noted above, another general strategy to employ when tax rates are anticipated to be higher in the future is to defer claiming deductions.  Doing so maximizes the value of the deductions.  This can be accomplished, depending on the facts of each situation, by purchasing capital assets used in the trade or business in the higher tax rate year and otherwise making business-related investments when rates are higher.  Also, it might be better in some circumstances and with respect to certain business assets to depreciate them rather than claim either expense method depreciation or first-year bonus depreciation.  On that point, give consideration to what might be done with the assets.  Is near term depreciation recapture a possibility?  Also, an evaluation should be made of whether it might be better to structure a lease as an operating lease rather than a capital lease.  A common aspect of an operating lease is that it usually has fewer upfront expenses. 

Another way to move deductions into a future higher tax year is to pay employee accrued vacation time and bonuses after March 15.  As applied to farming and ranching operation this point is limited to those that have employees, but for those that do, the strategy will cause the deduction and the expense to match on the tax return.  In that same vein, wait to establish a qualified retirement plan until the future, higher tax rate, year.  That will generate a larger deduction.  In the current year, a non-qualified retirement plan could be created. 

If charitable deductions are a normal or desired part of the overall tax plan, bunch them up in a higher tax rate year.   This has been a strategy that some have employed in recent years as the result of tax law changes, but it also works when rates are anticipated to be higher in the future. 

Farm income averaging.  A major tool for farmers is the ability to elect to income average over a three-year period.  The technique works well when rates rise because it allows the farmer to reduce income in the high tax rate year and spread it back over prior lower rate years and fill up any unused bracket amount. Of course, the technical rules must be followed, and only “electable farm income” counts, but it is a helpful strategy that many farmers and utilize. 

Conclusion

Tax planning always takes a bit of foresight as to how economic conditions will impact a client and that client’s business.  If the Congress reacts to those economic conditions with a political response that results in higher taxes, that has a bearing on tax planning.  While it is not possible to predict the future, having a tax plan (as well as an estate/business plan) in place that is flexible enough to change with the rules can provide lasting benefits. 

Also, I am sure that you can think of tax strategies in addition to those I have listed above.

March 14, 2022 in Income Tax | Permalink | Comments (0)

Saturday, March 12, 2022

Income Tax Deferral of Crop Insurance Proceeds

Overview

Generally, crop insurance proceeds must be reported into income in the year they are received.  But crop insurance proceeds received in 2021 for crops damaged in 2021 can, by election, be reported into income in 2022.  However, to be deferable, crop insurance must be paid on account of actual physical damage or destruction to the taxpayer’s crops.  That means that some types of crop insurance may not be deferable or may only be partially deferable.  In that event, how is the determination made as to what is deferable and what is not?

The tax deferability of crop insurance proceeds – it’s the topic of today’s post.

General Rules

What does deferral apply to?  In general, the proceeds from insurance coverage on growing crops are includible in gross income in the year actually or constructively received.  In effect, destruction or damage to crops and receipt of insurance proceeds are treated as a “sale” of the crop.  But, taxpayers on the cash method of accounting may elect to include crop insurance and disaster payments in income in the taxable year following the crop loss if it is the taxpayer's normal business practice to report income from sale of the crop in the later year.  I.R.C. §451(f); Treas. Reg. §1.451-6(a)(1).  Included are payments made because of damage to crops or the inability to plant crops (prevented planting payments). I.R.C. §451(f)(2).   The deferral provision applies to federal payments received for drought, flood or “any other natural disaster.”  I.R.C. §451(f)(1). 

Note:  USDA Wildfire and Hurricane Indemnity Program Plus (WHIP+) payments are considered to be the equivalent of “crop insurance.”  Thus, payment for damage occurring in 2021that was reimbursed under the WHIP+ program and was received in 2021 may be deferred to the 2022 tax year.

The 50 percent test.  Based on Rev. Rul. 74-145, 1974-1 C.B. 113, to be eligible to make an election to defer, the taxpayer must establish that a substantial part of the crop income (more than 50 percent) would have been reported in the following year under the taxpayer’s normal business practice.  If the 50 percent test is satisfied, an allocation may not be made between the two years – the taxpayer cannot elect to defer only a portion of the insurance proceeds to the following year.  It is an all or nothing election with respect to a single business.  But, when insurance proceeds are received on multiple crops, the “substantial portion” test applies to each crop independently if each crop is associated with a separate business of the taxpayer.  Otherwise, as noted, the 50 percent test is computed in the aggregate if the crops are reported as part of a single business and the election to defer is all or nothing.

The election.  The election is made by attaching a separate, signed statement to the income tax return (or an amended return) for the tax year of damage or destruction. The statement must include the taxpayer’s name and address (or that of the taxpayer’s agent), and must contain the following information:

  • A declaration that the taxpayer is making an election under I.R.C. 451(f) and Treas. Reg. §1.451-6(b)(1);
  • Identify the specific crop or crops destroyed or damaged;
  • State that under the taxpayer’s normal business practice the income derived from the crop(s) destroyed or damaged would have been included in gross income in the taxable year after the taxable year of the destruction or damage;
  • Note the cause of the destruction or damage of the crops and the date(s) on which the destruction or damage occurred;
  • Specify the total amount of payments received from insurance carriers; and
  • Provide the name(s) of any insurance carrier that made payment.

Note:  As noted, the election covers insurance proceeds attributable to all crops representing a trade or business.  A separate election should be made for each of the taxpayer’s distinct farming businesses for which separate books and records are maintained.  In addition, the election is binding for the tax year for which it is made and may only be revoked with IRS consent.  Treas. Reg. §1.451-6((b)(2). 

Tax Reporting

A farmer will receive Form 1099-Misc. for crop insurance and either Form 1099-G or Form CCC-1099-G for federal disaster payments.  As for the tax return, the election to defer crop insurance proceeds and disaster assistance is made by checking the box on line 6c of Form Schedule F and attaching the statement to the return.  The total crop insurance and federal crop disaster payments received for the tax year is reported on line 6a, even if an election is in place to include those amounts in income the next year.  The taxable amount is then entered on line 6b.  This amount does not include the proceeds that are elected to be include in income in the following year.  Then, if any crop insurance or disaster payments were deferred from the prior year into the current year, that amount is to be reported on line 6d. 

Deferral of Revenue/Yield-Based Insurance

A significant issue is whether the deferral provision also applies to crop insurance such as Revenue Protection (RP), Revenue Protection with Harvest Price Exclusion (RPHPE), Yield Protection (YP) and Group Risk Plan (GRP). These policies pay based on low revenue or yield.  However, the Code requires that, to be deferrable, payment under an insurance policy must have been made as a result of damage or destruction to crops or the inability to plant crops.

Other than the statutory language that makes prevented planting payments eligible for the one-year deferral, the IRS position as stated in Notice 89-55, 1989-1 C.B. 698 is that agreements with insurance companies providing for payments without regard to actual losses of the insured, do not constitute insurance payments for the destruction of or damage to crops.  Accordingly, payments made under the types of crop insurance that are not directly associated with an insured's actual loss, but are instead tied to low yields and/or low prices, may not qualify for deferral depending upon the type of insurance involved.  For example, RP policies insure producers against yield losses due to natural causes such as drought, rain, hail, wind, frost, insects and disease, as well as revenue losses tied to the difference between harvest price and a projected price.

Only the portion attributable to physical damage or destruction to a crop is eligible for deferral.  RPHPE, YP and GRP policies tie payment to price and/or yield and amounts paid under such policies are less likely to qualify for deferral or may not qualify in their entirety. 

While the IRS has not specified in regulations the appropriate manner to be utilized in determining the deferrable and non-deferrable portions, the following is believed to be an acceptable approach that would withstand IRS scrutiny:

Consider the following example (from, Principles of Agricultural Law, McEowen, Rel. 49-50 (Jan. 2022)):

Al Beback took out an insurance policy (RP) on his corn crop. Under the terms of the policy the approved corn yield was set at 170 bushels/acre, and the base price for corn was set at $6.50/bushel. At harvest, the price of corn was $5.75/bushel. Al’s insurance coverage level was set at 75 percent, and his yield was 100 bushels/acre. Al’s final revenue guarantee under the policy is 170 bushels x $6.50 x .75 = $828.75/acre. Al’s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($5.75/bushel) which equals $575/acre. Al’s insurance proceeds is the guaranteed amount ($828.75/acre) less the calculated revenue ($575/acre), or $253.75/acre.  His physical loss is the 170 bushel/acre approved yield less his actual yield of 100 bushels/acre, or 70 bushels/acre. Multiplied by the harvest price of $5.75/bushel, the result is a physical loss of $402.50/acre. Al’s price loss is computed by taking the base price of $6.50/bushel less the harvest price of $5.75/bushel, or $.75/bushel. When multiplied by the approved yield of 170 bushels/acre, the result is $127.50/acre. 

So, to summarize, Al has the following:

  • Total loss: (1) anticipated income/acre [170 bushels/acre @ $6.50/ bushel = $1105/acre] less (2) actual result [100

bushels/acre @ $5.75/acre = $575.00] for a result of $530.00/acre.

  • Physical loss: 70 bushels/acre x $5.75/bushel harvest price = $402.50/acre
  • Price loss: 170 bushels/acre x $.75/bushel = $127.50
  • Physical loss as percentage of total loss:  $402.50/530 = .7594
  • Insurance payment: $253.75/acre
  • Insurance payment attributable to physical loss (which is deferrable):  $253.75 x .7594 = $192.70/acre
  • Portion of insurance payment that is not deferrable: $253.75 – $192.70 = $61.05/acre

But, what if the harvest price exceeds the base price?  Then the above example can be modified as follows:

Assume now that the harvest price of corn was $7.50/bushel. Al’s final revenue guarantee under the policy is 170 bushels/acre x $7.50 x.75 = $956.25/acre. Al’s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($7.50/bushel) which equals $750.00/acre. Al’s insurance proceeds are the guaranteed amount ($956.25/acre) less the calculated revenue ($750.00), or $206.25/acre.  His yield loss is the 70 bushels/acre which is then multiplied by the harvest price of $7.50/bushel, for a physical loss of $525/acre.  Al’s price loss is zero because the harvest price exceeded the base price.

So, to summarize, Al has the following:

  • Total loss (per acre): $525.00 (physical loss) + $0.00 (price loss)
  • Physical loss as percentage of total loss:  $525/525 = 1.00
  • Insurance payment: $206.25/acre
  • Insurance payment attributable to physical loss (which is deferrable):  $206.25 x 1.00 = $206.25/acre
  • Portion of insurance payment that is not deferrable: $206.25 – 206.25 = $0.00

IRS Position

The above approach was developed several years ago by Paul Neiffer and I as we worked on the issue. I then pitched the approach to appropriate IRS personnel in the IRS National Office in Washington, D.C. and was informally told that the approach looked to be appropriate.  To this date, however, IRS has not made any official pronouncement that the allocations in the example meet with its approval.

In the 2021 IRS Pub. 225 (Farmer’s Tax Guide) the IRS notes that proceeds received from revenue insurance policies may be the result of either yield loss due to physical damage or to a decline in price occurring from planting to harvest.  The IRS states, “For these policies, only the amount of the proceeds received as a result of yield loss can be deferred.”  That’s a recognition that an allocation should be made to separate out the deferable portion (relating to yield loss) from the non-deferrable portion (relating to lost revenue).  While statements in an IRS publication are not “official” IRS policy and are not substantial authority, the statement is a recognition that an allocation is appropriate.     

Conclusion

Weather damage to crops is an issue that arises somewhere across the country on an annual basis, and the deferral rule under I.R.C. §451 can be helpful to maintain consistent tax reporting treatment when crop insurance proceeds and/or federal disaster payments replace the anticipated crop income.  However, the rules on deferral are important to follow, and the type of insurance policy may influence the amount, if any, of proceeds that can be deferred.  The portion of the insurance proceeds related to yield may be deferred.  The portion related to price is not deferable.  A crop insurance agent is likely to be able to break out the two components.

As a final note, several high-profile crop insurance fraud cases have been in the courts in recent years.  That means that the federal government is examining crop insurance claims closely.

March 12, 2022 in Income Tax | Permalink | Comments (0)

Saturday, March 5, 2022

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

Overview

In December, I posted a “hold-the-date” announcement for the 2022 summer national farm income tax/estate and business planning conferences that Washburn Law School will be conducting this summer.  The itineraries for each event are now finalized and registration will open soon.  Some have already booked their lodging and made travel plans.  The events are the highest quality, most practical professional tax and legacy planning conferences for practitioners with farm and ranch clients you can find anywhere in 2022.  Both conferences will also be simulcast live online in the event you aren’t able to attend in person.  In addition, each conference provides one hour of ethics for attorneys, CPAs and other tax practitioners. 

On June 13 and 14, the conference will be held at the Chula Vista Resort near the Wisconsin Dells.  On August 1 and 2, the conference will be at Fort Lewis College in Durango, Colorado.

In today’s article, I detail the speakers and the itineraries for each location.  2002 summer seminars – it’s the topic of today’s post.

The Speakers

In addition to myself, the following make the line-ups for the conferences:

Wisconsin Dells 

Joining me on Day 1 will be Paul Neiffer.  Paul is a CPA with CliftonLarsonAllen out of Walla Walla Washington.  He and I have worked together on numerous tax conferences for the past decade.  He specializes in income taxation, accounting services, and succession planning for farmers and agribusiness processors.  He is also a contributor at agweb.com and writes the Farm CPA Today blog. 

Also making presentations at the Wisconsin Dells conference will be Carlos Ramon, Dr. Allen Featherstone and Prof. Peter Carstensen.  Here are their brief bios:

Carlos Ramon.  Carlos is the Program Manager, Cyber & Forensic Services, with the IRS Criminal Investigation Division (IRS-CID).  He has over nineteen years of federal law enforcement experience, the last 16 of which have been with the IRS-CID.  With IRS-CID, Carlos has served (among other things) as an ID Theft Coordinator, and Program Manager for Cyber and Forensic Services. He is specially trained in different IRS-CI programs responsible for investigating criminal violations of the Internal Revenue Code and related financial crimes involving tax, money laundering, public corruption, cyber-crimes, identity theft, and narcotics.  Carlos holds a bachelor’s degree in Animal Science from Penn State University, a master’s in business administration from the Inter American University of Puerto Rico, and a Doctorate in Business Administration in Management Information System from the Ana G Mendez University. 

Dr. Allen M. Featherstone.  Dr. Featherstone is the Department Head of the Agricultural Economics Department at Kansas St. University where he also is the Director of the Master in Agribusiness Program.  His academic focus is on agriculture finance and his production economics research has investigated issues such as ground water allocation in irrigated crop production, comparison of returns under alternative tillage systems, the costs of risk, interactions of weather soils, and management on corn yields, analysis of the returns to farm equity and assets, and analysis of the optimizing behavior of Kansas farmers, examining the stability of estimates using duality, and examining the application of a new functional forms for estimating production relationships.

Peter C. Carstensen.  Prof. Carstensen is Professor of Law Emeritus at the University of Wisconsin School of Law.  From 1968-1973, he was an attorney at the Antitrust Division of the United States Department of Justice assigned to the Evaluation Section, where one of his primary areas of work was on questions of relating competition policy and law to regulated industries.  He has been a member of the faculty of the UW Law School since 1973.  He is also a Senior Fellow of the American Antitrust Institute.  His scholarship and teaching have focused on antitrust law and competition policy issues.  IN 2017, he published Competition Policy and the Control of Buyer Power, which received the Jerry S. Cohen Memorial Fund Writing Award for best antitrust book of 2017. 

Durango

The Day 1 lineup and topics are the same at the Durango event as they are at the Wisconsin Dells event.  Joining me on Day 2 at Durango will be the following:

Timothy P. O’Sullivan.  Tim is a senior partner with the Foulston law firm in Wichita, Kansas.  He represents clients primarily in connection with their estate and tax planning and the administration of trusts and estates. As part of his practice, Mr. O’Sullivan crafts wills, testamentary trusts, revocable living trusts, irrevocable trusts, dynasty or other types of generation-skipping trusts, “special needs” trusts, financial and healthcare powers of attorney, living wills, premarital agreements, stock purchase or buy-sell agreements, strategic gifting and estate tax planning, asset protection planning, governmental resource planning (e.g., Medicaid and SSI), family business succession plans, premarital agreements, IRA, 401k or other tax deferred beneficiary designations and deferral strategies, life insurance structures, family limited partnerships and limited liability companies, grantor retained annuity trusts (GRATs), private annuities, self-canceling installment notes (SCINs) and other instruments and estate planning techniques. A substantial portion of Mr. O’Sullivan’s practice also involves advising clients on strategies and provisions which enhance the preservation of family harmony in the estate planning process.

Mary Ellen Denomy.  Mary is a CPA with a specialty in oil and gas accounting, valuations and audits.  She is an Accredited Petroleum Accountant, Certified Fraud Deterrent Analyst and Master Analyst in Financial Forensics.  She has spoken across the country on oil and gas issues, been interviewed frequently and has testified as a successful expert.  Mary Ellen is a former member of the Board of the National Association of Royalty Owners (NARO), the Board of Examiners of the Council of Petroleum Accountants Societies, Past President of NARO-Rockies and former Trustee of Colorado Mountain College.  She is currently a licensed CPA in both Colorado and Arizona.

Mark Dikeman.  Mark is the Associate Director of the Kansas Farm Management Association as part of the Department of Agricultural Economics at Kansas State University.  Mark is responsible for implementing and maintaining an Extension educational farm business management program for commercial farms, resulting in the development of financial and production information to be used for comparable economic analysis by the farms as well as for research, policy and teaching.

John Howe.  John practices law in Grand Junction, Colorado with the law firm of Hoskin, Farina and Kampf.  John was raised in Southwestern Colorado and attended the Colorado School of Mines, graduating in 1983 with a bachelor’s degree in geophysical engineering. After a short stint in the oil and gas exploration industry, John attended the University of Colorado School of Law, graduating in 1989.  Following graduation, he clerked for Justice William H. Erickson of the Colorado Supreme Court and has practiced water and real estate law in Grand Junction for more than thirty years.

Michael K. Ramsey.  Mike is a partner in the firm of Hope, Mills, Bolin, Collins & Ramsey LLP located in Garden City, Kansas.  His law practice includes water rights, landowner oil and gas rights, agricultural business and estate planning.  Mike is a partner in an irrigated farming operation located in southwest Kansas. He has spoken on water law topics in Kansas to attorneys, financial institutions, utility company board members, agricultural producers, legislative committees and others. His clients have included users of surface and groundwater for irrigation, livestock, industrial and municipal purposes and groundwater management districts.  He a co-author with Peck, J. and Pitts, D. of "Kansas Water Rights: Changes and Transfers," 57 J.K.B.A. 21 (July 1988) and author of "Kansas Groundwater Management Districts: A Lawyer's Perspective," Vol. XV No. 3 Kan. J. of Law & Pub. Policy 517 (2006).  Mike’s law degree is from the University of Kansas School of Law.

Andrew Morehead.  Andy is a Public Accountant and Certified Financial Planner with a farm and small business practice in Eaton, Colorado and Torrington, Wyoming. He is a Past President of the National Society of Accountants, and is also a Past President of the Public Accountants Society of Colorado.  Andy is a former cattle rancher and farm equipment dealer in western Wyoming, and has taught at various tax-related professional continuing education programs for many years.

Shawn Leisinger.  Shawn is the Associate Dean for Centers and External Programs where he oversees development of Center programs and events that are held throughout the year. He also coordinates all continuing legal education programs sponsored by Washburn Law and other special events.  Shawn joined Washburn University School of Law on a full-time basis in 2010. Previously he served as Assistant General Counsel to the Kansas Corporation Commission Oil and Gas Conservation Division and as Assistant Shawnee County (Kansas) Counselor. Leisinger has coached the Washburn Law American Bar Association Client Counseling competition team since 2003 and the Negotiation competition team since 2008. He has also taught the Interviewing and Counseling and the Professional Responsibility courses and regularly teaches continuing legal education sessions.

Daily Schedules

Wisconsin Dells.  Here is how the topical sessions break out each day at the Wisconsin Dells conference (the speaker for each topic is indicated in parenthesis after the title of each session):

Day 1:

8:00 a.m.-8:05 a.m. – Welcome and Announcements

8:05 a.m.-9:05 a.m. - Tax Update – Key Rulings and Cases from the Past Year (or so) (McEowen)

This opening session begins with a review of the most significant recent income tax cases, IRS rulings and other tax administrative developments.  This session will help you stay on top of the ever-changing interpretations of tax law that impact your clients.   

9:05 a.m.-9:35 a.m. - Reporting of WHIP and Other Government Payments (Neiffer)

Farmers that participate in federal farm programs have unique tax reporting requirements and the programs have unique tax rules that apply.  This session will provide a review of the basic tax rules surrounding farm program payments, including new USDA programs that have been created for farmers in recent years.  Also reviewed will be the options for deferring revenue protection policies.

9:35 a.m.-9:55 a.m. (Morning Break)

9:55 a.m.-10:20 a.m. - Fixing Bonus Elections and Computations (McEowen)

The TCJA made several changes to bonus depreciation and the IRS issued a Revenue Procedure in 2019 allowing modifications of a bonus election.  Final regulations were published in late 2020 that withdrew a “look-through” rule for partnerships and clarify the application of I.R.C. §743(b) adjustments.  This session brings tax preparers up-to-date on dealing with changes to bonus elections and related computations.

10:20 a.m.-10:50 a.m. - Research and Development Credits (Neiffer)

Beginning in 2022, taxpayers must provide particular information when claiming a refund for research and development credits under I.R.C. §41 on an amended return.  What information is required?  What business components must be identified, and how are research activities performed to be documented?  How can an insufficient claim be perfected?  These issues and more will be addressed.

10:50 a.m.-11:20 a.m. – Farm NOLs (Neiffer)

In 2021, the IRS issued guidance on how farm taxpayers are to handle carryback elections related to farm net operating losses (NOLs) in light of all of the legislative rule changes in recent years.  This session reviews the guidance and illustrates how a farm taxpayer can elect to not apply certain NOL rules of the CARES Act, and how the COVID-Related Tax Relief Act (CTRA) election can be revoked. 

11:20 a.m.-Noon  -  The Taxability of Retailer Reward Programs; Tax Rules Associated with Demolishing Farm Structures (McEowen)

This session addresses the tax issues associated with farm clients receiving “rewards” from retailers that they transact business with.  How are the “rewards” to be reported?  Is the information that the retailer provides to the farmer correct?  This session sorts it out.  In addition, this session covers the proper tax treatment of demolishing farm structures.  Significant weather events in recent months in large areas of farm country destroyed or significantly damaged many farm structures.  When those structured are beyond repair and are demolished, what is the proper way to handle it for tax purposes? 

Noon-1:00 p.m. – Lunch

1:00 p.m.  – 2:15 p.m. IRS-CI: Emerging Cyber Crimes and Crypto Tax Compliance (Ramon)

This session explains how to identify a business email compromise and/or data breach and how to respond to it.  The session will also identify what the Dark Web is and how it is utilized for cybercrimes and identity theft.  Likewise, the session will help attendees to recognize the general terminology and tax treatment pertaining to virtual/crypto currency. In addition, the session will allow participants to gain a better understanding of the efforts by IRS-Criminal Investigation to combat cyber criminals and illicit activity.

2:15 p.m. – 2:45 p.m.  Potpourri – Part 1 (McEowen and Neiffer)

This session includes discussion of numerous tax issues of importance to farmers and ranchers.  The topics covered include how machinery trade transactions are handled and reported on Form 4797 and Form 4562; inventory accounting issues (what is included in inventory; how the Uniform Capitalization Rules impact inventory accounting; when accrual accounting is required; inventory valuation methods; and crop accounting).  Also covered will be the tax treatment of early termination of CRP contracts; partnership reporting; weather-related livestock sales; and contribution margin analysis

2:45 – 3:05 p.m. - Afternoon Break

3:05 p.m. – 4:25 p.m. Potpourri (cont.) (McEowen and Neiffer)

The potpourri session continues…and concludes.

Day 2:

7:30 a.m. – 8:00 a.m. – Registration

8:00 a.m. – 8:05 a.m. – Welcome and announcements

8:05 a.m. – 9:00 a.m. - Estate and Business Planning Caselaw and Ruling Update (McEowen)

Day 2 begins with a review of the big developments in the courts and with the IRS involving estate planning, business planning and business succession.  Stay on top of the issues impacting transition planning for your clients by learning how legal, legislative and administrative developments impact the estate and business planning process.

9:00 a.m. – 9:50 a.m. – The Use of IDGTs (and other strategies) For Succession Planning (McEowen)

Estate planning with intentionally defective grantor trusts (IDGTs) can have many advantages. This session will discuss the ins and outs of IDGTs, including how they may be a part of developing comprehensive estate plans and how they can be tax “effective” for federal estate tax purposes.

9:50 – 10:10 a.m. – Morning Break

10:10 a.m. – 11:25 a.m. – The Ag Economy and the Impact on Farm/Ranch Clients (Part 1)

Between the Upper and Nether Stone: Anticompetitive Conduct Grinding Down Farmers (Carstensen)

Enforcement of antitrust and related competition laws has become a major focus of the Biden Administration.  One primary area of concern is agriculture.  Farmers face significant risks of harm in their supply markets.  The impacts come from a variety of places: equipment which they cannot repair because of restraints imposed by the manufacturer, seeds and other inputs sold by a limited number of suppliers who restrict resale and lower cost distribution, increased prices of fertilizer associated with increased concentration in the production of that input.  On the output side, there is increased concentration in the markets into which farmers sell many of their crops and livestock.  Recently litigation has highlighted how a cartel of poultry integrators exploited growers, consumers, and workers.  Similar claims are pending in other output markets.  This presentation will provide a survey of the issues and the potential for positive or negative impact on farmers and their bottom line.

11:25 a.m. – Noon - Post-Death Dissolution of S Corporation Stock and Stepped-Up Basis; Last Year of Farming; Deferred Tax liability and Conversion to Form 4835 (McEowen)

Noon – 1:00 p.m. – Luncheon

1:00 p.m. – 2:15 p.m. - The Ag Economy and the Impact on Farm/Ranch Clients (Part 2)

Agricultural Finance and Land Situation – (Featherstone)

The current agricultural finance situation and land will be discussed.  Information will be provided on past, recent, and future developments.  Information on the income situation, the financial health of farm operations, and current land market trends will be provided.

2:15 – 2:55 p.m. – Post-Death Basis Increase – Is Gallenstein Still in Play?; Using an LLC to Make an S Election – (McEowen)

Can surviving spouses in non-community property states get a full basis step-up in jointly held property when the first spouse dies?  Gallenstein may still apply for some clients – what are those situations and what does it mean?  Also, the session will examine the procedures involved and the Forms to be filed when an S election is made via a limited liability company. 

2:55 p.m. – 3:15 p.m. Afternoon Break

3:15 p.m. – 3:25 p.m. – Getting Clients Engaged in the Estate/Business Planning Process – (McEowen)

In this brief session, a checklist will be provided designed to assist practitioners in getting clients engaged in the estate, business and succession planning process.  What can be done “jump start” the process for clients?

3:25 p.m. – 4:25 p.m.  – Ethical Problems in Estate and Income Tax Planning – (McEowen)

This session focuses on ethical situations that practitioners often encounter when counseling clients on estate/business planning or income tax planning.  The governing ethical rules are often not carefully tailored for estate and tax planners/preparers, and competing responsibilities often bedevil the professional.  So, how can the estate planning and/or income tax preparer stay “within the rails”?  This session will address the primary rules including the application of relevant portions of Circular 230.

Durango Seminar

Day 1:

8:00 a.m.-8:05 a.m. – Welcome and Announcements

8:05 a.m.-9:05 a.m. - Tax Update – Key Rulings and Cases from the Past Year (or so) (McEowen)

This opening session begins with a review of the most significant recent income tax cases, IRS rulings and other tax administrative developments.  This session will help you stay on top of the ever-changing interpretations of tax law that impact your clients.  

9:05 a.m.-9:35 a.m. - Reporting of WHIP and Other Government Payments (Neiffer)

Farmers that participate in federal farm programs have unique tax reporting requirements and the programs have unique tax rules that apply.  This session will provide a review of the basic tax rules surrounding farm program payments, including new USDA programs that have been created for farmers in recent years.  Also reviewed will be the options for deferring revenue protection policies.

9:35 a.m.-9:55 a.m. - Morning Break

9:55 a.m.-10:20 a.m. - Fixing Bonus Elections and Computations (McEowen)

The TCJA made several changes to bonus depreciation and the IRS issued a Revenue Procedure in 2019 allowing modifications of a bonus election.  Final regulations were published in late 2020 that withdrew a “look-through” rule for partnerships and clarify the application of I.R.C. §743(b) adjustments.  This session brings tax preparers up-to-date on dealing with changes to bonus elections and related computations.

10:20 a.m.-10:50 a.m. - Research and Development Credits (Neiffer)

Beginning in 2022, taxpayers must provide particular information when claiming a refund for research and development credits under I.R.C. §41 on an amended return.  What information is required?  What business components must be identified, and how are research activities performed to be documented?  How can an insufficient claim be perfected?  These issues and more will be addressed.

10:50 a.m.-11:20 a.m. – Farm NOLs (Neiffer)

In 2021, the IRS issued guidance on how farm taxpayers are to handle carryback elections related to farm net operating losses (NOLs) in light of all of the legislative rule changes in recent years.  This session reviews the guidance and illustrates how a farm taxpayer can elect to not apply certain NOL rules of the CARES Act, and how the COVID-Related Tax Relief Act (CTRA) election can be revoked. 

11:20 a.m.-Noon  -  The Taxability of Retailer Reward Programs; Tax Rules Associated with Demolishing Farm Structures (McEowen)

This session addresses the tax issues associated with farm clients receiving “rewards” from retailers that they transact business with.  How are the “rewards” to be reported?  Is the information that the retailer provides to the farmer correct?  This session sorts it out.  In addition, this session covers the proper tax treatment of demolishing farm structures.  Significant weather events in recent months in large areas of farm country destroyed or significantly damaged many farm structures.  When those structured are beyond repair and are demolished, what is the proper way to handle it for tax purposes? 

Noon-1:00 p.m. – Luncheon

1:00 p.m.  – 2:15 p.m. IRS-CI: Emerging Cyber Crimes and Crypto Tax Compliance (Ramon)

This session explains how to identify a business email compromise and/or data breach and how to respond to it.  The session will also identify what the Dark Web is and how it is utilized for cybercrimes and identity theft.  Likewise, the session will help attendees to recognize the general terminology and tax treatment pertaining to virtual/crypto currency. In addition, the session will allow participants to gain a better understanding of the efforts by IRS-Criminal Investigation to combat cyber criminals and illicit activity.

2:15 p.m. – 2:45 p.m.  Potpourri – Part 1 (McEowen and Neiffer)

This session includes discussion of numerous tax issues of importance to farmers and ranchers.  The topics covered include how machinery trade transactions are handled and reported on Form 4797 and Form 4562; inventory accounting issues (what is included in inventory; how the Uniform Capitalization Rules impact inventory accounting; when accrual accounting is required; inventory valuation methods; and crop accounting).  Also covered will be the tax treatment of early termination of CRP contracts; partnership reporting; weather-related livestock sales; and contribution margin analysis

2:45 – 3:05 p.m. - Afternoon Break

3:05 p.m. – 4:25 p.m. Potpourri (cont.) (McEowen and Neiffer)  

The potpourri session continues…and concludes.

DAY 2: 

7:30 a.m. – 8:00 a.m. – Registration

8:00 a.m. – 8:05 a.m. – Welcome and announcements

8:05 a.m. – 9:00 a.m. - Estate and Business Planning Caselaw and Ruling Update (McEowen)

Day 2 begins with a review of the big developments in the courts and with the IRS involving estate planning, business planning and business succession.  Stay on top of the issues impacting transition planning for your clients by learning how legal, legislative and administrative developments impact the estate and business planning process.

9:00 a.m. – 9:45 a.m. – The Use of IDGTs (and other strategies) For Succession Planning (McEowen)

Estate planning with intentionally defective grantor trusts (IDGTs) can have many advantages. This session will discuss the ins and outs of IDGTs, including how they may be a part of developing comprehensive estate plans and how they can be tax “effective” for federal estate tax purposes.

9:45 a.m. – 10:05 a.m.  – Morning Break

10:05 – 11:00 a.m. – Estate Planning to Minimize Income Taxation:  From the Mundane to the Arcane (O’Sullivan)

With the failure of the Biden legislative agenda in 2021 that would have had a deleterious effect on many estate planning techniques, and with estate and gift tax reduction techniques continuing to be relevant (for the immediate future) to a small minority of the population, income tax reduction techniques continue to be the major tax focus of the estate planner’s regimen.  This session will initially address simple, well understood but infrequently utilized- estate planning strategies, and then gravitate to more advanced complex techniques both within and without non-grantor trusts. These techniques can substantially reduce the income taxation burden on beneficiaries of estate plans while carrying out the grantor’s/testator’s other important estate planning goals, including asset protection, maintenance of plan integrity, flexibility and charitable giving.  Learn the techniques that can be implemented for particular clients.

11:00 a.m. – Noon – Oil and Gas Royalties and Working Interest Payments:  Taxation, Planning and Oversight (Denomy)

This presentation will cover how to properly report royalties and working interest payments on current tax returns.  We will then begin to look at estate planning recommendations for your clients.  Also discussed will be issues that you may be able to advise your clients about concerning whether they are being paid according to their agreements.  The session concludes with what it means to be called to be an expert as your client’s CPA.

Noon – 1:00 p.m. - Luncheon

1:00 p.m. – 1:50 p.m. - Economic Evaluation of a Farm Business (Dikeman)

This session will address key components of analyzing the economic health of a farm business.  How much did a farm really make?  Evaluating the economic performance of an agricultural business can be complicated.  With prepaid expenses and generous depreciation options, it is difficult to gauge farm performance especially by looking only at a tax return.  This session will look at the impact of income tax management decisions on the economic performance of a farm business.

1:50 p.m. – 3:05 p.m. – Appropriation Water Rights - Tax and Estate Planning Issues (Mike Ramsey; Andy Morehead; John Howe)

The panel will explore the nature and types of appropriation water rights that practitioners may encounter with their clients, jurisdictional differences and whether the rights are real or personal property interests.  Common ownership, conveyance and title problems will be discussed. Valuation issues will be addressed. There will be discussion about IRC Section 1031 exchanges and depletion issues with examples commonly encountered in sale and transfer transactions.   Concerning estate planning and estate, gift and generation skipping taxation, the potential use and utility of SLATS (spousal lifetime interest trusts), IDGTs (intentionally defective grantor trusts) and IRC Sections 2032A and 6166 will be covered. The emphasis will be on identification of issues with reference materials for further study.  

3:05 -3:25 p.m. – Afternoon Break

3:25 – 4:25 p.m. - Ethically Negotiating End of Life Family Issues (Leisinger)

This ethics exercise takes a look at the sometimes complex processes and issues that arise at end of life for family members.  Participants will be given confidential information and motivations from two different children of a parent who is at end of life and needing to liquidate assets to pay for nursing home care and other expenses.  Ethical rules for attorneys will be discussed and applied to the negotiation exercise and outcomes that participants will be asked to complete as part of the program. 

Conclusion

Registration will open soon for both events and will be available through my website – washburnlaw.edu/waltr.  I will also post here when registration is open and provide the link for you.  Again, if you aren’t able to attend in person, you may attend online.  Also, if you are a law student or undergraduate student interested in attending law school, please contact me personally for details on a discounted registration rate.

March 5, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, February 28, 2022

Expense Method Depreciation and Leasing - A Potential Trap

Overview

For tangible depreciable personal property (and some types of qualified real estate improvements), all or part of the income tax basis can be deducted currently in the year in which the property is placed in service (defined as when property is in a state of readiness for use in the taxpayer's trade or business), regardless of the time of year the asset was actually placed in service.  This is known as “expense method depreciation” and it is an off-the-top depreciation allowance that may be taken at the taxpayer's election each year.  I.R.C. §179.

For farmers and ranchers, the deduction can apply to a wide array of business assets.  But there is a potential trap that can apply to farm landlords that is often overlooked.  Expense method depreciation and a trap for the unwary – it’s the topic of today’s post.

Basics of Expense Method Depreciation

On a joint return, the aggregate basis amount eligible for the deduction is $1,080,000 at the federal level (for 2022), except for certain types of vehicles.  But, the maximum amount that can be claimed is limited to the taxpayer’s aggregate business taxable income (including I.R.C. §1231 gains and losses and interest from the working capital of the business).  Treas. Reg. §1.179-2(c).  The extent of a taxpayer’s income from the active conduct of a trade or business is determined in accordance with a facts and circumstances test to determine if the taxpayer “meaningfully participates in the management or operations of the trade or business.” Treas. Reg. §1.179-2(c)(6)(ii).  Wages and salaries that the taxpayer receives as an employee are included in the aggregate amount of active business taxable income of the taxpayer.  Moreover, a spouse's W-2 wage income is considered income from an active trade or business for this purpose if the couple files a joint income tax return.

The I.R.C. §179 limitation applies at the entity level for pass-through entities in addition to also applying at the individual taxpayer level.  That’s an important point for farming operations where family members are sharing ownership of equipment.  If a co-ownership arrangement is construed as a partnership, only one I.R.C. §179 limitation would apply to equipment purchases.  If the co-ownership is not a partnership, each taxpayer could count their respective share of equipment purchases for purposes of the I.R.C. §179 limitation.

Here are some other key points about the provision:

  • Property that is eligible for expense method depreciation is tangible, depreciable personal property. This includes costs to prepare and plant a vineyard, including labor costs. C.A. 201234024 (May 9, 2012).
  • Expense method depreciation is tied to the beginning of the taxpayer’s tax year.
  • Qualified leasehold improvement property and qualified retail improvement property are eligible for expense method depreciation as are air conditioning and heating units.
  • Certain items of tangible depreciable personal property are not eligible for expense method depreciation. In general, any property that would not be eligible for investment tax credit (under the rules when the investment tax credit was available) is ineligible for expense method depreciation. 
  • In addition, property acquired by gift, inheritance, by estates or trusts and property acquired from a spouse, ancestors or lineal descendants is not eligible for expense method depreciation. However, qualifying property held by a grantor trust is eligible for I.R.C. 179, but property held by an irrevocable trust is not. 
  • For property traded in, only the cash boot that is paid is eligible for expense method depreciation.
  • Expense method depreciation is phased out for taxpayers with cost of qualifying property purchases exceeding $2,700,000 (for 2022). For each dollar of investment in excess of $2,700,000 for the year, the allowable expense amount is reduced by $1. Thus, for 2022, at $2,700,000, the full deduction is available, and at $3,780,000, nothing is available.
  • Upon disposition of property on which an expense method depreciation election has been made, special income tax recapture rules may apply.
  • For expense method depreciation assets disposed of by installment sale, all payments received under the contract are deemed to have been received in the year of sale to the extent of expense method depreciation claimed on the property.
  • The expense method election for eligible property must be made on the first return (or on a timely filed amended return) for the year the elected property is placed in service. However, an expense method depreciation election can be made or revoked on an amended return for an open tax year (generally the most recent three years).

For the farmer or rancher, expense method depreciation can be claimed on machinery and equipment, as well as purchased breeding stock, pickup trucks and business automobiles, it can also be claimed on tile lines, fences, feeding floors, grain bins and silos.  But, of course, the trade-off is that if expense method depreciation is selected for a particular asset, the basis of the asset must be reduced by the amount of the expensing deduction.

Leases and the Non-Corporate Lessor Rule 

Non-corporate taxpayers that lease property to others that contains tangible property on which the landlord seeks to claim expense method depreciation, must satisfy two additional requirements.  I.R.C. §179(d)(5).  

  • First, the term of the lease must be less than 50 percent of the class life of the property.
  • Second, during the first 12 months of the lease, the deductions of the lessor with respect to the property (other than taxes, interest and depreciation) must exceed 15 percent of the rental income produced by the property. 

Note:  Presumably, the rule does not apply to S corporations. 

The rule makes it difficult for farm landlords to claim expense method depreciation with respect to many real estate improvements, particularly those that don’t require repairs and maintenance in the first 12-month period of the lease.

Note:  A non-corporate lessor is also eligible for I.R.C. §179 if the non-corporate lessor manufactured or produced the leased property.  I.R.C. §179(d)(5)(A). 

A Tax Court case a few years ago illustrates the peril posed to farm landlords by the non-corporate lessor rule.  In Thomann v. Comr., T.C. Memo. 2010-241, the taxpayers were a farm couple that owned and operated a 504-acre farm.  Around 2000, the couple orally leased 124 acres of their farmland along with buildings, grain storage bins and equipment to Circle T Farms, Inc., a hog farrow-to-finish business that the couple owned for $70,000 annual cash rent.  The corporation’s annual minutes for the years at issue, however, failed to specify what property the corporation was “renting” from the petitioners and did not provide details of any changes or additions to the lease. Instead, the minutes for the years at issue merely provided the dollar amounts without describing the property being “leased.” 

The petitioners orally leased the balance of their farmland (380 acres) to C&A, Inc., an unrelated party.  The husband also entered into an oral farming agreement with C&A that was put in writing in 2006 to state that the agreement “covered any future year[‘]s crops, so long as neither party requested a change on or before Sept[ember] 1 of the calendar year.”   

In 2004, 2005 and 2006, the petitioners purchased property that qualified for expense method depreciation.  On their tax return for 2004, they expensed $52,000 for drainage tile and a fence that was installed on the land that they leased to C&A, and $10,000 for material they purchased to remodel their farm office, including furniture and fixtures.  For 2005, they expensed $63,488 for a grain bin.  For 2006, they expensed $8,467 for a pickup truck and $31,000 for a grain bin and grain dryer.  The bin and dryer (and, presumably, the pickup truck) were orally leased to Circle T Farms for the $70,000 annual “cash rent.”  The IRS disallowed all of the expense method depreciation deductions for the farm-related property, citing the non-corporate lessor rule.

As for the office equipment, the court agreed with the IRS that the couple didn’t substantiate the deduction on their return and, as such, the court couldn’t determine whether the office material was eligible for expensing as “other property” under I.R.C. Sec. 1245.  Importantly, the court did not hold that the office materials were not I.R.C. §1245 property, but did hold that the taxpayers failed to present sufficient evidence to allow the court to determine whether the office materials were not “structural components” and would, therefore, be eligible for expense method depreciation.  So, an expense method deduction was denied for those items.  The court did not address the non-corporate lessor rule with respect to the office equipment.  

As for the grain bins, grain dryer, drainage tile, pickup truck and fence, the non-corporate lessor rule was applicable.  The couple claimed that the lease was for a year, renewable annually for another year and was, therefore, less than 50 percent of the class life of the farm-related property.  The Tax Court disagreed.  None of the leases were in writing and the couple didn’t provide any evidence of the actual lease terms.  As a result, the Tax Court concluded that the leases were for an indefinite period of time and did not have a term of less than 50 percent of the class life of the property.  The court also imposed an accuracy-related penalty of $16,209.

Note:  A lessor that merely rents property for the production of income isn’t eligible for expensing because the leased property is not used in the active conduct of the taxpayer’s trade or business.  Thus, cash rent leases also present a problem with respect to I.R.C. §179.  Thus, even if the non-corporate lessor test were satisfied in Thomann, I.R.C. §179 may still have been denied based on the nature of the leases involved. 

Conclusion

When it comes to many improvements on farmland, the non-corporate lessor rule is a major hurdle for farm landlords irrespective of whether the lease is cash rent or crop-share.  But, there is some doubt as to whether material participation share leases are subject to the rule. 

Farm leases may be short term, if they are in writing, but many may not even be in writing.  As Thomann illustrates, an oral lease can end up violating the rule.  Even if the test involving the length of the lease as compared to the class life of the farmland improvements is met, the improvements may not need repair and maintenance sufficient enough to allow the landlord to meet the other part of the non-corporate lessor rule.  That means that satisfaction of the “overhead” test may come down to how operating costs, if any, are allocated between the landlord and the tenant and how those costs relate to the rental amount.

The bottom line is that, for non-corporate farming operations, leases need to be in writing and drafted carefully with the non-corporate lessor rule in mind.  

February 28, 2022 in Income Tax | Permalink | Comments (0)

Friday, February 25, 2022

Tax Consequences When Farmland is Partitioned and Sold

Overview

I have had farm and ranch families tell me over years that they didn’t need to do estate/succession planning for various reasons and that they would simply “let the children figure it out.”  My retort to that is that if you do that, it’s likely that a judge will figure it out.  Indeed, one of those situations where a judge gets involved is when the parents have left farmland in co-equal ownership to multiple children after the last of the parents to die. 

What is a partition and sale action and what are the tax consequences – it’s the topic of today’s post.

Partition and Sale Action

Partition and sale of land is a legal remedy available if co-owners of land cannot agree on whether to buy out one or more of the co-owners or sell the property and split the proceeds.  It is often the result of a poorly planned farm or ranch estate where the last of the parents to die leaves the farm or ranch land equally to all of the kids and not all of them want to farm or they simply can’t get along.  Because they each own an undivided interest in the entire property, they each have the right of partition and sell to parcel out their interest.  See, e.g., Lowry v. Irish, No. 2019-0269-SG, 2020 Del. Ch. LEXIS 290 (Del. Chanc. Ct. Sept. 18, 2020). But, that rarely is the result because they aren’t able to establish that the tract can be split exactly equally between them in terms of soil type and slope, productivity, timber, road access, water, etc.  So, a court will order the entire property sold and the proceeds of sale split equally.  Tolle v. Tolle, 967 N.W.2d 376 (Iowa Ct. App. 2021); Koetter v. Koetter, No. A-17-1066, 2018 Neb. App. LEXIS 300 (Ct. App. Dec. 18, 2018). 

Note:  The court-ordered sale is most likely an unhappy result, and it can be avoided with appropriate planning in advance. 

Tax Consequences - Basics

What are the tax consequences of a partition and resulting sale?  A partition of property involving related parties comes within the exception to the “related party” rule under the like-kind exchange provision. This occurs in situations where the IRS is satisfied that avoidance of federal income tax is not a principal purpose of the transaction. Therefore, transactions involving an exchange of undivided interests in different properties that result in each taxpayer holding either the entire interest in a single property or a larger undivided interest in any of the properties come within the exception to the related party rule. But, as noted, this is only true when avoidance of federal income tax is not a principal purpose of the transaction.

As for the income tax consequences on the sale of property in a partition proceeding to one of two co-owners, such a sale does not trigger gain for the purchasing co-owner as to that co-owner’s interest in the property.

Is a Partition an Exchange?

If the transaction is not an “exchange,” it does not need to be reported to the IRS, and the related party rules are not involved.  If the property that is “exchanged” is dissimilar, then the matter is different.  Gain or loss is realized (and recognized) from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or extent. Treas. Reg. §1.1001-1(a). In the partition setting, that would mean that items of significance include whether debt is involved, whether the tracts are contiguous, and the extent to which they differ.

IRS ruling.  In 1954, the IRS ruled that the conversion of a joint tenancy in capital stock of a corporation into tenancy in common ownership (to eliminate the survivorship feature) was a non-taxable transaction for federal income tax purposes.  Rev. Rul. 56-437, 1956-2 C.B. 507. See also Priv. Ltr. Rul. 200303023 (Oct. 1, 2002); Priv. Ltr. Rul. 9633034 (May 20, 1996).  Arguably, however, the Revenue Ruling addressed a transaction distinguishable from a partition of property insomuch as the taxpayers in the ruling owned an undivided interest in the stock before conversion to tenancy in common and owned the same undivided interest after conversion. 

Partition as a Severance

A severance is not a sale or exchange.  A partition transaction, by parties of jointly owned property, is not a sale or exchange or other disposition.  See, e.g., Priv. Ltr. Rul. 200328034 (Oct. 1, 2002).  It is merely a severance of joint ownership. For example, assume that three brothers each hold an undivided interest as tenants-in-common in three separate tracts of land.  None of the tracts are subject to mortgages.  They agree to partition the ownership interests, with each brother exchanging his undivided interest in the three separate parcels for a 100 percent ownership of one parcel. None of them assume any liabilities of any of the others or receive money or other property as a result of the exchange. Each continues to hold the single parcel for business or investment purposes. As a result, any gain or loss realized on the partition is not recognized and is, therefore, not includible in gross income.  Rev. Rul. 73-476, 1973-2 C.B. 301.  However, in a subsequent letter ruling issued almost 20 years later, the IRS stated that the 1973 Revenue Ruling on this set of facts held that gain or loss is “realized” on a partition. It did not address explicitly the question of whether the gain or loss was “recognized” although the conclusion was that the gain was not reportable as income.  Priv. Ltr. Rul. 200303023 (Oct. 1, 2002).

To change the facts a bit, assume that two unrelated widows each own an undivided one-half interest in two separate tracts of farmland. They transfer their interests such that each of them now becomes the sole owner of a separate parcel.  Widow A’s tract is subject to a mortgage and she receives a promissory note from Widow B of one-half the amount of the outstanding mortgage.  Based on these facts, it appears that Widow A must recognize gain to the extent of the FMV of the note she received in the transaction because the note is considered unlike property.  Rev. Rul. 79-44, 1979-2 C.B. 265.

Based on the rulings, while they are not entirely consistent, gain or loss on a partition is not recognized (although it may be realized) unless a debt security is received, or property is received that differs materially in kind or extent from the partitioned property. The key issue in partition actions then is a factual one. Does the property received in the partition differ “materially in kind or extent” from the partitioned property or is debt involved?

Single or contiguous tracts?  It may also be important whether the partition involves a single contiguous tract of land or multiple contiguous tracts of land. However, in two other private rulings, the taxpayer owned a one-third interest in a single parcel of property with two siblings as tenants-in-common.  Priv. Ltr. Ruls. 200411022 and 200411023 (Dec. 10, 2003).  The parties agreed to partition the property into three separate, equal-valued parcels with each person owning one parcel in fee. The property was not subject to any indebtedness. The IRS ruled that the partition of common interests in a single property into fee interests in separate portions of the property did not cause realization of taxable gain or deductible loss.  Rev. Rul. 56-437, 1956-2 C.B. 507.

What about undivided interests?  Is there any difference taxwise between a partition with undivided interests that are transformed into the same degree of ownership in a different parcel and an ordinary partition of jointly owned property? Apparently, the IRS doesn’t think so.  In one IRS ruling, the taxpayers proposed to divide real property into two parcels by partition, and the IRS ruled that gain or loss would not be recognized. Ltr. Rul. 9327069 (Feb. 12, 1993).  Likewise, in another ruling, a partition of contiguous properties was not considered to be a sale or exchange.  Ltr. Rul. 9633028 (May 20, 1996). The tracts were treated as one parcel.

Conclusion

The partition of the ownership interests of co-owners holding undivided interests in real estate is often an unfortunate aspect of poor planning in farm and ranch estates.  That problem can be solved with appropriate planning.  If that planning is not accomplished during life, then it's likely that a judge will sort it out after death.  At least the tax consequences of a partition don’t appear to present a problem if the partition amounts to simply a rearrangement of ownership interests among the co-owners. 

February 25, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Tuesday, February 22, 2022

Nebraska Revises Inheritance Tax; and Substantiating Expenses

Overview

There have been several important developments in ag law and tax over the past couple of weeks worth noting.  So, before they pile up even further, I thought I would provide a quick update for you. 

A few recent developments touching ag law and tax – it’s the topic of today’s post.

Nebraska  - “The Good Life” Becomes a Better Place to Die

In 1895, Illinois was the first state to adopt a progressive inheritance tax on collateral heirs (an heir that is not in a direct line from the decedent, but comes from a parallel line.  The law was challenged as a violation of equal protection under the Constitution, but was upheld in 1898 in Magoun v. Illinois Trust and Savings Bank, et al., 170 U.S. 283 (1898).  As a result of the court’s decision, Nebraska adopted a progressive county-level inheritance tax in 1901.  The state’s inheritance tax system has changed little since that time.  Presently, Nebraska is the only state that uses the tax as a local government revenue source. 

But, this session the Nebraska Unicameral has passed (with only one vote in opposition) a bill that the Governor signed into law on February 17 revising the state’s county inheritance tax system (a tax on the privilege to inherit wealth). 

Note:  The lone vote in opposition to the bill was cast by a Senator from a district that has had counties in recent years where the inheritance tax generated zero revenue for the county.  It’s pretty easy to vote against a bill lowering (or eliminating a tax) when it doesn’t affect one’s constituents in the first place.

LB 310 changes the inheritance system for decedent’s dying after 2022.  Amounts passing to a surviving spouse remain exempt, and for “Class I relatives (near relatives – basically those persons up and down the decedent’s line), the 1 percent rate doesn’t change, but the exemption goes to $100,000 from the prior level of $40,000 per person.  For Class II relatives (aunts and uncles, nieces and nephews, and other lineal descendants of these relatives), the tax rate drops from 13 percent to 11 percent and the exemption increases from $15,000 per person to $40,000 per person.  For Class III “relatives” (everyone else), the rate is 15 percent, down from 18 percent, and the exemption will be $25,000 instead of the prior $10,000 amount.  Also included in the revised system is a provision exempting inheritances by persons under age 22 from all tax. 

Note:  Under LB 310, step-relatives are treated in the same manner as blood relatives with respect to the tax rate and exemption amounts based on their classification. 

The new inheritance tax system does require an estate’s personal representative to submit a report regarding inheritance taxes to the county treasurer of a county in which the estate is administered upon the distribution of any estate proceeds.  The Nebraska Department of Revenue must prepare a form for the personal representative’s report which will include information about the amount of the inheritance tax generated and the number of persons receiving property.  The report must also disclose the number of persons who do not reside in Nebraska that receive property that is subject to inheritance tax. 

More Substantiation Cases

In recent days, the U.S. Tax Court has issued a couple of opinions involving the expense substantiation rules of I.R.C. §274.  As we are in the midst of tax season, it is a good reminder that deductions are a matter of legislative “grace.”  If you claim a business deduction, you must substantiate it under the applicable rule(s).  Some types of expenses require more substantiation that do other expenses. 

Business Deductions Properly Denied 

Sonntag v. Comr., T.C. Sum. Op. 2022-3

The petitioners, a married couple, both had sources of income. The husband operated a music studio from a shed in their backyard. They used an electronic application to track their business expenses and receipts. On their joint 2017 return, they reported $247,201 in income from Form W-2. They claimed Schedule C deductions of $47,385, resulting in a business loss of $28,835. The deductions included amounts for travel expenses; air fare; meals and entertainment; bank charges; batteries; books and publications; a briefcase; credit card interest and fees; camera parts; costume cleaning; stage costumes; catering for special events; labor; office supplies; fees for physical training; postage/shipping; personal hygiene products; prop expenses; “research” admission fees; cable fees; Apple Music and Spotify subscriptions; Netflix subscriptions; studio supplies; cell phone expense; tools; and legal services. The IRS disallowed $37,800 of the deductions which included $11,713 of travel expenses; $5,763 of meal and entertainment expenses; and $20,324 of other expenses.

The Tax Court agreed with the IRS. Personal care expenses were properly denied. The credit card and annual fee expenses involved multiple personal transactions and weren’t substantiated as business expenses. The stage costume expense was not deductible because the husband testified that the shoes and clothes could also be worn as personal wear. The catering expenses were not properly substantiated, and the physical training expenses were also determined to be personal in nature as were the hygiene products. The research expenses were determined to be inherently personal. The cell phone expense was properly disallowed - some of the expense had been allowed. Other expenses were also disallowed for lack of substantiation – bank charges; batteries; books and publications; briefcase; camera parts; office supplies; and legal services. The claimed travel expenses were properly disallowed for failure to meet the heightened substantiation requirements of I.R.C. §274(d). Still other expenses were properly disallowed as both personal and unsubstantiated, including costume cleaning; labor; props; studio supplies; tools; and postage/shipping. 

Unreimbursed Employee Expenses Properly Substantiated 

Harwood v. Comr., T.C. Memo. 2022-8

The petitioner was a construction worker that worked for various employers over the tax years in issue. His work required him to leave home for significant “chunks of time.” He sought to deduct unreimbursed expenses for meals and entertainments, lodging, vehicle and other unreimbursed expenses that he incurred during his employment. The IRS disallowed a portion of the claimed deductions. The Tax Court upheld the petitioner’s deductions, noting that he had properly substantiated his travel, meals and lodging while away from home. He corroborated the amount, time, place and business purpose for each expenditure as I.R.C. §274(d) and Treas. Reg. §1.274-5T(b)(2)(ii)-(iii) requires. He also substantiated the auto expenses by documenting the business use and total use by virtue of a contemporaneous log. He also was “away from home” because his employment was more than simply temporary or only for a short period of time. The petitioner also proved that the dd not receive or have the right to receive reimbursement from his employer. 

Conclusion

The Nebraska modification of the county-level inheritance tax is step in the right direction for tax policy that has often ignored the inheritance tax.  On the unreimbursed business expense deduction issue, it’s imperative to maintain good records.  And not all expenses fall under the same substantiation rules.  That’s a key point that was brought out by the Tax Court last year in Chancellor v. Comr., T.C. Memo. 2021-50.  In Chancellor, the Tax Court pointed out that expenses that fall under the I.R.C. §274(d) umbrella cannot be substantiated (estimated) under the Cohan rule.  See Cohan v. Comr., 39 F.2d 540 (2nd Cir. 1930).  So, it’s important to understand which expenses are covered by the rule and those that aren’t, and what it takes to properly substantiate them.  But even if the Cohan rule applies it’s not a certainty that it will be a successful defense to an IRS audit.   

February 22, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Saturday, February 19, 2022

Proper Tax Reporting of Breeding Fees for Farmers

Overview

Farmers and ranchers enter into numerous transactions during a tax year that pose interesting questions for tax preparers.  Sometimes those questions involve the proper tax reporting treatment of income received from various activities that are related to the farming or ranching business.  Examples include Income from breeding fees; mineral and soil sales; crop share rents; livestock sales; and income from the sale of farm business assets.

Proper tax reporting of certain income sources for farmers and ranchers – it’s the topic of today’s post

Breeding Fees

Income reporting.  Amounts that a farmer or rancher receives as breeding fees are includible in gross income.  If part or all of the fee is later refunded because the animal did not produce live offspring, the breeding fees are still reported as income in the year received, with an offsetting deduction when the refund is made.

Deduct or capitalize – who’s at risk?  Normally, if a farmer pays a fee to have his own cow serviced by someone else’s bull, the fee is a deductible on Schedule F as a breeding fee.  But, a breeding fee might be classified as either a cost of raising or a cost of acquiring an animal, depending on which party bears the risk of loss that the breeding process may be unsuccessful. See, e.g. Duggar v. Comr., 71 T.C. 147 (1978), 1979-2 C.B. 1; Jordan v. Comr., T.C. Memo. 2000-206.  For example, in Priv. Ltr. Rul. 8304020 (Oct. 22, 1982), a farmer bred cattle through an embryo transplant arrangement with a reproduction Center.  The only guarantee that the Center made was that an impregnated cow would become pregnant within 90 days of the transplant.  The famer assumed all of the risk of loss associated with the embryo and the resultant calf.  The IRS determined that the fee for the embryo transplanting service was not merely an additional cost of purchasing a calf.  Accordingly, the fee was not expended to acquire or improve a capital asset and was currently deductible (along with the cost of the embryo, the cost to prepare the recipient cow).  Again, the key to this tax result was that the Center made no guarantee that the farmer would eventually possess a live and healthy cow. 

Compare the result in Priv. Ltr. Rul. 8304020 (Oct. 22, 1982) with that of Rev. Rul. 79-176, 1979-1 C.B. 123.  Under the facts of Rev. Rul., 79-176, the taxpayer leased cows from a breeder under a breeding service agreement. Under the terms of the lease, the taxpayer was guaranteed a live calf, healthy and sound for breeding purposes, at the time of weaning. If the calf died or was not suitable for breeding, the breeder would replace the calf with one from its herd.  Based on these facts, the IRS concluded that the taxpayer could not deduct the cost under the breeding servicing agreement because the payments were capital expenditures. These facts were different, the IRS pointed out, from those of Duggar v. Comr., 71 T.C. 14 (1978), acq. 1979-2 C.B. 1.  In Duggar, under a three-part Cattle Management Agreement and Sublease, a farmer leased 40 brood cows for the purpose of building a herd of Simmental cattle.  Under a management agreement, he paid a lease fee and a fee for maintenance and care of the leased cows.  Under a separate management agreement, he paid a fee for the raising of his weaned female calves.  The Tax Court held that he could deduct the cost of maintenance and care associated with the raising of weaned calves to breeding age because he bore the risk of loss.  That was unlike the facts of Rev. Rul. 79-176, where the farmer didn’t bear any risk of loss until the calves were weaned.  That meant the costs incurred before weaning had to be capitalized as additional costs of the calves.  See also Wiener v. Comr., 58 T.C. 81 (1972), aff’d., 494 F.2d 691 (9th Cir. 1974); Maple v. Comr., 440 F.2d 1055 (9th Cir. 1971).  Similarly, in Jordan v. Comr., T.C. Memo. 2000-206, the petitioners were guaranteed live foals under stallion service contracts which resulted in the associated breeding fees being capitalized rather than deducted on Schedule F.

Note:  In Duggar, the farmer’s expenses associated with the leased brood cows were nondeductible capital expenditures. The agreement was in effect for the purchase of weaned calves.

The bottom line is that a breeding fee is classified as either a cost of "raising" or a cost of "acquiring" an animal depending upon which party bears the risk of loss that the breeding process is unsuccessful.

Purchase of impregnated cows.  In Rev. Rul. 86-24, 1986-1 C.B. 80, a corporation owned purebred cows that, after hormone treatments, were artificially inseminated with semen from a purebred bull.  The embryos were surgically removed and implanted in the non-purebred cows.  After a positive pregnancy test, the corporation offered the implanted cows for public sale.  The cows were usually resold after giving birth to purebred calves.  The purchase price of each cow impregnated with an embryo transplant was equal to its fair market value (which was about three times greater than the fair market value of a cow not so impregnated.  The sale price of a cow after it gave birth to a purebred calf was equal to that of a non-impregnated cow.  The taxpayer (cash basis, calendar year) bought 10 impregnated cows and allocated the entire purchase price to the cows, and none to the purebred embryos.  Later in the tax year, 10 purebred calves were born (which the taxpayer intended to hold for sale) and the taxpayer then sold the cows for about one-third of what they were purchased for.  The taxpayer wanted to claim an ordinary loss with respect to the sale of the cows

The IRS determined that the purchase price of the impregnated cows had to be allocated to each cow and its embryo on the basis of the fair market value of each.  The eventual sale of the cows (within 24 months of their acquisition) would trigger ordinary income or loss.  However, because the taxpayer sold the cows for the same amount of cost that had to be allocated to them, there was no gain or loss on the sale of the cows.   The balance of the acquisition cost of the impregnated cows was allocated to the embryos was determined to be an amount expended in purchasing livestock that had to be capitalized.  The calves were not capital asset because they were held primarily for sale to customers in the ordinary course of business.  Thus, any gain or loss on their eventual sale would be ordinary in nature.  Neither the cost of the cows nor the basis allocated to the calves was currently deductible on Schedule F as a business expense. 

Note:  In Rev. Rul, 87-105, 1987-2 C.B. 46, the IRS modified Rev. Rul. 86-24 by stating that if before Feb. 24, 1986, the taxpayer had purchased a cow that was pregnant with a transplanted embryo or was subject to a binding written agreement to buy an impregnated cow, the cost allocated to the embryo can be deducted as a business expense under I.R.C. §162. 

Accrual method.  For a farmer on the accrual method of accounting, breeding fees are to be capitalized and allocated to the cost basis of the animal.  G.C.M. 39519 (Oct. 11, 1985).  Under the facts of the G.C.M., the taxpayer was trying to establish a breeding herd, and purchased cattle embryos and recipient cows.  The farmer and the seller allocated costs separately to breeding, embryo transplant, and maintenance services, and to the purchase price of the cows.  The question was whether the cost of the embryo transplants were deductible under I.R.C. §162 or had to be capitalized under I.R.C. §263.  The IRS concluded that the expense incurred for each embryo transplant was to be capitalized as the cost of acquiring a capital asset (the embryo) and, hence, was to be included in the cost basis of each cow. 

Conclusion

Breeding fees can generally be deducted as a farm business expense. However, if the breeder guarantees live offspring as a result of the breeding or other veterinary procedure, the fees must be capitalized into the cost basis of the offspring. For a taxpayer on the accrual method of accounting, breeding fees must be capitalized and allocated to the cost basis of the offspring.   

February 19, 2022 in Income Tax | Permalink | Comments (0)

Monday, February 14, 2022

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

Overview

Normally, when a farmer or rancher sells farm or ranch land the resulting gain is treated as capital gain.  That’s also the case for an investor in land that later sells it as an investment asset.   In both instances, the land is a capital asset that was being used in the seller’s trade or business or as an investment asset.  But, once the facts move outside of those confines the tax result can change.  For instance, what if  urban development was moving toward the farm or ranch and the seller, to take advantage of the upward price pressure on the land, started to parcel out the land and sell it in small tracts?  What if the seller had the land platted?  What if marketing steps were taken?  What if the buyer believed the land had a strategic location at the time of purchase, farmed it for a period of time and then began steps to prepare it to be sold off in smaller residential tracts at substantial gain?  Do those factors change the character of the gain? recognized on sale?  Possibly. 

General Rule

Sales that are deemed to be in the ordinary course of the taxpayer’s business generate ordinary income.  I.R.C. §1221(a)(1).  However, the sale of a capital asset (such as land) generates capital gain.  The different tax rates applicable to ordinary income and capital gain are often large for many taxpayers (sometimes as much as a 15 percentage-point difference) with the capital gain rates being lower.  So, a farmer, rancher or land investor will want to treat the gain from the sale of land as a capital gain taxed at the preferential lower rate.   That will be the outcome, unless the land is determined to have been held by the seller for sale to others in the ordinary course of their business. 

Facts Matter

Farmers and ranchers don’t normally sell land in the ordinary course of their farming or ranching business.  As noted above, the determination of the character of gain on sale is fact-dependent, with those facts bearing on the taxpayer’s primary purpose for holding the property.  If real estate is acquired for use in the taxpayer’s trade or business or for investment purposes, and retains that character, it is a capital asset, and the gain from sale will receive capital gains treatment.  That is a factual determination.

No single factor or combination of factors is controlling.  Based on decades of caselaw on the issue, the major factors appear to be as follows:  1) the taxpayer’s purpose in acquiring the property and holding the property before sale; 2) the frequency continuity, regularity and substantiality of sales of real properties; 3) the taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income; 4) the substantiality of sales of real properties; 5) the length of time the taxpayer held the real properties; 5) the extent of the taxpayer’s efforts to sell the property by advertising or otherwise; 6) whether the taxpayer used a business office for the sale of properties;  and 7) any improvements the taxpayer made to the real properties to increase sales revenue.  See Sovereign v. Comr., 281 F.2d 830 (7th Cir. 1960).

  • In Allen v. United States, No. 13-cv-02501-WHO, 2014 U.S. Dist. LEXIS 73367 (N.D. Cal. May 28, 2014), a married couple sold 2.63 acres of undeveloped land that generated over $60,000.  They reported the income as capital gain, but the IRS claimed that the income was "other income" taxable as ordinary income.  The couple admitted that they bought the land for the purpose of development, and they did attempt to find a partner to develop the property.  Ultimately, the property was sold to a developer and the couple received a payment each time a developed portion of the property was sold.  The IRS denied capital gain treatment, asserting that the income was from property "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." 

Note:          The term “customers” has been given a broad meaning except in those cases involving taxpayers dealing or trading in securities.  Basically, the IRS presumes that in real estate transactions a sale to any purchaser is a sale to a “customer.”  See, e.g., Pointer v. Comr., 48 T.C. 906 (1967).  The burden is on the taxpayer, based on solid facts, to establish otherwise.

The court noted that the determination of the nature of the income is a fact-based determination, and that the facts supported the IRS.  The taxpayers intended to develop and sell the property at the time it was acquired, and the taxpayers were active in getting the property developed.  The fact that the property was the only one purchased for development was not determinative.  The court granted summary judgment to the IRS. 

  • A U.S. Tax Court case, Fargo v. Comr., T.C. Memo. 2015-96, involved a partnership that acquired a leasehold interest in a tract of land with the intent to develop an apartment complex and retail space.  The lease originally ran for 20 years, but was extended for another 34 years.  The property generated only rental income and the taxpayer made no substantial effort to sell the property for 13 years. Ultimately, the property was sold for $14.5 million plus a share of the profits from the homes to be developed on the property.  The partnership reported $628,222 of capital gain, but IRS took the position that the transaction triggered $7.5 million of ordinary income.  The court agreed with the IRS.  The court noted the following factors were important in making the gain characterization distinction: (1) the property was initially acquired for developmental purposes; (2) efforts to obtain financing and continue that development were made; (3) the sale was to an unrelated party with the plan for the petitioner to develop the property; and (4) efforts continued to develop the property up until the purchase date.  While there were some factors that favored the taxpayer (only minor improvements were made; there were no prior sales; and no advertising or marketing had been performed), the court held that the factors weighed in the favor of the IRS and the sale was in the ordinary course of business under I.R.C. §1221(a)(1).
  • In Long v. Comr., 772 F.3d (11th Cir. 2014), the plaintiff, a real estate developer, entered into a contract with another party to buy land on which the plaintiff was planning on building a high-rise condominium building.  The plaintiff hired architects, sought a zoning permit, printed promotional materials about the condominium, negotiated contracts with purchasers of condominium units and obtained deposits for units.  However, the seller of the land unilaterally terminated the contract.  The plaintiff sued for specific performance and the trial court ordered the seller to honor the contract.  While the trial court's decision was on appeal, the plaintiff sold his position as the plaintiff in the contract litigation to a buyer for $5.75 million.  The IRS characterized the $5.75 million as ordinary income rather than capital gain.  The Tax Court agreed with the IRS on the basis that the plaintiff held the property (which the court said was the land subject to the contract) primarily for sale to customers in the ordinary course of business.  On appeal, the court reversed on the basis that the taxpayer never actually owned the land and instead sold a right to buy the land - a contractual right.  Accordingly, there was no intent to sell contract rights in the ordinary course of business.  The plaintiff intended the contract to be fulfilled and develop the property, and the sale of the right to earn future undetermined income was a capital asset. 
  • The Tax Court, in SI Boo, LLC v. Comr., T.C. Memo. 2015-19, held that ordinary income and self-employment tax was triggered on sale of properties acquired by tax deeds. The court noted that the taxpayers regularly did this.  While they bought the tax liens primary to profit from redemptions of the liens, the court determined that the repeated sales of properties forfeited to them as lien holders constituted ordinary income as a dealer in real estate.  They had also hired persons to act on their behalf to acquire the tax deeds, prepare the tracts for sale and maintain business records.  The court also held that, under another rule, the income from the sales was not reportable on the installment method. 
  • Boree v. Comr., 837 F.3d 1093 (11th Cir. Sept. 2, 2016), aff’g., T.C. Memo. 2014-85, involved a taxpayer that was a self-described real estate professional who received income from land sales.  The taxpayer reported the income as capital gain, but the Tax Court held that it was ordinary income because the taxpayer was found to have held the property primarily for sale to customers in the ordinary course of the petitioner's real estate business.  The court noted that the issue of whether the taxpayer was a developer (ordinary income treatment) or an investor (capital gain treatment) was fact dependent, and that the facts supported developer status.  That was the result because he held his business out to customers as a real estate business, and he engaged in development and frequent sales of numerous tracts over an extended period of time.  Also, in prior years, he had reported the income from sales as ordinary income and had deducted the expenses associated with the tracts. On appeal, the appellate court affirmed. 

Conclusion

The bottom line is that for most sales of farm or ranch land, the income from the sale will be characterized as capital gain.  However, with the right (or wrong) set of facts, the sale income could be characterized as ordinary.

February 14, 2022 in Income Tax | Permalink | Comments (0)

Wednesday, February 9, 2022

Ag Law and Tax Potpourri

Overview

I haven’t done a “potpourri” topic for a couple of months, so it is time for one.  There are always interesting developments happening in the courts and with the IRS.  Today’s edition of the “potpourri” is no different.

Recent miscellaneous developments in the courts and with the IRS – it’s the topic of today’s post.

No WOTC For “Weed” Business 

C.C.A. 202205024 (Nov. 30, 2021)

The taxpayer is a business that is engaged in the trade or business of trafficking marijuana.  Under federal law, marijuana is a Schedule I controlled substance under the Controlled Substances Act.  The taxpayer hires and pays wages to employees from one or more targeted groups provided under I.R.C. §51, and is otherwise eligible for the Work Opportunity Tax Credit (WOTC).  The IRS noted that I.R.C. §280E bars a deduction or credit for a business that traffics in controlled substances as defined by state or federal law.  Thus, the taxpayer was not eligible for any WOTC attributable to wages paid or incurred in carrying on a business of trafficking in marijuana. 

Note:  The IRS position is correct, based on the statute.  But, the discrepancy between federal law and the law of some states creates confusion and inconsistency.

IRS Email Approval of Supervisor Penalty Approval

C.C.A. 202204008 (Sept. 13, 2021)

Under I.R.C. §6751(b)(1), when an IRS agent makes an initial determination to assess penalties against a taxpayer, the agent must obtain “written supervisory approval” before informing the taxpayer of the penalties via a “30-day” letter.  Here, the IRS agent received written supervisory approval of the penalty recommendation via an email from his supervisor before issuing the 30-day letter to the taxpayer. The taxpayer sought to have the IRS remove the tax lien securing penalties imposed for his failure to furnish information on reportable transactions on the basis that IRS had failed to comply with I.R.C. §6751.  The taxpayer claimed that such failure made the penalties invalid and required the lien to be released.  The IRS Chief Counsel’s Office disagreed, finding that the IRS had complied with I.R.C. §6751.  The Chief Counsel’s Office noted that the U.S. Tax Court has held that compliance with the supervisory approval requirement doesn’t require written supervisory approval to be given on a specific form and that an email satisfied the statute, if not the Internal Revenue Manual. 

Low Soil Quality Doesn’t Reduce Assessment Value 

Reichert v. Scotts Buff County Board of Equalization, No. 20A 0061, (Neb. Tax Equal. And Rev. Com. Jan. 31, 2022)

The petitioner owned low soil quality farmland in western Nebraska and challenged the assessed value of the land of $312,376 for 2020 as determined by the county assessor.  The value had been set at $289,186 for 2020. The petitioner sought a value of $269,595 for 2020 in accordance with the land’s lower 2019 classification. The County Board of Equalization (CBOE) determined the taxable value of the property was $289,186 for tax year 2020.  The petitioner’s primary issue with the county’s valuation was that the county had upgraded the soil quality of the land from 2019 to 2020 to justify the higher valuation.  The petitioner provided a Custom Soil Resource Report conducted by the Natural Resources Conservation Service (NRCS) showing that the soil had a farmland classification of “not prime farmland” and should be put back to its prior classification at the lower valuation.    The CBOE determined that the value should be $289,186 for 2020.  The petitioner appealed. 

On review, the Nebraska Tax Equalization and Review Commission (Commission) affirmed the CBOE’s valuation.  The Commission noted that the CBOE’s valuation was based on state assessment standards that became law in 2019 as a result of LB 372 that amended Neb. Rev. Stat. §77-1363.  Under the revised law, the Land Capability Group (LCG) classifications must be based on land-use specific productivity data from the NRCS.  The Nebraska Dept. of Revenue Property Assessment Division used the NRCS data to develop a new LCG structure to comply with the statutory change.  Each county received the updated LCG changes and applied them to the land inventory in the 2020 assessment year.  The Commission noted that the petitioner’s NRCS report did not show the classification that each soil type should receive under the LCG system and, thus, did not rebut the reclassifications of the soil types for his farmland under an arbitrary or unreasonable standard. 

Note:  The case points out that the burden is in the taxpayer to establish that the assessed value is incorrect.  To rebut the presumption, the evidence provided must be specific as to soil type.  The Nebraska farmland tax valuation system is a frustration for many farmers and ranchers despite the change in the system made with the 2019 legislation. 

ESOP Didn’t Shield Taxpayer From Income 

Larson v. Comr., T.C. Memo. 2022-3

The petitioner, a CPA and an attorney, was also the fiduciary of an Employee Stock Ownership Plan (ESOP).  He placed restricted S corporate stock in the ESOP for his own benefit.  The petitioner claimed that the ESOP met the requirements of I.R.C. §401(a) such that the related trust was exempt from income tax under I.R.C. §501(a).    The IRS claimed that the stock value was to be included in his income because he (and the other control person) failed to enforce employment performance restrictions, and “grotesquely” failed to perform fiduciary duties associated with the ESOP.  The petitioner testified that he was not aware of his duties as a fiduciary, but the court didn’t believe the testimony.  The court noted that the petitioner waived the stock restrictions and breached his fiduciary duties which revealed an effort to avoid enforcement of the restrictions.  As such, there was no way he could lose control over the S corporation.  As a result, there was no substantial risk of forfeiture associated with the stock, and the value of the stock was properly included in the petitioner’s income in accordance with Treas. Reg. §1.83-3(a)-(b).  The court also upheld the denial of deductions for claimed business expenses incurred and paid by the S corporation. 

New ESA Policy for ESA Consultations 

EPA Announcement, January 11, 2022.  Effective upon announcement   

The Environmental Protection Agency (EPA) has announced a change in policy regarding Endangered Species Act (ESA) consultations (to determine the impact on endangered or threatened species in light of critical habitat) for newly registered pesticide active ingredients being registered under the Federal Insecticide, Fungicide, Rodenticide Act (FIFRA) for the first time.  Pesticides already registered under FIFRA or that have active ingredients already registered by EPA may not be subject to the same policy, but may still require ESA consultation but not under the ESA’s new policy. The EPA will determine whether formal or informal consultation is necessary on a case-by-case basis. 

Court Says Animal Chiropractic is Veterinary Medicine 

McElwee v. Bureau of Professional and Occupational Affairs, No. 1274 C.D. 2020, 2022 Pa. Commw. LEXIS 9 (Pa. Commw. Ct. Jan. 18, 2022)

The plaintiff is a licensed chiropractor that holds herself out to the public as an “animal chiropractor.”  She treats animals in her practice.  She is not a veterinarian and does not hold herself out as a veterinarian.  She is certified in veterinary chiropractic by the International Veterinary Chiropractic Association.  She receives medical records or x-rays when necessary from a treating veterinarian and reviews them to find infusions of the spine, breaks or fracturs of the spine, misalignments of the spine or any disk space between the vertebrae.  She then makes a treatment and care plan for the animal with or without the veterinarian’s input.  She also practices on animals of veterinarians, and requires animal owners to complete a consultation form granting authorization for her to provide chiropractic care to the animal’s owner.  All animals in her care must have a veterinarian before she will work with the animals. 

The defendant filed an order to show cause alleging that the plaintiff was subject to disciplinary action under state law because the services she performed in her practice constituted the unlicensed practice of veterinary medicine.  The plaintiff sought a hearing on the matter and the hearing examiner issued a proposed adjudication and order concluding that the plaintiff was engaged in the unlicensed practice of veterinary medicine.  The State Board of Veterinary Medicine issued a final adjudication finding the plaintiff, and the plaintiff appealed.  The court rejected the plaintiff’s claim that animal chiropractic was unregulated not subject to the Board’s authority.  The court held that even though animal chiropractic was not specifically regulated under the Veterinary Medicine Practice Act, it was regulated by the Board. 

Note:  Occupational licensure is highly questionable.  In this case, there was no allegation that the plaintiff was not performing as an animal chiropractor in any manner other than with professional competence. 

February 9, 2022 in Environmental Law, Income Tax, Real Property, Regulatory Law | Permalink | Comments (0)

Saturday, February 5, 2022

Purchase and Sale Allocations Involving CRP Contracts

Overview

It is not unusual for farmland enrolled in the Conservation Reserve Program (CRP) to be sold with several years remaining on the CRP contract.  Also, economic conditions may exist which provide an incentive for a landowner to terminate the contract early and put the land back into production or lease it to another farmer for a higher rent amount.  But, what are the economic and tax consequences when these situations occur?

The economic and tax consequences of selling land subject to a CRP contract and early contract termination – it’s the topic of today’s post.

In General

Under the typical CRP contract, farmland is placed in the CRP for a ten-year period.  Contract extensions are available.  Crops cannot be grown on the enrolled land, and enrolled land cannot be grazed unless the USDA authorizes it in special situations (such as drought).  The landowner is required to maintain a grass cover on the ground which may involve planting appropriate wild grasses and other vegetation and to perform mid-contract maintenance of the enrolled land in accordance with USDA/FSA specifications. 

If the landowner terminates the contact early, an early termination “penalty” applies.  In reality, however, the “penalty” really amounts to liquidated damages.  The question, however, from a tax standpoint, is whether the amount the landowner must pay is a nondeductible as a fine or penalty imposed by a governmental entity for the violation of a law.  See I.R.C. §162(f).  Likewise, if land that is enrolled in the CRP is sold, the seller must pay back to the USDA all CRP rents that they have already received, plus interest, and liquidate damages (which might be waived) unless the buyer agrees to continue to have the land enrolled in the CRP.  If the buyer does not agree to continue to keep the land in the CRP, what are the tax consequences to the seller? 

Purchase Price Allocation to CRP Contract

The requirement that an owner of CRP land pay a penalty in the form of reimbursing the USDA all CRP rents received, plus interest and damages, is synonymous with a lessee’s termination of a lease when the obligations under the lease exceed the benefits.  For a lessee that terminates a lease and pays a cancellation fee to do so, the lessee is generally allowed a deduction.  The rationale for allowing a deduction is that the lessee does not receive a future benefit, as long as the lease cancellation payment is not integrated in some manner with the acquisition of another property right.  If, on the other hand, the termination payment is part of a single overall plan involving the acquisition of an affirmative benefit, the payment must be capitalized.  See Priv. Ltr. Rul. 9607016 (Nov. 20, 1995). 

Note:  While not involved in the CRP setting, when a lessee terminates an existing lease by purchasing the leased property, I.R.C. §167(c)(2) bars an allocation of a portion of the cost to the leasehold interest.  The taxpayer must allocate the entire adjusted basis to the underlying capital asset. 

Selling a CRP Contract - Price Allocation

The IRS has ruled that a taxpayer who sold the right to 90 percent of the revenue from three CRP contracts that had approximately 11 years remaining was required to report the lump sum payment as ordinary gross income in the year of receipt.  In Priv. Ltr. Rul. 200519048 (Jan. 27, 2005), The taxpayer relinquished all rights to the CRP payments that were sold but agreed to comply will all of the provisions of the CRP contract, including the damage provisions that would apply if he breached the CRP contract terms.  The taxpayer’s return for the year of sale reported the entire amount received for the sale on Form 4835.  On the following year’s return, the taxpayer included the annual CRP payment from the remaining 10 percent on Form 4835 and claimed a deduction for the part which sold the prior year.  On the next year’s return, the taxpayer included the total CRP payment and did not offset it with the amount he received from the buyer.  The taxpayer later filed amended returns to remove the amount reported as income on Form 4835 in the year of sale, and to remove the expense deduction that was claimed on the following year’s return.  The taxpayer claimed that the lump-sum was not income in the year of sale because he did not have the unrestricted right to the funds (due to the damage clause applying in the event of noncompliance), and only held them as a conduit.  The IRS disagreed, noting that the taxpayer had received the proceeds from the sale of the CRP contracts, with the risk of nonpayment by the USDA shifted to the purchaser.  The IRS also stated that amounts received under a claim of right are includable in income, even though the taxpayer may have to repay some portion at a later date.  In addition, the IRS noted that a lump sum payment for the right to future ordinary income generally results in ordinary income in the year of receipt.  On this point, the IRS cited Cotlow v. Comr., 22 T.C. 1019 (1954), aff’d., 228 F.2d 186 (2nd Cir. 1955).  In Cotlow, a life insurance agent bought the rights to assigned commissions for renewals of life insurance from other insurance agents and had ordinary income in the year of receipt from those assigned renewal commissions.

Note:  The purchasing party may pay the early termination costs.  In such event, the payment should be considered part of the land, as an additional cost incurred to acquire full rights in the property (i.e., a payment made to eliminate an impediment to full use of the property).

Early Termination Payments

Generally.  A landlord that makes a payment to the tenant to obtain early cancelation of a lease, where the payment is not considered an amount paid to renew or renegotiate a lease, is considered a capital expenditure that the landlord can amortize. Treas. Reg. §1.263(a)-4(d)(7).  The amortization period depends on the intended use of the property subject to the canceled lease, but normally the amount paid is capitalized and amortized over the lease’s remaining term.  Rev. Rul. 71-283, 1971-2 C.B. 168.  That certainly is the case if the landlord is regaining possession of the land, but if the payment is to allow the sale of the farm, the cost should be added to the landlord’s basis in the farmland and deducted as part of the sale. 

As applied to CRP contracts.  A landlord paying early CRP termination costs to enter into a new lease of farmland with another farmer should capitalize and amortize the costs over the remaining term of the CRP contract that is being terminated.  See, e.g., Miller v. Comr., 10 B.T.C. 383 (1928).  That’s the case where a lease cancelation is not tied to substantial improvements that are to be made to the property.  See, e.g., Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir.1981).  However, the IRS might claim that such costs should be amortized over the term of the new lease if the new lease is for a longer period that the remaining term of the CRP contract.  See Montgomery v. Comr., 54 T.C. 986 (1970).  The U.S. Court of Appeals for the Ninth Circuit has questioned this position, noting that the Tax Court decision seeming to bolster the IRS position relied on court cases that seemed to alternate between using the unexpired lease term versus the new lease term.  Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir. 1981). The Ninth Circuit established the Miller case as the general rule that lease cancelation costs should typically be written off over the unexpired term of the canceled lease.

Conclusion

Over 20 million acres are presently enrolled in the CRP.  Sometimes a landowner enrolling land in the CRP wants to sell the land or simply terminate the contract early due to economic conditions.  It’s important to know the tax consequences when engaging in those transactions.

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

Thursday, February 3, 2022

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

Overview

With today’s article, I conclude my journey through the big developments of 2021 that didn’t make my “Top 10” list.  In Part 7 today, I look at two cases that are presently before the U.S. Supreme Court.  One case involves a state’s right to take tort recoveries from Medicaid beneficiaries.  The other case addresses whether courts can excuse a missed statutory income tax filing deadline.  Both of these issues are important – one for Medicaid planning, and asset protection strategies; the other case might be critical for determining when principles of fairness might apply when an income tax deadline is missed.   

The conclusion of the “Almost Top Ten” of 2021 – it’s the topic of today’s post.

State Medicaid Recovery

Gallardo v. Marstiller, 963 F.3d 1167 (11th Cir. 2020), cert. granted sub nom., Gallardo v. Dudek, 141 S. Ct. 2884 (2021)

Background

Planning for long-term health care needs is a recommended part of estate planning for many people.  This is particularly true for farm and ranch (and other small) businesses where the desire is to transition the business into subsequent generations of the family.  Without a plan in place, spending $100,000 annually on a long-term care bill could cause a business succession plan or family estate planning goals to not be met as desired.  Medicaid planning is part of long-term care planning. 

Medicaid is the joint federal/state program that is the primary public assistance available to help pay for long-term care – if the beneficiary has little to no “available” assets.  In addition, once a state provides Medicaid benefits to a beneficiary, the state can seek reimbursement (“recovery”) from the beneficiary’s estate upon death to a certain extent for benefits paid during life.  That is designed to protect, at least in part, the taxpaying public.  A state may also obtain reimbursement from third parties for Medicaid expenses paid to injured beneficiaries.  But, to what extent?  That’s the issue that is presently before the U.S. Supreme Court.

In Gallardo, the plaintiff was severely injured in 2008 after being hit by a pickup truck when she got off a school bus.  She still remains in a persistent vegetative state.  The state (Florida) Medicaid program (e.g., Florida taxpayers) paid $862,688.77 for her medical care.  Her parents sued the truck driver and the school district which resulted in a settlement of $800,000.  Of that amount, $35,367.52 was designated as being for past medical expenses.  None of it was designated as being for future medical expenses.  The state Medicaid agency neither participated in or agreed to the settlement terms, but 42 U.S.C. §1396k(a)(1)(A) requires the state Medicaid program to be reimbursed from any third party because Medicaid is to be a “payor of last resort” for medically necessary goods and services provided to a recipient.  Indeed, state law provides for a superior lien with respect to third-party benefits regardless of whether the Medicaid beneficiary has been made whole or other creditors have been paid.  Fla. Stat. §409.910(1).  But, the state’s recovery is not to be in excess of the amount of medical assistance paid by Medicaid.  42 U.S.C. §1396a(a)(25)(H).  Under Florida’s formula, in the event of a beneficiary’s tort recovery, the state gets 50 percent of the recovery (after fees and costs) up to the total amount provided in medical assistance by Medicaid.  Thus, the state asserted a lien for $862,688.77 on the tort action and any future settlement – even though the settlement specified that $35,367.52 was for past medical expenses.  During an administrative hearing, the state claimed entitlement to the amounts it paid to the beneficiary from the portion of the settlement representing compensation for the plaintiff’s future medical expenses.  The plaintiff sued for a declaration that, under federal law, the state couldn’t be reimbursed from any part of the settlement other than that representing compensation for past medical expenses - $35,367.52.  The trial court granted the plaintiff’s motion for summary judgment, finding that state law was preempted by federal law.   The state Medicaid agency appealed. 

Note:  During the pendency of the appeal, the Florida Supreme Court held in a different case that state federal law authorizes the state to be reimbursed out of personal injury settlements only from the portion representing past medical expenses.  Giraldo v. Agency for Health Care Administration, 248 So. 3d 53 (Fla. 2018). 

The appellate court reversed, determining that federal law does not preempt state law permitting a state Medicaid agency to seek reimbursement from portions of a settlement that represent all future medical care (as well as past), and that the parties’ allocation to past and future medical care didn’t bind the state agency.  This was particularly the case, the appellate court noted, because the parties to the settlement did not seek the state Medicaid agency’s input on the settlement allocation.  Indeed, the appellate court determined that federal Medicaid law merely bars a state from attaching its lien against any part of a settlement that is not designated as payments for medical care (to the extent of Medicaid benefits provided).  The appellate court also upheld the state’s reimbursement formula. 

Conclusion

The U.S. Supreme Court agreed to hear the case, and oral argument was held in early January of 2022.  It will be interesting to see how the Court decides the case.  Certainly, however the Court decides will potentially “tee-up” the issue for state legislatures to address how their respective state Medicaid recovery statutes are worded and what policy is desired when third-party payments to Medicaid beneficiaries are involved.

Missed Tax Deadline

Boechler, P.C. v. Commissioner, 967 F.3d 760 (8th Cir. 2000), cert. granted, 142 S. Ct. 55 (2021)

Background

In 2015, the IRS notified the plaintiff (a law firm) about the failure to file employee tax withholding forms.  The plaintiff didn’t respond, and the IRS imposed a 10 percent intentional disregard penalty of $19,250.  The plaintiff challenged the penalty in a Collection Due Process (CDP) hearing, which resulted in the penalty being imposed, with interest.  On July 28, 2017, the IRS Office of Appeals mailed its CDP hearing determination to sustain the proposed levy on the plaintiff’s property to collect the penalty plus interest.  That plaintiff received the notice on July 31, 2017, which informed the plaintiff that the deadline for submitting a petition for another CDP hearing was 30 days from the date of determination – August 28, 2017.  As an alternative, the plaintiff could petition the Tax Court to review the determination of the IRS Office of Appeals.  But, again, the statutory time frame for seeking Tax Court review involved filing a petition with the Tax Court within 30 days of the determination.  I.R.C. §6330(d)(1).  The plaintiff filed its petition with the Tax Court on August 29, 2017 – one day late.  Accordingly, the IRS moved to dismiss the plaintiff’s petition on the grounds that the Tax Court lacked jurisdiction.  The plaintiff, however, claimed that the statute was not jurisdictional (even though the statute says “(and the Tax Court shall have jurisdiction with respect to such matter).”  Instead, the plaintiff claimed that the filing deadline was subject to “equitable tolling” and that the 30-day deadline should be computed from the date the notice was received.  The Tax Court disagreed with the plaintiff and issued an order dismissing the case for lack of jurisdiction – I.R.C. §6330(d)(1) was jurisdictional. 

Note: When equitable tolling is applied, a court has the discretion to ignore a statue of limitations and allow a claim if the plaintiff did not or could not discover the “injury” until after the expiration of the limitations period, despite due diligence on the plaintiff’s part.   

Appellate Decision

The plaintiff appealed.  The appellate court pointed out that a statutory time limit is generally jurisdictional when the Congress clearly states that it is and noted that the Ninth Circuit had recently held that the statute was jurisdictional.  Duggan v. Comr., 879 F.3d 1029 (9th Cir. 2018).  The appellate court went on to state that the “statutory text of §6330(d)(1) is a rare instance where Congress clearly expressed its intent to make the filing deadline jurisdictional.”   On the plaintiff’s claim that pegging the 30-day timeframe to the date of determination was a Due Process or Equal Protection violation, the appellate court disagreed.  The appellate court, on this issue, noted that the plaintiff bore the burden to establish that the filing deadline is arbitrary and irrational.  Ultimately, the appellate court determined that the IRS had a rational basis for starting the clock on the 30-day timeframe from the date of determination because it streamlines and simplifies enforcement of the tax code.  Measuring the 30 days from the date of receipt, the appellate court pointed out, would cause the IRS to be unable to levy at the statutory uniform time and, using the determination date as the measuring stick safeguards against a taxpayer refusing to accept delivery of the notice as well as supports efficient tax enforcement.   

U.S. Supreme Court

The U.S. Supreme Court, on September 30, 2021, agreed to hear the case. Both the plaintiff and the IRS are focused on test for equitable tolling set forth in United States v. Kwai Fun Wong, 575 U.S. 402 (2015).  That case involved 28 U.S.C. §2401(b), a statute that establishes the timeframe for bring a tort claim against the United States.  There a slim 5-4 majority held that a rebuttable presumption of equitable tolling applied.  The presumption can be rebutted if the statute shows that the Congress “plainly” gave the time limits “jurisdictional consequences.”  In that instance, time limits would be jurisdictional and not subject to equitable tolling.   

The beef comes down to how to read the statute.  The statute at issue, I.R.C. §6330(d)(1) states in full:

“(1) PETITION FOR REVIEW BY TAX COURT

The person may, within 30 days of a determination under this section, petition the Tax Court for review of such determination (and the Tax Court shall have jurisdiction with respect to such matter).”

The IRS asserts that “such matter” refers to the petition that has been filed with the Tax Court that meets the 30-day deadline.  This is the view that the appellate court adopted as did the Ninth Circuit in Duggan.  However, the plaintiff claims that “such matter” refers to “such determination” and, in turn, “determination under this section” with no additional jurisdictional requirement involving timely filing.  According to this view, the Tax Court’s jurisdiction is not limited to IRS determinations for which a petition is filed with the Tax Court within 30 days.  As such, equitable tolling can apply.  Indeed, this is the view that the D.C. Circuit utilized in Myers v. Commissioner, 928 F.3d 1025 (D.C. Cir. 2019) in a case involving a whistleblower tax statute that is similarly worded. 

Conclusion

It will be interesting to see how the Court interprets the statute.  Clearly, based on the facts, equitable tolling should not apply.  The plaintiff negligently didn’t respond to the notice, negligently missed the filing deadline and then came up with a creative argument to try to bail itself out of a bad result created by that negligence.  No colorable argument can be made that the plaintiff was confused about the deadline.  Clearly, if the Court allows for equitable tolling in this case, given the facts of the case, there will be an increase in cases that argue for equitable tolling to be applied. 

However, the Congress did create an unclear antecedent in the statue.  Maybe that’s not as bad as a dangling participle, but the poor drafting has landed a case in the Supreme Court’s lap. 

This concludes my journey through the “Almost Top 10” of 2021.  Now back to “regular programming.”

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

Tuesday, January 25, 2022

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

Overview

Today’s article is the fourth in a series discussing what I view of significant developments in 2021 that weren’t quite big enough to make my “Top Ten” list.  This time I discuss for tax four tax developments that occurred in 2021 that weren’t quite big enough to make the “Top Ten.”

More significant developments of 2021 in ag law and tax – it’s the topic of today’s post.

Estate Tax Closing Letter Doesn’t Preclude Later Exam of Form 706

C.C.A. 202142010 (Apr. 1, 2021)

IRS Letter 627, an estate tax return closing letter, is issued to an estate and specifies the amount of the net estate tax, the state death tax credit or deduction, and any generation transfer tax for which an estate is liable. The position of the IRS, however, is that the letter is not a formal closing agreement.  Thus, the issuance of the letter does not bar the IRS from reopening or reexamining the estate tax return to determine estate tax liability if:  (1) there is evidence of fraud, malfeasance, collusion, concealment or misrepresentation of a material fact; (2) there is a clearly defined, substantial error based on an established IRS position; or (3) another circumstance indicating that a failure to reopen the case would be a serious administrative omission. Thus, when the IRS issues Letter 627 after accepting the return as filed, the issuance does not constitute an examination and IRS may later examine Form 706 associated with the estate that received the letter. 

IRS Supervisor Review - “Immediate Supervisor” is Person Who Actually Supervised Exam

Sand Investment Co., LLC v. Comr., 157 T.C. No. 11 (2021)

Under the Internal Revenue Code (Code), an IRS examining agent must obtain written supervisory approval to the agent’s determination to assess a penalty on any asserted tax deficiency. Under I.R.C. §6751(b)(1), the approval must be from the agent’s “immediate supervisor” before the penalty determination if “officially communicated” to the taxpayer. In a partnership audit case under the 1982 Tax Equity and Fiscal Responsibility Act (TEFRA), supervisory approval generally must be obtained before the Final Partnership Administrative Adjustment (FPAA) is issued to the partnership. See, e.g., Palmolive Building Investors, LLC v. Comr., 152 T.C. 75 (2019). If an examiner obtains written supervisory approval before the FPAA was issues, the partnership must establish that the approval was untimely. See, e.g., Frost v. Comr., 154 T.C. 23 (2020). 

In this case, the IRS opened a TEFRA examination of the petitioner’s 2015 return. The IRS auditor’s review was supervised by a team manager. While the audit was ongoing, the agent was promoted and transferred to a different team, but continued handling the audit still under the supervision of the former team manager. Ultimately, the agent asserted an accuracy-related penalty against the petitioner and the former team manager signed the approval form. The next day, the auditor sent the petitioner several documents indicating that a penalty might be imposed. Two days later the new team manager also signed the auditor’s penalty approval form. The petitioner challenged the imposition of penalties because the new team manager hadn’t approved the penalty assessment before the auditor sent the penalty determination to the petitioner. The Tax Court held that the supervisor who actually oversaw the agent’s audit of the petitioner was the “immediate supervisor” for purposes of the written supervisory approval requirement of I.R.C. §6751(b)(1). There was no evidence that the new team manager had any authority to supervise the agent’s audit of the petitioner. 

Meal Portion of Per Diem Allowance Eligible to be Treated As Attributed to a Restaurant. 

IRS Notice 2021-63, 2021-49 IRB 835

Under I.R.C. §274(n)(1) and Treas. Reg. §1.274-12, a deduction of any expense for food or beverages generally is limited to 50 percent of the amount otherwise deductible (i.e., as an ordinary and necessary business expense that is not lavish or extravagant under the circumstances). However, the Consolidated Appropriations Act, 2021, provides that that the full cost of such an expense is deductible if incurred after Dec. 31, 2020, and before Jan. 1, 2023, for food or beverages "provided by a restaurant." Meals obtained from a grocery or convenience store do not qualify.  The IRS, with this notice, specified that a taxpayer may treat the meal portion of a per diem rate or allowance paid or incurred after Dec. 31, 2020, and before Jan. 1, 2023, for meals purchased while traveling away from home as being attributable to food or beverages provided by a restaurant. 

Note:   The Notice is effective for expenses incurred by an employer, self-employed individual or employees described in I.R.C. §62(a)(2)(B) through (E) after December 31, 2020, and before January 1, 2023.

Credit Card Reward Dollars May Be Taxable

Anikeev, et ux. v. Comr., T.C. Memo. 2021-23

The petitioners, husband and wife, spent over $6 million on their “Blue Cash” American Express credit cards (“Blue Card”) from 2013 to 2014.  They used their Blue Cards to accumulate as many reward points as possible, which they did by using the cards to buy Visa gift cards, money orders or prepaid debit card reloads that they later used to pay the credit card bill. The credit card earned then five percent cash back on certain purchases after spending in $6,500 in a single calendar year. Before purchases were sufficient for them to reach the five percent level, the card earned one percent cash back on certain purchases. Rewards were issued in the form of “rewards dollars” that could be redeemed for gift cards and statement credits.

In 2013, the petitioners charged over $1.2 million for the purchase of Visa gift cards, reloadable debit cards and money orders.  In 2014 they charged over $5.2 million primarily for the purchase of Visa gift cards.  They then used the Visa gift cards to buy money orders which they used to pay the American Express bills. 

They redeemed $36,200 in rewards dollars from the card as statement credits in 2013 and $277,275 in 2014. The petitioners did not report these amounts as income for either year. The IRS audited and took the position that the earnings should have been reported as “other income.” The petitioners claimed that when a payment is made by a seller to a customer, it’s generally seen as a “price adjustment to the basis of the property” – the “rebate rule.” Rev. Rul. 79-96, 1976-1 C.B. 23.  Under this rule, a purchase incentive is not treated as income. Instead, the incentive is treated as a reduction of the purchase price (and associated reduction of basis) of what is purchased with the rewards or points. Thus, points and cashback earned on spending are viewed as a price adjustment. The petitioners, citing this rule, pointed out that the “manner of purchase of something…does not constitute an accession of wealth. The IRS, conversely, asserted that the rewards were taxable upon receipt because the petitioners did not purchase goods or services for which a rebate or purchase price adjustment could be applied.  Instead, the IRS claimed that the petitioners purchased cash equivalents – Visa gift cards; reloadable debit cards; and money orders.  See, e.g., Tech. Adv. Memo. 200437030 (Apr. 30, 2004).  As cash equivalents, the rewards paid to the petitioners as statement credits were an accession to wealth and, thus, gross income under I.R.C. §61. 

The Tax Court agreed that gift cards were a “product” – they couldn’t be redeemed for cash and were not eligible for deposit into a bank account.  Likewise, the Tax Court determined that that Visa gift cards provided a service to the petitioners via a product stating that, “[p]roviding a substitute for a credit card is a service via a product which is commonly sold via displays at drug stores and grocery stores.”  Thus, the portion of their reward dollars associated with gift card purchases weren't taxable under the “rebate rule.”  However, the Tax Court held that the petitioners’ direct purchases of money orders and reloads of cash into the debit cards using their credit card was different in that the petitioners were buying “cash equivalents” rather than a rebate on a purchase. They were not a product subject to a price adjustment and were not used to obtain a product or service. Because there was no product or service obtained in connection with direct money order purchases and cash reloads, the reward dollars associated with those purchases were for cash infusions.

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

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

January 25, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Thursday, January 13, 2022

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

Overview

The time has come to “unveil” the two biggest two developments in agricultural law and taxation for 2021.  As I have been pointing out in the previous articles in this series, agricultural law and agricultural tax law intersect with everyday life of farmers and ranchers in many ways.  Some of those areas of intersection are good, but some are quite troubling.  In any event, it points to the need for being educated and having good legal and tax counsel that is well-trained in the special rules that apply to agriculture.

This is the fifth and final installment in my list of the “Top Ten” agricultural law and tax developments of 2021.  The list is comprised of what are, in my view, the most important developments in agricultural law (which includes taxation that impacts farmers and ranchers) to the sector as a whole.  The developments primarily are focused on the impact to production agriculture, but the issues involved will also have effects that spillover to rural landowners and agribusinesses as well as consumers of agricultural products.

The Second and First most important agricultural law and tax developments of 2021 – it’s the topic of today’s post.

2.    Developments Involving “Waters of the United States” (WOTUS).

Background.  The scope of the federal government’s regulatory authority over wet areas on private land, streams and rivers under the Clean Water Act (CWA) has been controversial for more than 40 years. Many court opinions have been filed attempting to define the scope of the government’s jurisdiction.  On two occasions, the U.S. Supreme Court attempted to clarify the 1986 regulatory definition of a WOTUS, but in the process of rejecting the regulatory definitions of a WOTUS developed by the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COE), the Court didn’t provide clear direction for the lower courts.  See Solid Waste Agency of Northern Cook County v. United States Army Corps of Engineers, 531 U.S. 159 (2001); Rapanos v. United States, 547 U.S. 175 (2006).  The lower courts have also had immense difficulties in applying the standards set forth by the U.S. Supreme Court. 

Particularly with its Rapanos decision, the Court failed to clarify the meaning of the CWA phrase “waters of the United States” and the scope of federal regulation of isolated wetlands. The Court did not render a majority opinion in Rapanos, instead issuing a total of five separate opinions. The plurality opinion, written by Justice Scalia and joined by Justices Thomas, Alito and Chief Justice Roberts, would have construed the phrase “waters of the United States” to include only those relatively permanent, standing or continuously flowing bodies of water that are ordinarily described as “streams,” “oceans,” and “lakes.”  In addition, the plurality opinion also held that a wetland may not be considered “adjacent to” remote “waters of the United States” based merely on a hydrological connection. Thus, in the plurality’s view, only those wetlands with a continuous surface connection to bodies that are “waters of the United States” in their own right, so that there is no clear demarcation between the two, are “adjacent” to such waters and covered by permit requirement of Section 404 of the CWA.

Justice Kennedy authored a concurring opinion, but on much narrower grounds.  In Justice Kennedy’s view, the lower court correctly recognized that a water or wetland constitutes “navigable waters” under the CWA if it possesses a significant nexus to waters that are navigable in fact or that could reasonably be so made. But, in Justice Kennedy’s view, the lower court failed to consider all of the factors necessary to determine that the lands in question had, or did not have, the requisite nexus. Without more specific regulations comporting with the Court’s 2001 SWANCC opinion, Justice Kennedy stated that the COE needed to establish a significant nexus on a case-by-case basis when seeking to regulate wetlands based on adjacency to non-navigable tributaries, in order to avoid unreasonable application of the CWA. In Justice Kennedy’s view, the record in the cases contained evidence pointing to a possible significant nexus, but neither the COE nor the lower court established a significant nexus. As a result, Justice Kennedy concurred that the lower court opinions should be vacated, and the cases remanded for further proceedings.

Justice Kennedy’s opinion was neither a clear victory for the landowners in the cases or the COE. While he rejected the plurality’s narrow reading of the phrase “waters of the United States,” he also rejected the government’s broad interpretation of the phrase. While the “significant nexus” test of the Court’s 2001 SWANCC opinion required regulated parcels to be “inseparably bound up with the ‘waters’ of the United States,” Justice Kennedy would require the nexus to “be assessed in terms of the statute’s goals and purposes” in accordance with the Court’s 1985 opinion in United States v. Riverside Bayview Homes. 474 U.S. 121 (1985). 

The “Clean Water Rule.”  The Obama Administration attempted take advantage of the lack of clear guidance on the scope of federally jurisdictional wetland by issuing an expansive WOTUS rule.  The EPA/COE regulation was deeply opposed by the farming/ranching and rural landowning communities, and triggered many legal challenges.   The courts were, in general, highly critical of the regulation, invalidating it in 28 states by 2019. The CWR became a primary target of the Trump Administration.

The “NWPR Rule.”  The Trump Administration essentially rescinded the Obama-era rule and replaced it with its own rule – the “Navigable Waters Protection Rule” (NWPR). 85 Fed. Reg. 22, 250 (Apr. 21, 2020).  The NWPR redefined the Obama-era WOTUS rule to include only: “traditional navigable waters; perennial and intermittent tributaries that contribute surface water flow to such waters; certain lakes, ponds, and impoundments of jurisdictional waters; and wetlands adjacent to other jurisdictional waters.  In short, the NWPR narrowed the definition of the statutory phrase “waters of the United States” to comport with Justice Scalia’s approach in Rapanos.  Thus, the NWPR excluded from CWA jurisdiction wetlands that have no “continuous surface connection” to jurisdictional waters.  The rule much more closely followed the Supreme Court’s guidance issued in 2001 and 2006 that did the Obama-era rule, but it was challenged by environmental groups.  Indeed, the NWPR has been challenged in 15 cases filed in 11 federal district courts.  

2021 developments.  In early 2021, the U.S. Court of Appeals for the Tenth Circuit reversed a Colorado trial court that had entered a preliminary injunction barring the NWPR from taking effect in Colorado as applied to the discharge permit requirement of Section 404 of the CWA.  The result of the appellate court’s decision is that the NWPR became effective in every state.  Colorado v. United States Environmental Protection Agency, 989 F.3d 874 (10th Cir. 2021). 

A primary aspect of the litigation involving the NWPR is whether it should apply retroactively or whether it is limited in its application on a prospective basis.  For example, in United States v. Lucero, 989 F.2d 1088 (9th Cir. 2021), the defendant, in 2014, operated a business that charged construction companies for the dumping of soil and debris on dry lands near San Francisco Bay. The Environmental Protection Agency (EPA) later claimed that the dry land was a “wetland” subject to the dredge and fill permit requirements of Section 404 of the Clean Water Act (CWA). As a result, the defendant was charged with (and later convicted of) violating the CWA without any evidence in the record that the defendant knew or had reason to know that the dry land was a wetland subject to the CWA.

On further review, the appellate court noted that the CWA prohibits the “knowing” discharge of a pollutant into covered waters without a permit. At trial, the jury instructions did not state that the defendant had to make a “knowing” violation of the CWA to be found guilty of a discharge violation. Accordingly, the appellate court reversed on this point. However, the appellate court ruled against the defendant on his claim that the regulation defining “waters of the United States” was unconstitutionally vague, and that the 2020 Navigable Waters Protection Rule should apply retroactively to his case. 

The NWPR was also held to apply prospectively only in United States v. Acquest Transit, LLC, No. 09-cv-555, 2021 U.S. Dist. LEXIS 40143 (W.D. N.Y. Mar. 3, 2021) and United States v. Mashni, No. 2:18-cv-2288-DCN, 2021 U.S. Dist. LEXIS 123345 (S.D. S.C. Jul. 1, 2021). 

Most recently, a federal district court in South Carolina remanded the NWPR to the EPA. South Carolina Coastal Conservation League, et al. v. Regan, No. 2:20-cv-016787-BHH, 2021 U.S. Dist. LEXIS 132031 (D. S.C. Jul. 15, 2021).  The NWPR was being challenged on the scope issue.  Even though the NWPR was remanded, the court left the rule intact.  That fit with the strategy of present Administration.  If the court had invalidated the NWPR, then the Administration would have had to defend the Obama-era rule in court.  By not vacating the NWPR allows the current administration to proceed in trying to write a new rule without bothering to defend the Obama-era rule in court.

In Pasqua Yaqui Tribe v. United States Environmental Protection Agency, No. CV-20-TUC-RM, 2021 U.S. Dist. LEXIS 163921 (D. Ariz. Aug. 30, 2021). the court vacated the NWPR.  The court’s order did not specify the scope of the vacatur, but the EPA and the COE soon announced that neither agency would implement the NWPR on a nationwide basis, and will rely on the pre-2015 regulatory definition of a WOTUS until a new rule is developed.  This all means that projects that have already received a CWA permit based on the NWPR can continue to rely on the permit until it expires.  If a project has received an approved jurisdictional determination based on the NWPR may rely on it for five years from the date of issuance regardless of whether the project has already received a CWA permit based on the jurisdictional determination.  For projects that have received a preliminary jurisdictional determination after the date of the court’s opinion may continue to rely on it. 

New proposed rule.  On December 7, 2021, the EPA and the COE published a proposed rule redefining a WOTUS in accordance with the pre-2015 definition of the term. 86 FR 69372 (Dec. 7, 2021).  Under the proposed rule, EPA states its intention to define a WOTUS in accordance with the 1986 regulations as further defined by the courts since that time. In addition, the proposed rule would base the existence of a WOTUS on the “significant nexus” standard set forth in prior Supreme Court decisions. As such, a WOTUS would include traditional navigable waters; territorial seas and adjacent wetlands; most impoundments of a WOTUS and wetlands adjacent to impoundments or tributaries that meet either the relatively permanent standard or the significant nexus standard; all waters that are currently used or were used in the past or may be susceptible to use in interstate or foreign commerce, including all waters that are subject to the ebb and flow of the tide. The proposed rule defines “interstate waters” as “all rivers, lakes, and other waters that flow across, or form a part of State boundaries” regardless of whether those waters are also traditionally navigable. A “tributary” is also defined as being a WOTUS if it fits in the “other waters” category via a significant nexus with covered waters or if it is relatively permanent. The EPA and COE further define the “relatively permanent standard” as “waters that are relatively permanent, standing or continuously flowing and waters with a continuous surface connection to such waters.” The “significant nexus standard” is defined as “waters that either alone or in combination with similarly situated waters in the region, significantly affect the chemical, physical, or biological integrity of traditional navigable waters, interstate waters, or the territorial seas (the "foundational waters").” The comment period on the proposed rule expires on February 7, 2022. 

Related WOTUS issue.  During 2021 another significant case with WOTUS-related issues continued to wind its way through the court system.  In Sackett v. Environmental Protection Agency, 8 F.4th 1075 (9th Cir. 2021), the plaintiffs bought a .63-acre lot in 2004 on which they intended to build a home. The lot is near numerous wetlands the water from which flows from a tributary to a creek, and eventually runs into a lake approximately 100 yards from the lot. The lake is 19 miles long and is a WOTUS subject to the CWA which bars the discharge of a pollutant, including rocks and sand into it. The plaintiffs began construction of their home, and the EPA issued a compliance order notifying the plaintiffs that their lot contained wetlands due to adjacency to the lake and that continuing to backfill sand and gravel on the lot would trigger penalties of $40,000 per day. The plaintiff sued and the EPA claimed that its administrative orders weren’t subject to judicial review. Ultimately the U.S. Supreme Court unanimously rejected the EPA’s argument and remanded the case to the trial court for further proceedings. The EPA withdrew the initial compliance order and issued an amended compliance order which the trial court held was not arbitrary or capricious. The plaintiffs appealed and the EPA declined to enforce the order, withdrew it and moved to dismiss the case. However, the EPA still maintained the lot was a jurisdictional wetland subject to the CWA and reserved the right to bring enforcement actions in the future. In 2019, the plaintiffs resisted the EPA’s motion and sought a ruling on the motion to bring finality to the matter. The EPA claimed that the case was moot, but the appellate court disagreed, noting that the withdrawal of the compliance order did not give the plaintiffs final and full relief. On the merits, the appellate court noted that the lot contained wetlands 30 feet from the tributary, and that under the “significant nexus” test of Rapanos v. United States, 547 U.S. 715 (2006), the lot was a regulable wetland under the CWA as being adjacent to a navigable water of the United States (the lake). 

Note:  On September 22, 2021, the plaintiffs filed a petition with the U.S. Supreme court asking the Court to review the case.  The Supreme Court set January 14, 2022, as the conference date to determine whether it will accept the case for review and decision.

Update:  On January 24, 2022, the U.S. Supreme Court granted certiorari. The Court will be deciding whether the Ninth Circuit used the proper test to decide whether the wetlands at issue are “waters of the United States” for purposes of the CWA.  The Sacketts are asking the Court to use the four-justice plurality in Rapanos v. United States, 547 U.S. 175 (2006).  Under that test, wetlands are only subject to the CWA when they have a continuous surface water connection to regulated waters. 

1.    The Failure of “Build Back Better” to Become Law.

Without doubt, the biggest development of 2021 was the failure of H.R. 5376, known as “Build Back Better” (BBB) to become law. The BBB would have also been the biggest development had it also become law.  There are numerous provisions in the BBB that would have impacted farmers and ranchers significantly.  While the bill did pass the U.S. House on November 19, the version that passed was a “slimmed-down” version that did not contain many of the more onerous (as viewed by agriculture) provisions that were originally included.  The Senate failed to take up the legislation before the end of 2021.

The following are some of the more significant provisions that were originally included in H.R. 5376 that didn’t make it into the House passed version:

  • Increase in corporate tax rate to 26.5 percent;
  • Modifications to the “stepped-up” basis rule at death;
  • Increase in top individual marginal rate to 39.6 percent;
  • A phase-out or elimination of the 20 percent qualified business income deduction;
  • Increase in top capital gain rate to 25%;
  • Reduction in the federal estate/gift tax unified credit exemption equivalent;
  • Change in the grantor trust rules;
  • Change in the present interest annual exclusion rule;
  • Increase in the top federal estate/gift tax marginal rate;
  • Valuation discounting rules; and
  • Increase in value reduction for land in decedent’s estate under Sec. 2032A

But, there remained certain provisions in H.R. 5376 of relevance to agricultural producers.  Those include the following:

  • An increase in the state and local tax deduction (SALT) from the present $10,000 amount to $80,000 (MFJ);
  • A surcharge on high income earners;
  • Expansion of the NIIT (3.8 percent) to trade or business income for taxpayers with taxable income exceeding $400,000 (single); $500,000 (MFJ), and application of the NIIT to trade or business income of estates/trusts;
  • Limit on contributions to traditional or Roth IRAs for persons with combined IRA and defined contribution account balances exceeding $10 million and adjusted taxable income exceeds the $400,000/$500,000 thresholds; required distributions for accounts where owner has combined values exceeding $10 million; no “backdoor” Roths;
  • Expansion of Medicare to cover dental, hearing and vision care;
  • No oil and gas drilling on non-wilderness portion or ANWR; and
  • Moratorium on offshore oil and gas leasing in Eastern Gulf of Mexico, Atlantic and Pacific federal waters.

Going forward into 2022, Democrats are expected to make efforts to advance their priorities in a filibuster-proof reconciliation bill containing the White House economic recovery “blueprint.”  Disputes over the structure of several tax incentives remain at the center of bicameral talks aimed at clearing the way for the Senate to pass and the House to clear a revised version of H.R. 5376.  The House appears to be focused on implementing H.R. 5376 and salvaging parts of it if the bill does not pass the Senate in the same form it passed the House.  Democrats also are pushing to double the current IRS budget and are pitching the move as a revenue raiser by virtue of increased revenue from audits. 

On the other side of the aisle, Republicans are pushing to make the point that temporary tax breaks followed by extensions would further fuel already high inflation and add to the deficit.  Senate Republicans appear to be focused on keeping the corporate tax rate at 21 percent, the top individual rate at 37 percent and top capital gains rate at 20 percent. 

As of today, there is no clear sign about how a deal will be cut on a fiscal 2022 omnibus spending deal before the February 18 expiration of the current stopgap spending law.  There is no current ongoing negotiation with respect to H.R. 5376,  Another issue for 2022 is what the Congress might do with respect to extending tax provisions that have currently expired.  There are about two dozen provisions that expired at the end of 2021.  Perhaps there will be a push for a separate extender bill for renewal of popular provisions such as a tax break for mortgage insurance premiums, the ($300/$600) above-the-line deduction for charitable deductions, and an increase to age 75 for the start of required minimum distributions from retirement plans.

Conclusion

So there you have it - five articles discussing the ten biggest developments in agricultural law and taxation for 2021.  What else was the law concerned with involving agriculture in 2021 that didn’t make the “Top Ten” list?  Next, I will start looking at those issues.

January 13, 2022 in Environmental Law, Income Tax | Permalink | Comments (0)

Tuesday, January 4, 2022

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

Overview

As I pointed out in Sunday’s article, agricultural law and agricultural tax law intersect with everyday life of farmers and ranchers in many ways.  Some of those areas of intersection are good, but some are quite troubling.  In any event, it points to the need for being educated and having good legal and tax counsel that is well-trained in the special rules that apply to agriculture.

This is the second installment in my list of the “Top Ten” agricultural law and tax developments of 2021.  The list is comprised of what are, in my view, the most important developments in agricultural law (which includes taxation that impacts farmers and ranchers) to the sector as a whole.  The developments primarily are focused on the impact to production agriculture, but the issues involved will also have effects that spillover to rural landowners and agribusinesses as well as consumers of agricultural products.

The Eighth and Seventh most important agricultural law and tax developments of 2021 – it’s the topic of today’s post.

8.  Ag Nuisance Litigation in North Carolina.  In recent years, North Carolina has been the focus of much ag nuisance litigation, particularly targeted at large-scale hog confinement operations.  Legal developments flowing from the various cases has influenced the North Carolina legislature as well as legislatures in other states (such as Florida and Indiana) to modify their Right-To-Farm (RTF) laws in an attempt to provide greater legal protection to agricultural operations.  In 2021, there were further developments in North Carolina involving nuisance and that state’s RTF law.

The North Carolina RTF law was originally enacted in 1979 with the state policy goal to: "[R]educe the loss to the State of its agricultural and forestry resources by limiting the circumstances under which an agricultural or forestry operation may be deemed a nuisance." After many nuisance suits were filed against confinement hog operations, the legislature amended the RTF in 2013. The amendment specified that an ag operation that has been in business for at least a year and has not fundamentally changed is protected from a nuisance action as a result of changed conditions surrounding it if the ag operation was not a nuisance at the time it began. The plaintiffs refiled their suits in 2014 in federal district court based on the amended law. The federal court held that the RTF law did not apply to shield hog producers and five juries rendered verdicts for the plaintiffs. The legislature again amended the RTF law in 2017 and 2018 to expand its protection for agricultural operations.

There were two additional court opinions in 2021 involving the North Carolina RTF law.  In Barden v. Murphy-Brown, LLC, No. 7:20-CV-85-BR, 2021 U.S. Dist. LEXIS 47809 (E.D. N.C. Mar. 15, 2021), the plaintiff sued the defendant in 2020 for trespass, negligence, civil conspiracy and unjust enrichment arising from odor, dust, feces, urine and flies from a neighboring hog facility that housed 20,000-head of the defendant’s hogs. The plaintiff sought compensatory and punitive damages. The defendant sought to dismiss the complaint for failure to join to the lawsuit the farmer that operated the hog facility via a contact with the defendant as an indispensable party. The court disagreed, as the farmer’s conduct was likely irrelevant to the outcome of the litigation and any impact that an adverse judgment against the defendant might have on the farmer’s interests at the farm was speculative. The defendant also sought dismissal on the basis that the plaintiff’s complaint failed to state a claim for relief that was other than speculative. The defendant cited the North Carolina RTF law as barring all of the plaintiff’s claims.

The federal trial court disagreed with the defendant, noting that conditions constituting a nuisance can also constitute a trespass (and other causes of action). Thus, the plaintiff’s complaint was not restricted to allegations of a nuisance cause of action which the RTF law would bar. The court noted that the RTF law was different from other state RTF laws that covered non-nuisance tort claims related to farming operations along with nuisance claims. The RTF law only covered nuisance-related claims and had no application to non-nuisance claims. As to whether the plaintiff adequately alleged the non-nuisance claims, the court concluded that the plaintiff sufficiently alleged, at a minimum, a claim for unintentional trespass by not consenting to dust, urine and fecal matter from entering its property. On the plaintiff’s negligence claim, the court determined that it was reasonably foreseeable that if the defendant did not act reasonably in managing the facility that dust and animal waste would be present on the plaintiff’s property. As such, the defendant owed the plaintiff a duty and there was a causal link with any potential breach of that duty. Thus, the plaintiff properly stated a claim for negligence. The plaintiff also alleged that the defendant conspired with its corporate parent to mislead the public about the science of hog manure removal and various constitutional violations. The court rejected this claim because any conspiracy was between the defendant and its corporate parent and not with any independent party. The plaintiff also claimed that the defendant unjustly enriched itself by using the plaintiff’s property for a de facto easement without paying for it. The court rejected the claim because the plaintiff had conferred no benefit on the plaintiff which gave rise to any legal or equitable obligation on the defendant’s part to account for the benefit received. However, the court refused to strike the plaintiff’s allegations relating to the defendant’s Chinese ownership, influence and exploitation as well as the defendant’s financial resources. The court determined that such allegations had a bearing on the defendant’s motivation, extent of harm and ability to implement alternative technology. 

A second court opinion involving the North Carolina RTF law was issued in late 2021.  In Rural Empowerment Association for Community Help v. State, No. COA21-175, 2021 N.C. App. LEXIS 733 (N.C. Ct. App. Dec. 21, 2021), the plaintiffs filed suit in 2019 challenging the constitutionality of the RTF law. The plaintiffs sued in 2019 challenging the constitutionality of the RTF law on its face because they claimed the law exceeded the scope of the state’s police power. The defendants moved to dismiss the case and the trial court granted the defendant's motion to dismiss and denied the plaintiffs’ motion for summary judgment. On appeal, the appellate court affirmed. The state appellate court agreed with the trial court that limiting the potential nuisance liability from ag, forestry, and related operations furthered the state’s goal of protecting ag activities and encouraging the availability and continued production of agricultural products. The appellate court also determined that the RTF law amendments were a valid exercise of legislative and state police powers and did not violate the state Constitution’s Law of the Land Clause or the Due Process Clause. The appellate court also determined that the amendments were not a special or private law, and didn’t deprive any prospective plaintiff of the right to a jury trial. 

Note:   It is anticipated that the state appellate court opinion, if upheld on any appeal, will provide further guidance to other states and RTF laws. 

7.  Federal Court Determines Whether Withheld Taxes and Other Pre-Paid Taxes Can Be Deprioritized in Chapter 12 Bankruptcy. As originally enacted, Chapter 12 did not create a separate tax entity for Chapter 12 bankruptcy estates for purposes of federal income taxation.  That shortcoming precludes debtor avoidance of potential income tax liability on disposition of assets as may be possible for individuals who file Chapter 7 or 11 bankruptcy.  But, an amendment to Chapter 12 in 2005 made an important change.  As modified, tax debt associated with the sale of an asset used in farming can be treated as unsecured debt that is not entitled to priority and ultimately discharged.  Without this modification, a farmer faced with selling assets to satisfy creditors could trigger substantial tax liability that would impair the chance to reorganize the farming business under Chapter 12.  Such a farmer could be forced into liquidation.

A question that was addressed by a federal trial court in Indiana in 2021 was how taxes that the debtor had already paid are to be treated.  Can previously paid or withheld taxes be pulled back into the bankruptcy estate where they are “stripped” of their priority (i.e., deprioritized)?  That is a very significant question for a Chapter 12 farm debtor that also has off-farm income of a spouse that helps support the farming operation.

In United States v. Richards, No. 1:20-cv-02703-SEB-MG, 2021 U.S. Dist. LEXIS (S.D. Ind. Sept. 30, 2021), the debtors, a married farm couple, filed Chapter 12 bankruptcy in 2018 after suffering losses from negative weather events and commodity market price declines during 2013 through 2015. The primary lender refused to renew the loan which forced liquidation of the farm’s assets in the spring of 2016. During 2016, the debtors sold substantially all of the farm equipment, vehicles and other personal property assets as well as grain inventory. The proceeds were paid to the primary lender as well as other lenders with purchase money security interests in relevant assets. After filing Chapter 12, the debtors sold additional farmland. The asset sales triggered substantial income tax obligations for 2016, 2017 and 2018 tax years. The debtors Chapter 12 plan made no mention concerning whether off-farm earnings, tax withholdings or payments the debtors voluntarily made to the IRS, or a claim or refund would remain property of the bankruptcy estate after Plan confirmation. The plan did, however, divide the debtors federal tax obligations into 1) tax liabilities for income arising from the sale, transfer, exchange or other disposition of any property used in the debtors’ farming operation “Section 1232 Income”; and 2) tax liabilities arising from other income sources – “Traditional income.” Tax liabilities associated with Traditional Income would retain priority status, but taxes associated with Section 1232 Income would be de-prioritized (regardless of when the liability was incurred) and treated as general unsecured claims that would be discharged upon Plan completion if not paid in full. Under the reorganization Plan, the debtors would pay directly the tax liability associated with Traditional Income incurred after the Chapter 12 filing date. Under the Plan, unsecured claims would be paid on a “pro rata” basis using the “marginal method” along with other general unsecured claims. The Section 1232 taxes would be computed by excluding the taxable income from the disposition of assets used in farming from the tax return utilizing a pro forma tax return. The Plan was silent concerning how the Debtors’ withholding payments and credits for each tax year were to be applied or allocated between any particular tax year’s income tax return and the corresponding pro forma return.

The IRS filed a proof of claim for the 2016 and 2017 tax years in the amount of $288,675.43. The debtors objected to the IRS’s claim, but did seek to reclassify $5,681 of the IRS claim as general unsecured priority status. The IRS failed to respond, and the bankruptcy court granted the debtors approximately $280,000 in tax relief for 2016 and 2017. The debtors then submitted their 2018 federal and state returns showing a tax liability of $58,380 and their pro forma return for 2018 excluding the income from the sale of farm assets which showed a tax liability of $3,399. The debtors, due to withholding and estimated tax, inadvertently paid $9,813 to the IRS during 2018. They claimed $6,414 was an overpayment and listed that amount on the Pro Forma return as a refund. The IRS amended its proof of claim and asserted a general unsecured claim of $42,200 for the 2018 tax year (excluding penalties and interest). The IRS claimed that none of the debtors’ tax liability qualified for non-priority treatment under 11 U.S.C. §1232, and that it had a general unsecured claim for $42, 220 for the 2018 tax year. To reach that amount, the IRS allocated tax withholdings and credits of $9,813 to the assessed tax due on the debtors’ pro forma return which reduced that amount to zero, and then allocated the remaining $6,414 of withholdings, payments and credits to the outstanding tax liability of $48,634. IRS later added $6,347 of net investment income tax that the debtors had reported on their return but IRS had excluded due to a processing error. The debtors objected to the IRS’s claim and asserted it should not be increased by either the $6,414 overpayment or the $6,347 of net investment income tax. The debtors sought to adjust the IRS claim to $54,981 and have the court issue a refund to them of $6,414 or reduce distributions to the IRS until the refund obligation had been satisfied. The IRS objected on the basis that the court lacked jurisdiction to compel the issuance of a refund or credit of an overpayment, and that the debtors were not entitled to the refund or credit of the overpayment shown on the pro forma return as a matter of law.

The bankruptcy court sustained the debtors’ objection to the extent the 2018 refund was applied to the IRS’s claim in a manner other than provided for under the confirmed plan. Specifically, the bankruptcy court held that the IRS had exercised a setoff that was not permitted under 11 U.S.C. §553 which violated the plan’s bar against any creditor taking any action “to collect on any claim, whether by offset or otherwise, unless specifically authorized by this Plan.” But, the bankruptcy court held that it lacked jurisdiction to compel the issuance of a refund or credit of an overpayment and that the debtors were not entitled to the refund or credit of overpayment as a matter of law. This was because, the court determined, the refund was not “property of the estate” under 11 U.S.C. § §542 and 541(a). Later, the bankruptcy court held that the overpayment reflected on the pro forma return was “property of the estate” and withdrew its prior analysis of 11 U.S.C. §§542 and 505(a)(2)(B). Thus, the bankruptcy court allowed the IRS’s 2018 general unsecured tax claim in the amount of $54,981 and ordered the Trustee to pay distributions to the debtors until the overpayments had been paid to the debtors.

The IRS appealed, claiming that the bankruptcy court erred in allowing the IRS’s proof of claim in the amount of $54,981 rather than $48,567, and ordering the IRS to issue the debtors a refund or credit of any overpayment in the amount of $6,414. Specifically, the IRS asserted that 11 U.S.C. §1232 did not provide the debtors any right to an “overpayment” or “refund” because it only applies to “claims” - tax liability after crediting payments and withholdings. The IRS based its position on Iowa Department of Revenue v. DeVries, 621 B.R. 445 (8th Cir. B.A.P. 2020). However, the trial court noted distinctions with the facts of DeVries. Here, the sale of property at issue occurred post-petition and involved a claim objection after the Plan had already been confirmed. The appellate court noted that the IRS did not object to the terms of the Plan, and under 11. U.S.C. §1232 the debtors can deprioritize all post-petition Sec. 1232 liabilities, not just a portion. The application of the marginal method resulted in a tax liability of $54,981 to be paid in accordance with 11 U.S.C. §1232. The non-§1232 tax liability was $3,399. The debtors inadvertently paid $9,813 to the IRS and were entitled to a refund of $6,414, and the IRS could not apply that amount against the Sec. 1232 liabilities in calculating its proof of claim. The refund amount was “property of the estate” under 11 U.S.C. §1207(a)(2).

Note:   On November 30, 2021, an appeal was docketed with the U.S. Circuit Court of Appeals for the Seventh Circuit.

Devries and Richards are important cases for practitioners helping farmers in financial distress.  11 U.S.C. §1232 is a powerful tool that can assist making a farm reorganization more feasible.  The Indiana case is a bit strange.  In that case, the debtors were also due a refund for 2016.  A pro-forma return for that year showed a refund of $1,300.  Thus, the issue of a refund being due for pre-petition taxes could have been asserted just as it was in the Iowa case.  Another oddity about the Indiana case is that the 2018 pro-forma (and regular) return was submitted to the IRS in March of 2019.  Under 11 U.S.C. §1232, the “governmental body” has 180 days to file its proof of claim after the pro forma tax return was filed.  The IRS timely filed its proof of claim and later filed an amended proof of claim which was identical to the original proof of claim.  The IRS filed an untimely proof of claim in one of the other jointly administered cases.

Procedurally, in the Indiana case, a Notice regarding the use of 11 U.S.C. §1232 should have been filed with the court to clarify the dates of Notice to the IRS (and other governmental bodies) of the amount of the priority non-dischargeable taxes and 11 U.S.C. §1232 taxes to be discharged under the plan.  That is when the issue of the refund would have been raised with the IRS.  However, there was no Notice of the filing of the pro-forma return with the court.  It will be interesting to see how the U.S. Court of Appeals handles the Indiana case on appeal.

Note:   Going forward, Chapter 12 reorganization plans should provide that if a pro-forma return shows that the debtor is owed a refund the governmental bodies will pay it.  

Conclusion

The next article will detail the Sixth and Fifth most important ag law and tax developments of 2021.  Stay tuned. 

January 4, 2022 in Bankruptcy, Civil Liabilities, Income Tax | Permalink | Comments (0)