Monday, August 16, 2021
On Friday, September 3, I will be hosting an “Ag Law Summit” at Nebraska’s Mahoney State Park. This one-day conference will address numerous legal and tax issues of current relevance. The conference will also be broadcast live online.
The Ag Law Summit – it’s the topic of today’s post.
Topics and Speakers
Proposed legislation and policy implications. The day begins with my overview of what’s happening with proposed legislation that would impact farm and ranch estate and business and income tax planning. Many proposals are being discussed that would dramatically change the tax and transfer planning landscape. From the proposed lowering of the federal estate tax exemption, to the change in the step-up basis rule at death, to changes in the rules governing gifts, there is plenty to discuss. But, the list goes on. What about income tax rates and exemptions? What about capital gain rates? There are huge implications if any of these changes are made, let alone all of them. What does the road forward for ag producers look like? What changes need to be made to keep the family farm intact? The discussion during this session should be intense!
State ag law update. Following my discussion of what is going on at the federal level, the discussion turns to the state level. Jeff Jarecki, an attorney with Jarecki Lay & Sharp P.C. out of Albion and Columbus, NE will team up with Katie Weichman Zulkoski to teach this session. Katie is a lawyer in Lincoln, NE that works in lobbying and government affairs. They will provide a NE legislative update specific to agriculture and review significant federal developments that impact agriculture – including the current Administration’s proposed 30 by 30 plan.
Farm succession planning. After the morning break. Dan Waters, a partner in the Lamson, Dugan & Murray firm in Omaha will get into the details of the mechanics of transitioning a farming/ranching business to subsequent generations. How do you deal with uncertainty in the factors that surround estate and business planning such as commodity prices, land values, taxation, and government programs? This session will examine various case studies and the use of certain tools to address the continuity question.
Luncheon. During the catered lunch, the speaker is Janet Bailey. Janet has been involved in ag and food policy issues for many years and has an understanding of rural issues. Her presentation will be addressed to legal and tax professionals that represent rural clients. How can you maintain a vibrant practice in a rural community? What other value does a rural practice bring to the local area? The session’s focus is on the importance of tax and legal professionals to small towns in the Midwest and Plains.
Special use valuation. If the federal estate tax exemption is reduced, the ability to value the ag land in a decedent’s estate at it’s value for ag purposes rather than fair market value will increase in importance. During this session, I will provide an overview of the key points involved in this very complex provision of the tax Code. What steps need to be taken now to ensure that the eventual decedent’s estate qualifies to make the special use valuation election on the federal estate tax return? How do farmland leases impact the qualification for the election and avoidance of recapture tax being imposed? Those are just a couple of the topics that will be addressed.
Ag entrepreneur’s toolkit. This final session for the day will cover the business and tax law feature of limited liability companies. The session is taught by Prof. Ed Morse of the Creighton University School of Law and Colten Venteicher, an attorney with the Bacon, Vinton, Venteicher firm in Gothenburg, Nebraska. They will address some of the practical considerations for how to properly use the LLC in the context of farm and ranch businesses.
The Summit will be broadcast online for those unable to attend in-person. Washburn Law is an NASBA CPE provider. The program will qualify in the taxes area for the minutes noted next to each presentation for both the online and in-person attendees. The goal of the Summit is tto continue providing good legal and tax educational information for practitioners with a rural client base. That will aid in the provision of excellent legal and tax services for those rural clients and will, in turn, benefit the associated rural communities.
We hope that you will join us either in-person or online for the Summit on September 3. For more information and to register, click here: https://www.washburnlaw.edu/employers/cle/aglawsummit.html
Thursday, August 5, 2021
I just returned from a speaking trip that took me through several states in the West. While many parts of Kansas have had plentiful rainfall this Spring and Summer, many parts of the West have not. Much of the West is struggling with drought and fire this summer and a smoky haze lingers over many areas.
Sometimes drought and other weather conditions can cause livestock owners to sell more livestock than normally would be sold in a particular year. When that happens, special tax rules can apply to address the additional income triggered by the excess sales.
Weather-related sales of livestock – it’s the topic of today’s post
There are two statutory deferral strategies available to defer the income from excess livestock sold over normal business practice if the sale was on account of a weather-related condition.
Involuntary conversion. If a farmer sells livestock (other than poultry) held for draft, dairy or breeding purposes in excess of the number that would normally be sold during the time period, the sale or exchange of the excess number may be treated as a nontaxable involuntary conversion if the sale occurs because of drought, flood, fire or other weather-related condition. I.R.C. §1033(e).
The livestock sold or exchanged must be replaced within two years after the year in which proceeds were received with livestock similar or related in service or use (in other words, dairy cows for dairy cows, for example), and be held for the same purpose that the animals given were held. Treas. Reg. §1.1033(e)-1(d). This is why, for example, dairy cows can be replaced with dairy cows, but they can’t be replaced with breeding animals. But, if the taxpayer can prove that it is not feasible to reinvest the proceeds in property similar or related in use, the proceeds can be reinvested in other property used for farming purposes (except real estate). Similarly, if it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into property that is not like-kind or real estate used for farming purposes. I.R.C. §1033(f).
The tax on the sale is triggered when the replacement animals are sold.
The two-year replacement period is extended to four years in areas designated as eligible for assistance by the federal government (i.e., by the President or any agency or department of the federal government). I.R.C. §1033(e)(2)(A). For example, if a farmer sells excess livestock in 2021, the replacement period begins in 2022 and runs through 2025.
Presumably, any livestock sales that occur before the designation of an area as eligible for federal assistance would also qualify for the extended replacement period if the drought, flood, or other weather-related conditions that caused the sale also caused the area to be so designated. The replacement property must be livestock that is similar or related in service or use to the animals disposed of. Also, the Treasury Secretary has the authority to extend, on a regional basis, the period for replacement if the weather-related conditions continue for more than three years. I.R.C. §1033(e)(2)(B).
Note: Notice 2006-82, I.R.B. 2006-39, 529, IRS specified that the replacement period will be extended until the end of the taxpayer’s first taxable year ending after the first “drought-free year” for the applicable region. “Drought-free year” means the first 12-month period that (1) ends on August 31; (2) ends in or after the last year of the taxpayer’s four-year replacement period; and (3) does not include any weekly period for which exceptional, extreme or severe drought is reported for any location in the applicable region. “Applicable region” is defined as the county that experienced drought conditions on account of which the livestock was sold or exchanged and all contiguous counties. “Exceptional, extreme or severe drought is to be determined by reference to U.S. drought monitor maps which are accessible at http://www.drought.unl.edu/dm/archive.html. IRS also publishes, by the end of September every year, a list of counties for which extreme or severe drought was reported during the preceding 12 months. For 2020, the IRS issued Notice 2020-74, 2020-41 IRB on September 22, 2020, providing guidance on the replacement period under IRC §1033(e).
The election to defer the gain is made by attaching a statement to the return providing evidence of the weather-related condition that caused the early sale, the computation of the gain realized, the number and kind of livestock sold and the number and kind of livestock that would have been sold under normal business practices. The election can be made at any time within the normal statute of limitations for the period in which the gain is recognized, assuming that it is before the expiration of the period within which the converted property must be replaced. Treas. Reg. §1.1033(e)-1(e). If the election is filed and eligible replacement property is not acquired within the applicable replacement period (usually four years), an amended return for the year in which the gain was originally realized must be filed to report the gain. But, if the animals are replaced, for the tax year in which the livestock are replaced, the taxpayer should include information with the return that shows the purchase date of the replacement livestock, the cost of the replacement livestock and the number and kind of the replacement livestock. The election must be made on the return for the first tax year in which any part of the gain from the sale is realized. It’s also very important for a taxpayer to maintain sufficient records to support the nonrecognition of gain.
Note: For livestock that are partnership property and are sold by the partnership, the election is the responsibility of the partnership. The partners do not individually make the election to defer recognizing the gain. Rosefsky v. Comm’r, 599 F.2d 515 (2d Cir. 1979).
If insurance proceeds are received that exceed the tax basis of the involuntarily converted animals, the excess is taxable gain that is also deferrable if an election is made to defer the gain and the livestock are replaced within the applicable timeframe. In that instance, the deferred amount is taxed at the time the replacement animals are sold.
Note: However, it may be advantageous from a tax standpoint for the rancher to report the gain on the animals in order to claim ordinary depreciation on the replacement animals.
Under I.R.C. §1033(a)(2)(C), the statutory period for the IRS to assess any deficiency for any tax year where part of the gain under the involuntary conversion rules is realized doesn’t expire before three years from the date the taxpayer notifies the IRS of the replacement of the converted property or of an intention not to replace. If there is a deficiency, the IRS may assess the deficiency for up to three years from the notification. This means that the general three-year statute of limitations is extended. The effect of this is that if a livestock owner doesn’t intend to replace the excess livestock when they are sold, the gain should be reported. This will avoid having to file an amended return in the future. Alternatively, the second provision – the one-year deferral provision could be utilized.
One-year deferral. Under the second provision, if farm and ranch taxpayers on the cash method of accounting are forced because of drought or other weather-related condition to dispose of livestock (raised or purchased animals that are held either for resale or for productive use) in excess of the number that would have been sold under usual business practices, they may be able to defer reporting the gain associated with the excess until the following taxable year. I.R.C. §451(g). In addition, the taxpayer's principal business must be farming in order to take advantage of this provision. In 1989, the IRS issued a very favorable ruling concerning what constitutes a farming business. Priv. Ltr. Rul. 8928050, April 18, 1989. In this ruling, a rancher had $121,000 a year gross income from ranching, and made $65,000 a year off the farm and it was determined that his principal business was farming where he devoted 750 to 1,000 hours per year to the ranch and his wife contributed about 300 hours. This ruling is a strong indication that taxpayers need not have all of their time on the farm in order to take advantage of this rule.
Deferral of income is limited to sales in excess of “usual business practices.” Also, an election for one-year deferral is valid if made during the application replacement period for the livestock under I.R.C. § 1033(e).
Note: The gain to be postponed is equal to the total income realized from the sale of all livestock divided by the total head sold, with that result multiplied by the excess number of head sold because of the weather-related condition. The excess is determined by comparing the actual number of head sold to those that would have been sold under usual business practices in the absence of the weather condition. It is common to use the taxpayer’s most recent three-year average in determining the number of livestock that would be sold under normal business practices. However, that is not the actual rule. Under Treas. Reg. §1.451-7(b) it is a facts circumstances test.
At the time the tax return is due for the year of the casualty, the livestock owner may not be sure of which election is the best one to make. In that event, a “protective” election can be made under I.R.C. §1033 for that tax year. If the livestock can be replaced within the applicable replacement period, the involuntary election can be revoked and the return for the casualty year can be amended to make the election to defer the gain for one year. In that instance, the return for the year after the casualty would also have to be amended to report the deferred gain.
Relatedly, a taxpayer can make an election under I.R.C. §451(g) until the four-year period for reinvestment of the property under I.R.C. §1033 expires. That means that if a livestock owner elects involuntary conversion treatment and fails to acquire the replacement livestock within the four-year period, the I.R.C. §451(g) election to defer the gain for one year can still be made. If that happens the livestock owner will have to file an amended return for the casualty year to make the I.R.C. §451(g) election and revoke the I.R.C. §1033(e) election, and the next year to report the gain deferred to that year.
These rules can be helpful for livestock owners dealing with drought and other weather-related conditions that have excess livestock sales. The two rules differ in terms of the type of livestock covered; the period within which to make the election; how the postponement works; the cause of the sale; whether a disaster need be declared; whether a repurchase of livestock is required; whether there is a carryover basis rule; and whether there is a replacement period.
Use the rule that works best for you.
Wednesday, August 4, 2021
Tax developments continue to occur in the courts, state agencies and the IRS. Today’s post addresses some of the developments that are relevant to rural landowners in addition to recurring issues that impact all taxpayers.
A potpourri of tax developments – it’s the topic of today’s post.
Assignment of Income Doctrine At Issue
Berry v. Comr., T.C. Memo. 2021-52
The petitioner and spouse owned 50 percent of an S corporation engaged in construction projects. They were also involved in drag racing. They reported the income and expenses of the racing operation on the S corporation’s books. The IRS took the position that the taxpayers merely assigned the income of the racing operation to the S corporation while in fact they were separate operations. The Tax Court upheld the IRS position that the income had to be reported on the taxpayers' personal return as other income. The S corporation also claimed an I.R.C. §179 deduction for the cost of a utility trailer and an excavator. The IRS also disallowed this deduction. The Tax Court determined that the petitioner failed to show that the trailer was used for business purposes. Instead, it was used to transport race cars. The I.R.C. §179 expense for the excavator was disallowed because all the S corporation could show with respect to the purchase was an undated bill of sale. The petitioner established that he made a cash withdrawal and purchased a money order for the purchase of the excavator, but failed to prove that the cash withdrawal was connected to the purchase.
Travel Expenses Not Deductible
West v. Comr., T.C. Memo. 2021-21
The petitioner lived in Georgia, but worked in Louisville, Kentucky as a nurse. She deducted over $30,000 in travel-related expenses traveling between Kentucky and Georgia. The IRS denied the deductions and the Tax Court agreed. The Tax Court determined that the petitioner’s tax home was Kentucky. She had no business ties in Georgia and her job in Kentucky was not temporary. The petitioner also rented an apartment in Kentucky, filled prescriptions there and registered her car in Kentucky. The Tax Court noted that those facts further indicated that Kentucky was the petitioner’s tax home.
Payment For Water Right is Business Expense.
Priv. Ltr. Rul. 202129001 (Apr. 21, 2021)
The IRS, in a private ruling, determined that a contractually obligated payment for part of the cost of acquiring a water right was an ordinary expense. The right, IRS determined, was used to mitigate environmental damage from a tract of real estate, not improve it. Also, because the water right was used to combat groundwater draw down was a business expense, the taxpayer was eligible to deduct the payment for tax purposes.
Study Hours Don’t Count Toward 750-Hour test
The petitioners, a married couple, sustained losses on rental properties from 2008-2010 and deducted them as non-passive losses on the basis that the wife was a real estate professional in accordance with I.R.C. §469(c)(7). As such, she had to put more than 50 percent of the personal services that she performed for any given year into real property trades or businesses in which she materially participated, and perform more than 750 hours of services during the tax year in real property trades or businesses in which she materially participated. The trial court determined that the wife did not satisfy the 750-hour test because it was not permissible to count her hours spent during 2008-2009 studying for her real estate license. The appellate court affirmed on this point, and also affirmed the trial court’s finding that the wife failed to meet the 750-hour test in 2010 because the time spent working on the couple’s personal properties could not count toward the required 750 hours to be spent on real property trades or businesses.
Alimony Deduction Tied To Former Spouse
Berger v. Comr., T.C. Memo. 2021-89
The petitioners, a married couple paid their former son-in-law to visit their grandchildren and deducted the amounts as “alimony.” The IRS denied the deduction and the Tax Court affirmed on the basis that the deduction belongs exclusively to the former spouse, the petitioners’ daughter. The Tax Court noted that alimony obliges the former spouse, not anyone else that makes payments on behalf of an ex-spouse. The Tax Court also held that the petitioners could not deduct amounts allegedly as business expenses as rent for a greenhouse related to a cannabis business due to a lack of evidence that the amounts were spent on a business.
Solar Power Generation Taxed Assessed as “Farmland”
2021, A5434, eff. Jul. 9, 2021
New Jersey law now provides that land on which a dual-use solar energy project is constructed and approved is eligible for farmland assessment, subject to certain conditions. To receive farmland assessment, a dual-use solar energy project must: (1) be located on unpreserved farmland that is in operation as a farm in the tax year for which farmland assessment is applied for; (2) in the tax year preceding the construction, installation, and operation of the project, the acreage used for the dual-use solar energy project must have been valued, assessed, and taxed as land in agricultural or horticultural use; (3) be located on land that continues to be actively devoted to agricultural and horticultural use, and meets the income requirements set forth in state law for farmland assessment; and (4) have been approved by the state Department of Agriculture. In addition, no generated energy from a dual-use solar energy project is considered an agricultural or horticultural product, and no income from any power sold from the dual-use solar energy project is considered income for the purposes of eligibility for farmland assessment. To be eligible, the owner of the unpreserved farmland must obtain the approval of the Department of Agriculture, in addition to any other approvals that may be required pursuant to federal, state or local law, rule, regulation, or ordinance, before the construction of the dual-use solar energy project.
Corporate Payment of Personal Expenses Not Deductible
Blossom Day Care Centers, Inc. v. Comr., 2021 T.C. Memo. 86
The petitioner paid for personal expenses of its officers and their family members via credit cards issued in the petitioner’s name. The cards were also used to pay officers (and family members) personal credit card, and family members continued to make personal purchases on the petitioners’ cards even during periods when they were not employees of the petitioner. The IRS disallowed the deductions, and the Tax Court agreed. The petitioner also recorded the personal expenditures as a “Note Receivable from Officers” in multiple entries on the corporate books and maintained a running balance, indicating the personal nature of the expenses. The Tax Court also disallowed the petitioner’s I.R.C. §45A tax credit (Indian tax credit) because the petitioner was owned 51 percent by an Indian.
Hoop Buildings are Farm Machinery and Equipment in Missouri
MDOR Priv. Ltr. Rul. No. LR 8152 (Jun. 29, 2021)
A taxpayer sold hoop buildings that are designed and used for livestock production. The buildings are of a permanent nature and can be used in multiple livestock production cycles. The Missouri Department of Revenue (MDOR) determined that is a buyer used a hoop building exclusively, solely, and directly for raising livestock for ultimate sale at retail, the hoop building constitutes "farm machinery and equipment" exempt from sales and use tax under Mo. Rev. Stat. §144.030(2)(22). In addition, the MDOR concluded that the mere fact that the purchaser ultimately attaches the system to a wood or concrete foundation does not make the hoop building subject to sales and use tax. But, MDOR determined that the taxpayer's sales of hoop buildings would not be exempt from sales and use tax as farm machinery and equipment if they are used for purposes such as grain, hay, and other commodity storage, feed rations storage, sand, salt and gravel storage, and storage of equipment and machinery. The MDOR reasoned that hoop buildings used for grain storage are not used in the production of crops. Grain storage is not an agricultural purpose under Mo. Rev. Stat. §144.030.2(22). Neither is the storage of machinery and equipment.
These are some recent state and federal developments touching upon legal issues that farmers, rancher and rural landowners face. Some of the developments have also been more general in nature. Today’s post has been a “heads-up” on just a few.
Saturday, July 31, 2021
An issue that is problematic for many taxpayers that find themselves under audit with the IRS are the potential litigation and administrative costs if the matter were to end up in court. The IRS knows this and, as a result, sometimes asserts a tenuous position in situations where the amount in controversy is not enough to make it worth the taxpayer challenging the IRS position.
When can a taxpayer recover litigation costs against the IRS – it’s the topic of today’s post.
Tax Code Requirements
Under I.R.C. §7430, a taxpayer can receive an award of litigation costs in cases against the United States that involve the determination of any tax, interest or penalty. To be eligible to recover litigation costs, a taxpayer must satisfy four requirements: 1) be the “prevailing party”; 2) have exhausted available administrative remedies within the IRS; 3) not have unreasonably protracted the proceeding; and 4) make a claim for “reasonable” costs. The taxpayer must satisfy all four requirements. See, e.g., Minahan v. Comr., 88 T.C. 492 (1987). The decision to award fees is within the discretion of the Tax Court. That means any decision denying attorney fees to a prevailing taxpayer is reviewed under an abuse of discretion standard.
Note. Under the Tax Court’s rules, a party seeking to recover reasonable litigation costs must file a timely motion in the proper manner. U.S. Tax Court Rules, Title XXIII, Rule 231(a).
Exhaustion. Litigation costs will not be awarded unless the court determines that the prevailing party has exhausted available administrative remedies within the IRS. I.R.C. § 7430(b)(1). For example, when a conference with the IRS Office of Appeals is available to resolve disputes, a party is deemed to have exhausted administrative remedies only by participating in the conference before filing a Tax Court petition or requesting a conference (even if it isn’t granted) before the IRS issues a statutory notice of deficiency. See, e.g, Veal-Hill v. Comr., 812 Fed. Appx. 387 (7th Cir. 2020).
Unreasonable protraction. To be rewarded litigation costs, the taxpayer must not unreasonably protract the proceeding. I.R.C. §7430(b)(3). In Estate of Lippitz, et al. v. Comr., T.C. Memo. 2007-293, the petitioner sought innocent spouse relief and the IRS conceded the case. The petitioner sought to recover litigation costs and the IRS objected. The Tax Court largely rejected as meritless an IRS argument that the petitioner was otherwise disqualified from recovery due to her unreasonable protraction of proceedings. The dispute involved tax deficiencies from 1980-1985 stemming from the now-deceased spouse’s assignment of income to various trusts. The IRS based its argument on the taxpayer's failure to comply with an almost 20-year old summons that the taxpayer had no reason to know about concerning the couple’s joint liability until the IRS later “resurrected” it in 2003.
Prevailing party. Perhaps the requirement that is the most complex and generates the most litigation is that the taxpayer must be the “prevailing party.” A taxpayer can be a “prevailing party” only if the taxpayer satisfies certain net worth requirements or “substantially prevails” with respect to the amount in controversy on “the most significant issue or set of issues presented. I.R.C. §7430(c)(4)(A). An application to recover an award for fees and other expenses must be filed with the court within 30 days of the final judgment in the case. 28 U.S.C. §2412(d)(1)(B).
The net worth requirement is incorporated into the “prevailing party” requirement and specifies that a taxpayer’s net worth must not exceed $2 million. I.R.C. §7430(c)(4)(A)(ii). For this purpose, “net worth” is determined on the basis of the cost of acquisition of assets under generally accepted accounting principles (GAAP) rather than the fair market value of assets. See, e.g, Swanson v. Commissioner, 106 T.C. 76 (1996); see also H.R. Rept. No. 96-1418, 96th Cong., 2d Sess. 15 (1980). Depreciation is taken into account. Also, notes receivable are taken into account under GAAP. The acquisition cost of a note exchanged for cash is the amount of cash received in exchange for the note. If the interest on the note is unstated, it is recorded in the books as having value in an amount that reasonably approximates the fair value of the note.
A taxpayer cannot meet the prevailing party requirement, however, if the IRS takes a position with respect to the taxpayer’s return that is “substantially justified.” In other words, a taxpayer can’t “substantially prevail” if the IRS position is substantially justified.
For the IRS, a substantially justified position is one that has a reasonable basis in fact – one that is supported by sufficient relevant evidence that a reasonable mind might accept as adequate to support a conclusion. See Pierce v. Underwood, 487 U.S. 552 (1988). Reasonableness is based on the facts of the case and legal precedent. Maggie Management Co. v. Comr., 108 T.C. 430 (1997). The IRS position must also have a reasonable basis in law – the legal precedent must substantially support the IRS position based on the facts of the case. The courts have interpreted this standard as requiring sufficient relevant evidence that a reasonable mind might accept as adequate to support a conclusion. See, e.g., Pierce v. Underwood, 487 U.S. 552 (1988). Thus, the IRS could take a position that is substantially justified even if it is incorrect if a reasonable person could believe it to be correct. See, e.g., Maggie Management Co. v. Comr., 108 T.C. 430 (1997). Likewise, the IRS position could be substantially justified where only factual issues are in question. See, e.g., Bale Chevrolet Co. v. United States, 620 F.3d 868 (8th Cir. 2010). Also, the IRS concession of a case or an issue doesn’t mean that its position was unreasonable. It’s merely a factor for consideration.
What the IRS does at the administrative level have no bearing on whether its litigating position is substantially justified. The administrative process and the court process are two separate matters. I.R.C. §7430 distinguishes between administrative and judicial proceedings. See, e.g., Pacific Fisheries, Inc. v. United States, 484 F.3d 1103 (9th Cir. 2007). IRS conduct occurring after the petition is filed is all that matters. This means that the IRS can create a multitude of problems for a taxpayer, justified or not, at the administrative level and fees cannot be recovered because the conduct occurred pre-petition. That is the case even if the IRS conduct during the administrative process caused the litigation. See, e.g., Friends of the Benedictines in the Holy Land, Inc. v. Comr., 150 T.C. 107 (2018).
All of this means that the bar is set rather low for the IRS to establish a litigating position that is substantially justified. Conversely, the bar is set high for a taxpayer to be a “prevailing party” to be able to recover litigation costs.
Note. An exception exists for a “qualified offer.” A qualified offer is one that is made pre-trial. If the taxpayer makes such an offer and the IRS rejects it and the taxpayer goes on to win at the Tax Court, the taxpayer can be compensated for litigation fees that are incurred after the offer was made. I.R.C. §§7430(c)(4)(B)(i); 7430(c)(4)(E)(i).
The Tax Court recently issued an opinion in a case involving the issue of whether the petitioner was entitled to litigation fees. In Jacobs v. Comr., T.C. Memo. 2021-51, the petitioner had been a trial lawyer with the U.S. Department of Justice before becoming a full-time professor at a university in Washington, D.C. During this time, he was also an adjunct professor at another university in Washington, D.C., and a “Visiting Scholar” at yet another university for three months on the West Coast. He ultimately became a professor at a second West Coast university. On his tax returns for these years (2014 and 2015), he claimed $54,000 Schedule C deductions related to payments for meals and lodging for his Visiting Scholar position, the business use of his home, bar association dues and other professional fees, and travel expenses. The IRS audited the returns and denied the deductions.
After a tortured appeals process involving the Taxpayer Advocate Service, the U.S. Treasury Inspector General for Tax Administration, and four IRS Appeals offices, the IRS offered the petitioner a settlement proposal allowing most of the claimed deductions. The petitioner confirmed receipt of the settlement offer, but didn’t respond further. Five months later, the IRS Appeals Office turned the matter over to the IRS Chief Counsel’s Office to prepare the case for trial. At a Tax Court status conference a few days later, the IRS Chief Counsel conceded the case in its entirety and filed a stipulation of settled issues a couple of weeks later.
The petitioner then filed a motion for $32,000 of litigation costs. Those costs included fees for expert witnesses and lawyers. The IRS objected to the motion on the basis that its position in the Tax Court proceedings at the time the answer was filed (that the petitioner was not entitled to the deductions) was substantially justified.
The Tax Court noted that the petitioner bore the burden to establish that his expenses were deductible as ordinary and necessary business expenses under I.R.C. §162 and were not associated with the taxpayer’s activities as an employee. See, e.g., Weber v. Comr., 103 T.C. 378 (1994), aff’d., 60 F.3d 1104 (4th Cir. 1995). The Tax Court determined that a reasonable person could have concluded that a reasonable person could have concluded that the petitioner had not satisfied this burden by the time the IRS filed its answer. Accordingly, the Tax Court denied the petitioner’s motion for litigation costs.
The Jacobs case, although a negative result for the petitioner, is instructive on how difficult it is for a taxpayer to recover litigation costs from the IRS. It’s also an example of how the IRS can create an administrative “nightmare” for the taxpayer causing the taxpayer to ring up thousands of dollars of fees and costs with no hope of recovering those expenses. Litigation fees are only awarded for “litigation” – matters that happen after the IRS files its answer to the taxpayer’s Tax Court petition.
Many taxpayers would conclude that the system is “rigged.” Indeed, the present statutory construct allows the IRS to continue to assert positions with little basis in law when the amount in controversy is less than the anticipated attorney fees without much risk of being challenged in court.
Saturday, July 17, 2021
Three recent court cases touch on issues that often face clients. One involves the tricky issue of what is a taxpayer’s “tax home.” Another case involves the issue of unforeseen circumstances as an exception to the two-year ownership and usage requirement for the principal residence gain exclusion provision. The final case for discussion today involves the deduction for gambling losses, and a rather unique set of facts.
Recent tax decisions in the courts – it’s the topic of today’s blog post.
Tax “Home” At Issue
Geiman v. Comr., T.C. Memo. 2021-80
An individual’s “tax home” is the geographical area where the person earns the majority of their income. The location of the permanent residence doesn’t matter for this purpose. The tax home is what the IRS uses to determine whether travel expenses for business are deductible. It’s the taxpayer’s regular place of business – the general area where business or work is located.
This distinction between a taxpayer’s personal residence and their tax home often comes into play for those that have an indefinite work assignment(s) that last more than a year. In that situation, the place of the assignment becomes the taxpayer’s tax home. That means that the taxpayer can’t deduct any business-related travel expenses. This points out another key distinction – the costs of traveling back and forth from the tax home for business are deductible, but commuting expenses associated from home to work are not.
That brings us to Mr. Geiman, the petitioner in this case. He was a licensed union journeyman electrician who owned a trailer home and a rental property in Colorado. His membership in his local union near his home gave him priority status for jobs in and around that area. When work dried up in the area near his home, he traveled to jobs he could obtain through other local unions. As a result, he spent most of 2013 working jobs in Wyoming and elsewhere in Colorado. On his 2013 return, he claimed a $39,392 deduction for unreimbursed employee business expenses – meals; lodging; vehicle expenses (mileage); and union dues. He also claimed a deduction of $6,025 for “other” expenses such as a laptop computer, tools, printer and hard drive. The petitioner claimed a home mortgage interest deduction on the 2013 return for the Colorado home. He voted in Colorado, his vehicles were registered there, and he received his mail at his Colorado home. The IRS disallowed the deductions.
The Tax Court noted that a taxpayer can deduct all reasonable and necessary travel expenses “while away from home in pursuit of a trade or business” under I.R.C. §162(a)(2). As noted above, a taxpayer’s “tax home” for this purpose means the vicinity of the taxpayer’s principal place of business rather than personal residence. In addition, when it differs from the vicinity of the taxpayer’s principal place of employment, a taxpayer’s residence may be treated (as noted above) as the taxpayer’s tax home if the taxpayer’s principal place of business is temporary rather than indefinite. If a taxpayer cannot show the existence of both a permanent and temporary abode for business purposes during the tax year, no deductions are allowed.
The Tax Court cited three factors, based on Rev. Rul. 73-529, 1973-2 C.B. 37, for consideration in determining whether a taxpayer has a tax home – (1) whether the taxpayer incurred duplicative living expenses while traveling and maintaining the home; (2) whether the taxpayer has personal and historical connections to the home; and 3) whether the taxpayer has a business justification for maintaining the home. Upon application of the factors, the Tax Court held that the petitioner’s tax home was his Colorado home for 2013. His work consisted of a series of temporary jobs, each of which lasted no more than a few months. That meant that he did not have a principal place of business in 2013. He paid a mortgage on the Colorado home, and had significant personal and historical ties to the area of his Colorado home where he had been a resident since at least 2007. Also, his relationship with the local union near his Colorado home gave him a business justification for making his home where he did in Colorado. Thus, the Tax Court concluded that the petitioner was away from home for purposes of I.R.C. §162(a)(2), allowing him to deduct business-related travel expenses.
But, Geiman had a problem. He didn’t keep good records of his expenses. Ultimately, the Tax Court said what he had substantiated could be deducted. Thus, the Tax Court allowed substantiated meal expenses which were tied to a business purpose to be deducted. The Tax Court also allowed lodging expenses to be deducted to the extent they were substantiated by time, place and business purpose for the expense. The Tax Court also allowed a deduction for business mileage at the IRS rate where it was substantiated by starting and ending point – simply using Google maps was insufficient on this point. The Tax Court also allowed the petitioner’s claimed deductions for union and professional dues, but not “other expenses” for lack of proof that they were incurred as an ordinary and necessary business expense. The end-result was that the Tax Court allowed deductions totaling approximately $7,500.
Unforeseen Circumstances Exception to Two-Rule Home Ownership Rule At Issue
United States v. Forte, No. 2-:18-cv-00200-DBB, 2021 U.S. Dist. LEXIS (D. Utah Jun. 21, 2021)
Upon the sale of the principal residence, a taxpayer can exclude up to $500,000 of the gain from tax. That’s the limit for a taxpayer filing as married filing jointly (MFJ). For a single filer, the limit is $250,000. I.R.C. §121(b)(1-2). To qualify for the exclusion, the taxpayer must own the home and use it as the taxpayer’s principal residence for at least two years before the sale. I.R.C. §121(a). If the two-year requirement can’t be met, a partial exclusion is possible and there are some exceptions that can, perhaps, apply. For example, if the taxpayer’s job changed that required the taxpayer to move to a new location, or health problems required the sale, those are recognized exceptions to the two-year rule. There’s also another exception – an exception for “unforeseen” circumstances. I.R.C. §121(b)(5)(C)(ii)(III). The unforeseen circumstances exception was at issue in a recent case.
In this case, the defendants, a married couple, bought a home in 2000 and lived there until 2005 when they sold it. They put about $150,000 worth of furniture in the home. In 2003, they bought a lot with the intent to build a home. They took out a loan an began construction on the home. They also did not get paid the full contract amount for the 2005 home sale and couldn’t collect fully on the seller finance notes. They experienced financial trouble in 2005, but moved into the new home in December of 2005 and purchased an adjacent lot for $435,000 with the intent to retain a scenic view from their new home.
After moving into their new home, the defendants sought to refinance the loan to a lower interest rate, but were unable to do so due to bad credit. Thus, a friend helped them refinance by allowing them to borrow in his name. They then executed a deed conveying title to the friend. A trust deed named the friend as Trustor for the defendants as beneficiaries. The friend obtained a $1.4 million loan, kept $20,000 of the proceeds and used the balance to pay off the defendants’ loans. The defendants made the mortgage payments on the new loan. In 2006, they also executed a deed for the adjacent lot in the friend’s favor. In 2007, the friend signed a quitclaim deed conveying the home’s title to the defendants. The loan on the home went into default, and the defendants then transferred title to an LLC that they owned. They then sold the home and the adjacent lot for $2.7 million later in September of 2007 and moved out.
An IRS agent filed a report allowing a basis increase in the initial home for the furniture that was sold with that home, and determined that the defendants could exclude $458,333 of gain on the 2007 sale of the new home even though they had not lived there for two years before the sale. Both the IRS and the defendants challenged the agent’s positions and motioned for summary judgment. The defendants claimed that they suffered unexpected financial problems requiring the sale before the end of the two-year period for exclusion of gain under I.R.C. §121. As such, the defendants claimed that they were entitled to a partial exclusion of gain for the period that they did own and use the home.
The court noted that the defendants’ motion for summary judgment required them to show that there was no genuine issue of material fact that the home sale was not by reason of unforeseen circumstances. The court denied the motion. A reasonable jury, the court determined, could either agree or disagree with the agent’s report. While the defendants were experiencing financial problems in 2005 before moving into the new home, the facts were disputed as to when they realized that they would not be able to collect the remaining $695,000 of holdbacks from the buyers of the first home. The court also denied the defendants’ motion that they were entitled to a basis increase for the cost of the furniture placed in the initial home. The defendants failed to cite any authority for such a basis increase.
Drug-Induced Gambling Losses Disallowed
Mancini v. Comr., No. 19-73302, 2021 U.S. App. LEXIS 19362 (9th Cir. Jun. 29, 2021), aff’g., T.C. Memo. 2019-16
All gambling winnings are taxable income. Unless a taxpayer is in the trade or business of gambling, and most aren’t, it’s not correct to subtract losses from winnings and only report the difference. But, a taxpayer that’s not in the trade or business of gambling can list annual gambling losses as an itemized deduction on Schedule A up to the amount of winnings. But, to get around the limitations, can a gambling loss be characterized as casualty loss? This last point was at issue in this case.
The petitioner was diagnosed with Parkinson’s disease in 2004 and began taking prescription medicine to help him control his movements. Over time, the medication dosage was increased. The petitioner had been a recreational gambler, but in 2008 he began gambling compulsively. By the end of 2010 he had drained all of his bank accounts and almost all of his retirement savings. In 2009, he started selling real estate holdings for less than fair market value and used the proceeds to pay his accumulated gambling debt. In 2010, his doctor took him off his medication and his compulsive gambling ceased along with his compulsive cleanliness, and suicidal thoughts. The medication he had been on was known to lead to impulse control disorders, including compulsive gambling.
On his 2008-2010 returns he reported gambling winnings and also deducted gambling losses to the extent of his winnings. He later filed amended returns characterizing the gambling losses as casualty losses. While the Tax Court determined that the compulsive gambling was a likely side effect of the medication, the Tax Court agreed with the IRS that the gambling losses were not deductible under I.R.C. §165. Also, the gambling losses over a three-year period failed the “suddenness” test to be a deductible casualty loss. In addition, the Tax Court found that the petitioner had failed to adequately substantiate the losses. On appeal, the appellate court affirmed.
Tax Court cases with good discussion of issues of relevance to many never cease to keep rolling in.
Thursday, July 15, 2021
The second of the two national conferences on Farm/Ranch Income Tax and Farm/Ranch Estate and Business Planning is coming up on August 2 and 3 in Missoula, Montana. A month later, on September 3, I will be conducting an “Ag Law Summit” at Mahoney State Park located between Omaha and Lincoln, NE.
Upcoming conferences on agricultural taxation, estate and business planning, and agricultural law – it’s the topic of today’s post.
The second of my two 2021 summer conferences on agricultural taxation and estate/business planning will be held in beautiful Missoula, Montana. Day 1 on August 2 is devoted to farm income taxation, with sessions involving an update of farm income tax developments; lingering PPP and ERC issues (as well as an issue that has recently arisen with respect to EIDLs); NOLs (including the most recent IRS Rev. Proc. and its implications); timber farming; oil and gas taxation; handling business interest; QBID/DPAD planning; FSA tax and planning issues; and the prospects for tax legislation and implications. There will also be a presentation on Day 1 by IRS Criminal Investigation Division on how tax practitioners can protect against cyber criminals and other theft schemes.
On Day 2, the focus turns to estate and business planning with an update of relevant court and IRS developments; a presentation on the farm economy and what it means for ag clients and their businesses; special use valuation; corporate reorganizations; the use of entities in farm succession planning; property law issues associated with transferring the farm/ranch to the next generation; and an ethics session focusing on end-of life decisions.
If you have ag clients that you do tax or estate/business planning work for, this is a “must attend” conference – either in-person or online.
For more information about the Montana conference and how to register, click here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html
On September 3, I will be holding an “Ag Law Summit” at Mahoney St. Park, near Ashland, NE. The Park is about mid-way between Omaha and Lincoln, NE on the adjacent to the Platte River and just north of I-80. The Summit will be at the Lodge at the Park. On-site attendance is limited to 100. However, the conference will also be broadcast live over the web for those that would prefer to or need to attend online.
I will be joined at the Summit by Prof. Ed Morse of Creighton Law School who, along with Colten Venteicher of the Bacon, Vinton, et al., firm in Gothenburg, NE, will open up their “Ag Entreprenuer’s Toolkit” to discuss the common business and tax issues associated with LLCs. Also on the program will be Dan Waters of the Lamson, et al. firm in Omaha. Dan will address how to successfully transition the farming business to the next generation of owners in the family.
Katie Zulkoski and Jeffrey Jarecki will provide a survey of state laws impacting agriculture in Nebraska and key federal legislation (such as the “30 x 30” matter being discussed). The I will address special use valuation – a technique that will increase in popularity if the federal estate tax exemption declines from its present level. I will also provide an update on tax legislation (income and transfer taxes) and what it could mean for clients.
The luncheon speaker for the day is Janet Bailey. Janet has been deeply involved in Kansas agriculture for many years and will discuss how to create and maintain a vibrant rural practice.
If you have a rural practice, I encourage you to attend. It will be worth your time.
For more information about the conference, click here: https://www.washburnlaw.edu/employers/cle/aglawsummit.html
The Montana and Nebraska conferences are great opportunities to glean some valuable information for your practices. As noted, both conferences will also be broadcast live over the web if you can’t attend in person.
Friday, July 9, 2021
The IRS has finally 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.
Handling farm NOLs – it’s the topic of today’s post
The Tax Cuts and Jobs Act (TCJA) limited the deductibility of an NOL arising in a tax year beginning after 2017 to 80 percent of taxable income (computed without the NOL deduction). Under the TCJA, no NOL carryback was allowed unless the NOL related to the taxpayer’s farming business. A farming NOL could be carried back two years, but a taxpayer could make an irrevocable election to waive the carryback. The 80 percent provision also applied to farm NOLs that were carried back for NOLs generated in years beginning after 2017. Under the TCJA, post-2017 NOLs do not expire.
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) suspended the 80 percent limitation for NOLs through the 2020 tax year. The suspension applies to all NOLs, farm or non-farm, arising in tax years beginning in 2018-2020. The CARES Act also removed the two-year carryback option for farm NOLs and replaced it with a five-year carryback for all NOLs arising in a tax year beginning after 2017 and before 2021. Under the carryback provision, an NOL could be carried back to each of the five tax years preceding the tax year of the loss (unless the taxpayer elected to waive the carryback). That created an issue – some farmers had already carried back an NOL for the two-year period that the TCJA allowed.
The COVID-Related Tax Relief Act (CTRA) of 2020 amended the CARES Act to allow taxpayers to elect to disregard the CARES Act provisions for farming NOLs. This is commonly referred to as the “CTRA election.” Under the CTRA election, farmers that had elected the two-year carryback under the TCJA can elect to retain that carryback (limited to 80 percent of the pre-NOL taxable income of the carryback year) rather than claim the five-year carryback under the CARES Act. In addition, farmers that previously waived an election to carryback an NOL can revoke the waiver.
The CTRA also specifies that if a taxpayer with a farm NOL filed a federal income tax return before December 27, 2020, that disregards the CARES Act amendments to the TCJA, the taxpayer is treated as having made a “deemed election” unless the taxpayer amended the return to reflect the CARES Act amendments by the due date (including extensions of time) for filing the return for the first tax year ending after December 27, 2020. This means that the taxpayer is deemed to have elected to utilize the two-year carryback provision of the TCJA.
On June 30, 2021, the IRS issued Rev. Proc. 2021-14, 2021-29 I.R.B. to provide guidance for taxpayers with an NOL for a tax year beginning in 2018-2020, all or a portion of which consists of a farming loss. The guidance details how the taxpayer can elect to not apply certain NOL rules of the CARES Act, and how the CTRA election can be revoked. Rev. Proc. 2021-14 is effective June 30, 2021.
Affirmative election. The Rev. Proc. specifies that a taxpayer with a farming NOL, other than a taxpayer making a deemed election, may make an “affirmative CTRA election” to disregard the CARES Act NOL amendments if the farming NOL arose in any tax year beginning in 2018-2020. An affirmative election allows the farm taxpayer to carryback a 2018-2020 farm NOL two years instead of five years. To make an affirmative election, the taxpayer must satisfy all of the following conditions:
- The taxpayer must make the election on a statement by the due date, including extensions of time, for filing the taxpayer’s Federal income tax return for the taxpayer’s first tax year ending after December 27, 2020. This means that for calendar year individuals and C corporations, the date is October 15, 2021.
- The top of the statement must state: "The taxpayer elects under § 2303(e)(1) of the CARES Act and Revenue Procedure 2021-14 to disregard the amendments made by § 2303(a) of the CARES Act for taxable years beginning in 2018, 2019, and 2020, and the amendments made by § 2303(b) of the CARES Act that would otherwise apply to any net operating loss arising in any taxable year beginning in 2018, 2019, or 2020. The taxpayer incurred a Farming Loss NOL, as defined in section 1.01 of Rev. Proc. 2021-14 in [list each applicable taxable year beginning in 2018, 2019, or 2020]."
Note. The election is all-or-nothing. The taxpayer must choose either the two-year farm NOL carryback provision for all loss years within 2018-2020, or not.
- The taxpayer attaches a copy of the statement to any original or amended federal income tax return or application for tentative refund on which the taxpayer claims a deduction attributable to a two-year NOL carryback pursuant to the affirmative election.
For taxpayers that follow the Rev. Proc. and make an affirmative election, the Rev. Proc. specifies that the 80 percent limitation on NOLs will apply to determine the amount of an NOL deduction for tax years beginning in 2018-2020, to the extent the deduction is attributable to NOLs arising in tax years beginning after 2017. In addition, the CARES Act carryback provisions will not apply for NOLs arising in tax years beginning in 2018-2020.
Deemed election procedure. In §3.02 of the Rev. Proc., the IRS sets forth the procedure for a taxpayer to follow to not be treated as having made a deemed election. For taxpayers that made a deemed election under the CARES Act, the election applies unless the taxpayer amends the return the deemed election applies to reflecting the CARES Act amendments by due date specified in the Rev. Proc. Also, for taxpayers that made a deemed election under the CARES Act and IRS rejected the two-year carryback claims, Rev. Proc. 2021-014 establishes the steps the taxpayer may take to pursue those claims. Those steps require the taxpayer to submit complete copies of the rejected applications or claims, together with income tax returns for the loss year(s). The top margin of the first page of a complete copy of each application or claim should include, “Deemed Election under Section 3.02(2) of Rev. Proc. 2021-14.” The Rev. Proc. states that resubmission of previously rejected claims should be sent by the Rev. Proc. due date.
Note. The taxpayer is not treated as having made a deemed election if the taxpayer subsequently files an amended return or an application for tentative refund by the due date of the Rev. Proc.
For a taxpayer that elected not to have the two-year carryback period apply to a farming NOL incurred in a tax year beginning in 2018 or 2019, the Rev. Proc. specifies that the taxpayer may revoke the election if the taxpayer made the election before December 27, 2020, and makes the revocation on an amended return by the date that is three years after the due date, including extensions of time, for filing the return for the tax year the farming NOL was incurred. If the NOL is not fully absorbed in the five-year earlier carryback year, the balance carries forward to the fourth year back and subsequent years in the carryback period until it is fully absorbed. The taxpayer may also amend the returns for the years in the five-year carryback period, if needed, to utilize the benefits of I.R.C. §1301 (farm income averaging).
Note. A statement must be attached to the return to revoke the prior election to waive the carryback period. The statement must read as follows: “Pursuant to section 4.01 of Rev. Proc. 2021-14 the taxpayer is revoking a prior I.R.C. §172(b)(1)(B)(iv) or I.R.C. §172(b)(3) election to not have the two-year carryback period provided by I.R.C. §172(b)(1)(B)(i) apply to the farm NOL, as defined in section 1.01 of Rev. Proc. 2021-14, incurred in the taxable year.”
Area of uncertainty. What remains unclear after the issuance of Rev. Proc. 2021-14 is whether the affirmative CTRA election can be made to use the two-year carryback if a farmer had previously waived the five-year carryback. The Rev. Proc. is not clear on this point.
Example. Hamilton Beech is a calendar year farmer. He sustained a farming NOL in 2019. 2017, however, was a good year financially and Hamilton wanted to use the TCJA two-year carryback provision so that he could use the 2019 NOL to offset the impact of the higher tax brackets on his taxable income for 2017. Unfortunately, the CARES Act (enacted into law on March 27, 2020) eliminated the two-year carryback provision leaving Hamilton with the choice of either carrying the 2019 NOL to 2014 or forgoing the five-year carryback. 2014 was a low-income year for Hamilton. Thus, Hamilton elected to waive the five-year NOL carryback provision on his 2019 return that he filed after March 27, 2020 (but before December 27, 2020) and the attached statement made reference to I.R.C. §172(b)(3) and not I.R.C. §172(b)(1)(B)(iv).
Because Hamilton filed his 2019 return after March 27, 2020, and before December 27, 2020, uncertainty exists concerning his ability to make an affirmative election under the Rev. Proc. to disregard the CARES Act five-year NOL carryback provision. If he can, he would be able to use the two-year carryback rule to offset his higher income in 2017. One approach for Hamilton would be for him to amend his 2019 return, citing Rev. Proc. 2021-14, Section 3.01 and state that he has met the conditions of Section 3.01(2).
Note. The taxpayer must also attach a statement to an amended return for the loss year, that states at its top: “Pursuant to section 4.01 of Rev. Proc. 2021-14, the taxpayer is revoking a prior I.R.C. §172(b)(1)(B)(iv) or I.R.C. §172(b)(3) election not to have the two-year carryback period provided by I.R.C. §172(b)(1)(B)(i) apply to the Farming Loss NOL, as defined in section 1.01 of Rev. Proc. 2021-14, incurred in the taxable year.”
Mixed NOLs. If a taxpayer has an NOL that is a mixture of farm and non-farm activities, the portion of the NOL that is attributable to the farming activity may be carried back either two or five years consistent with the guidance of the Rev. Proc. The non-farm portion of the NOL may not be carried back two years. Also, the election to waive the carryback period is all-or-nothing. It is not possible to separately waive a farm NOL carryback from a non-farm NOL.
The Congress has made tax planning with farm NOLs difficult in recent years with numerous rule changes. The recent guidance from the IRS, though issued late, is helpful on several points.
Monday, June 28, 2021
The U.S. Tax Court has issued several interesting and important decisions in recent days. Among other matters, the Tax Court has addressed when cost of goods sold can be deducted; when basis reduction occurs as a result of debt forgiveness; the requirements for a theft loss deduction; and the substantiation required for various deductions.
Recent Tax Court cases of interest – it’s the topic of today’s post.
To Recover Cost of Goods Sold, Taxpayer Must Have Gross Receipts From Sale of Goods
BRC Operating Company LLC v. Comr., T.C. Memo. 2021-59
During tax years 2008 and 2009, the petitioner paid about $180 million to acquire minerals and lease interests in West Virginia, Pennsylvania, Ohio and Kentucky. The petitioner planned to explore for, mine and produce natural gas for sale. On Form 1065, the petitioner reported, as costs of goods sold, estimated drilling costs for natural gas exploration and mining in the amount of $100 million for tax year 2008 and $60 million for tax year 2009 and passed those amounts through to investors. However, the petitioner did not drill (except for two test wells), receive drilling services from third parties or receive drilling property during these years. In addition, the petitioner didn’t report any gross receipts or sales during these years that were attributable to the sale of natural gas. The IRS fully disallowed the amounts claimed for costs of goods sold on the basis that the petitioner had failed to satisfy the “all-events” test and the economic performance requirement of I.R.C. §461(h)(1).
The Tax Court upheld the IRS determination, noting that the petitioner conceded that the drilling of the test wells was irrelevant and that it had not received any income from the wells. Thus, it was inappropriate to characterize the passed-through amounts as costs of goods sold in the amount of $100 million for 2008 and $60 million in 2009 for drilling costs for natural gas mining. There were no gross receipts for natural gas for either 2008 or 2009. There were no receipts from the sale of goods to offset by costs.
The Timing of Basis Reduction Associated With Discharged Debt
Hussey v. Comr., 156 T.C. 12 (2021)
In 2009 the petitioner purchased 27 investment properties on which he assumed outstanding loans totaling $1,714,520. By 2012 he was struggling to make payments on the loans. He sold 16 of the properties in 2012, with 15 of them being sold at a loss. After the sales, the lender restructured the the debt and issued a Form 1099-C for each property sold at a loss evidencing the amount of debt forgiven. The petitioner sold additional investment properties in 2013 at a loss. The lender again restructured the debt, but didn’t issue Form 1099-Cs for 2013. In late 2015, the lender noted that $493,141 was the remaining amount to be booked as a loan loss reserve recovery as of October 25, 2015.
After filing an initial return for 2012, the petitioner filed Form 1040X for 2012 on January 14, 2015. The Form 4797 attached to the amended return stated that petitioner had sold 17 properties for a loss totaling $613,263. On Form 982 petitioner reported that he had excludable income of $685,281 "for a discharge of qualified real property business indebtedness applied to reduce the basis of depreciable real property" (i.e., the debt discharged from the lender). On October 15, 2014, the petitioner filed Form 1040 for 2013. On Form 4797 included with that return, petitioner reported that in 2013 he had sold six investment properties and his primary residence (which was also listed as an investment property) for a loss totaling $499,417 ($437,650 for the investment properties and $61,767 for his primary residence). On October 15, 2015, the petitioner filed Form 1040 for 2014. The petitioner reported a net operating loss carryforward of $423,431 from 2013. On Form 982 petitioner reported he had excludable income of $65,914 from a discharge of qualified real property business debt. A Form 1099-C showed that the petitioner received a discharge of debt of $65,914 from the 2014 sale of his primary residence (the same residence reported as sold in his 2013 tax return). The IRS disallowed the loss deductions claimed on petitioner’s 2013 Form 4797. For 2014, the IRS disallowed the loss carryover deduction from 2013.
The issue was whether the basis reduction as a result of the debt discharge occurred in 2012 or 2013. Also, at issue was whether there was any debt discharge in 2013. The Tax Court, in a case of first impression, laid out the statutory analysis. The Tax Court noted that, in general, a taxpayer realizes gross income under I.R.C. §61(a)(11) when a debt is forgiven. But, under I.R.C. §108(a)(1)(D), forgiveness of qualified real property business debt is excluded from income. However, the taxpayer must reduce basis in the depreciable real property under I.R.C. §108(c)(1)(A). I.R.C. §1017 requires the reduction of basis to occur at the beginning of the tax year after the year of discharge. But, I.R.C. §1017(b)(3)(F)(iii) provides that in the case of property taken into account under I.R.C. §108(c)(2)(B) which is related to the exclusion for qualified real property business debt, the reduction of basis occurs immediately before the disposition of the property (if earlier than the beginning of the next taxable year).
The Tax Court reasoned that because the petitioner received a discharge of qualified real property debt and sold properties in 2012, he was required to reduce his bases in the disposed properties immediately before the sales of those properties in 2012. The Tax Court rejected the taxpayer’s arguments that because the aggregated bases in his unsold properties in 2012 exceeded the discharged amount, he did not need to reduce his bases until 2013. The Tax Court noted instead that selling properties from the group triggered I.R.C. §1017(b)(3)(F)(iii) with respect to the bases of the properties sold regardless of the remaining bases in the properties not sold.
Note. The key point of the case is that the basis reduction rule associated with the forgiveness of qualified real property debt is an exception to the general rule that basis reduction occurs in the year following the year of debt discharge.
No Deductible Theft Loss Associated With Stock Purchase
Baum v. Comr., T.C. Memo. 2021-46.
The petitioners, a married couple, bought corporate stock from a third party’s mother after the third party “encouraged” them to do so. The petitioners lost money on the stock and deducted the losses as theft losses on the basis that they were defrauded in the purchase based on false pretenses. The IRS denied the deductions.
Under state (CA) law, theft by false pretenses requires that the defendant to have made a false pretense or representation to the owner of property with the intent to defraud the owner of that property, and that the owner transferred the property to the defendant in reliance on the representation. Here, the Tax Court noted, the petitioners did their own investigation, confirming the information presented to them. They also provided records of communications between them and the promoter about the investments. But they failed to provide specific evidence that the third party’s representations were false or that they were made with the intent to defraud. The Tax Court held that the taxpayers failed to prove the elements for theft by false pretenses and that there was no reasonable prospect of recovery. Accordingly, the Tax Court upheld the IRS position.
Deductions Fail For Lack of Substantiation
Chancellor v. Comr., T.C. Memo. 2021-50
It’s a well-known principle that deductions are a matter of legislative grace. For a taxpayer to take advantage of that grace, the deductions must be substantiated. This grace isn’t freely bestowed. It’s also important to properly categorize deductions. Some reduce gross income to adjusted gross income, while others are of the “below-the-line” type that reduce adjusted gross income to taxable income. Most of the business-related deductions are “above-the-line” while most of those that are non-business are below-the line. There are also substantiation requirements that apply, and another rule that can come into play when the taxpayer doesn’t have the proper documentation to substantiate deductions – the “Cohan” rule (named after entertainer George M. Cohan). The Cohan rule allows the Tax Court to guess at the correct amount of a deduction for a taxpayer when the taxpayer can show that expenses were actually incurred and meet the legal requirement for the deduction being claimed. But, the Cohan rule can be wiped-out by a statute that has very specific substantiation requirements. One such statute is I.R.C. §274(d).
In this case, the petitioner reported approximately $40,000 of income on her 2015 return and claimed about $33,000 of deductions. The deductions included Schedule A deductions of $6,500 for charitable donations and $4,500 for sales taxes. Schedule C deductions were claimed for meals and entertainment; car and truck expense; utilities for a home office; legal fees; advertising; and “other” expenses. The IRS disallowed all of the Schedule C deductions and the Schedule A deductions for charity and sales taxes.
The Tax Court determined that the petitioner could not meet the specific receipt substantiation requirements for the cash donations to charity under I.R.C. §170(f) or for sales taxes. However, the Tax Court could use the sales tax tables to substantiate the sales tax deduction. The Tax Court determined that the petitioner could not satisfy the heightened substantiation deduction requirements of I.R.C. §274(d) or §280A for the Schedule C (business-related) deductions. Claimed deductions associated with the petitioner’s home office, advertising, legal and post office expense could be estimated under the Cohan rule. For those expenses, the petitioner could show some expenditures that were connected to the legal requirements for the particular deduction.
Note. The case is a good one for how the Tax Court sorted out the various types of deductions in terms of the applicable substantiation rules, and whether or not the Cohan rule would apply.
These recent Tax Court decisions are a continuing illustration of the interesting and important issues that are seemingly constantly before the court.
Monday, June 7, 2021
The U.S. legal system has a long history of allowing debtors to hold specified items of property exempt from creditors (unless the exemption is waived). This, in effect, gives debtors a “head start” in becoming reestablished after suffering economic reverses. But, how extensive is the list of exempt property, and does it include federal and state refunds.
The ability (or not) to treat tax refunds as exempt from creditors in bankruptcy – it’s the topic of today’s post.
Bankruptcy Exemptions – The Basics
Typically, one of the largest and most important exemptions is for the homestead. Initially even the exempt property is included in the debtor's estate in bankruptcy, but the exempt assets are soon returned to the debtor. Only nonexempt property is used to pay the creditors.
Each of the 50 states has developed a unique list of exemptions available to debtors. 18 states and the District of Columbia allow debtors to choose between their state exemptions or the federal exemptions. The remaining states have chosen to “opt-out” of the federal exemptions. Under the 2005 Bankruptcy Act, to be able to utilize a state’s exemptions, a debtor must have resided in the state for 730 days preceding the bankruptcy filing. If the debtor did not reside in any one state for 730 days immediately preceding filing, then the debtor may use the exemptions of a state in which the debtor resided for at least 180 days immediately preceding filing. If those requirements cannot be met, the debtor must use the federal exemptions.
Tax Refunds as Exempt Property – The Moreno Case
Each state’s statutory list of exempt assets in bankruptcy will determine the outcome of whether tax refunds are exempt. But, a recent case involving the state of Washington’s exemption list is instructive on how other states might approach the matter.
Facts of Moreno. In In re Moreno, No. 20-42855-BDL, 2021 Bankr. LEXIS 1262 (Bankr. W.D. Wash. May 11, 2021), the debtor filed Chapter 7 (liquidation) bankruptcy in late 2020. The debtor then filed her 2020 federal income tax return on January 28, 2021, and later received a tax refund of $10,631.00. That refund was made up of $572 of withheld taxes; $2,800 of a “Recovery Rebate Credit” (RRC); $1.079 of an Additional Child Tax Credit (ACTC); and $5,500 of an Earned Income Tax Credit (EITC). The bankruptcy trustee sought to include almost all of the debtor’s tax refund in the bankruptcy estate, excluding only 0.3 percent of the total amount ($31.89) based on the debtor’s Chapter 7 filing being December 30, 2020 (i.e., only one day of 2020 fell after the date the debtor filed bankruptcy).
Timing of filing. The debtor claimed that the tax refund arose post-petition because she filed the return post-petition. Consequently, the debtor claimed, the tax refund was not property of the bankruptcy estate. The court disagreed, noting that under 11 U.S.C. §541(a)(1), the bankruptcy estate includes all legal or equitable interests of the debtor in property as of the date the case commences. Based on that, the court determined that the debtor had obtained an interest in the tax refund as she earned income throughout 2020. Thus, the tax refund for the prepetition portion of the tax year were rooted in her prepetition earnings and were property of the bankruptcy estate regardless of the fact that she had to file a return to receive the refund.
RRC. The debtor used the state’s list of exemptions and the trustee conceded that certain portions of the debtor’s prorated tax refund were exempt. Specifically, the trustee did not dispute the debtor's right to retain the full RRC in the amount of $2,800. 11 U.S.C. §541(b)(11), enacted December 27, 2020, specifically excluded the RRC from the debtor’s bankruptcy estate.
Withheld taxes. The debtor filed an amended Schedule C on which she claimed that $572 of her 2020 refund attributable to withheld tax was exempt under state law. The trustee disagreed and the debtor failed to explain how state law applied to withheld taxes. However, the trustee conceded that amount was exempt as personal property (up to a dollar limitation). Rev. Code Wash. §6.15.010(1)(d)(ii). This same part of the state exemption statute, the trustee concluded, entitled the debtor to an additional exemption of $2,630, the balance allowable as exempt personal property after allowing the debtor to exempt $370 in cash and checking accounts.
ACTC and EITC. As for the part of the refund attributable to the ACTC and the EITC, the debtor claimed that it was exempt under Rev. Code Wash. §6.15.010(1)(d)(iv) as any past-due, current or future child support “that is paid or owed to the debtor” or as “public assistance” under Rev. Code Wash. §74.04.280 and 74.04.005. The trustee claimed that the ACTC was encompassed by the remaining “catch-all” exemption for personal property of Rev. Code Wash. §6.15.010(1)(d)(ii). However, the court noted that if the catch-all provision didn’t apply to the ACTC, it could be applied to the debtor’s other debts to the benefit of the debtor. Thus, the court needed to determine whether both the ACTC and the EITC were exempt under state law.
The Court first concluded that neither the ACTC nor the EITC portions of the tax refund constituted “child support” under RCW § 6.15.010(1)(d)(iv). Instead, the court determined that the plain meaning of “child support” refers to payments legally required of parents. That was not the case with neither the ACTC nor the EITC. The court likewise concluded that the credits were not “public assistance” as defined by Rev. Code Wash. §§ 74.04.280 and 74.04.005. Based on state law, the court noted, the credits would have to be “public aid to persons in need thereof for any cause, including…federal aid assistance.” Rev. Code Wash. §74.04.005(11). The court determined that the credits, under this statute, could only possibly be exempt as “federal aid assistance” which is defined under Rev. Code Wash. § 74.04.005(8) to include “[T]he specific categories of assistance for which provision is made in any federal law existing or hereafter passed by which payments are made from the federal government to the state in aid or in respect to payment by the state for public assistance rendered to any category of needy persons for which provision for federal funds or aid may from time to time be made, or a federally administered needs-based program.”
The court determined that the state definition of “federal aid and assistance” applied to assistance in the form of monetary payments from the federal government to needy persons, but did not describe federal tax credits. Instead, tax credits are paid by the federal government directly to taxpayers. However, the court also noted that the statutory definition also included “federal aid assistance” and any “federally administered needs-based program.” As such, it was possible that the credits could be exempt as “assistance” from a “federally administered needs-based program.” On this point, the court noted that there was no statutory language nor legislative history associated with the credits indicating that they were part of a federally administered needs-based program. In addition, there was no caselaw on point that provided any light on the subject. However, disagreeing with the trustee’s objection to the categorization of any federal tax credit as a federally administered needs-based program, the court relied on court opinions from other states construing similarly worded state statutes to conclude that both the ACTC and the EITC were “federally administered needs-based programs” exempt from bankruptcy under Rev. Code Wash. §74.04.280. See In re Farnsworth, 558 B.R. 375 (Bankr. D. Idaho 2016); In re Hardy, 787 F.3d 1189 (8th Cir. 2015); In re Hatch, 519 B.R. 783 (Bankr. S.D. Iowa 2014); In re Tomczyk, 295 B.R. 894 (Bankr. D. Minn. 2003).
The Moreno case, even though it involved the particular language of one state’s exemption statute, provides good insight as to how bankruptcy courts in other states would analyze the issue of whether federal tax credits (and other tax benefits) are exempt from a debtor’s bankruptcy estate.
Monday, May 31, 2021
The donation of a permanent conservation easement on farm or ranch land can provide a significant tax benefit to the donor. The rules are complex and must be carefully complied with to obtain the tax benefits that are possible – qualified farmers and ranchers can deduct up to 100 percent of their income (i.e., the contribution base). For others, the limit is 50 percent of annual income.
But, the IRS has a history of auditing returns claiming deductions for conservation easements, and winning in court on the issue. But, is the tide starting to turn with respect to one of the IRS “arrows” it uses to attack conservation easement deductions?
The trouble with permanent conservation easement donations and current litigation on the “extinguishment” regulation – it’s the topic of today’s post.
The donation of a permanent conservation easement is accomplished via a transaction that involves a legally binding agreement that is voluntarily entered into between a landowner and qualified charity – some form of land trust or governmental agency. Under the agreement, the landowner allows a permanent restriction on the use of the donated land so as to protect conservation characteristics associated with the tract. See I.R.C. §170(h). But, all of the applicable tax rules must be precisely complied with in order to generate a tax deduction. This is one area of tax law where a mere “foot-fault” can be fatal.
The key to securing a tax deduction for the donation of a permanent conservation easement is the proper drafting of the easement deed (as well as an accurate and detailed appraisal of the property). That’s the instrument that conveys the legal property interest of the easement to the qualified charity (qualified land trust, etc.). This document must be drafted very precisely. For example, the donor must not reserve rights that are conditioned upon the donee’s consent. This is termed a deemed consent provision and it will cause the donated easement to fail to be a perpetual easement – one of the requirements to get a charitable contribution deduction. See Treas. Regs. §§1.170A-14(e)(2); 1.170A-14(g)(1); 1.70A-14(g)(6)(ii).
The IRS also takes the position that the perpetuity requirement is not met if a mortgage on the property is not subordinated. For instance, in Palmolive Building Investors, LLC v. Comr., 149 T.C. 380 (2017), a charitable deduction was denied because the mortgages on the property were not subordinated to the donated façade easements as Treas. Reg. §1.170A-14(g)(2) requires. In addition, the deed at issue stated that the mortgagees had prior claims to extinguishment proceeds. That language violated the requirement set forth in Treas. Reg. §1.170A-14(g)(6)(ii). A savings clause in the deed did not cure the defective language because the requirements of I.R.C. §170 must be satisfied at the time of the easement is donated.
The caselaw also supports the IRS position that development rights and locations for development cannot be reserved on the property subject to the easement if it changes the boundaries for the easement. In other words, the IRS position is that the easement deed language must place a perpetual encumbrance on specifically defined property that is fixed at the time of the grant. However, if the easement only allows the boundary of potential development to be changed on a portion of a larger parcel that is subject to the easement restrictions and neither the acreage of potential development nor the easement is enhance, the perpetuity requirement remains satisfied. See, e.g., Bosque Canyon Ranch II, L.P. v. Comr., 867 F.3d 547 (5th Cir. 2017); Treas. Reg. §1.170A-14(f).
Another problem with easement deeds that the IRS watches for is whether the deed language allows the donor and donee to mutually agree to amend the deed. If this reserved right is present, the IRS takes the position that the easement is not perpetual in nature and does not satisfy the perpetuity requirement of I.R.C. §170(h)(2)(C). But, there is an exception. Amendment language is allowed if any subsequent transfer by the donee (via amendment language in the deed) facilitates the conservation purpose of the original transfer to the donee organization. Treas. Reg. 1.170A-14(c)(2); see also Butler v. Comr., T.C. Memo. 2012-72.
The Extinguishment Regulation
Another requirement of securing a charitable deduction for a donated conservation easement is that the charity must be absolutely entitled to receive a portion of any proceeds received on account of condemnation or casualty or any other event that terminates the easement. Treas. Reg. §1.170A-14(g)(6). This is required because of the perpetual nature of the easement. But, exactly how the allocation is computed is difficult to state in the easement deed. The basic point, however, is that the allocation formula cannot result in what a court (or IRS) could deem to be a windfall to the taxpayer. See, e.g., PBBM-Rose Hill, Ltd. v. Comr., 900 F.3d 193 (5th Cir. 2018); Carroll v. Comr., 146 T.C. 196 (2016). In addition, the allocation formula must be drafted so that it doesn’t deduct from the proceeds allocable to the donee an amount that is attributable to “improvements” that the donor makes to the property after the donation of the permanent easement. If such a reduction occurs, the IRS presently takes the position that no charitable deduction is allowed because the specific requirements of the proceeds allocation formula are not satisfied. This seems counter-intuitive, but it is an IRS audit issue with respect to donations of permanent conservation easements.
If the donee acquires the fee simple interest in the real estate that is subject to the easement, the donee’s ownership of both interests would merge under state law and thereby extinguish the easement. This, according to the IRS, would trigger a violation of the perpetuity requirement. Consequently, deed language may be included to deal with the merger possibility. But, such language is problematic if it allows the donor and donee to contractually agree to extinguish the easement without a court proceeding. Leaving merger language out of the easement deed would seem to result in the IRS not raising the merger argument until the time (if ever) the easement interest and the fee interest actually merge.
Litigation on the extinguishment regulation. The Tax Court has decided a couple of cases recently involving the extinguishment regulation. In Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020), various investors created the petitioner in 2007 and bought 143 cares on a mountain near Chattanooga, Tennessee for $1.7 million. The following year, the petitioner donated 106 acres to a qualified land trust as a permanent conservation easement and claimed a $9.5 million deduction. The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution. That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement.
The IRS denied the charitable deduction for violating the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6), because the qualified land trust was not entitled to a proper proportionate share of proceeds if the easement were acquired through eminent domain at some future date. On the contrary, the easement language in the deed had the effect of allocating to the petitioner all of the value of any land improvements made after the easement was donated. The full Tax Court agreed with the IRS position on the allocation issue, and also upheld the validity of the regulation on the basis that the extinguishment regulation had been properly promulgated and did not violate the Administrative Procedure Act (APA). The full Tax Court also determined that the construction of I.R.C.§170(h)(5), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
In a related memorandum opinion, Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made. It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed. However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable.
The Tax Court again upheld its proportionate value approach in a case where the deed granting the easement reduced the donee’s share of the proceeds in the event of extinguishment by the value of improvements (if any) that the donor made. Smith Lake, LLC v. Comr., T.C. Memo. 2020-107. As such, the petitioner had not satisfied the perpetuity requirement of I.R.C. §170(h)(5)(A). The Tax Court upheld the validity of the regulation and the petitioner’s claimed deduction was denied.
Litigation continues at the appellate court. The petitioner in the Oakbrook case has appealed the Tax Court’s opinion to the U.S. Circuit Court of Appeals for the Sixth Circuit, claiming that the Treasury violated the APA in creating the extinguishment regulation by not soliciting comments and failing to reasonably interpret the underlying statute. The petitioner latched onto the Judge Holmes’ dissent in the full Tax Court opinion, that determined that the IRS had not properly considered public comments as the APA required. Judge Holmes viewed the majority interpretation as having the future effect of denying many more charitable deductions associated with conservation easements. The petitioner is also claiming on appeal that the deed language satisfied the perpetuity requirement, and that the petitioner shouldn't be liable to "predict and compensate the donee for hypothetical events outside of the donor's control." The petitioner is also claiming that the IRS arguments concerning the deed language relating to the perpetuity requirement weren’t raised at the Tax Court level and should be barred on appeal. The petitioner also claims that the deed language has been commonly used for over 30 years, and, as such, the current IRS position is contrary to the Congressional purpose of the statute to incentivize conservation.
It will be interesting to see how the Oakbrook case is decided at the Sixth Circuit. A decision is expected by the end of summer. Thousands of permanent conservation easement donations hang in the balance.
Friday, May 21, 2021
The first of two summer conferences focusing on agricultural taxation and farm/ranch estate and business planning sponsored by Washburn Law School is coming up soon on June7-8. The live presentation will be at the Shawnee Lodge and Conference Center near West Portsmouth, Ohio. Attendance may also be online because we will be broadcasting the conference live.
This year’s conference includes a component focusing on the farm economy. I want to focus on that presentation for today’s article. Understanding ag economics is critical to a complete ability to represent a farmer or rancher in tax as well as estate/business planning.
The farm economy and the upcoming Ohio conference – it’s the focus of today’s post.
The Ag Economy
As is well known the general economy is struggling. Of course, the struggles are related to the economy trying to recover from the various state-level shut-downs. But what about the ag economy? Understanding the economics that farm and ranch clients are dealing is critical for tax practitioners and those that advise farmers and ranchers on estate and business planning matters.
So, what are the key points concerning the farm economy right now that planners must understand?
Net farm income. For starters U.S. net farm income was higher in 2020 than it was in 2019. When government payments are included, net farm income was 46 percent higher than in 2019 representing the fourth highest amount for any year since 1970. That’s good news for ag producers, rural communities and the practitioners that represent them. However, it’s also important to understand that 38 percent of the total amount was from government payments and not the private marketplace. That’s also a record – and not a good one. What government giveth, government can taketh away.
Earlier this year, USDA projected net farm income to drop eight percent compared to 2020. But, even with that drop, net farm income would still be 21 percent higher than the 2000-2019 average. So far this year grain prices for the major row-crop commodities (corn, soybeans and wheat) have been soaring. These prices have been driven by strong export demand, tight stocks, weather concerns in South America and the U.S. economy coming out of the various state-level shutdowns.
Cattle market. So far this year, the cattle market has shown improved beef demand as restaurants reopen and exports have been strong. There is also a smaller 2021 calf crop. However, there are challenges on the processing side of the equation with capacity issues and higher feed prices presenting difficulties. In addition, drought in cattle country will always be a concern.
Dairy. As for the dairy industry, demand is showing greater strength and dairy prices are increasing. This can also be a resulting impact of the loss of numerous dairy farms in recent years that lowers production. However, feed cost is wiping out all of the impact of higher dairy prices.
Exports. In 2020, total ag exports were also seven percent higher than they were in 2019. U.S. ag exports to China alone were 91 percent higher in 2020 than they were in 2019, with total ag exports to China being higher in 2020 than at any point during the Obama Administration (or any prior Administration). China is a critically important market for U.S. ag producers. China has approximately 20 percent of global population but only seven percent of the world’s arable land. China must import food from elsewhere. The Trump Administration got serious with China’s global trade conduct, imposed tariffs and other sanctions against it to the benefit of U.S. agriculture. Whether this pattern continues is an open question.
So far in 2021, total U.S. ag exports are up 24 percent compared to last year. A large part of that is due to the increased level of exports to China. But, there are numerous other ag export markets around the world to keep an eye on.
Accounting. What about the farm balance sheet? How is it looking. For starters, U.S. farmland values continue to hold steady if not slightly higher. The primary influencers of land values are commodity prices, government support programs, the supply of land, interest rates and inflation in the general economy. Shocks to one or more of those factors could impact land values significantly.
Farm working capital has seen four straight years of increases after reaching a low point in 2016. However, total farm debt continues to inch upward the U.S. farm debt to asset ratio is at its highest point in about 12 years (though still far below where it was during the height of the farm debt crisis of the 1980s. Overall, farm balance sheets (especially for crop producers) have improved primarily because of higher government payments, higher commodity prices and strong land values.
Prognosticating the Future
What does the future hold for the agricultural sector in the U.S.? For starters, there is a different administration consisting largely of retreads that have been in the bureaucratic swamp for decades. They love to regulate economic activity. While taxpayer dollars may still flow to the sector, that doesn’t mean it will be to support traditional and “ad hoc” farm programs. It’s more likely that taxpayer dollars will flow to support “food stamps” (remember, a record number of people were on food stamps the last time the current USDA Secretary held the position) and “rural development” and conservation programs. Of course, with taxpayer dollars flowing to support conservation activities on farms and ranches comes regulation of private property.
The next Farm Bill comes up in 2023. What will be the focus of the debate? Of course, much depends on the outcome of the 2022 mid-term elections. Will there be an examination of the existing farm programs and how they apply to large farms compared to smaller ones? Will there be an even greater focus on the environment? Will the “waters of the United States” (WOTUS) rule be revisited yet again? What about efforts to regulate carbon? What about the illegal immigration issue and the current policy fostering a wide-open border? What about ethanol production? Recently, the Iowa Governor was quoted as saying, “Every day under normal circumstances hunger is a reality for one in nine Iowans.” Iowa prides itself is being the nation’s leader in ethanol production. In light of that, let the Governor’s quote sink-in. Also, recall where the current USDA Ag Secretary is from.
As noted above, ag trade and exports is in a rather good spot right now. There was an emphasis on bilateral rather than multilateral trade agreements. Will that continue? Probably not. It’s likely that there will be an emphasis on rejoining various multilateral trade agreements. What will be the impact on U.S. ag? What about China? It now has more leverage on trade deals with the U.S.
There are always external factors and policies that bear on the bottom-line of agricultural producers. What are those going to be? In 2015, the Congress passed, and the President signed into law, a $305 billion infrastructure bill. Now, the present (old) Administration is at it again wanting to spend taxpayer dollars on “infrastructure.” I guess that’s an admission that the 2015 bill didn’t work – or maybe the new push for another bill is just an attempt to throw money around to potential voters.
Another factor influencing farmers and ranchers is tax policy. The potential for increased income and capital gain rates, the removal of “stepped-up” basis at death, higher estate and gift tax rates coupled with lower exemptions, and a higher corporate tax rate is significant.
In the general economy, inflation and unemployment are lurking. Fuel (and other input) prices are up in some places by 50 percent since the beginning of the year – a significant input cost for ag producers. That, coupled with record taxpayer dollars flowing into the sector are being capitalized into higher food prices. Providing lower-income people with non-taxable cash has caused them not to seek jobs and has caused unemployment to be higher than what it otherwise would be. The economy is presently characterized by a high level of job openings and high unemployment at the same time. Let that sink in.
As the Congress tosses around trillion-dollar spending bills, it represents spending money that the government doesn’t have. So, the government just makes more by printing it (or borrowing it). The influx of money in the economy makes the dollars that are already there worth less. Remember, the promise was that “no one making less than $400,000 would have their taxes go up.” Ok, but the money you have in your pocket is worth less. Same difference? Not quite. Inflation deals more harshly with lower-income persons than it does with someone of greater wealth and with higher income. Even without factoring in the rise in fuel and food prices, inflation was at 4.2 percent in April, the sharpest spike since 2008.
What do these external factors mean for agriculture? Any one of them can be bad. A combination of them can be really bad. Now is not the time to be buying more things on credit. It’s time to be prudent with the income that is presently there. Pay-off debt. Tidy-up estate plans. Righten the “ship” and get ready. The ride could get rough.
Join us at the Ohio conference either in person or via the online simulcast and join in the discussion. You don’t want to miss this one. For more information and to register, you can click here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html
Wednesday, May 12, 2021
My article last month on the use of the revocable trust in an estate plan generated many nice comments. You can read that article here: https://lawprofessors.typepad.com/agriculturallaw/2021/04/the-revocable-living-trust-is-it-for-you.html. I also received several questions concerning what happens from an income tax standpoint when the grantor of the trust dies. After answering those questions, I thought it might be a good idea to write an article on it for the blog.
What are the income tax impacts of a revocable trust when the grantor dies – it’s the topic of today’s post.
Income Tax Issues for the Year of Death
When the grantor of a revocable trust dies, the trust assets are not impacted. The trust continues according to its terms and, as mentioned in last month’s article, the assets contained in the trust are not included in the decedent’s probate estate. For income tax purposes, the trust is required to obtain a taxpayer identification number (TIN). That’s the case even if the trust had obtained a TIN during the grantor’s lifetime. Treas. Reg. §301.6109-1(3)(i)(A). That means that the trustee will likely have to establish new accounts for the trust with banks and other financial institutions with which the trust does business.
For the year of the grantor’s death, all tax items must be allocated between the grantor and the trust for the pre-death and post-death periods. This requires the trustee to establish some type of system to make sure that the proper amounts of income, loss, deduction, credit, etc., are allocated appropriately in accordance with the trust’s method of accounting.
Returns and Reporting Issues
When the grantor of a revocable trust dies, the trust is no longer a grantor trust. Thus, all tax-related activity of the trust that occurred before the grantor’s death during the year of death must be reported on the grantor’s final income tax return. Upon the grantor’s death, the trust becomes a separate taxpayer (from the grantor’s estate) with a calendar year as its tax year. I.R.C. §644(a). Because of this separate taxpayer status, the grantor’s estate will also have to obtain a TIN and report tax items separately from those of the trust.
Note: If the terms of the trust require all of the trust income to be distributed annually but not trust corpus, the trust is a “simple” trust. If not, the trust is a “complex” trust.
Note: The grantor’s estate can elect either a fiscal year or a calendar year for tax reporting purposes. When a grantor dies late in the year, it may be beneficial for the executor of the grantor’s estate to elect a fiscal year. That may provide some ability to use tax-deferral techniques for the estate or the beneficiaries and can allow the executor more time to deal with administrative duties concerning the estate.
One technique that can help simplify tax filings after the grantor dies is for the trustee to work with the administrator of the grantor’s estate in considering whether to make an I.R.C. §645 election. The election can be used for certain revocable trusts, and has the effect of treating the trust as part of the decedent’s estate. I have written about the I.R.C. §645 election here: https://lawprofessors.typepad.com/agriculturallaw/2020/11/merging-a-revocable-trust-at-death-with-an-estate-tax-consequences.html. To recap that article, the election can reduce the number of separate income tax returns that will have to be filed after the grantor’s death. The irrevocable election is made via Form 8855.
A Sec. 645 election makes available several income tax advantages that would not otherwise be available in a separate trust tax filing. I detailed those in my article linked above that I wrote last fall, but for our purposes here, while the election is in force (two years if no federal estate tax return is required to be filed; other deadlines apply if a Form 706 is required (See Treas. Reg. §1.645-1(f)) income and deductions are reported on a combined basis – all trust income and expense is reported on the estate’s income tax return. The one exception is for distributable net income (DNI). DNI is computed separately. The combined reporting on the estate’s income tax return might be on a fiscal year instead of the calendar year-end that is required for trusts.
When the election period terminates, the “electing trust” is deemed to be distributed to a new trust. That’s a key point to understand. The new trust must use the calendar year for reporting purposes. As a result, the trust beneficiaries might receive two Schedule K-1s if the co-electing estate files on a fiscal year.
If the decedent’s estate was large enough to require the filing of Form 706, the assets in the revocable trust are aggregated and reported on Schedule G. They are not listed separately. Part 4 should be answered, “yes.” In addition, a verified copy of the trust should be attached to Form 706.
Complexity of Farm Estates
A decedent’s estate is a separate entity for income tax purposes. In general, an estate’s net income, less deductions for the value of property distributed to heirs, is taxed to the estate. The distributions are taxed to the heirs in the calendar year which includes the last day of the estate fiscal year during which the distributions were made. When these principles are applied to the unique aspects of a farmer’s estate, problems (and opportunities) arise. A farmer’s estate has numerous attributes that require specialized application of the general principles of estate income taxation. Those include the seasonal nature of the business with bunching of income and expense in different times of the year; a complex mix of land and depreciable property that is subject to recapture; inventory; common use of income tax deferral due techniques; the problem of establishing income tax basis in property; determining accurate property inventories; and unique capital gain holding periods for certain assets.
A revocable trust is a common and often beneficial part of the estate plan of a farmer or rancher. But, understanding the tax issues when the trust grantor dies is important. Likewise, fitting the tax aspects a revocable trust that are triggered by the grantor’s death with the overall complexity of an agricultural estate is crucial.
Monday, May 10, 2021
In late March, a group of five Democrat Senators from northeastern states introduced the “Sensible Taxation and Equity Promotion (STEP) Act. Similar legislation has been introduced into the U.S. House, also from an East Coast Democrat. These bills, combined with S.994 that I wrote about last time, would make vast changes to the federal estate and gift tax system, have a monumental impact on estate planning for many – including farm and ranch families – and would also make significant income tax changes. The STEP Act also has a retroactive effective date of January 1, 2021. That makes planning to avoid the impacts next to impossible. Today’s focus will be on the provisions of the STEP Act.
The key components of the STEP Act and its impacts and planning implications – it’s the topic of today’s post.
Income Tax Provisions
Before addressing the STEP Act’s provisions, it’s important to remember other proposals that are on the table. Those include an income tax rate increase on taxable income exceeding $400,000 (actually about $450,000) by setting the rate at 39.6 percent. Also, for these taxpayers, the itemized deduction tax benefit is capped at 28 percent. That makes deductions less valuable. In addition, the PEASE limitation of three percent would be restored. This limitation reduces itemized deductions by three percent of adjusted gross income (AGI) over a threshold, up to 80 percent of itemized deductions. Also, proposed is a phase-out of the qualified business income deduction (QBID) of I.R.C. §199A. The phaseout of the QBID would impact many taxpayers with AGI less than $400,000.
The STEP Act is largely concerned with capital gains and trusts. The STEP Act applies the 39.6 percent rate to capital gains exceeding $1,000,000. Passive gains exceeding this threshold would be taxed at 43.4 percent after adding in the additional 3.8 percent net investment income tax of I.R.C. §1411 created by Obamacare. An additional $500,000 exclusion is provided for the transfer of a personal residence ($250,000 for a taxpayer with single filing status). Also, outright charitable donations of appreciated property are excluded, but (apparently) not transfers to charitable trusts), and some assets held in retirement accounts.
From an estate planning standpoint, if this provision were to become law a “lock-in” effect would occur to some extent – taxpayers would simply hold assets until death to receive the basis adjustment at death equal to the asset’s fair market value (I.R.C. §1014). Unless, of course, the “stepped-up” basis rule is eliminated.
Note: Planning strategies such as charitable remainder trusts (maybe), appropriate timing of the harvesting of gains and losses and similar techniques can be used to keep income under the $1 million threshold. Also, especially for high-income taxpayers residing in states with relatively high income tax rates, a tax minimization strategy has been the use of the incomplete non-grantor trust (ING). An ING is a self-settled, asset protection trust that allows a grantor to fund the trust without incurring gift tax while also achieving non-grantor status for income tax purposes. The typical structures is to establish the trust is a state without an income tax with the grantor funding the ING with appreciated assets having a low basis. The ultimate sale of the trust assets thereby avoids state income tax. The IRS has announced that it is studying INGs and will not issue any further rulings concerning them. Rev. Proc. 2021-3, 2021-1, IRB 140, Sec. 5.
The Step Act also proposes new I.R.C. §1261 which, under certain circumstances, imposes income recognition on gains at the time an asset is transferred to a trust. Under this provision, gain recognition occurs at the time of a transfer to a non-grantor trust, as well as a grantor trust if the trust assets (corpus) will not be included in the grantor’s estate. If the corpus will be included in the grantor’s estate at death, there apparently is no gain until a triggering event occurs. Proposed I.R.C. §1261(b)(1)(A).
Note: The lack of clarity of the STEP Act’s language concerning transfers to grantor trusts creates confusion. Seemingly the relinquishment of all retained powers under I.R.C. §2036 would mean that the trust corpus would not be included in the grantor’s estate, and the transfer to trust would be an income recognition event. It simply is not clear what the STEP Act’s language, “would not be included” means.
Apparently, a transfer to a non-grantor marital trust is not an income recognition event. Proposed I.R.C. §1261(c)(2). Similarly, a transfer qualified disability trust or cemetery trust does not trigger gain recognition. As noted above, the language is unclear whether a transfer in trust to a charity is excluded from recognition. However, a transfer to a natural person that is other than the transferor’s spouse is taxed at the time of the transfer.
Assets that are held in a non-grantor trust would be deemed to be sold every 21 years. That will trigger gain to the extent of unrealized appreciation every 21 years, with the first of these “trigger dates” occurring in 2026.
The STEP Act also requires annual reporting for trusts with more than $1 million of corpus or more than $20,000 of gross income. The reporting requires providing the IRS with a balance sheet and an income statement, and a listing of the trustee(s), grantor(s) and beneficiaries of the trust.
Note: The built-in gain on an asset that is transferred during life either outright to a non-spouse or to a type of trust indicated above cannot be spread over 15 years. However, the transfer of illiquid property (e.g., farmland) to a non-grantor trust that is not otherwise excluded is eligible for installment payments over 15 years, with interest only needing to be paid during the first five years. If the tax on the appreciated value is caused by death, the tax can be paid over 15 years by virtue of I.R.C. §6166.
Grantor trusts – sales and swaps. An important estate planning technique for higher wealth individuals in recent years designed to reduce potential estate tax involves the sale or gifting of assets to a grantor trust. The goal of such a transaction is to make a completed transfer for federal estate and gift tax purposes, but retain enough powers so that the transfer is incomplete for income tax purposes. This is the “intentionally defective grantor trust” (IDGT) technique. The result of structuring the transaction in this manner is that the future appreciation of the assets that are sold to the trust is removed from the grantor’s estate, and the grantor remains obligated for the annual income tax liability. Of course, the trust could reimburse the grantor for that tax obligation. Thus, the grantor ends up with a tax-free “gift” to the trustee of the trust’s income tax liability. This allows the trust assets to grow without loss of value to pay taxes.
The IRS blessed the IDGT technique in Rev. Rul. 85-13, 1985-1 C.B. 184. In the Ruling, the IRs determined that the grantor’s sale of the asset to the trust did not trigger income tax – the grantor was simply “selling” to himself. The irrevocable, completed nature of the transfer to the trust coupled with grantor trust status for income tax purposes is done by particular trust drafting language. Also, that language can be drafted to allow the grantor to “swap” low basis assets in the trust with assets having a higher basis. This allows the “swapped-out” asset to receive a basis increase at the time of the grantor’s death by virtue of inclusion in the grantor’s estate. I.R.C. §1014.
Under the STEP Act, a sale to a grantor trust might be treated as a transfer in trust. If that is what the language means, then Rev. Rul. 85-13 is effectively repealed. It also appears that swaps to a grantor trust would be treated that same as a sale. If this is correct, IDGTs as a planning tool are eliminated.
GRATs. One popular estate planning technique for the higher-valued estates has been the use of a grantor-retained annuity trust (GRAT). With this approach, the grantor transfers assets to a trust in return for an annuity. As the trust assets grow in value, any value above the specified annuity amount benefits the grantor’s heir(s) without being subject to federal gift tax. However, under the STEP Act, a transfer to a grantor trust is taxable if all of the transferred assets are not included in the grantor’s estate. But, if all of the assets transferred to a grantor trust are included in the grantor’s estate, the transfer to the trust is not a taxable event.
This language raises a couple of questions. One of the characteristics of a GRAT is that it can be drafted to make a portion taxable. In that case, it is not completely includible in a decedent’s estate. Likewise, if property is transferred into a GRAT and the transferor dies during the GRAT’s term and the I.R.C. §7520 rate rises, then less than all of the corpus of the GRAT is included in the decedent’s estate. See Treas. Reg. §20.2036-1, et seq. This would appear to mean that, under the STEP Act, the transfer to the GRAT would be a taxable event. It is also unclear whether the use of a disclaimer in the context of a GRAT will eliminate this potential problem.
Estate Tax Deduction
Income taxes that the STEP Act triggers would be deductible at death as an offset against any estate tax that is due on account of the taxpayer’s death.
The Constitutional Issue
As noted above, the STEP Act carries a general effective date of January 1, 2021. It is retroactive. If that retroactive provision were to hold, many (if not all) planning options that could presently be utilized will be foreclosed. But is a retroactive tax provision constitutional?
To be legal, a retroactive tax law change can satisfy the constitutional due process requirement if it is rationally related to a legitimate purpose of government. Given the enormous amount of spending that the Congress engaged in during 2020 to deal with the economic chaos caused by various state governors shuttering businesses, a "legitimate purpose" could be couched in terms of the “need” to raise revenue. See, e.g., Pension Benefit Guaranty Corporation v. R.A. Gray & Co., 467 U.S. 717 (1984); United States v. Carlton, 512 U.S. 26 (1994); In re Fifield, No. 04-10867, 2005 Bankr. LEXIS 1210 (Bankr. D. Vt. Jun. 20, 2005). That’s the case even though historic data indicate that government revenues rarely increase in the long-term from tax increases – particularly the type of tax increases that are presently being proposed.
Will the STEP Act become law as proposed? Probably not. But, combined with S. 994 the two proposals offer dramatic changes to the rules surrounding income tax, as well as federal estate and gift tax. With the proposal to basically double the capital gains tax rate, it could be a good idea to intentionally trigger what would be a gain under the STEP Act. Doing so would at least remove those assets from the transferor’s estate. In general, “harvesting” gains now before a 39.6 percent rate applies could be a good strategy. Also, estate plans should be reexamined in light of the possible removal of the fair market value basis rule at death. Consideration should be given to donating capital gain property to charity, setting up installment sales of property, utilizing the present like-kind exchange rules and making investments in qualified opportunity zones.
Is all planning basically eliminated for 2021? I don’t know. There simply is no assurance whether transfers made to lock in the existing federal estate and gift tax exemption, utilize valuation discounts, etc., will work. If the STEP Act is enacted, perhaps one strategy that will work would be to gift cash (by borrowing if necessary). If the STEP Act is not enacted, then utilizing grantor trusts with sales and swaps could be an effective technique to deal with a much lower exemption.
One key to estate planning is to have flexibility. The use of disclaimer language in wills and trusts is one way to provide flexibility. Coupled with a rescission provision, disclaimer language included in documents governing transactions completed in 2021 might work…or might not. It’s also possible that such a strategy could work for estate and gift tax purposes, but not for income tax purposes.
Another technique might be to set up an installment sale of assets to a marital trust for the spouse’s benefit that gives the spouse a power of appointment and entitles the spouse to lifetime income from the entire interest payable at least annually (basically a QTIP trust for the spouse (see I.R.C. §2523(e)). The STEP Act indicates that such a transfer would not be a gain recognition event – marital trusts are excluded so long as the spouse is a U.S. citizen. The surviving spouse would be given the power to appoint the entire interest and it could be exercised in favor of the surviving spouse or the estate of the surviving spouse. No person other than the surviving spouse could have any power to appoint any part of the interest to any person other than the surviving spouse. With a disclaimer provision the surviving spouse could disclaim all interest in the trust if the STEP Act is not enacted (or is enacted but becomes effective after the transfer by installment sale). The disclaimer would then shift the assets into a trust for the surviving spouse’s heirs. There are other techniques that could be combined with this approach to then add back the spouse. If the STEP Act is enacted, the assets could remain in the marital trust and not trigger gain recognition. The point is that the disclaimer adds tremendous flexibility (until disclaimers are eliminated – but the drafters of the STEP Act haven’t figured that out yet).
Also, I haven’t even discussed the proposed American Families Plan yet. On that one, Secretary Vilsack’s USDA put out an incredibly misleading press release titled, “The American Families Plan Honors America’s Family Farms.” In it, the USDA claims that the proposed changes to the federal estate tax would apply to only two percent of farms and ranches. That’s true as long as the family continues to own the farm and is materially participating in the farming operation. What the USDA didn’t mention is that the American Families Plan eliminates many income tax deductions and will increase the federal income tax bill for practically all farmers and ranchers.
Presently, there is considerable uncertainty in the income tax and estate/business planning environment. Also, the next shift in the political winds could wipe-out all of these proposed changes (if enacted) and the rules will swing back the other direction.
There’s never a dull moment. I can’t emphasize enough how important it is to attend (either in-person or online) this summer’s national conference on farm income tax and estate/business planning. It’s imperative to get on top of these issues. For more information on those conferences click here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html and here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html
Saturday, May 1, 2021
May 1, 2021 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Friday, April 30, 2021
Periodically on this blog, I summarize recent cases of interest to those involved in agriculture and tax practitioners in general. Today is one of those days.
Recent court developments of interest – it’s the topic of today’s post.
Defendant’s Removal of Trees Within Conservation Easement Not a Nuisance
Cergnul v. Bradfield, 2021 Ind. App. Unpub. LEXIS 295 (Ind. Ct. App. Apr. 9, 2021)
The developers of a subdivision agreed to record a conservation easement twenty feet wide along two boundaries of the subdivision after complaints by local farmers. The conservation easement’s purpose was to preserve the visual aesthetic for residents who enjoyed the rural setting. Although the restrictive covenants that were recorded did not reference the conservation easement, the developer recorded a final plat that explicitly referred to the conservation easement. The defendant purchased a lot in the subdivision and proceeded to remove some trees and brush from within the conservation easement. The defendant had reviewed the restrictive covenants, which had not been updated after the final plat was recorded. The defendant also had met with a representative of the subdivision’s homeowner’s association, who advised the defendant that he could clear the trees and brush so long as he did not change the grade of the land. The plaintiff was an adjoining neighbor outside the subdivision who sought damages for the loss of quiet enjoyment of his property.
The trial court found that the plaintiff lacked standing to challenge the activity within the conservation easement. Further, the trial court noted that the plaintiff failed to demonstrate that he had been denied a property right. On appeal, the plaintiff argued that although he lacked standing to enforce the conservation easement, he was entitled to damages to address a nuisance. The plaintiff noted that the developers had set aside a conservation easement pursuant to state law and that the defendant’s conduct amounted to nuisance per se. The appellate court noted that the conservation easement enabling statute did not provide the plaintiff with a private right of enforcement. Alternatively, the plaintiff argued that the defendant’s conduct created a nuisance per accidens as the right to the quiet enjoyment of his property had been destroyed. The appellate court noted that whether the defendant’s conduct qualified as a nuisance per accidens depended on whether his conduct would cause actual physical discomfort to a person of ordinary sensibilities. The appellate court found that the plaintiff failed to show any such evidence, and as a result, affirmed the trial court’s decision and denied the nuisance damages sought by the plaintiff.
No Attorney-Client Privilege For Communications Between Trustee and Attorney
In re Estate of McAleer, No. 6 WAP 2019, 2021 Pa. LEXIS 1524 (Pa. Sup. Ct. Apr. 7, 2021)
The decedent created a revocable trust and named his son as the sole trustee. The trust named the son and his two step-brothers as beneficiaries. In 2014, the trustee filed a first and partial accounting of the trust. A step-brother objected and the trustee hired two separate law firms to respond to the step-brother’s objections. After an evidentiary hearing, the probate court dismissed the objections. During the court process, additional filings indicated that about $124,000 of trust funds had been expended from the trust for attorney’s fees and costs through 2015. The step-brothers then filed a petition to determine the reasonableness of the fees. In early 2016, the trustee filed a second and final accounting to which the step-brothers also objected. The trustee claimed that he had no obligation to provide the step-brothers with copies of billing invoices because they were protected by attorney-client privilege. The probate court disagreed and ordered the trustee to forward the unredacted invoices to the step-brothers withing 30 days. The trustee disclosed the invoices, but filed an interlocutory appeal on the issue of the attorney invoices.
The state Supreme Court upheld the probate court’s ruling, noting that the assertion of privilege requires sufficient facts be established to show that the privilege has been properly invoked. According to the state Supreme Court, the trustee had not established those facts. The state Supreme Court also held that the privilege didn’t apply because the interests the privilege protected conflicted with “weightier obligations” – the fiduciary duty of the trustee to provide information to the beneficiaries outweighed the privilege. This was especially the case because the attorney fees were paid from the trust.
Will Authorized Court To Review Sale/Transfer of Farmland
In re Estate of Burge, No. 19-1881, 2021 Iowa App. LEXIS 214 (Iowa Ct. App. Mar. 17, 2021)
The decedent left her estate to her three children and six grandchildren. Two of her children sought to probate the will as executors. One of the executors died shortly after, and his wife participated in the proceedings as the executor and sole beneficiary of his estate. The will distributed a lump sum to the now deceased son if he “is surviving on the death of the survivor” of the decedent. The will distributed half of the remainder to the three children in equal shares and the other half to the six grandchildren in equal shares. The decedent’s will also granted four grandchildren an option to purchase all of her farmland. If they chose to exercise this option, the will directed them to pay a penalty if they sold the farmland within 15 years. The will also had a provision that offered one of the decedent’s children, the remaining executor, to receive his share of the estate in farmland, provided that he could agree upon a division with the grandchildren. Both the grandchildren and the executor exercised their option to purchase the farmland.
The first proposed contract filed by the executor to purchase the farmland was rejected by the trial court because some of the beneficiaries did not participate in negotiations or agree to the terms. The executor filed a second proposed contract to transfer the decedent’s farmland to himself and the four grandchildren. The trial court approved this contract but included direction that if the executor continued with the exercise of his option, he would not be entitled to his residuary share of the estate. Two of the four grandchildren and the executor appealed, and argued that the trial court should not have removed them as residue beneficiaries. The executor also argued that the trial court should have excluded his deceased brother’s wife as a beneficiary.
The appellate court held that since the deceased son survived the decedent, the deceased son’s wife was entitled to his share of the estate as the sole beneficiary. The two grandchildren argued that the executor had the sole right to sell the real estate without court oversight, because the will provided an unrestricted power of sale. The appellate court disagreed and noted that the decedent’s will contained numerous provisions on the sale in her will, namely that the court could resolve any dispute as to the reasonableness of the terms and conditions of the sale. The two grandchildren also argued that the first proposed contract was binding and that the trial court was bound to accept it without modification. The appellate court noted that the first proposed contract did not provide for the executor’s share of the farmland, and the farmland sale/transfer was subject to the terms and conditions in the will and court review for reasonableness.
FBAR Penalties Not Subject to “Full Payment” Rule
Mendu v. United States, No. 17-cv-738-T, 2021 U.S. Claims LEXIS 537 (Fed. Cl. Apr. 7 2021)
The plaintiff was assessed approximately $750,000 of “willful” Foreign Bank and Financial Account (FBAR) penalties. Such penalties can reach up to 50 percent of the highest account balance of the foreign account. He paid $1,000 of the penalty amount and then sued in the U.S. Court of Federal Claims under the Tucker Act to recover the $1,000 as an illegal exaction. The IRS counterclaimed, seeking the entire judgment of $750,000 plus interest. The plaintiff moved to dismiss his complaint on the basis that the court lacked jurisdiction over the illegal exaction claim on the basis of Flora v. United States, 362 U.S. 145 (1960). Such dismissal would nullify the court’s jurisdiction over the counterclaim of the IRS. Under Flora, in accordance with 28 U.S.C. §1346(a)(1), a taxpayer seeking to file a federal tax claim in federal court (other than the U.S. Tax Court) must pay the full amount of the tax before filing suit. However, the plaintiff claimed that 28 U.S.C. §1346(a)(1) only applied to “internal revenue taxes” and claims related to “internal revenue laws.” The petitioner noted that Bedrosian v. United States, 912 F.3d 144 (3d Cir. 2018) hinted that FBAR penalties may fall within the reach of 28 U.S.C. §1346(a).
The court, in ruling for the plaintiff, flatly rejected the Bedrosian decision in holding that FBAR penalties are not subject to the Flora rule because they are not internal revenue laws or internal revenue taxes. The court noted that FBAR penalties are contained in Title 31 of the U.S. Code rather than Title 26 (the Internal Revenue Code), and that this placement was intentional. Title 31, the court noted, has as its purpose, the regulation of private behavior rather than the purpose of being a charge imposed for the purpose of raising general revenue. In addition, the court concluded that FBAR penalties are unlike civil penalties in that they contain no statutory cross-reference that equate “penalties” with “taxes.” The court also reasoned that the if the full payment rule didn’t apply to FBAR penalties there wouldn’t be any concern that the collection of FBAR penalties would be seriously impaired because they are enforced via a civil action to recover a civil penalty. That meant that there were no administrative collection procedures for FBAR penalties with which a partial payment illegal exaction claim would interfere. Thus, the court concluded that the Congress did not intend to subject FBAR penalty suits to the full payment rule.
There’s always action in the courts and with the IRS. That’s especially true this tax season which continues…
Wednesday, April 28, 2021
Summer Conferences – NASBA Certification! (and Some Really Big Estate Planning Issues - Including Basis)
This summer Washburn Law School is sponsoring along with other co-sponsor two conferences on farm income tax and farm/ranch estate and business planning. The conferences, while primarily directed to practitioners that advise farmers and ranchers, is also for agricultural producers and others interested in learning about tax and estate/business planning issues. Now, Washburn Law School has been certified by the National Association of State Boards of Accountancy (NASBA) as a provider of continuing professional education (CPE). That means that CPAs and accountants can receive CPE credit for attending online or in person.
Summer conferences – the topic of today’s post.
Ohio and Montana
The first summer conference is on June 7-8 at the Shawnee State Park Lodge and Conference Center near West Portsmouth, Ohio. The second summer conference is slated for August 2-3 at the Hilton Garden Inn located in Missoula, MT.
For more information, here is the link to the Ohio seminar: https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html.
The co-sponsors for the Ohio event are as follows:
The Wright and Moore Law Company of Delaware, OH; AgriLegacy; and BASE.
You may learn more about each one here:
For more information about the Montana seminar, click on the following link: https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html.
In addition to the sponsors of the Ohio seminar, an addition sponsor is the Budd-Falen Law Firm in Cheyenne, Wyoming. More information about the firm can be found here: https://buddfalen.com/.
Critical Issues for 2021 (and Potentially Beyond)
The political power advantage in Washington, D.C. is razor thin but proposed legislation, if it were to become law would make significant impacts on tax and estate planning for many farmers and ranchers. The mindset of the current administration is generally opposed to people that work for themselves – such people can’t be as easily controlled. That means that many in agriculture are in the crosshairs of policy.
So what will we be talking about at the summer conferences? A major emphasis will be on how to plan for proposed changes in the law, and how the changes will impact farming and ranching operations.
Here’s just a few of the things we will address:
- The current proposal to tax any transfer of property (after an exclusion amount) either during lifetime or at death that has a net gain associated with the transfer. What are the implications of this for certain types of trusts?
- The proposal to require all non-grantor trusts to report gain on appreciated assets contained in the trust every 21 years, and provide to the IRS a balance sheet, income statement and a list of the trustees, grantors and beneficiaries.
- The impact of proposed legislation on installment payment of federal estate tax and special use valuation.
- Potential changes in the level of the present interest annual exclusion and the establishment of a lifetime ceiling on gifts.
- The proposed reduction in the federal estate tax applicable exclusion to an amount significantly less than the current $11.7 million amount, and an increase in the tax rate applicable to taxable estates.
- The proposed change to the current “coupling” of the federal estate and gift tax systems.
- The proposed elimination of “Dynasty Trusts” and “Intentionally Defective Grantor Trusts.”
- The proposed changes to Grantor-Retained Annuity Trusts that would basically eliminate them as a planning concept.
- The proposed elimination of valuation discounting as planning strategy.
- The proposed increase in the capital gains tax rate
- The proposed increase in the corporate tax rate
What About the Estate Tax and Income Tax Basis?
While it now looks as if the federal estate tax exemption will not be reduced, as I wrote here, https://lawprofessors.typepad.com/agriculturallaw/2021/02/what-now-part-two.html, the really big issue is income tax basis. Currently, an asset that is included in a decedent’s estate at death for tax purposes receives an income tax basis in the hands of the heir(s) equal to the fair market value of the asset at the time of death. I.R.C. §1014. This is commonly referred to as “stepped-up” basis. Thus, if the heir were to sell the asset capital gains tax for the heir would be computed as the difference between the selling price of the asset and the value at the time of the heir inherited the asset. For an asset that is sold shortly after inheritance, the capital gains tax is likely to be minimal to none.
If the stepped-up basis rule were to be eliminated, the heir would receive the decedent’s income tax basis. For farmland that the decedent owned for many years, for example, that basis could be much lower than the date-of-death value. That would be particularly the case if the decedent had received the farmland by gift, receiving the donor’s income tax basis in the farmland at the time of the gift. The result would be heir’s being hit with large capital gains tax, or simply refusing to sell the land (if possible) and creating a “lock-in” effect with respect to certain assets.
What would be particularly troubling is if the income tax basis rule were changed such that the appreciation in a property’s value would be taxed at the decedent’s death rather than waiting for the heir to sell the property.
A change in the income tax basis rule would substantially impact estate and business planning. This is particularly true with respect to farm and ranch estates where many assets have a low basis – either from being owned for many years or because of income tax planning strategies that have substantially diminished or eliminated the basis in assets. Changing to a “carry-over” basis rule at death would also be an absolute nightmare for tax professionals. That was certainly the case the last time a carry-over basis rule was tried during the Carter administration. The protests from the practitioner community (and others) were so substantial that the Congress repealed the rule before it took effect.
This basis issue will be a significant topic of discussion at the summer seminars. What planning steps can be taken to plan to avoid this proposed rule change? The answer to that question depends on whether the change in the rule will be retroactively effective. If retroactive, then that will foreclose many (if not all) planning options that could be utilized now.
To be legal, a retroactive tax law change can satisfy the constitutional due process requirement if it is rationally related to a legitimate purpose of government. Given the enormous amount of spending that the Congress engaged in during 2020 to deal with the economic chaos, a "legitimate purpose" could be couched in terms of the “need” to raise revenue. See, e.g., Pension Benefit Guaranty Corporation v. R.A. Gray & Co., 467 U.S. 717 (1984); United States v. Carlton, 512 U.S. 26 (1994); In re Fifield, No. 04-10867, 2005 Bankr. LEXIS 1210 (Bankr. D. Vt. Jun. 20, 2005). That’s even though historic data indicate that government revenues don’t necessarily increase in the long-term from tax increases.
This is definitely the summer to attend one of these events. The planning issues loom large. The economic impacts of the proposed changes can be substantial and ripple throughout the entire economy. In addition to income tax, these critically important estate planning issues will be unraveled and open for discussion at the summer seminars. I encourage anyone interested in agriculture, sustainability and transition of the family farm and food production to attend – either online or in-person. These will be vitally important conferences. NASBA certification will allow those needing CPE to attend online and receive credit. That’s a big plus!
Sunday, April 25, 2021
The general rule is that discharge of indebtedness produces ordinary income – known as cancellation of debt income (CODI). I.R.C. § 61(a)(12). However, there are exceptions to the general rule. One of those exceptions concerns a debtor that is “insolvent” but not in bankruptcy. An insolvent debtor that’s not in bankruptcy doesn’t have CODI to report. But how is insolvency to be measured? In 2017, the U.S. Tax Court clarified the issue. Unfortunately, just recently the IRS voiced its disagreement with the Tax Court’s 2017 opinion.
The definition of “insolvency” for purposes of the exclusion from income of CODI – it’s the topic of today’s post.
An important part of debt resolution is the income tax consequences to the debtor. Actually, there are two major categories of income tax consequences--(1) gain or loss if property is transferred to the lender in satisfaction of indebtedness and (2) possible CODI to the extent debt discharged exceeds the fair market value of property given up by the debtor.
Recourse debt. The handling of discharge of indebtedness income depends upon whether the debt was recourse or nonrecourse. With recourse debt, the collateral stands as security on the loan. If the collateral is insufficient, the debtor is personally liable on the obligation and the debtor's non-exempt assets are reachable to satisfy any deficiency. The bulk of farm and ranch debt is recourse debt.
For recourse debt, when property is given up by the debtor, the income tax consequences involve a two-step process. Basically, it is as if the property is sold to the creditor, and the sale proceeds are applied on the debt. First, there is no gain or loss (and no other income tax consequence) up to the income tax basis on the property. The difference between fair market value and the income tax basis is gain or loss. There is no relief from gain--even if the taxpayer is insolvent. This is the end of the first step in the process--treated as a hypothetical sale on the debt being discharged. Second, if the indebtedness exceeds the property's fair market value, the difference is discharge of indebtedness income.
Nonrecourse debt. For nonrecourse debt, the collateral stands as security on the obligation. But if the collateral is worth less than the balance on the debt, the debtor does not bear personal liability on the obligation. Therefore, the creditor must look solely to the collateral in the event of default. Very little farm and ranch debt is nonrecourse, except perhaps for some installment land contracts and commodity loans from the Commodity Credit Corporation to the extent that the debtor may pay off the loan with a sufficient amount of an eligible commodity having a price support value equal to the outstanding value of the loan (or less than the value of the loan in the case of a “marketing assistance loan”).
Handling nonrecourse debt involves a simpler one-step process. See, e.g., Comr. v. Tufts, 461 U.S. 300 (1983). Fair market value is ignored, and the entire difference between the income tax basis of any property involved (and transferred to the creditor) and the amount of debt discharged is gain (or loss). There is no CODI.
There are several relief provisions that a debtor may be able to use to avoid the general rule that CODI constitutes income.
Bankruptcy. A debtor in bankruptcy does not report CODI as income. I.R.C. §108(a)(1)(A). However, the debtor must reduce tax attributes (including operating losses and investment tax credits carried forward) and reduce the income tax basis of their property. Losses are reduced dollar for dollar; credits are reduced one dollar for three dollars (one dollar of credit offsets three dollars of CODI). To preserve net operating losses and tax credit carryovers, a debtor may elect to reduce the basis of depreciable property before reducing other tax attributes.
Real property business debt. Taxpayers other than C corporations can elect to exclude from gross income amounts realized from the discharge of “qualified real property business indebtedness.” I.R.C. §108(a)(1)(D). Instead, the income tax basis of the property is reduced.
Note: The provision does not apply to farm indebtedness.
Solvent farmers. For all debtors other than farmers, once solvency is reached there is CODI. For solvent farm debtors, however, the discharge of indebtedness arising from an agreement between a person engaged in the trade or business of farming and a “qualified person” to discharge “qualified farm indebtedness” is eligible for special treatment. I.R.C. §108(a)(1(C). A special procedure for reducing tax attributes and reducing the basis of property is available to the debtor.
A “qualified person” is someone who is “actively and regularly engaged in the business of lending money and who is not somehow related to or connected with the debtor.” “Qualified farm indebtedness” means indebtedness incurred directly in connection with the operation by the taxpayer of the trade or business of farming and 50 percent or more of the average annual gross receipts of the taxpayer for the three proceeding taxable years (in the aggregate) must be attributable to the trade or business of farming. In many instances, the presence of off farm income can make qualifying for the solvent farm debtor rule difficult. Also, a cash rent landlord is likely to be deemed to not be engaged in the trade or business of farming such that discharge of indebtedness is not discharge of qualified farm indebtedness. See, e.g., Lawinger v. Comr., 103 T.C. 428 (1994).
If the requirements are met, a solvent farm debtor first reduces tax attributes in the following order:
- Net operating loss of the taxable year and any carryover losses to that year.
- General business credits (including investment tax credits carried over to that year).
- Minimum tax credit
- Capital losses for the year and capital losses carried over to that year.
- Passive activity loss and credit carryovers.
- Foreign tax credits
Again, losses reduce CODI dollar for dollar. One dollar of credits reduces three dollars of CODI.
After the reduction of tax attributes, solvent farm debtors reduce the income tax basis of property used in a trade or business or held for the production of income in the following order:
- Depreciable property.
- Land used or held for use in the trade or business of farming.
- Other qualified property.
Note: An election can be made to reduce the basis of depreciable property first, before reducing the tax attributes. This may help to preserve the tax attributes for later use.
If, after tax attributes and property basis is reduced, discharge of indebtedness remains, the remainder is income.
Purchase price adjustment. For solvent taxpayers who are not in bankruptcy, any negotiated reduction in the selling price of assets does not have to be reported as discharge of indebtedness income. I.R.C. §108(e)(5). To be eligible, the debt reduction must involve the original buyer and the original seller.
Insolvent debtors. Debtors who are insolvent but not in bankruptcy likewise do not have CODI. I.R.C. §108(a)(1)(B). But, again, insolvent debtors must reduce tax attributes and reduce the income tax basis of property. It is handled much like debtors in bankruptcy make the calculations. However, the amount of income from discharge of indebtedness that can be excluded from income is limited to the extent of the debtor's insolvency. If the amount of debt discharged exceeds the amount of the insolvency, income is triggered as to the excess. Thus, for the rule of insolvent taxpayers to apply, the taxpayer must be insolvent both before and after the transfer of property and transfer of indebtedness.
The determination of the taxpayer’s solvency is made immediately before the discharge of indebtedness. “Insolvency” is defined as the excess of liabilities over the fair market value of the debtor’s assets. Both tangible and intangible assets are included in the calculation. Likewise, both recourse and nonrecourse liabilities are included in the calculation, but contingent liabilities are not. The separate assets of the debtor’s spouse are not included in determining the extent of the taxpayer’s insolvency.
Historically, the courts have held that property exempt from creditors under state law is not included in the insolvency calculation. However, the IRS ruled in mid-1999 that property exempt from creditors under state law is included in the insolvency calculation. Priv. Ltr. Rul. 9932013 (May 4, 1999), revoking Priv. Ltr. Rul. 9125010 (Mar. 10, 1991); Tech. Adv. Memo. 9935002 (May 3, 1999). In 2001, in Carlson v. Comr., 116 T.C. 87 (2001), the Tax agreed with the IRS position. The Tax Court held that a commercial fishing license was an “asset” because the license could be used, in combination with other assets, to immediately pay the income tax on canceled-debt income.
Recent Tax Court clarification. In Schieber v. Comr., T.C. Memo. 2017-32, the petitioner retired from a police force in 2005 and began receiving monthly distributions from his pension plan. The plan withheld federal income tax from the payments. The plan specified that the petitioner could not convert his interest in the plan into a lump-sum cash amount, assign the interest, sell the interest, borrow against the interest, or borrow from the plan. Upon the petitioner’s death, his surviving wife would receive payments for her life. In 2009, GMAC canceled approximately $450,000 of the petitioner’s mortgage debt that was secured by some of the petitioner’s non-residential real estate. The petitioner was not in bankruptcy in 2009. The canceled debt included $30,076 of interest. The petitioner excluded the forgiven interest from income because he had not deducted it on his Form 1040. See I.R.C. §108(e)(2). That provision specifies that “no income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.”
While the IRS conceded this point concerning the interest exclusion, the IRS claimed that the petitioner’s interest in the principal amount of $418,596 that was canceled should be included in income. The petitioner claimed that the pension plan should not be considered an asset for purposes of the insolvency computation of I.R.C. §108(d)(3). Under that provision a taxpayer may exclude canceled debt from income to the extent of the taxpayer’s insolvency, defined as the extent to which the taxpayer’s liabilities exceed the fair market value of the taxpayer’s assets.
I.R.C. §108(d)(3) does not define the term “assets.” As noted above, in Carlson v. Comr., 116 T.C. 87 (2001), the full Tax Court determined that the value of an exempt asset could be included in the insolvency calculation if it gives the taxpayer “the ability to pay an immediate tax on income” from the canceled debt. In Schieber, the petitioner claimed that he couldn’t access the pension funds by its terms. The IRS did not challenge that point, instead claiming that the point was irrelevant. Instead, the IRS claimed that the petitioner’s right to receive monthly payments caused the plan to be considered an “asset.” The Tax Court disagreed, clarifying that its prior decision in Carlson only extended to assets that gave the taxpayer the “ability to pay an immediate tax on income” from the canceled debt, not the ability to pay the tax gradually over time.
Just recently, the IRS announced its disagreement with the Tax Court’s opinion in Schieber. A.O.D. 2021-1, IRB 2021-15.
The Tax Court’s Schieber decision provided clarity concerning the definition of “assets” for purposes of the insolvency calculation of I.R.C. § 108(d)(3). If an asset doesn’t provide the debtor with the ability to pay an immediate tax on income, the asset’s value is excluded from the insolvency computation. Schieber cites back to the full Tax Court opinion in Carlson for its rationale. Unfortunately, the IRS audit and litigation position appears to be unchanged.
Monday, April 19, 2021
Today's post is a bibliography of my ag law and tax blog articles of 2016. Earlier this year I have provided bibliographies for you of my blog articles for 2020, 2019, 2018 and 2017. This now completes the bibliographies since I began the blog in July of 2016. At the end of 2021, I will post a lengthy blog article of all of the articles published through that timeframe.
The 2016 bibliography of articles – it’s the subject matter of today’s post.
Treasury Attacks Estate and Entity Planning Techniques With Proposed Valuation Regulations
Using an LLC to Reduce S.E Tax and the NIIT
IRS Audit Issue – S Corporation Reasonable Compensation
Rents Are Passive, But They Can Be Recharacterized - And Grouped (Sometimes)
Tribute To Orville Bloethe
Registration of a Pesticide Doesn't Mean It Might Not Be Misbranded
Death of Livestock In Blizzard Was a Covered Loss by “Drowning”
FIFRA Pre-Emption of Pesticide Damage Claims
Agritourism Acts, Zoning Issues and Landowner Liability
The “Agriculture” Exemption From The Requirement To Pay Overtime Wages
The Scope and Effect of Equine Liability Acts
What’s a Rural Landowner’s Responsibility Concerning Crops, Trees and Vegetation Near an Intersection?
Some Thoughts on Production Contracts
Prison Sentences Upheld For Egg Company Executives Even Though Government Conceded They Had No Knowledge of Salmonella Contamination.
Registration of a Pesticide Doesn't Mean It Might Not Be Misbranded
FIFRA Pre-Emption of Pesticide Damage Claims
Air Emissions, CWA and CERCLA
Are Seeds Coated With Insecticides Exempt From FIFRA Regulation?
The Situs of a Trust Can Make a Tax Difference
Treasury Attacks Estate and Entity Planning Techniques With Proposed Valuation Regulations
Common Estate Planning Mistakes of Farmers
Staying on the Farm With the Help of In-Home Care
Including Property in the Gross Estate to Get a Basis Step-Up
Farm Valuation Issues
The Future of the Federal Estate Tax and Implications for Estate Planning
Tribute To Orville Bloethe
House Ways and Means Committee Has A Blueprint For Tax Proposals - Implications For Agriculture
In Attempt To Deny Oil and Gas-Related Deductions, IRS Reads Language Into the Code That Isn’t There – Tax Court Not Biting
IRS Does Double-Back Layout on Self-Employment Tax
S.E. Tax on Passive Investment Income; Election Out of Subchapter K Doesn’t Change Entity’s Nature; and IRS Can Change Its Mind
Handling Depreciation on Asset Trades
Claiming “Bonus” Depreciation on Plants
Proper Reporting of Crop Insurance Proceeds
Permanent Conservation Easement Donation Opportunities and Perils
Sales By Farmers/Rural Landowners Generate Common Questions
Expense Method Depreciation - Great Tax Planning Opportunities On Amended Returns
The DPAD and Agriculture
Donating Food Inventory to a Qualified Charity - New Opportunity for Farmers
Farm Valuation Issues
Treatment of Farming Casualty and Theft Losses
More on Handling Farm Losses
Selected Tax Issues For Rural Landowners Associated With Easement Payments
Are You A Farmer? It Depends!
Rents Are Passive, But They Can Be Recharacterized - And Grouped (Sometimes)
It’s Fall and Time to “Hoop it Up”!
Utilizing the Home Sale Exclusion When Selling the Farm
Farmland Acquisition – Allocation of Value to Depreciable Items
Tribute To Orville Bloethe
IRS Continues (Unsuccessfully) Attack on Cash Accounting By Farmers
The Uniform Capitalization Rules and Agriculture
The Non-Corporate Lessor Rule – A Potential Trap In Expense Method Depreciation
Texas Mineral Estates, Groundwater Rights, Surface Usage and the “Accommodation Doctrine”
So You Want To Buy Farmland? Things to Consider
What’s the Character of the Gain From the Sale of Farm or Ranch Land?
Utilizing the Home Sale Exclusion When Selling the Farm
New Food Safety Rules Soon to Apply to Farmers and Others In the Food Production Chain
New Regulations on Marketing of Livestock and Poultry
The Future of Ag Policy Under Trump
Verifying Employment – New Form I-9; The Requirements and Potential Problem Areas
Feedlot Has Superior Rights to Cattle Sale Proceeds
Watercourses and Boundary Lines
April 19, 2021 in Business Planning, Civil Liabilities, Contracts, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Monday, April 12, 2021
Income tax (as well as other forms of taxes) has been an element of life for over a century in the United States. Tax issues seemingly permeate just about everything a person does and shapes one’s behavior. In today’s article I summarize several recent tax-related cases to illustrate my point of how pervasive tax issues are.
Tax issues in various contexts in recent court cases – it’s the topic of today’s post.
Taxpayer Unable to Establish Funds Used to Cover Expenses as Loans or Gifts
Oss v. Dep’t. of Revenue, No. TC-MD 190304N, 2020 Ore. Tax LEXIS 47 (Ore. T.C. Jul. 30, 2020)
An issue that presents itself more than we would like to admit is the proper characterization of financial assistance provided to a child by a parent or parents. The issue sometimes comes up when a parent dies without clear specification in a will or a trust of the nature of the transfer. This often flares up when other children are present, and their inheritance would be diminished if the transfer were considered to be a gift.
This matter came up in a recent Oregon case. In the case, the plaintiff operated a recreational marijuana business as a single-member limited liability company. The plaintiff’s business and personal expenses were largely cash-based. Under the cash accounting method, the plaintiff reported on his 2015 Schedule C: gross receipts of $1,153,466; cost of goods sold of $1,100,217; and gross income of $53,249. After reviewing the plaintiff’s 2015 tax return and analyzing the plaintiff’s gross receipts using an indirect analysis, the defendant determined the plaintiff had $1,144,181 in purchases and had substantiated $287,414 in nondeductible expenses, resulting in $1,431,595 in outgoing cash. As a result, the defendant increased the plaintiff’s 2015 gross receipts by $278,129, which was the amount outgoing cash exceeded the plaintiff’s gross receipts.
The plaintiff argued that the additional funds used to cover expenses were attributable to a combination of loans, gifts, and savings. Specifically, the plaintiff claimed that he received $120,000 from his father as a result of four nontaxable loans and $150,000 in nontaxable gifts from his grandfather over six years. The plaintiff also claimed to have built up a reserve of cash savings by spending less on living expenses than the defendant had determined in its indirect income analysis.
The state tax court noted that taxpayers are required to keep adequate records in order to determine their correct tax liability. The court determined that the plaintiff was unable to establish that he received a loan from his father, gifts from inheritance funds, or cash savings. The plaintiff only had a handwritten note from his father and no bank statements or testimony to establish the loans or gifts existed. The court also noted that the plaintiff likely understated his annual living expenses by relying on bankruptcy standards to estimate living expenses. As a result, the court held that the defendant had properly adjusted the plaintiff’s gross receipts for 2015.
Settlement Proceeds Are Taxable Income
Blum v. Comr., T.C. Memo. 2021-18
On this blog, I have published a couple of detailed articles on the tax treatment of court settlements and judgments. You may read those here:https://lawprofessors.typepad.com/agriculturallaw/2019/07/tax-treatment-of-settlements-and-court-judgments.html and here https://lawprofessors.typepad.com/agriculturallaw/2020/12/taxation-of-settlements-and-court-judgments.html The issue came up again in a recent case involving a lawsuit against a law firm for malpractice.
In the case, the petitioner was involved in a personal injury lawsuit and received a payment of $125,000 to settle a malpractice suit against her attorneys. She did not report the amount on her tax return for 2015 and the IRS determined a tax deficiency of $27,418, plus an accuracy-related penalty. The IRS later conceded the penalty, but maintained that the amount received was not on account of personal physical injuries or personal sickness under I.R.C. §104(a)(2). The Tax Court agreed with the IRS because the petitioner’s claims against the law firm did not involve any allegation that the firm’s conduct had caused her any physical injuries or sickness, but merely involved allegations that the firm had acted negligently in representing her against a hospital.
IRS Listing of Taxpayers With Significant Tax Debt Constitutional
Rowen v. Comr., 156 T.C. No. 8 (2021)
Currently, a push is being made in D.C. for an “infrastructure” bill. I guess the massive one in 2015 didn’t do the trick. The current proposal, just like the one in 2015, has a bunch of “stuff” in it that has little to nothing to do with infrastructure. In the 2015 legislation, one of those non-infrastructure provisions was an IRS “travel ban.” That “travel ban” provision came up in a recent case when a taxpayer claimed it was unconstitutional.
Section 32101, subsection (a) of the “Fixing America’s Surface Transportation” (FAST) Act created I.R.C. §7345 which authorizes the IRS to certify lists of seriously delinquent taxpayers to the Treasury Department that will then send those lists to the State Department for denial or revocation of a listed taxpayer’s passport. In the recent case, the petitioner had unpaid tax debt of nearly $500,000 and the IRS certified to the Treasury Department that the petitioner had a “seriously delinquent tax debt” within the meaning of I.R.C. §7345(b), giving the U.S. Secretary of State the ability to deny or revoke the petitioner’s passport. The petitioner sued for a determination that the certification was erroneous under I.R.C. §7345(e)(1) and moved for summary judgment on the basis that I.RC. §7345 violated the Due Process Clause of the Constitution and illegally infringed his right to travel internationally. The petitioner also claimed that I.R.C. §7345 violated his human rights under the Universal Declaration of Human Rights.
The Tax Court held that I.R.C. §7345 is not constitutionally defective because it doesn’t restrict the right to international travel and that the IRS was entitled to judgment as a matter of law. The Tax Court noted that all passport-related decisions are left to the Secretary of State and that the authority of the Secretary of State to revoke a passport doesn’t derive from I.R.C. §7345. The Tax Court noted that the constitutionality of the authority granted to the Secretary of State by FAST Act section 32101(e) was not an issue in the case and, therefore, the Court expressed no view on that issue.
Failure to Substantiate Eliminates Charitable Deduction
Chiarelli v. Comr., T.C. Memo. 2021-27
If there is one thing that is certain about tax law, it is that deductions are a matter of “legislative grace” and a taxpayer must be able to substantiate them if challenged. Recently, the U.S. Tax Court dealt with yet another case involving the substantiation of deductions.
Under the facts of this case, the petitioner made numerous charitable donations of clothing, furniture and antiques that he inherited. However, the petitioner didn’t maintain any proper receipts from the charitable donees, he didn’t keep reliable records in lieu of receipts. The petitioner also didn’t have contemporaneous written acknowledgements for his contributions exceeding $250, and didn’t satisfy the heightened record keeping and return statement requirements for contribution exceeding $5,000. Appraisals of the donated items didn’t account for the items’ physical condition and age, and didn’t include any mention of the appraiser’s qualifications or a statement that the each appraisal was prepared for income tax purposes. The petitioner also did not complete the appraisal summary on Form 8283.
The Tax Court rejected the petitioner’s substantial compliance argument noting that while the petitioner provided supplemental information, the supplemental information was also incomplete. The Tax Court also rejected the petitioner’s claim that he cured his defective submissions by responding to IRS's request for additional documentation within 90 days in accord with Treas. Reg. §1.170A-13(c)(4).
Conservation Easement Deduction Allowed for Donated Façade Easement
C.C.M. AM 2021-001 (Mar. 8, 2021)
Conservation easement deduction cases are everywhere. The IRS is all over taxpayers engaged in donating permanent conservation easement to a qualified charity and claiming a charitable deduction for the loss of value to their land caused by the easement. Recently the IRS put out more guidance on donated conservation easements in the form of a Memo from the IRS Chief Counsel’s Office.
The taxpayer in the Memo donated an easement on a building in a registered historic district on which the taxpayer had installed an accessibility ramp to comply with the Americans With Disabilities Act (ADA). The IRS determined that the installation of the ramp would not disqualify the taxpayer’s deduction. The IRS viewer the ramp as “upkeep” essential to the preservation of the structure. Such upkeep, if required to comply with the ADA, does not jeopardize the donor’s eligibility for a charitable deduction under I.R.C. §170(h)(4)(B) with respect to a building in a registered historic district.
The manner in which taxation impacts daily life is staggering. The cases discussed in today’s post illustrate just some of the ways that a taxpayer can get crosswise with the IRS. Take heed!
Saturday, April 10, 2021
Many farmers participate in federal farm programs and receive subsidies on a per-person basis. There are limits to the amount of subsidies that can be received. However, to be eligible to participate in most federal farm programs the applicant (individual or entity) must have an average adjusted gross income (AGI) of $900,000 or less.
What is AGI for farm program eligibility purposes? How is it computed? Does it matter if the applicant is an individual or an entity?
The computation of AGI for farm program eligibility purposes – it’s the topic of today’ post.
A prerequisite to participating in many federal farm programs is annually certifying that average AGI doesn’t exceed a $900,000 threshold. The measuring period is the prior three years, skipping the immediately prior year. The $900,000 limit applies to most USDA farm programs, but there are some exceptions – particularly those concerning conservation or disasters. An applicant must provide the IRS with written consent to allow the USDA to verify AGI. The consent (via USDA Form CCC-941) allows the IRS to verify to the FSA, based on a farm program applicant’s tax return information, whether (for most farm programs) the $900,000 limit is not exceeded. The consent covers the three tax years that precede the immediately preceding tax year for which farm program benefits are being sought. Thus, for 2021, the relevant tax years are 2019, 2018 and 2017. For a farmer or a farming operation that has not been operating for the three-year period before the immediately preceding year, the FSA uses an average of income for the years of operation. FSA 5-PL, Para. 312, subparagraph F.
Note: Worksheets used in determining AGI calculations should be retained for at least three years.
Defining AGI – The FSA Way
As noted, average AGI is measured over the three taxable years preceding the most immediately preceding complete taxable year for which benefits are requested. FSA 5-PL, Para. 293. The FSA, in its 5-PL at Paragraph 296, subparagraph B, sets forth the following Table for guidance on AGI determinations using a producer/applicant’s data that has been reported to the IRS:
If determining AGI for….
Then see IRS Form….
AND use the amount entered on….
1120 or 1120-S
Either of the following:
· Line 30 (total taxable income) plus line 19 (charitable contributions)
· For S corporations, use only Form 1120-S, line 21 (ordinary business income).
Estates or trusts
Line 23 (taxable income) plus line 13 (charitable deductions)
LLCs, LLPs, LP or similar type organization taxed as partnership
Line 22 (total income from trade or business) plus line 10 (guaranteed payments to partners).
Line 8b (AGI)
Tax-exempt or charitable organizations
Line 31 (unrelated business taxable income) minus income that CCC determines to be from noncommercial activity.
For a sole proprietor filing a joint return, an exception exists from the need to report the full amount reported as AGI on the final IRS tax return for the applicable year. Under the exception, a certification may be provided by a CPA or an attorney that specifies what the amounts would have been if separate tax returns would have been filed for the applicable year. FSA 5-PL, Para. 296, subparagraph A.
Schedule K Issues
IRS Form 1120-S and Form 1065 do not refer to income or deductions reported on Schedule K-1. A Schedule K-1 is the IRS Form that is used to report amounts that are passed through to each taxpayer that has an interest in a “flow-through” entity such as an S corporation, partnership, trust or an estate. Consequently, any I.R.C. §179 deduction (i.e., expense method depreciation) would not be factored into the average AGI computation for a farming operation that is a flow-through entity seeking farm program benefits. But it would be taken into account for a C corporation. Thus, a C corporation and an S corporation with identical taxable incomes may not be treated similarly for farm program eligibility purposes. This is particularly true for an S corporation farming entity, for example, that has AGI over the $900,000 threshold without factoring in any I.R.C. §179 amount but is under the limitation when the I.R.C. §179 deduction is taken into account.
Threatened with litigation on this disparate treatment, the FSA backed down and the 5-PL was later amended to reflect the rule change allowing the I.R.C. §179 deduction for flow-through entities as well as sole proprietorships and C corporations. However, FSA still ignores other K-1 items in the computation of AGI for purposes of the $900,000 AGI computation. At least this is the position of the national FSA. There may be variations at the local and state level. Consistent application of the regulations has never been a staple of the FSA.
Certifying Income – Form CCC-941
A producer seeking farm program benefits, as noted above, must annually certify income to the FSA to ensure that the $900,000 threshold (in most instances) is not exceeded. The verification process starts with the FSA’s referral of the applicant’s AGI certification and written consent to the IRS to use the applicant’s tax information on file and disclose certain information to the FSA for AGI verification purposes. FSA 5-PL, Para. 301, Subparagraph A. Consent for disclosure of tax information is valid only if the IRS receives it within 120 calendar days of the date the Form CCC-941 was signed. FSA 5-PL, Para. 301, Subparagraph E.
If an attorney or CPA statement is provided, both the statement and the completed Form CCC-941 must be submitted to the local FSA office before the Form CCC-941 is considered to be complete and AGI is updated in the producer’s file. The submitted Form CCC-941 is then sent to the IRS and the statement of the attorney/CPA is attached to a copy of the Form that FSA retains. FSA 5-PL, Para. 302, Subparagraph A.
Form CCC-941 is required to determine payment eligibility for all persons; legal entities; interest holders in a legal entity, including embedded entities to the fourth level of ownership interest, regardless of the level of interest held; and, members of a general partnership or joint venture, regardless of the number of members. FSA 5-PL, Par. 294. It is submitted under the same name and TIN as is used for tax filing purposes. For example, for farm assets and land that have been transferred to a revocable trust, the identification on Form CCC-941 is the grantor’s name and Social Security number.
If Form CCC-941 is not filed for a program year, the producer is not eligible for farm program payments for that year. Any program payments erroneously paid will have to be returned, with interest.
Note: Technically, the FSA rules state that to comply with the AGI requirement for the applicable crop, program or fiscal year, a person or legal entity must provide either a completed Form CCC-941 for that year or a statement from a CPA or attorney that the average AGI does not exceed the applicable limitation. But, in all cases, the portions of Form CCC-941 pertaining to consent of disclosure of tax information must be completed and signed by the person (or entity) subject to AGI compliance. FSA 5-PL, Par. 294, subparagraph B.
The form must be personally signed by the applicant – either in their own name or, if the application is on behalf of an entity, by the designated officer(s). If the applicant is a minor, the Form can be signed by a parent or guardian. One spouse cannot sign for the other spouse, however, absent a duly executed power-of-attorney (POA). Likewise, neither IRS Form 2848 nor an FSA POA (Form 211) is acceptable. FSA 5-PL, Para. 302, Subparagraph C.
Note: A Table contained in the FSA 5-PL, Amendment 4, page 6-34 at Para. 302, subparagraph C, sets forth the signature authority for Form CCC-941.
If the applicant is a grantor trust, the Form must denote the grantor’s name. For a deceased person, Form CCC-941 may be filed by the surviving spouse, an authorized representative or an entity that is responsible for filing the final Federal income tax return for the decedent. FSA 5-PL, Para. 302, subparagraph D. If filing is by an authorized representative, proof of such authorization must be provided by attachment to Form CCC-941.
If a Form CCC-941, as submitted to the IRS, is incomplete or illegible it will be returned to the FSA along with IRS Notice 1398 containing the reason(s) for the rejection. FSA 5-PL, Para. 301, Subparagraph H. The FSA will then contact the person or entity that submitted the Form and explain the reason(s) for the rejection as well as provide assistance to get the Form corrected. Id., Subparagraph H.
Form CCC-941 authorizes the FSA to obtain AGI data from the IRS. When the IRS receives the Form, it matches the identity of the name on the Form with the tax records associated with the name. The IRS then calculates AGI according to the FSA’s definition of the term and reports to the FSA whether the applicant is within the $900,000 threshold. If the IRS reports to the FSA that a producer is over the AGI limit, FSA then sends the producer a letter informing them that they have 30 days to provide a third-party verification by a CPA or an attorney that the producer’s average AGI is within the threshold along with associated tax records. If an entity is the farmer, this letter will be required for both the entity and the individual. If, upon review, the FSA still deems the producer to not be eligible for benefits, the producer may file an administrative appeal within 30 days of the determination.
Note: It’s important for a producer/applicant to respond to the FSA within the 30-day timeframe so as to preserver administrative appeal rights. However, the FSA 5-PL does state that appeal rights exist even if requested information is not timely provided. FSA 5-PL, Para. 297, Subparagraph E.
The failure to provide the FSA with correct and accurate information to establish AGI compliance can result in ineligibility for all program payments and benefits that are subject to the AGI limitation for the applicable years. In addition, the producer/entity will have to refund any benefits already paid due to the incorrect information and face possible civil or criminal prosecution. FSA 5-PL, Para. 297, Subparagraph D.
A person or entity that lacks tax records or is not required to file tax returns may document AGI by providing to FSA annual budgets and a statement of operations; annual public financial disclosures; financial statements; or any other documentation as FSA deems acceptable.
Note: Some farmers have expressed concern about the information the IRS shares with the FSA. However, the IRS does not report the applicant’s income, AGI (or average AGI), or any determination on the applicant’s eligibility or ineligibility for farm program payments. The IRS merely computes AGI according to the FSA approach and reports to the FSA whether the producer/applicant is over or under the applicable threshold. FSA 5-PL, Para. 303, subparagraph B. FSA maintains the information that the IRS provides to it in a secure database, and the information is not subject to a Freedom of Information Act request. Id., subparagraph C.
Exception for Exceeding the AGI Threshold
The 75 percent test. There are some farm programs for which the $900,000 AGI limit does not apply if at least 75 percent of AGI is derived from farming, ranching or forestry activities. For this purpose, “farm AGI” is comparable to net income from farming and may be identical to net farm profit (or loss) on Schedule F. The FSA definition of “farm AGI” also includes income from the sale of farmland, breeding livestock and ag conservation easements, for example. However, the term does not include income derived from the sale of farm equipment as well as income derived from the sale of production inputs and services. However, if at least two-thirds of total AGI from all sources is from farming, the income from the sale of farm equipment and production inputs and services counts as farm AGI. FSA 5-PL, Para. 312, subparagraph F.
In recent years, the market facilitation program (MFP) and the Coronavirus Food Assistance Program (CFAP) are examples of farm programs that don’t subject the applicant to a $900,000 AGI limitation. A producer applying for benefits from such a program must certify that the 75 percent test is satisfied. For this purpose, the FSA might require the producer to sign Form CCC-942. Alternatively, a letter from the producer’s professional tax preparer (an attorney of a CPA) can suffice. For entities that are applying for benefits, a certification letter is required for the entity and for the individual producer.
Note: The FSA cannot send certifications with respect to the 75 percent farm AGI test to the IRS for verification.
For purposes of the 75 percent test, the FSA, in a Table in the FSA 5-PL, Amendment 6, Para. 312, subparagraph B, defines income from farming, ranching and forestry. The Table illustrates that the term is defined broadly.
Wages paid by a farm employer do not constitute farm income. Thus, if an applicant’s only income is from wages earned via employment with, for example, a farming C corporation, the wages do not count as farm income for purposes of the 75 percent test. But, of course, this is only an issue if the producer/applicant’s income is over the $900,000 threshold.
The FSA regulations and associated guidance do not address whether income from a farmer’s foreign sales that are funneled through an IC-DISC counts as farm income for purposes of the 75 percent test. An IC-DISC allows a farmer that will be selling into an export market to essentially transfer income from the farmer to the tax-exempt IC-DISC via an export sales commission. An IC-DISC can be formed and utilized by any taxpayer that manufactures, produces, grows or extracts (MPGE) property in the U.S. that is held primarily for sale, lease or rental in the ordinary course of the taxpayer’s trade or business. That definition certainly includes farmers. The property to be exported is transferred to the IC-DISC which then sells the assets into an export market. While there is no “official” guidance on the issue, it would seem reasonable that such income counts as farm income.
Farmers participating in federal farm programs are subject to many detailed rules. In recent years, such payments have made up a substantial portion of total farm income. That makes compliance with the rules and staying within the average AGI limit critical.