Wednesday, January 29, 2020

Unique, But Important Tax Issues – “Claim of Right”; Passive Loss Grouping; and Bankruptcy Taxation

Overview

It’s not unusual for a taxpayer to present the tax preparer with unique factual situations that aren’t commonplace and have very unique rules.  Today’s post digs into three of those areas that often generate many questions from practitioners, and also aren’t handled easily by tax software.

Unique, but important tax issues - the topic of today’s post.

“Claim of Right” Doctrine Denies Remedy for Stock Sale

Heiting v. United States, No. 19-cv-224-jdp, 2020 U.S. Dist. LEXIS 10967 (W.D. Wisc. Jan. 23, 2020)

In 1932, the U.S. Supreme Court created the “claim of right” doctrine.  American Oil Consolidated v. Burnet, 286 U.S. 417 (1932)It applies when a taxpayer receives income, but the income is subject to a contingency or other significant restriction that might remove it from the taxpayer.  In that situation, the taxpayer need not recognize the income.  In essence, the doctrine applies when the taxpayer doesn’t have a fixed right to the income.  If the taxpayer ultimately has to return the income that has been recognized, the taxpayer might be entitled to receive an offsetting deduction or a tax creditI.R.C. §1341. 

The “claim of right” doctrine arose in a recent Wisconsin federal court case in a rather unique situation.  Under the facts of the case, the plaintiffs, a married couple, created a revocable living trust in 2004 and amended it in 2012. The trust was created under Wisconsin law and named a bank as trustee with a different bank as successor trustee. The trust language gave the trustee broad discretion to invest, reinvest, or retain trust assets. However, the trust barred the trustee from doing anything with the stock of two companies that the trust held. The trustee apparently did not know of the prohibition and sold all of the stock of both companies in late 2015, triggering a taxable gain of $5,643,067.50. The sale proceeds remained in the trust. Approximately three months later, in early 2016, the trustee learned of the trust provision barring the stock sale and repurchased the stock with the trust’s assets. The grantors then revoked the trust later in 2016.

On their 2015 return, the plaintiffs reported the gain on the stock sale and paid the resulting tax. On their 2016 return, the plaintiffs claimed a deduction under I.R.C. 1341 for the tax paid on the stock sale gain the prior year. The IRS denied the deduction and the plaintiffs challenged the denial.  The IRS motioned to dismiss the case. The plaintiffs relied on the “claim of right” doctrine of I.R.C. §1341– they reported the income and paid the tax.  Under I.R.C. §1341, the plaintiffs had to: (1) establish that they included the income from the stock sale in a prior tax year; (2) show that they were entitled to a deduction because they did not have an unrestricted right to the income as of the close of the earlier tax year; and (3) show that the amount of the deduction exceeds $3,000. If the requirements are satisfied, a taxpayer can claim the deduction in the current tax year or claim a credit for the taxes paid in the prior year.

The IRS claimed that the plaintiffs could not satisfy the second element because the plaintiffs were not actually required to relinquish the proceeds of the stock sale. The court agreed, noting that once the stocks were sold the plaintiffs had the unrestricted right to the proceeds as part of the revocable trust, as further evidenced by them revoking the trust in 2016. The court noted that neither the trustee nor the plaintiffs had any obligation to repurchase the stock. The court also noted that under Wisconsin trust law, the plaintiffs could have instructed the trustee to do anything with the proceeds of the stock sale, and that they had the power to consent to the trustee’s action of selling the stock. In other words, they were not duty-bound to require the trustee to buy the stock back. Accordingly, the court determined that I.R.C. §1341 did not provide a remedy to the plaintiffs, and that any remedy, if there was one, would be against the trustee. 

Grouping and the Passive Loss Rules

Eger v. United States, 405 F. Supp. 3d 850 (N.D. Cal. 2019)

 Under I.R.C. §469, the deduction of losses from a “passive activity” is limited to the amount of passive income from all passive activities of the taxpayer.  Stated another way, a passive activity loss is the excess of the aggregate losses from all passive activities for the year over the aggregate income from all passive activities for that particular year.  For taxpayers with multiple activities, Treas. Reg. §1.469-4(c)(1) provides for a grouping of legal entities if the activities constitute an appropriate economic unit for the measurement of gain or loss. Also, rental activities can generally be grouped together.  Grouping can be helpful to satisfy the material participation tests of I.R.C. §469 to avoid the application of the passive loss rules.  This grouping issue came up in a recent federal case in Oklahoma involving rental activities. 

In the case, the plaintiff was a real estate professional within the meaning of I.R.C. §469(c)(7) that owned three properties (vacation properties) in different states that he offered for rent via management companies at various times during the year in issue. The plaintiff reserved the right for days of personal use of each rental property. The plaintiff sought to group the vacation rental properties with his other rental activities as a single activity for purposes of the material participation rules of I.R.C. §469. The IRS denied the grouping on the basis that the vacation rental properties were not rental properties on the basis that the average period of customer use for the vacation rentals was seven days or less as set forth in Treas. Reg. §1.469-1T(e)(3)(ii)(A), and that the petitioner was the “customer” rather than the management companies.

The court agreed with the IRS position on the basis that the plaintiff’s retained right to use each vacation property eliminated the management companies from having a continuous or recurring right to use the property when applying the test of Treas. Reg. §1.469-1(e)(3)(iii)(D) providing for measuring the period of customer use. As such, the facts of the case differed substantially from the contracts at issue in White v. Comr., T.C. Sum. Op. 2004-139 and Hairston v. Comr., T.C. Memo. 2000-386.  Thus, the management companies were not customers with a continuous right to use the properties, but merely provided marketing and rental services for the petitioner to rent out the properties. 

Prior Bankruptcy Filings Extends Non-Dischargeability Period

In re Nachimson v. United States, 606 B.R. 899 (Bankr. W.D. Okla. 2019)

The creation of the bankruptcy estate as a new taxpayer, separate from the debtor, highlights the five categories of taxes in a Chapter 7 or 11 case.  Category 1 taxes are taxes where the tax return was due more than three years before filing.  These taxes are dischargeable unless the debtor failed to file a return or filed a fraudulent return.  Category 2 taxes are the taxes due within the last three years.  These taxes are not dischargeable but are entitled to an eighth priority claim in the bankruptcy estate, ahead of the unsecured creditors.  Category 3 taxes are the taxes for the portion of the year of bankruptcy filing up to the day before the day of bankruptcy filing.  If the debtor's year is closed as of the date of filing, the taxes for the first year, while not dischargeable, are also entitled to an eighth priority claim in the bankruptcy estate.  If the debtor's year is not closed, the entire amount of taxes for the year of filing are the debtor's responsibility.  Category 4 taxes are the taxes triggered on or after the date of filing and are the responsibility of the bankruptcy estate.  Taxes due are paid by the bankruptcy estate as an administrative expense.  If the taxes exceed the available funds, the tax obligation remains against the bankruptcy estate but does not return to the debtor.  Category 5 taxes are for the portion of the year beginning with the date of bankruptcy filing (or for the entire year if the debtor's year is not closed) and are the responsibility of the debtor.

In a recent Oklahoma case, the debtor filed Chapter 7 in late 2018 after not filing his 2013 and 2014 returns. The 2013 return was due on October 15, 2014, and the 2014 return was due April 15, 2015. The debtor had previously filed bankruptcy in late 2014 (Chapter 13). That prior case was dismissed in early 2015. The debtor filed another bankruptcy petition in late 2015 (Chapter 11). Based on the facts, the debtor had been in bankruptcy proceedings during the relevant time period, (October 15, 2014, through October 25, 2018) for a total of 311 days. 11 U.S.C. § 523(a)(1)(A) provides, in general, that a discharge of debt in bankruptcy does not discharge an individual debtor from any debt for an income tax for the periods specified in 11 U.S.C. § 507(a)(8). One of the periods provided under 11 U.S.C. § 507(a)(8), contained in 11 U.S.C. § 507(a)(8)(A)(i), is the three years before filing a bankruptcy petition. Also, 11 U.S.C. § 507(a)(8) specifies that an otherwise applicable time period specified in 11 U.S.C. § 507(a)(8) is suspended for any time during which the stay of proceedings was in effect in a prior bankruptcy case or during which collection was precluded by the existence of one or more confirmed bankruptcy plans, plus 90 days.  When a debtor files multiple, successive bankruptcy cases, the ordinary operation of the automatic stay 11 U.S.C. § 507(a)(8) is altered by 11 U.S.C. § 362(c)(3)(A) which specifies that if a debtor had a case pending within the preceding one-year period that was dismissed, then the automatic stay with respect to any action taken with respect to a debt or property securing that debt terminates with respect to the debtor on the 30th day after the filing of the later case.

The debtor sought to have his 2013 and 2014 tax liabilities discharged in the present bankruptcy case under 11 U.S.C. §523(a)(1)(A) on the basis that the filing dates for those returns were outside the three-year look-back period. The IRS took the position that the three-year “look-back” period was extended due to the debtor's bankruptcy filings. The court agreed with the IRS, noting that the three-year look-back period began on October 25, 2015. However, the court concluded that an issue remained as to whether the look-back period extended back 401 days, or only for the first 30 days following each bankruptcy filing as provided by 11 U.S.C. § 362(c)(3)(A). Based on a review of applicable bankruptcy case law, the court concluded that the tolling provision of 11 U.S.C. § 507(a)(8) was not impacted by the automatic nature of 11 U.S.C. § 362(c)(3)(A). Instead, for purposes of the tolling provision, the stay of proceedings was in effect in each of debtor's three previous cases until each was dismissed. Therefore, the court found that the look-back period extended back three years plus 401 days. Since the debtor filed the bankruptcy petition in the present case on October 25, 2018, the three-year plus 401-day look-back period reached back to September 19, 2014. Because the debtor's 2013 and 2014 tax liabilities were due after that date (including the extension for the 2013 liability), neither was dischargeable in the current bankruptcy case. 

Conclusion

Some clients have standard, straightforward returns.  Others have very complicated returns that present very unique issues.  The cases discussed today point out just three of the ways that tax issues can be very unique and difficult to sort out. 

January 29, 2020 in Bankruptcy, Income Tax | Permalink | Comments (0)

Monday, January 27, 2020

Ag Law and Tax in the Courts – Bankruptcy Debt Discharge; Aerial Application of Chemicals; Start-Up Expenses and Lying as Protected Speech

Overview

A couple of weeks ago I did a post on some recent developments in the courts involving ag law and ag tax.  Since that time, there have been additional important court developments.  Before getting deep into tax season, it may be a good idea to provide a summary of a few of these cases.

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

Bankruptcy Discharge and Fraud

In re Kurtz, 604 B.R. 349 (Bankr. D. Neb. 2019)

A major feature of bankruptcy in the United States is the ability to discharge at least some debt.  This makes possible the “fresh start” for debtors. But, some debtors and debts are not eligible for discharge.  Of the several categories of debts that aren’t eligible for discharge, one category is reserved for debts associated with the debtor’s fraudulent conduct.  In this case, the creditor was a landlord and the debtor was the farm tenant who put up hay and other crops on the landlord’s land. The parties did not have a written lease agreement, but the landlord assumed the lease was a 50-50 crop share agreement where the parties would split the expenses and the sale proceeds equally. The record was unclear as to what the tenant understood the relationship to be, but he did make statements to others that it was a cash rent lease. The tenant did not pay the landlord after the first two cuttings of hay because he incurred expenses while cutting. After the third cutting was bailed the landlord contacted the tenant about payment. The tenant told the landlord that he could have the proceeds from the third cutting of hay and that the tenant was finished farming for the landlord. The tenant paid a third party to stack the hay. When the landlord attempted to sell the hay he discovered that the tenant had already given the hay to a third party to settle a debt. Both parties submitted expenses related to the hay crop that year.

The landlord filed a complaint in the tenant’s bankruptcy case alleging fraud and misrepresentation seeking that the debt to the landlord not be discharged. The bankruptcy court agreed, determining that the landlord proved that the tenant’s obligation of $5,916.50 was exempt from discharge because of the debtor’s false representation. The bankruptcy court determined that the full debt owed to the landlord was $22,292.84 based on the oral lease, but that the only part of that amount derived from fraud was the amount related to the third cutting of hay - $5,370.50 plus $546 for stacking. The balance of the unpaid debt arose from a general misunderstanding that wasn’t settled before the debtor put up the first two hay cuttings. The only blatant dishonesty, the bankruptcy court determined, concerned the third cutting.  

Aerial Application of Ag Chemicals Not Inherently Dangerous

Keller Farms, Inc. v. Stewart, No. 1:16 CV 265 ACL, 2018 U.S. Dist. LEXIS 210209 (E.D. Mo. Dec. 13, 2018), aff’d. sub. nom., Keller Farms, Inc. v. McGarity Flying Service, LLC, No. 18-3755, 2019 U.S. App. LEXIS 36664 (8th Cir. Dec. 11, 2019)

This case involves a dispute involving alleged damage to the plaintiffs’ trees caused by chemicals that allegedly drifted during aerial application. The plaintiffs attempted to hold liable both the aerial applicator and the landowner that hired the applicator. The plaintiffs claimed the landowner was vicariously liable (liable because of the relationship with the applicator) for the applicator’s actions because aerial spraying of burndown chemicals is an "inherently dangerous activity." The trial court granted the defendants’ motion for Judgment as a Matter of Law on the plaintiff's trespass claim, but the remaining issues were left for the jury to resolve. The jury returned a verdict in favor of the defendants on the negligence and negligence per se claims. The plaintiffs filed a motion for a new trial, arguing the verdict was against the weight of the evidence; that the trial court erred in excluding evidence; and that the trial court erred in granting the defendants’ Motion for Judgment as a Matter of Law. The trial court, however, denied the plaintiff’s motion for a new trial.

On appeal, the appellate court affirmed. The appellate court determined that the jury’s verdict was not against the weight of the evidence, and that the aerial application of herbicides was commonplace and not inherently dangerous. In addition, the appellate court noted that the defendants’ evidence was that the herbicides did not actually drift onto the plaintiffs’ property and that the applicator complied with all label requirements and sprayed during optimal conditions. The appellate court also determined that the trial court had ruled properly on evidentiary matters and that the plaintiff had not proven the alleged monetary damages to the trees properly. The appellate court also upheld the trial court’s denial of the plaintiff’s motion for a new trial.

The Line Between Nondeductible Start-Up Expenses and Deductible Business Expenses

Primus v. Comr., T.C. Sum. Op. 2020-2

The petitioner lived in New York and bought a property in Quebec containing 200 maple trees with a significant number of them being mature, maple syrup-producing trees. The tract contained other types of trees and pasture ground and hay fields and a small amount of ground suitable for growing crops. There were also various improvements on the tract. Before collecting sap and producing syrup, the petitioner thinned underbrush and later installed a pipeline to collect sap. Sap production began in 2017. When the petitioner bought the property in 2012, the cleared the areas of the tract where he planned to plant blueberry bushes. He ordered 2,000 blueberry bushes in 2014 and planted them in 2015. He reported a substantial amount of farming-related expenses in 2012 and 2013, with most of the expenses attributable to costs of repairs to improvements on the property. The petitioner deducted expenses attributable to preparatory costs for the production of selling maple syrup and blueberries as trade or business expenses under I.R.C. §162 (or as I.R.C. §212 expenses for income-producing property).

The IRS denied the deductions, asserting that they were nondeductible start-up expenses under I.R.C. §195 on the basis that the petitioner had not yet begun the business of producing maple syrup and blueberries. The Tax Court upheld the IRS position. The Tax Court noted that expenses are not deductible as trade or business expenses until the business is actually functioning and performing the activities for which it was organized. Here, the petitioner had not actually started selling blueberries or sap in either 2012 or 2013.  That meant that the expenses incurred in 2012 and 2013 were incurred to prepare the farm to produce sap and plant blueberries, and were nondeductible startup expenses. The thinning activities, while a generally acceptable industry practice, did not establish that the business had progressed beyond the startup phase. In addition, during the years at issue, the petitioner had not collected sap, installed any infrastructure needed to convert sap into syrup, or bought any blueberry bushes. 

Lying With Purpose of Harming Livestock Facility is Protected Speech

Animal Legal Defense Fund v. Schmidt, No. 18-2657-KHV, 2020 U.S. Dist. LEXIS 10202 (D. Kan. Jan. 22, 2020)

The plaintiffs are a consortium of activist groups regularly conduct undercover investigations of livestock production facilities. Some of the plaintiffs gain access to farms through employment without disclosing the real purpose for which they seek employment (and lie about their ill motives if asked) and wear body cameras while working. For those hired into managerial and/or supervisory positions, they gain the ability to close off parts of the facility to avoid detection when filming and videoing. The film and photos obtained are circulated through the media and with the intent of encouraging public officials, including law enforcement, to take action against the facilities. The employee making the clandestine video or taking pictures, is on notice that the facility owner forbids such conduct via posted notices at the facility. The other plaintiffs utilize the data collected to cast the facilities in a negative public light, but do no “investigation.”

In 1990, Kansas enacted the Kansas Farm Animal and Field Crop and Research Facilities Protect Act (Act). K.S.A. §§ 47-1825 et seq.  The Act makes it a crime to commit certain acts without the facility owner’s consent where the plaintiff commits the act with the intent to damage an animal facility. Included among the prohibited acts are damaging or destroying an animal facility or an animal or other property at an animal facility; exercising control over an animal facility, an animal from an animal facility or animal facility property with the intent to deprive the owner of it; entering an animal facility that is not open to the public to take photographs or recordings; and remaining at an animal facility against the owner's wishes. K.S.A. § 47-1827(a)-(d). In addition, K.S.A. § 47-1828 provides a private right of action for "[a]ny person who has been damaged by reason of a violation of K.S.A. § 47-1827 against the person who caused the damage." For purposes of the Act, a facility owner’s consent is not effective if it is induced by force, fraud, deception duress or threat. K.S.A. § 47-1826(e). The plaintiff challenged the constitutionality of the Act, and filed a motion for summary judgment. The defendant also motioned for summary judgment on the basis that the plaintiffs lacked standing or, in the alternative, the Act barred trespass rather than speech.

On the standing issue, the trial court held that the plaintiffs lacked standing to challenge the portions of the Act governing physical damage to an animal facility (for lack of expressed intent to cause harm) and the private right of action provision, However, the trial court determined that the plaintiffs did have standing to challenge the exercise of control provision, entering a facility to take photographs, etc., and remaining at a facility against the owner’s wishes to take pictures, etc. The plaintiffs that did no investigations but received the information from the investigations also were deemed to have standing on the same grounds. On the merits, the trial court determined that the Act regulates speech by limiting what the plaintiffs could say and by barring pictures/videos. The trial court determined that the provisions of the Act at issue were content-based and restricted speech based on viewpoint – barring only that speech that would harm an animal facility. The trial court determined that barring lying is only constitutionally protected when it is associated with a legally recognizable harm, and the Act is unconstitutional to the extent it bars false speech intended to damage livestock facilities. Because the provisions of the Act at issue restrict content-based speech, its constitutionality is measured under a strict scrutiny standard. As such, a compelling state interest in protecting legally recognizable rights must exist. The trial court concluded that even if privacy and property rights involved a compelling state interest, the Act must be narrowly tailored to protect those rights. By focusing only on those intending to harm owners of a livestock facility, the Act did not bar all violations of property and privacy rights. The trial court also determined that the Governor was a proper defendant. 

The status of the litigation presently rests with the Kansas Attorney General and the Governor to determine the next step(s) to be taken.

Conclusion

There is never a dull moment in agricultural law and taxation.  I will provide more updates like this is in future posts.

January 27, 2020 in Bankruptcy, Civil Liabilities, Criminal Liabilities, Income Tax | Permalink | Comments (0)

Thursday, January 23, 2020

Substantiation – The Key To Tax Deductions

Overview

The IRS has specific rules for claiming deductions on a tax return.  Those rules differ depending on the type of deduction claimed and the Code section at issue.  In all circumstances, substantiation of the claimed deduction is critical.  How that substantiation must occur is what differs depending on the type of deduction being claimed.  Is it a business expense?  Is it a charitable deduction?  Is some other type unique expense for which a deduction can be legitimately claimed?  It’s important to know the rules that apply.

Substantiating deductible expenses – it’s the topic of today’s post.

Charitable Deductions

Regulations - TD 9836. Substantiation and Reporting Requirements for Cash and Noncash Charitable Contribution Deductions (Jul. 27, 2018).  In 2008, the Treasury issued proposed regulations governing the tax reporting of charitable contributions.  In 2018, the Treasury finalized those regulations with only slight modification.  Under the final regulations, a donor must maintain records of charitable contributions. For cash contributions, the donor must retain a canceled check, or other reliable written record showing the donee’s name, date of contribution and amount. While some charitable organizations provide a blank form for donors to complete, the Preamble to the final regulations specify that a blank form is insufficient to satisfy record keeping requirements for tax purposes to substantiate the donation. For contributions over $250, the donee organization must provide a contemporaneous written acknowledgment of the gift. I.R.C. §170(f)(8). In addition, the final regulations state that a donor may be required to complete and submit a Form 8283, depending on the type of gift and the amount. The Preamble to the final regulations provides that the Form 8283 itself does not meet the contemporaneous written acknowledgment requirement. Rather, a separate written acknowledgment is required.

The final regulations note that appraisals are required for non-money contributions over $5,000, and state that an appraiser can meet the requisite education and experience requirements by successfully completing professional or college-level coursework. But mere attendance is not sufficient, and evidence of successful completion is required. For contributions exceeding $500,000 in value, the appraisal must be attached to the donor’s income tax return. Under the final regulations, the appraisal is not attached just to the return of the contribution year but must also be attached to any return involving a carryover year (due to the limitation on the charitable contribution deduction). 

Conservation easement donations.  The rules for claiming a charitable deduction for a contributed permanent conservation easement to a qualified land trust are also particular.  I have written about those requirements in previous posts, and there continue to be cases that point out just how particular those rules are. 

Recent cases.

 Loube v. Comr., T.C. Memo. 2020-3In this case a married couple was denied a charitable deduction for gifts of property.  The couple bought a house on .38 acres with the purpose of demolishing the house and building a new residence on the tract. To further that purpose, they entered into an agreement with a charity to perform the deconstruction of the existing house and donate personal property in the home to the charity. An appraiser determined that the cost to reproduce the house would be $674,000. After subtracting labor costs and other fees, as well as profit for a construction company and the cost of new material cost and depreciation, the resulting fair market value for the deconstructed house was determined to be $297,000.

On their 2013 return, the couple claimed a $297,000 non-cash charitable contribution deduction for the donation of the improvements to the charity. On the appraiser summary attached to the return, the petitioners identified the donated property as “other” and noted that the “house improvements” were in “excellent” condition. However, the appraisal form did not indicate the date of the donation or the petitioners’ cost basis in the improvements. In addition, the appraiser did not sign the appraisal form.

The IRS denied the deduction on the basis that the appraisal did not appraise each donated item separately. The Tax Court upheld the IRS position and also noted that the petitioners did not strictly comply with Treas. Reg. §1.170A-13 which specifically required the petitioners to provide sufficient information to evaluate their reported contributions. The Tax Court held that basis was an important factor that needed evidentiary support. The Tax Court also noted that the petitioners failed to denote the contribution date or provide a reasonable cause explanation for their inability to provide basis information. 

TOT Property Holdings, LLC v. Comr., Docket No. 005600-17 (U.S. Tax Ct. Dec. 13, 2019).  The petitioner engaged in a syndicated easement transaction whereby it made a $6.9 million charitable contribution for an easement on 637 acres of a 652-acre parcel donated to a land conservancy. The IRS denied a charitable deduction due to the easement deed not satisfying the perpetuity requirement and imposed a 40 percent gross valuation misstatement and negligence penalties. The Tax Court agreed, determined that the actual value of the easement donation was less than 10 percent of what was originally reported on the petitioner’s return. In the process, the Tax Court gave more credibility to the approach of the appraiser for the IRS. 

Presley v. Comr., No. 18-90008, 2019 U.S. App. LEXIS 32018 (10th Cir. Oct. 25, 2019, aff’g., T.C. Memo. 2018-171. The petitioner claimed a charitable deduction in 2010 for over $107,000 attributable to land improvements to property that a charity owned. The improvements occurred over several years and were made by the petitioner’s LLC. The petitioner did not claim any charitable deductions in the years that the improvements were made. The IRS denied the deduction and the Tax Court agreed. The petitioner conceded that the did not own the improvements, and the Tax Court noted that the petitioner could not claim the deduction in 2010 because the improvements were paid for in years preceding 2010. In addition, the Tax Court noted that even if the improvements had been paid for in 2010, the amounts that the LLC paid for were not directly connected with or solely attributable to the rendering of services by the LLC to the charity as Treas. Reg. §1.170A-1(g) requires. In addition, the Tax Court determined that the petitioner did not satisfy the substantiation requirements and did not include Form 8283 and did not have an appraisal of the improvements made as required when a charitable deduction exceeding $5,000 is claimed. 

Business-related deductions. 

Gebman v. Comr., T.C. Memo. 2020-1.  In this case, the petitioners (a married couple) claimed a large net operating loss (NOL), but failed to file with the return a concise statement detailing the amount of the NOL claimed and all material facts relating to the NOL including a schedule showing how the NOL deduction was computed. The IRS rejected the NOL deduction and the Tax Court agreed. The Tax Court noted that the petitioners bore the burden to substantiate the claimed deduction and that the petitioners had provided no detailed information supporting the NOL. The Tax Court also noted that the petitioners bore the burden of proof to establish both the existence of the NOLs for prior years and the NOL amounts that can be carried forward to the years at issue. The petitioners did not satisfy these requirements either. The only “proof” the petitioners had was submitted copies of tax returns on which they reported the losses. The Tax Court declined to hold that submitted copies of returns was sufficient substantiation. 

Taylor II v. Comr., T.C. Memo. 2019-102.  The petitioner claimed a casualty loss on the 2008 return (before the rules deducting casualty losses changed to what they are now) for damage from a hurricane. An insurance company paid over $2.3 million in claims, and the claimed deduction was $888,345. The petitioner reported a basis in the property of $6.5 million, insurance reimbursement of $2.3 million and a pre-casualty fair market value of $15,442,059 and a post-casualty fair market value of $12,250,000. The pre-casualty FMV was based on the 2009 listing price of the property reduced for time spent on the market. No testimony was provided as to post-casualty FMV. The Tax Court (Judge Paris) noted that to compute a casualty loss deduction, the pre and post-FMV values of the impacted property must be computed and the property basis must be established. The Tax Court noted that decline in value can alternatively be established via the regulations under I.R.C. §165 if the taxpayer has repaired the property damage resulting from the casualty, the taxpayer may use the cost of repairs to prove the loss of value to the property from the casualty. In that instance, the taxpayer must show that (a) the repairs are necessary to restore the property to its condition immediately before the casualty, (b) the amount spent for such repairs is not excessive, (c) the repairs do not care for more than the damage suffered, and (d) the value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty. The Tax Court noted that the record did not establish that the valuations were based on competent appraisals, and didn’t indicate how the petitioner’s CPAs determined the pre or post-casualty FMV of the property, even though the pre-casualty FMV was consistent with the value reported to the insurance company. The Tax Court concluded that the appraisals were not reliable measures of the taxpayer's casualty loss and didn’t rely on them. In addition, the taxpayer received insurance payments that exceed the cost of repairs. That meant that a casualty loss deduction couldn’t be claimed based on the regulations. The Tax Court disallowed any casualty loss deduction. 

Draper v. Comr., T.C. Memo. 2019-95. The petitioner operated a property development business through his C corporation, but failed to properly document the business purpose of some of the claimed expenses. The Tax Court, agreeing with the IRS, denied business expense deductions for numerous meals, entertainment and travel expenses. The Tax Court allowed current deductions for marketing and promotional expenses , but noted that some expenses involved the cost of bidding on a contract which were not currently deductible. In addition, the Tax Court determined that assets sold did not qualify for capital gain treatment, and that deductions claimed in one year that were recovered in another year (such as a refund of state income tax) had to be included in income in the received. 

Baca v. Comr., T.C. Memo. 2019-78.  The petitioner’s job required him to move and operate oil fracking equipment away from his home residence. He deducted the associated travel costs and the IRS disallowed the deductions. The Tax Court agreed with the IRS because the petitioner’s tax home had shifted due to the indefinite work position. The petitioner also owned multiple businesses for which deductions were claimed. The Tax Court also upheld the denial of the business-related deductions due to lack of documentation. Auto-related expenses were also denied due to a lack of a log or diary and the necessary detail for vehicle expense substantiation. Also disallowed was the petitioner’s expense method depreciation deduction for tools on the petitioner’s 2012 return because they were purchased and placed in service in 2011. The Tax Court also denied other expenses due to a lack of documentation or failure to show a business relationship to the expense including a deduction for contract labor because the petitioners could not show how much the worker was paid. 

Dasent v. Commissioner, T.C. Memo. 2018-202.  The petitioners, a married couple claimed various business expenses on Schedule C. They self-prepared their return for 2014, the year in issue. Their Schedule C reported no gross receipts and total expenses of $28,173. They also claimed unreimbursed employee expenses of $23,931 on Schedule A. The IRS denied the Schedule C and Schedule A deductions and also took the position that the petitioners failed to report $25,622 of IRA distributions (and the associated penalty for early withdrawal). The IRS also determined that the petitioners failed to report $123,168 of cancelled debt income. The IRS also imposed a penalty for underpayment of tax associated with the substantial understatement of tax. The Tax Court determined that the wife failed to provide sufficient evidence that she was engaged in a business with a profit motive. The Tax Court also concluded that the wife failed to substantiate any of the business expenses associated with the wife’s business and provided no means for the court to estimate those expenses under the Cohan rule. In addition, the court noted that the Cohan rule has no application to I.R.C. §274(d) expenses (e.g., travel and entertainment expenses, gifts and listed property which are subject to strict substantiation requirements). While the petitioners claimed that they should not be subject to the 10 percent penalty for early withdrawal from their IRA because the withdrawn funds were used to pay for their daughter’s college tuition, The Tax Court, however, upheld the penalty because the petitioners failed to establish that the withdrawn funds were actually used to pay the daughter’s tuition. The Tax Court also upheld the imposition of a 20 percent penalty for substantial understatement of tax. On that issue, the Tax Court noted that the petitioners were college-educated and used a tax software (TurboTax), that software was not the same as relying on professional tax advice. 

Hagos v. Comr., T.C. Memo. 2018-166.  The petitioner claimed deductions for uniforms, shirts, shoes, mileage and other expenses associated with his job as a driver for a ride sharing company. While the IRS allowed some deductions, many were disallowed due to lack of substantiation and the lack of supporting records. 

Wax v. Comr., T.C. Memo. 2018-63.  The petitioners, a married couple, claimed various deductions on behalf of their children as well as auto expenses and meal and entertainment expenses. However, the court held that they failed to meet the strict substantiation requirements of I.R.C. §274(d). They failed to show that the expenses for the children were bona fide or reasonable compensation relating to the value of the services provided. Expenses also failed to be separated between business-related and personal.

Conclusion

The cases are many and varied that point out just how important it is to properly substantiate deductions.  The substantiation rules differ depending on the type of deduction being claimed.  Good recordkeeping is essential and the failure to do so can make a return “low-hanging fruit” for the IRS to easily pluck. 

January 23, 2020 in Income Tax | Permalink | Comments (0)

Tuesday, January 21, 2020

Does the Penalty Relief for a “Small Partnership” Still Apply?

Overview

Every partnership (defined as a joint venture or any other unincorporated organization) that conducts a business is required to file a return for each tax year that reports the items of gross income and allowable deductions. I.R.C. §§761(a); 6031(a).  If a partnership return is not timely filed (including extensions) or is timely filed but is inadequate, a monthly penalty is triggered that equals $210 times the number of partners during any part of the tax year for each month (or fraction thereof) for which the failure continues.  This is for returns that are to be filed in 2021.  However, the penalty amount is capped at 12 months.  Such an entity is also subject to rules enacted under the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982.  These rules established unified procedures for the IRS examination of partnerships, rather than a separate examination of each partner.

An exception from the penalty for failing to file a partnership return could apply for many small business partnerships and farming operations.  But this relief is tied to a provision that is no longer in the Code as of January 1, 2018.  So, does the relief still apply when the law it was tied to is gone?  The IRS answered this question last week.

The “small partnership” exception from the penalty for late filing the partnership return – it’s the topic of today’s post.

Exception for Failure to File Partnership Return

The penalty for failure to file is assessed against the partnership.  While there is not a statutory exception to the penalty, it is not assessed if it can be shown that the failure to file was due to reasonable cause. I.R.C. §6689(a). The taxpayer bears the burden to show reasonable cause based on the facts and circumstances of each situation.  On the reasonable cause issue, the IRS, in Rev. Proc. 84-35, 1984-1 C.B. 509, established an exception from the penalty for failing to file a partnership return for a “small partnership.”  Under the Rev. Proc., an entity that satisfies the requirements to be a small partnership will be considered to meet the reasonable cause test and will not be subject to the penalty imposed by I.R.C. §6698 for the failure to file a complete or timely partnership return.  However, the Rev. Proc. noted that each partner of the small partnership must fully report their shares of the income, deductions and credits of the partnership on their timely filed income tax returns.

So, what is a small partnership?  Under Rev. Proc. 84-35 (and I.R.C. §6231(a)(1)(B)), a “small partnership” must satisfy six requirements:

  • The partnership must be a domestic partnership;
  • The partnership must have 10 or fewer partners;
  • All of the partners must be natural persons (other than a nonresident alien), an estate of a deceased partner, or C corporations;
  • Each partner’s share of each partnership item must be the same as the partner’s share of every other item;
  • All of the partners must have timely filed their income tax returns; and
  • All of the partners must establish that they reported their share of the income, deductions and credits of the partnership on their timely filed income tax returns if the IRS requests.      

The Actual Relief of the Small Partnership Exception

Typically, the small partnership exception is limited in usefulness to those situations where the partners are unaware of the partnership return filing requirement or are unaware that they have a partnership for tax purposes, and the IRS asserts the penalty for failing to file a partnership return.  In those situations, the partnership can use the exception to show reasonable cause for the failure to file a partnership return.  But, even if the exception is deemed to apply, the IRS can require that the individual partners prove that they have properly reported all tax items on their individual returns. 

In addition, if the small partnership exception applies, it does not mean that the small partnership is not a partnership for tax purposes.  It only means that the small partnership is not subject to the penalty for failure to file a partnership return and the TEFRA audit procedures.

Why does the “small partnership exception” only apply for TEFRA audit procedures and not the entire Internal Revenue Code?  It’s because the statutory definition of “small partnership” contained in I.R.C. §6231(a)(1)(B) applies only in the context of “this subchapter.”  “This subchapter” means Subchapter C of Chapter 63 of the I.R.C.  Chapter 63 is entitled, “Assessment.”  Thus, the exception for a small partnership only means that that IRS can determine the treatment of a partnership item at the partner level, rather than being required to determine the treatment at the partnership level.  The subchapter does not contain any exception from a filing requirement.  By contrast, the rules for the filing of a partnership return (a “partnership” is defined in I.R.C. §761, which is contained in Chapter 1) are found in Chapter 61, subchapter A – specifically I.R.C. §6031.  Because a “partnership” is defined in I.R.C. §761 for purposes of filing a return rather than under I.R.C. §6231, and the requirement to file is contained in I.R.C. §6031, the small partnership exception has no application for purposes of filing a partnership return.  Thus, Rev. Proc. 84-35 states that if specific criteria are satisfied, there is no penalty for failure to file a timely or complete partnership return.  There is no blanket exception from filing a partnership return.  A requirement to meet this exception includes the partner timely reporting the share of partnership income, deductions and credits on the partner’s tax return. Those amounts can’t be determined without the partnership computing them, using accounting methods determined by the partnership and perhaps the partnership making elections such as I.R.C. §179

The small partnership exception does not apply outside of TEFRA. Any suggestion otherwise is simply a misreading of the Internal Revenue Code.

Repeal by the Bipartisan Budget Act of 2015

The statutory definition of a “small partnership” contained in I.R.C. §6231(a)(1)(B) effective for tax years beginning on or after January 1, 2018.  The Bipartisan Budget Act of 2015 (BBA) repealed the TEFRA audit rules entirely and replaced it with a new system for auditing partnerships. 

So, that repeal wipes out the penalty relief that was tied to it, right?  Not so fast says the IRS.  In Program Manager Technical Advice 2020-01 (Nov. 19, 2019), the IRS noted that the Congress enacted the late-filing partnership return penalty of I.R.C. §6698 in 1978 (pre-TEFRA), and that it “apply automatically to a small partnership that meets certain criteria.”  The Conference Report accompanying the provision indicated an exception for a “small partnership” “so long as each partner fully reports his share of the income, deductions and credits of the partnership.”  H.R. Rep. No. 95-1800, at 221 (1978).  In Rev. Proc. 81-11, 1981-1 C.B. 651, the IRS provided a set of criteria under which partnerships with 10 or fewer partners would not be subject to the penalty of I.R.C. §6698.  It was later superseded by Rev. Proc. 84-35 after the TEFRA rules came out in 1982.

However, the IRS noted in Program Manager Technical Advice 2020-01 (Nov. 19, 2019), that the definition of a “small partnership” was not changed.  TEFRA made no change to I.R.C. §6698.  Thus, the IRS concluded, the BBA had no impact on the “application of the exception to the partnership failure to file penalty.  Rather, the BBA simply restored pre-TEFRA law which already contained the penalty relief for a small partnership.  Here’s how the IRS put it:  “…it is irrelevant that there does not exist any current section 6231(a)(1)(B) that is generally effective and applicable to partnerships seeking relief under Revenue Procedure 84-35.  Moreover, the legislative history of section 6698, which is the basis for the relief provided in Revenue Procedure, is still relevant, and the scope of the section 6698 penalty for failure to file a partnership return has not been affected by the repeal of the TEFRA provisions.  Thus, Revenue Procedure 84-35 is not obsolete and continues to apply.”  The IRS concluded by stating that it may develop procedures consistent with Rev. Proc. 84-35 to ensure that any partnership claiming relief is, in fact, entitled to the relief. 

Under the BBA, a “small partnership” can elect out of the new rules.  A “small partnership” is one that is required to furnish 100 or fewer Schedules K-1 for the year.  In addition, the partnership must have partners that are individuals, corporations or estates.  If a partnership fits within the definition and desires to be excluded from the BBA provisions, it must make an election on a timely filed return and include the name and identification number of each partner. If the election is made, the partnership will not be subject to the BBA audit provisions and the IRS will apply the audit procedures for individual taxpayers.   There are more specifics on the election in the regulations, but a drawback of the election might be that a small partnership electing out of the BBA audit provisions could be at a higher audit risk. IRS has seemingly indicated that this could be the case.

Applying the Small Partnership Exception – Practitioner Problems

So how does the small partnership exception work in practice? Typically, the IRS will have asserted the I.R.C. §6698 penalty for the failure to file a partnership return.  The penalty can be assessed before the partnership has an opportunity to assert reasonable cause or after the IRS has considered and rejected the taxpayer’s claim.  When that happens, the partnership must request reconsideration of the penalty and establish that the small partnership exception applies so that reasonable cause exists to excuse the failure to file a partnership return.

Throughout this process, the burden is on the taxpayer. That’s a key point.  In most instances, the partners will likely decide that it is simply easier to file a partnership return instead of potentially getting the partnership into a situation where the partnership (and the partners) have to satisfy an IRS request to establish that all of the partners have fully reported their shares of income, deductions and credits on their own timely filed returns. As a result, the best approach for practitioners to follow is to simply file a partnership return so as to avoid the possibility that IRS would assert the $210/partner/month penalty and issue an assessment notice.  IRS has the ability to identify the non-filed partnership return from the TIN matching process.  One thing that is for sure is that clients do not appreciate getting an IRS assessment notice.

The Actual Relief of the Small Partnership Exception

Typically, the small partnership exception is limited in usefulness to those situations where the partners are unaware of the partnership return filing requirement or are unaware that they have a partnership for tax purposes, and the IRS asserts the penalty for failing to file a partnership return.  In those situations, the partnership can use the exception to show reasonable cause for the failure to file a partnership return.  But, even if the exception is deemed to apply, the IRS can require that the individual partners prove that they have properly reported all tax items on their individual returns. 

Conclusion

The best position is to simply not be late in filing partnership returns.  But, if it happens, the penalty relief of Rev. Proc. 84-35 still applies if the requirements are satisfied. 

January 21, 2020 in Income Tax | Permalink | Comments (0)

Friday, January 17, 2020

Principles of Agricultural Law

Overview

Principles2020springedition400x533The fields of agricultural law and agricultural taxation are dynamic.  Law and tax impacts the daily life of a farmer, rancher, agribusiness and rural landowner practically on a daily basis.  Whether that is good or bad is not really the question.  The point is that it’s the reality.  Lack of familiarity with the basic fundamental and applicable rules and principles can turn out to be very costly.  As a result of these numerous intersections, and the fact that the rules applicable to those engaged in farming are often different from non-farmers, I started out just over 25 years ago to develop a textbook that addressed the major issues that a farmer or rancher and their legal and tax counsel should be aware of.  After three years, the book was complete – Principles of Agricultural Law - and it’s been updated twice annually since that time. 

The 46th edition is now complete, and it’s the topic of today’s post – Principles of Agricultural Law.

Subject Areas

The text is designed to be useful to farmers and ranchers; agribusiness professionals; ag lenders; educational professionals; laywers, CPAs and other tax preparers; undergraduate and law students; and those that simply want to learn more about legal and tax issues.  The text covers a wide range of topics.  Here’s just a sample of what is covered:

Ag contracts.  Farmers and ranchers engage in many contractual situations, including ag leases, to purchase contracts.  The potential perils of verbal contracts are numerous as one recent bankruptcy case points out.  See, e.g., In re Kurtz, 604 B.R. 549 (Bankr. D. Neb. 2019).  What if a commodity is sold under forward contract and a weather event destroys the crop before it is harvested?  When does the law require a contract to be in writing?  For purchases of goods, do any warranties apply?  What remedies are available upon breach? If a lawsuit needs to be brought to enforce a contract, how soon must it be filed?

Ag financing.  Farmers and ranchers are often quite dependent on borrowing money for keeping their operations running.  What are the rules surrounding ag finance?  This is a big issue for lenders also?  For instance, in one recent Kansas case, the lender failed to get the debtor’s name exactly correct on the filed financing statement.  The result was that the lender’s interest in the collateral (a combine and header) securing the loan was discharged in bankruptcy.   In re Preston, No. 18-41253, 2019 Bankr. LEXIS 3864 (Bankr. D. Kan. Dec. 20, 2019). 

Ag bankruptcy.  A unique set of rules can apply to farmers that file bankruptcy.  Chapter 12 bankruptcy allows farmers to de-prioritize taxes.  That can be a huge benefit.  Knowing how best to utilize those rules is very beneficial.

Income tax.  Tax and tax planning permeate daily life.  Deferral contracts; depreciation; installment sales; like-kind exchanges; credits; losses; income averaging; reporting government payments; etc.  The list could go on and on.  Having a basic understanding of the rules and the opportunities available can add a lot to the bottom line of the farming or ranching operation. 

Real property.  Of course, land is typically the biggest asset in terms of value for a farming and ranching operation.  But, land ownership brings with it many potential legal issues.  Where is the property line?  How is a dispute over a boundary resolved?  Who is responsible for building and maintaining a fence?  What if there is an easement over part of the farm?  Does an abandoned rail line create an issue?  What if land is bought or sold under an installment contract? 

Estate planning.  While the federal estate tax is not a concern for most people and the vast majority of farming and ranching operations, when it does apply it’s a major issue that requires planning.  What are the rules governing property passage at death?  Should property be gifted during life?  What happens to property passage at death if there is no will?  How can family conflicts be minimized post-death?  Does the manner in which property is owned matter?  What are the applicable tax rules?  These are all important questions.

Business planning.  One of the biggest issues for many farm and ranch families is how to properly structure the business so that it can be passed on to subsequent generations and remain viable economically.  What’s the best entity choice?  What are the options?  Of course, tax planning is part and parcel of the business organization question. 

Cooperatives.  Many ag producers are patrons of cooperatives.  That relationship creates unique legal and tax issues.  Of course, the tax law enacted near the end of 2017 modified an existing deduction for patrons of ag cooperatives.  Those rules are very complex.  What are the responsibilities of cooperative board members? 

Civil liabilities.  The legal issues are enormous in this category.  Nuisance law; liability to trespassers and others on the property; rules governing conduct in a multitude of situations; liability for the spread of noxious weeds; liability for an employee’s on-the-job injuries; livestock trespass; and on and on the issues go.  It’s useful to know how the courts handle these various situations.

Criminal liabilities.  This topic is not one that is often thought of, but the implications can be monstrous.  Often, for a farmer or rancher or rural landowner, the possibility of criminal allegations can arise upon (sometimes) inadvertent violation of environmental laws.  Even protecting livestock from predators can give rise to unexpected criminal liability.  Mail fraud can also arise with respect to the participation in federal farm programs.  The areas of life potentially impacted with criminal penalties are worth knowing, as well as knowing how to avoid tripping into them.

Water law.  Of course, water is essential to agricultural production.  Water issues vary across the country, but they tend to focus around being able to have rights to water in the time of shortage and moving the diversion point of water.  Also, water quality issues are important.  In essence, knowing whether a tract of land has a water right associated with it, how to acquire a water right, and the relative strength of that water rights are critical to understand.

Environmental law.  It seems that agricultural and the environment are constantly in the news.  The Clean Water Act, Endangered Species Act and other federal (and state) laws and regulations can have a big impact on a farming or ranching operation.  Just think of the issues with the USDA’s Swampbuster rules that have arisen over the past 30-plus years.  It’s good to know where the lines are drawn and how to stay out of (expensive) trouble.

Regulatory law.  Agriculture is a very heavily regulated industry.  Animals and plants, commodities and food products are all subject to a great deal of regulation at both the federal and state level.  Antitrust laws are also important to agriculture because of the highly concentrated markets that farmers buy inputs from and sell commodities into.  Where are the lines drawn?  How can an ag operation best position itself to negotiate the myriad of rules?   

Conclusion

The academic semesters at K-State and Washburn Law are about to begin for me.  It is always encouraging to me to see students getting interested in the subject matter and starting to understand the relevance of the class discussions to reality.  The Principles text is one that can be very helpful to not only those engaged in agriculture, but also for those advising agricultural producers.  It’s also a great reference tool for Extension educators. 

If you are interested in obtaining a copy, you can visit the link here:  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html

January 17, 2020 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)

Monday, January 13, 2020

Top Ten Agricultural Law and Tax Developments of 2019 (Numbers 2 and 1)

Overview

Over the last several posts, I have been commenting on the most important developments legal and tax developments in 2019 on farmers, ranchers, agribusiness and rural landowners.  Today I am down to the two biggest developments. 

The “top two” of the “top ten” – it’s the topic of today’s post.

Number 2:     Year-End Tax and Retirement Legislation

In late December, the Congress passed Omnibus spending bills containing multiple parts that impact retirement provisions and disaster relief tax rules.  The legislation also contains certain tax extender provisions and repeals of some of the taxes contained in Obamacare.  The President signed “The Further Consolidated Appropriations Act” (H.R. 1865, PL 116-94) and “The Consolidated Appropriations Act, 2020” (H.R. 1158, PL 116-93) into law on December 20.  Contained in the Omnibus legislation is the “Taxpayer Certainty and Disaster Tax Relief Act of 2019” (“Disaster Act”) which provides relief for taxpayers affected by disasters in 2018 through Jan. 19, 2020.  Also included in the Omnibus legislation is the “Setting Every Community Up for Retirement Enhancement Act” (SECURE Act).

Here are the parts of the various bills that impact agriculture:

Retirement Provisions

The Act passed the house on May 23, but the Senate never took it up.  Nevertheless, the SECURE Act provisions did get included in the Omnibus legislation largely unmodified.  The legislation represents the first major retirement legislation since the Pension Protection Act of 2006.

There are many important changes that the SECURE Act makes to retirement planning.  The following are what are likely to be the most important to farm and ranch families:Here are the key highlights of the SECURE Act:

  • An increase in the required minimum distribution (RMD) age for distributions from a traditional IRA from the year in which an individual turns 70.5 to the year the individual turns 72. This provision matches the existing rules for 401(k)s and Roth IRAs. The provision is applicable to persons that did not reach age 70.5 by the end of 2019. SECURE Act §114(a), amending I.R.C. §401(a)(9(C)(i)(I).    
  • A repeal of the rule barring contributions to a traditional IRA by persons age 70.5 and up. There was no such rule that barred post-age 70.5 contributions to a Roth IRA.  SECURE Act §107(a), repealing I.R.C. §219(d)(1).
  • The amount of a taxpayer’s qualified charitable distributions (QCDs) from an IRA direct to a qualified charity that are not includible in gross income for a tax year is reduced(but not below zero) by the excess of the total amount of IRA deductions allowed to the taxpayer for all tax years ending on or after the date the taxpayer attains age 70.5, over the total amount of reductions for all tax years preceding the current tax year.  SECURE Act §107(b), amending I.R.C. §408(d)(8)(A).  In other words, the amount of a QCD is reduced by the amount of any deduction attributable to a contribution to a traditional IRA made after age 70.5. The provision is effective for contributions made for tax years beginning after 2019 and for distributions for tax years beginning after 2019. 
  • Part-time employees are allowed to contribute to a 401(k) plan. SECURE Act §112(a)(1), amending I.R.C. §412(k)(2)(D).  
  • The legislation provides a small employer pension plan start-up credit maximum set at the greater of $500, or the lesser of $250 for each employee of the eligible employer who is non-highly-compensated and who is eligible to participate in the plan or $5,000. Secure Act §104(a), amending I.R.C. §45E(b)(1). 
  • The new law expands the ability to run multiple employer plans and make the process easier overall by allowing small employers to band together to set up and offer 401(k) plans with less fiduciary liability concern and less cost than presently exists. This provision is effective for plan years beginning after 2020.  SECURE Act §101, amending I.R.C. §413(e) and various portions of ERISA.

Note:  Under prior law, plans of different businesses could be combined into one plan, but if one employer in the multi-employer plan failed to meet its requirements to qualify for the plan, then the entire plan could be disqualified.  The SECURE Act also no longer requires that members of a multi-employer plan have common interests in addition to participating in the retirement plan.

 

  • The legislation adds a new exemption from the 10 percent penalty of I.R.C. §72(t) for early withdrawals from a retirement account. Under the provision, a parent is allowed to withdraw up to $5,000 of funds penalty-free from a 401(k), IRA or other qualified retirement plan within a year of a child’s birth or the finalization of a child’s adoption.  The provision is applicable for distributions made after 2019.  SECURE Act §113, amending various I.R.C. sections. 
  • Under prior law, funds contained in IRAs (and qualified plans) that a non-spouse inherited IRA could be withdrawn over the beneficiary’s life expectancy. Now, so-called “stretch” IRAs are eliminated by virtue of requiring non-spouse IRA beneficiaries (except for a minor child of the IRA owner, disable person, chronically ill individual, or anyone who is not more than 10 years younger than the IRA owner) to withdraw funds from inherited accounts within 10 years. Estimates are that this provision will generate at least $15 billion in additional tax revenue in the first 10 years.  The provision is effective January 1, 2020.  SECURE Act, §401(a)(1), amending I.R.C. §401(a)(9)(E) and (H)(ii).  

Note:  The provision applies to all qualified plans such as 401(k), 403(b) and 457(b) plans.  It also applies to ESOPs, cash balance plans, 401(a) plans (defined contribution) as well as lump-sum distributions from defined benefit plans, and IRAs. However, it does not apply to a spousal rollover. When the owner dies, their spouse may roll over their spouse’s IRA into their own IRA.

Extenders

The Congress allowed numerous tax provisions to expire at the end of 2017 and 2018.  Other parts of the Omnibus legislation address some of the expired provisions, restoring them retroactively and extending them through 2020.  Here’s a list of the more significant ones for farmers and ranchers:

  • The provision excluding from income qualified principal residence debt that has been forgiven (up to $2 million; $1 million for married taxpayers filing separately) is restored for 2018 and 2019 and extended through 2020. R.C. §108(a)(1)(E as amended by §101(a) of the Disaster Act.  The provision also applies to qualified principal residence debt discharged via a binding written agreement entered into before 2021.  Disaster Act §101(b) amending I.R.C. §108(h)(2)
  • The deduction for mortgage insurance premiums is retroactively reinstated and extended through 2020. This provision is extended through 2020 for amounts paid or incurred after Dec. 31, 2017.  Disaster Act §102 amending I.R.C. §163(h)(3)(E)(iv)(l).   
  • The medical expense deduction floor is set at 7.5 percent for 2019 and 2020. Disaster Act §103, amending I.R.C. §213(f).
  • The legislation restores the qualified tuition (and related expenses) deduction for 2018 and 2019 and extends it through 2020. Disaster Act §104, amending I.R.C. §222(e).
  • The biodiesel fuel tax credit is extended through 2020. Disaster Act §121(a), amending I.R.C. §40A(g)
  • The tax credit for nonbusiness energy property (e.g., windows, doors, skylights, roofs, etc.) for personal residences is extended for tax years beginning after 2017 and before 2021. Disaster Act §123, amending I.R.C. §25C(g)(2). 
  • The tax credit for electricity producer from certain “renewable” resources is extended for qualified facilities constructed before January 1, 2021. Disaster Act §127(a), amending various subsections of I.R.C. §45(d).  For wind facilities the construction of which begins in calendar year 2020, the applicable credit is reduced by 40 percent. Disaster Act §127(c)(2)(A), amending I.R.C. §45(b)(5). 
  • The tax credit for manufacturers of energy-efficient residential homes is extended for homes acquired before January 1, 2021. Disaster Act §129, amending I.R.C. §45L(g). 
  • The TCJA changed the rules for deducting losses associated with casualties and disasters. The Disaster Act modifies those TCJA rules and provides that taxpayers impacted by a qualified disaster beginning January 1, 2018, and ending 60 days after the date of enactment, can make tax-favored withdrawals from retirement plans.  In addition, the modification provides for an automatic 60-day filing extension of all tax deadlines for those taxpayers affected by federally declared disasters that are declared after December 20, 2019. Disaster Act §205, amending I.R.C. §7508A,
  • The modification to the “kiddie-tax” contained in the Tax Cuts and Jobs Act (TCJA) is repealed effective January 1, 2020, but an election can be made to have the new rules apply to the 2018 and 2019 tax years. This means that children’s unearned income will be taxed at their parents’ highest marginal tax rate rather than the rates applicable to trusts and estates, and the taxable income of a child attributable to earned income will be taxed under the rates for single individuals.  SECURE Act §501(a), amending I.R.C. §1(j)(4).   

Number 1:     QBI Final Regulations and QBI Ag Co-Op Proposed Regulations

In the fall of 2018, the Treasury issued proposed regulations under I.R.C. §199A that was created by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017.  REG-107892-18 (Aug. 8, 2018).    The proposed regulations were intended to provide taxpayers guidance on planning for and utilizing the new 20 percent pass-through deduction (known as the QBID) available for businesses other than C corporations for tax years beginning after 2017 and ending before 2026.   While some aspects of the proposed regulations are favorable to agriculture, other aspects created additional confusion, and some issues were not addressed at all (such as the application to agricultural cooperatives).  In early 2019, the Treasury issued final regulations and cleared up some of the confusion.  Here are the main summary points of the final regulations:

  • Common ownership and aggregation. The proposed provided a favorable aggregation provision that allows a farming operation with multiple businesses (e.g., row-crop; livestock; etc.) to aggregate the businesses for purposes of the QBID.  This was, perhaps, the best feature of the proposed regulations with respect to agricultural businesses because it allows a higher income farming or ranching business to make an election to aggregate their common controlled entities into a single entity for purposes of the QBID.  This is particularly the case with respect to cash rental entities with incomes over the QBID threshold.  Common ownership is required to allow the aggregation of entities to maximize the QBID for taxpayers that are over the applicable income threshold.  Treas. Reg. §1.199A-4(b).  “Common ownership” requires that each entity has at least 50 percent common ownership.   the final regulations provide that siblings are included as related parties via I.R.C. §§267(b) and 707(b).  Including siblings in the definition of common ownership for QBID purposes will be helpful upon the death of the senior generation of a farming or ranching operation.
  • Passive lease income. One of the big issues for farmers and ranchers operating as sole proprietorships or as a pass-through entity is whether land rental income constitutes QBI.  The proposed regulations confirmed that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity.  That’s particularly the case if the rental is between “commonly controlled” entities.  But, the proposed regulations could also have meant that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID.  If that latter situation were correct it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID.  Thus, clarification was needed on the issue of whether the rental of property, regardless of the lease terms will be treated as a trade or business for aggregation purposes as well as in situations when aggregation is not involved.  That clarification is critical because cash rental income may be treated differently from crop-share income depending on the particular Code section involved.  See, e.g., §1301.   

            The final regulations did not provide any further details on the QBI definition of trade or  business.  That means that each individual set of facts will be key with the relevant factors  including the type of rental property (commercial or residential); the number of properties  that are rented; the owner’s (or agent’s) daily involvement; the type and significance of    any ancillary services; the terms of the lease (net lease; lease requiring landlord expenses;     short-term; long-term; etc.).  Certainly, the filing of Form 1099 will help to support the    conclusion that a particular activity constitutes a trade or business.  But, tenants-in-common that don’t file an entity return create the implication that they are not engaged in a trade or business activity. 

            The final regulations clarify (unfortunately) that rental to a C corporation cannot create a  deemed trade or business.  That’s a tough outcome as applied to many farm and ranch businesses and will require some thoughtful discussions with tax/legal counsel about restructuring rental agreements and entity set-ups.  Before the issuance of the final regulations, it was believed that land rent paid to a C corporation could still qualify as a trade or business if the landlord could establish responsibility (regularity and continuity) under the lease. Landlord responsibility for mowing drainage strips (or at least being responsible for ensuring that they are mowed) and keeping drainage maintained (i.e., tile lines), paying taxes and insurance and approving cropping plans, were believed to be enough to qualify the landlord as being engaged in a trade or business.  That appears to no longer be the case.

  • Commodity trading. The concern under the proposed regulations a person who acquired a commodity (such as wheat or corn for a hog farm), and transported it to the ultimate buyer might improperly be considered to be dealing in commodities. This would have resulted in the income from the activity treated under a less favorable QBI with none of the commodity income eligible for the QBID for a high-income taxpayer.  This is also an important issue for private grain elevators.  A private grain elevator generates income from the storage and warehousing of grain.  It also generates income from the buying and selling of grain.  Is the private elevator’s buying and selling of grain “commodity dealing” for purposes of I.R.C. §199A?  If it is, then a significant portion of the elevator’s income will not qualify for the QBID.  The final regulations clarify that the brokering of agricultural commodities is not treated under the less favorable QBI provision applicable for higher income taxpayers. 

I.R.C. §199A has special rules for patrons of ag cooperatives.  These rules stem from the fact that farmers often do business with agricultural (or horticultural) cooperative. A farmer patron could have QBI that is not tied to patronage with a cooperative and QBI that is tied to patronage with a cooperative.  The Treasury issued proposed regulations in June of 2019 on the ag cooperative QBI matter.  Here are the highlights of the 2019 proposed regulations:

*          Under Prop. Treas. Reg. §1.199A-7(c), patronage dividends or similar payments may be  included in the patron’s QBI to the extent that these payments: (i) are related to the patron’s  trade or business; (ii) are qualified items of income, gain, deduction, or loss at the  cooperative’s trade or business level; and (iii) are not income from a specified service trade  or business (SSTB) (as defined in I.R.C. §199A(d)(2)) at the cooperative level.  But, they  are only included in the patron’s income if the cooperative provides the required  information to the patron concerning the payments.  Prop. Treas. Reg. §199A-7(c)(2).   

*          The amount of a patron’s deduction that can be passed through to the patron is limited to the portion of the patron’s deduction that is allowed with respect to qualified production   activities income to which the qualified payments (patronage dividends and per unit  retains) made to the patron are attributable.  I.R.C. §199A(g)(2)(E).  In other words, the distribution     must be of tax items that are allocable to the cooperative’s trade or business on behalf of or with a patron.  The cooperative makes this determination in accordance with Treas. Reg. §1.199A-3(b). This is, essentially, the domestic production activities deduction computation of former I.R.C. §199, except that account is taken for non-patronage income not being part of the computation. 

*          The farmer-patron must reduce the “patron’s QBID” by a formula that is the lesser of 9 percent of QBI that relates to I.R.C. §199A(b)(7)(A)-(B).

*          An optional safe harbor allocation method exists for patrons under the applicable threshold  of I.R.C. §199A(e)(2) ($160,700 single/$321,400 MFJ for 2019) to determine the reduction.  Under the safe harbor, a patron must allocate the aggregate business expenses and W-2 wages ratably between qualified payments and other gross receipts to determine QBI.  Prop. Treas. Reg. §1.199A-7(f)(2)(ii).  Thus, the amount of deductions apportioned     to determine QBI allocable to qualified payments must be equal to the proportion of the total deductions that the amount of qualified payments bears to total gross receipts used to determine QBI. The same proportion applies to determine the amount of W-2 wages  allocable to the portion of the trade or business that received qualified payments.    

Note.  The proposed regulations attempting to illustrate the calculation only mention gross receipts from grain sales.  There is no mention of gross receipts from farm equipment, for example (including I.R.C. §1245 gains from the trade-in of farm equipment).  Based on the language of Prop. Treas. Reg. §1.199A-7(f)(2)(ii), gross receipts from the sale of equipment and machinery should be included in the calculation and the farmer would have to allocate gross receipts from equipment sales between patronage and non-patronage income.  Indeed, in prior years, depreciation may have been allocated between patronage and non-patronage income.  Likewise, the example doesn’t address how government payments received upon sale of grain are to be allocated. 

Conclusion

That concludes the top ten list for 2019.  Looking back at the Top Ten list, a couple of observations can be made.  Clearly, the make-up of the U.S. Supreme Court is highly important to agriculture.  Also, the Presidential Administration shapes policy within the regulatory agencies that regulate agricultural and landowner activity, as well as tax policy.  Agriculture, on the whole, benefited from favorable U.S. Supreme Court opinions, regulatory developments and tax policy in 2019.

What will 2020 bring? 

January 13, 2020 in Cooperatives, Income Tax | Permalink | Comments (0)

Monday, December 30, 2019

The “Almost Top Ten” Ag Law and Ag Tax Developments of 2019

Overview

It’s the time of year again where I sift through the legal and tax developments impacting agriculture from the past year, and rank them in terms of their importance to farmers, ranchers, agribusinesses, rural landowners and the ag sector in general. 

As usual, 2019 contained many legal developments of importance.  There were relatively fewer major tax developments in 2019 compared to prior years, but the issues ebb and flow from year-to-year.  It’s also difficult to pair things down to ten significant developments.  There are other developments that are also significant.  So, today’s post is devoted to those developments that were left on the cutting table and didn’t quite make the “Top Ten” for 2019.

The “almost top ten of 2019” – that’s the topic of today’s post.

Chapter 12 Debt Limit Increase

To be eligible for Chapter 12 bankruptcy, a debtor must be a “family farmer” or a “family fisherman” with “regular annual income.”  A “family farmer” is defined as an individual or individual and spouse who earned more than 50 percent of their gross income from farming either for the taxable year preceding the year of filing or during the second and third tax years preceding filing; have more than 50 percent of their debt be debt from a farming operation that the debtor owns or operates; and, the aggregate debt must not exceed a threshold amount. That threshold amount has only adjusted for inflation since enactment of Chapter 12 in 1986, even though farms have increased in size and capital needs faster than the rate of inflation.  When enacted, 86 percent of farmers were estimated to qualify for Chapter 12.  That percentage had declined over time due to the debt limit only periodically increasing with inflation and stood at $4,411,400 as of the beginning of 2019.  Thus, fewer farmers were able to use Chapter 12 to deprioritize taxes associated with the sale of farm assets used in the farming operation and ultimately put together a reorganization plan that will allow the farmer to stay on the farm to continue production activities, make restructured loan payments and have some debt written off.  However, as of August 23, 2019, the debt limit for a family farmer filing Chapter 12 was increased to $10,000,000 for plans filed on or after that date.  H.R. 2336, Family Farmer Relief Act of 2019, signed into law on Aug. 23, 2019 as Pub. L. No. 116-51.

Which Government Agency Sues a Farmer For a WOTUS Violation?

In 2019, a federal trial court allowed the U.S. Department of Justice (DOJ) to sue a farmer for an alleged CWA dredge and bill permit violation without a specific recommendation from the Environmental Protection Agency (EPA).  The farmer was alleged to have discharged “pollutants” into a “waters of the United States” (WOTUS) as a result of tractor tillage activities on his farmland containing or near to wetlands contiguous to a creek that flowed into a WOTUS.  Staff of the U.S. Army Corps of Engineers (COE) saw the tilled ground and investigated.  The COE staff then conferred with the EPA and referred the matter to the U.S. Department of Justice (DOJ).  The DOJ sued (during the Obama Administration) for enforcement of a CWA §404 permit “by the authority of the Attorney General, and at the request of the Secretary of the Army acting through the United States Corps of Engineers.”  The DOJ alleged that the equipment "constituted a 'point source'" pollutant under the CWA and "resulted in the placement of dredged spoil, biological materials, rock, sand, cellar dirt or other earthen material constituting “pollutants” (within the meaning of 33 U.S.C. § 1362(6)) into waters of the United States. The DOJ alleged that the defendant impacted water plants, changed the river bottom and/or replaced Waters of the United States with dry land, and "resulted in the 'discharge of any pollutant' within the meaning of 33 U.S.C. § 1311(a)."  The farmer moved for summary judgment on the basis that the CWA authorizes only the EPA Administrator to file a CWA §404 enforcement action and that the court, therefore, lacked jurisdiction.  The court disagreed and determined that the defendant could be sued by the U.S. Department of Justice upon the mere recommendation of the COE and without a specific recommendation from the EPA alleging a CWA violation, and in a situation where the CWA did not determine any CWA jurisdiction and only the COE did.  This finding was despite a 1979 Attorney General opinion No. 197 determining that the EPA and not the COE has the ultimate authority to construe what is a navigable WOTUS.  Ultimately, the parties negotiated a settlement costing the farmer over $5 million.  United States v. Lapant, No. 2:16-CV-01498-KJM-DB, 2019 U.S. Dist. LEXIS 75309 (E.D. Cal. May 3, 2019)United States v. Lapant, No. 2:16-CV-01498-KJM-DB, 2019 U.S. Dist. LEXIS 93590 (E.D. Cal. Jun. 3, 2019).

USDA’s Swampbuster “Incompetence”

How does the USDA determine if a tract of farmland contains a wet area that is subject to the Swampbuster rules?  That’s a question of key importance to farmers.  That process was at issue in a 2019 case, and the court painted a rather bleak and embarrassing picture of the USDA bureaucrats.  In fact, the USDA-NRCS was brutalized (rightly so) by the appellate court’s decision for its lack of candor and incompetence.  I will skip the details here (I covered the case in a blog post earlier in 2019), but the appellate court dealt harshly with the USDA.  The USDA uses comparison sites to determine if a particular site is a wetland subject to Swampbuster rules.  In this case, the USDA claimed that 7 C.F.R. § 12.31(b)(2)(ii) allowed them to select a comparison site that was "on the same hydric soil map unit" as the subject property, rather than on whether the comparison site had the same hydrologic features as the subject tract(s).  The appellate court rejected this approach as arbitrary and capricious, noting that the NRCS failed to try an "indicator-based wetland hydrology" approach or to use any of their other tools when picking a comparison site. In addition, the appellate court noted a COE manual specifies that, “[a] hydrologist may be needed to help select and carry out the proper analysis" in situations where potential lack of hydrology is an issue such as in this case.   However, the NRCS did not send a hydrologist to personally examine the plaintiff’s property, claiming instead that a comparison site was not even necessary.  Based on 7 C.F.R. §12.32(a)(2), the USDA claimed, the removal of woody hydrophytic vegetation from hydric soils to permit the production of an agricultural commodity is all that is needed to declare the area "converted wetland."  The appellate court concluded that this understanding of the statue was much too narrow and went against all the other applicable regulatory and statutory provisions by completely forgoing the basis of hydrology that the provisions are grounded in.   Accordingly, the appellate court reasoned that because hydrology is the basis for a change in wetland determination, the removal of trees is merely a factor to determine the presence of a wetland, but is not a determining factor.  In addition, the appellate court pointed out that the NRCS never indicated that the removal of trees changed the hydrology of the property during the agency appeal process – a point that the USDA ignored during the administrative appeal process.  The court’s decision is a step in the right direction for agriculture.  Boucher v. United States Department of Agriculture, 934 F.3d 530(7th Cir. 2019). 

No More EPA “Finger on the Scales”

During 2019, a federal trial court ruled that the EPA has the authority to bar persons currently receiving grant money from the EPA to serve on EPA scientific advisory committees.  That’s an important development for the regulated community, including farmers and ranchers.  The court’s opinion ended an Obama-era EPA policy of allowing EPA advisory committee members to be in present receipt of EPA grants.  At issue in the case was a directive of the Trump-EPA regarding membership in its federal advisory committees.  The directive specified “that no member of an EPA federal advisory committee be currently in receipt of EPA grants.” The directive reversed an Obama-era rule that allowed scientists in receipt of EPA grants to sit on advisory panels.  That rule was resulting in biased advisory committees stacked with committee members that opposed coal and favored an expansive “Waters of the United States” rule among other matters.  In defending its policy change, the EPA explained that “while receipt of grant funds from the EPA may not constitute a financial conflict of interest, receipt of that funding could raise independence concerns depending on the nature of the research conducted and the issues addressed by the committee.” Thus, the change was necessary “to ensure integrity and confidence in its advisory committees.” The trial court found the EPA’s explanation to be within the zone of reasonableness. Based on these findings, the trial court held that the EPA action was rational, considered the relevant factors and was within the authority delegated to the agency.  The court granted the EPA’s motion to dismiss the case. Physicians for Social Responsibility v. Wheeler, 359 F. Supp. 3d 27 (D. D.C. 2019).

Coming-To-The-Nuisance By Staying Put?

Nuisance lawsuits filed against farming operations are often triggered by offensive odors that migrate to neighboring rural residential landowners.  In these situations courts consider numerous factors in determining whether any particular farm or ranch operation is a nuisance.    Factors that are of primary importance are priority of location and reasonableness of the operation.  Together, these two factors have led courts to develop a “coming to the nuisance” defense.  This means that if people move to an area they know is not suited for their intended use, they should be prohibited from claiming that the existing uses are nuisances.  But, what if the ag nuisance comes to you?  Is the ag operation similarly protected in that situation?  An interesting Indiana court case in 2019 dealt with the issue.  In the case, the defendants were three individuals, their farming operation and a hog supplier.  Basically, a senior member of the family retired to a farm home on the premises and other family members established a large-scale confined animal feeding operation (CAFO) on another part of the farm nearby.  The odor issue got bad enough that the retired farmer sued.  However, the court determined that the CAFO was operated properly, had all of the necessary permits, and was within the zoning laws.  The court noted that the plaintiff alleged no distinct, investment-backed expectations that the CAFO had frustrated.  The court upheld the state right-to-farm law and also determined that a “taking” had not occurred because the plaintiff had not sold his home and moved away from the place where he grew up and lived all of his life.  Himsel v. Himsel, No. 18A-PL-645, 2019 Ind. App. LEXIS 181 (Ind. Ct. App. Apr. 22, 2019).

Obamacare Individual Mandate Unconstitutional

In his decision in 2012 upholding Obamacare as constitutional, Chief Justice Roberts hinged the constitutionality of the law on the individual mandate (contained in I.R.C. §5000A) being a tax and, therefore, within the taxing authority of the Congress.  Thus, if the tax is eliminated or the rate of the penalty tax taken to zero is the law unconstitutional?  That’s a possibility now that the tax rate on the penalty is zero for tax years beginning after 2018.  In late 2018, a federal district court noted that the payment was distinct from the individual mandate and determined that the individual mandate was no longer constitutional as of January 1, 2019 because it would no longer trigger any tax. In addition, because the individual mandate was the linchpin of the entire law, the court determined that the provision could not be severed from the balance of the law. As a result, the court reasoned, as of January 1, 2019, Obamacare no longer had any constitutional basis.  Texas v. United States, 340 F.3d 579 (N.D. Tex. 2018).  In 2019, the appellate court affirmed.  Texas v. United States, No. 19-10011, 2019 U.S. App. LEXIS 37567 (5th Cir. Dec .18, 2019).  The appellate court determined that the individual mandate was unconstitutional because it could no longer be read as a tax, and there was no other constitutional provision that justified that exercise of congressional power.  Watch for this case to end up back before the Supreme Court.  The case is of monumental importance not only on the health insurance issue.  Obamacare contained many taxes that would be invalidated if the law were finally determined to be unconstitutional. 

Conclusion

These were the developments that didn’t quite make the “Top 10” of 2019.  In Wednesday’s post, I will start the trek through the Top 10 of 2019.

December 30, 2019 in Bankruptcy, Environmental Law, Income Tax, Regulatory Law | Permalink | Comments (0)

Tuesday, December 24, 2019

Year-End Legislation Contains Tax Extenders, Repealers and Modifications to Retirement Provisions

Overview

Last week, the Congress passed Omnibus spending bills containing multiple parts that impact retirement provisions and disaster relief tax rules.  The legislation also contains certain tax extender provisions and repeals of some of the taxes contained in Obamacare.  The President signed “The Further Consolidated Appropriations Act” (H.R. 1865, PL 116-94) and “The Consolidated Appropriations Act, 2020” (H.R. 1158, PL 116-93) into law on December 20.  Contained in the Omnibus legislation is the “Taxpayer Certainty and Disaster Tax Relief Act of 2019” (“Disaster Act”) which provides relief for taxpayers affected by disasters in 2018 through Jan. 19, 2020.  Also included in the Omnibus legislation is the “Setting Every Community Up for Retirement Enhancement Act” (SECURE Act).

New tax and retirement-related provisions – it’s the topic of today’s post.

Repealed Provisions

Obamacare.  The Omnibus legislation repeals the following taxes contained in Obamacare:

  • Effective January 1, 2014, §9010 of Obamacare imposed an annual flat fee on covered entities engaged in the business of providing health insurance with respect to certain health risks.  That tax is repealed effective for tax years beginning after 2020. Further Consolidated Appropriations Act of 2020, Div. N, Sec. 502. 
  • Obamacare added I.R.C. §4191(a) to impose an excise tax of 2.3 percent on the sale of a taxable medical device by the manufacturer, producer, or importer of the device for sales occurring after 2012. The new law repeals the excise tax for sales occurring after Dec. 31, 2019.  Further Consolidated Appropriations Act of 2020, N, Sec. 501.
  • Obamacare added I.R.C. §4980I to add a nondeductible excise tax on insurers when the aggregate value of employer-sponsored health insurance coverage for an employee, former employee, surviving spouse or other primary insured individual exceeded a threshold amount. This tax, referred to as a tax on “Cadillac” plans, is repealed for tax years beginning after 2019. Further Consolidated Appropriations Act of 2020, N Sec. 503.

Note:  The PCORI taxes on insured and self-insured plans, set to expire in 2019, were extended 10 years.

Retirement Provisions

The Setting Every Community Up for Retirement Enhancement Act of 2019 (“SECURE Act”) passed the house on May 23, but the Senate never took it up.  Nevertheless, the SECURE Act provisions did get included in the Omnibus legislation largely unmodified.  The legislation represents the first major retirement legislation since the Pension Protection Act of 2006.

Here are the key highlights of the SECURE Act:

  • An increase in the required minimum distribution (RMD) age for distributions from a traditional IRA from the year in which an individual turns 70.5 to the year the individual turns 72. This provision matches the existing rules for 401(k)s and Roth IRAs. The provision is applicable to persons that did not reach age 70.5 by the end of 2019. SECURE Act §114(a), amending I.R.C. §401(a)(9(C)(i)(I).    

Note:  Proposed Senate legislation would set the RMD at age 75.  There have also been some discussions among staffers of tax committees of exempting smaller IRA account balances from the RMD rule.  

  • The amount of a taxpayer’s qualified charitable distributions from an IRA direct to a qualified charity that are not includible in gross income for a tax year is reduced(but not below zero) by the excess of the total amount of IRA deductions allowed to the taxpayer for all tax years ending on or after the date the taxpayer attains age 70.5, over the total amount of reductions for all tax years preceding the current tax year.  SECURE Act §107(b), amending I.R.C. §408(d)(8)(A).  The provision is effective for contributions made for tax years beginning after 2019 and for distributions for tax years beginning after 2019. 
  • A repeal of the rule barring contributions to a traditional IRA by persons age 70.5 and up. There was no such rule that barred post-age 70.5 contributions to a Roth IRA.  SECURE Act §107(a), repealing I.R.C. §219(d)(1).
  • Part-time employees are allowed to contribute to a 401(k) plan. SECURE Act §112(a)(1), amending I.R.C. §412(k)(2)(D).  
  • The legislation provides a small employer pension plan start-up credit maximum set at the greater of $500, or the lesser of $250 for each employee of the eligible employer who is non-highly-compensated and who is eligible to participate in the plan or $5,000. Secure Act §104(a), amending I.R.C. §45E(b)(1). 
  • The new law expands the ability to run multiple employer plans and make the process easier overall by allowing small employers to band together to set up and offer 401(k) plans with less fiduciary liability concern and less cost than presently exists. This provision is effective for plan years beginning after 2020.  SECURE Act §101, amending I.R.C. §413(e) and various portions of ERISA.
  • The legislation adds a new exemption from the 10 percent penalty of I.R.C. §72(t) for early withdrawals from a retirement account. Under the provision, a parent is allowed to withdraw up to $5,000 of funds penalty-free from a 401(k), IRA or other qualified retirement plan within a year of a child’s birth or the finalization of a child’s adoption.  The provision is applicable for distributions made after 2019.  SECURE Act §113, amending various I.R.C. sections. 
  • Under prior law, funds contained in IRAs (and qualified plans) that a non-spouse inherited IRA could be withdrawn over the beneficiary’s life expectancy. Now, so-called “stretch” IRAs are eliminated by virtue of requiring non-spouse IRA beneficiaries (except for a minor child of the IRA owner, chronically ill individual, or anyone who is not more than 10 years younger than the IRA owner) to withdraw funds from inherited accounts within 10 years. Estimates are that this provision will generate at least $15 billion in additional tax revenue in the first 10 years.  The provision is effective January 1, 2020.  SECURE Act, §401(a)(1), amending I.R.C. §401(a)(9)(E) and (H)(ii).  

Example:  Harold left his IRA to his 27-year-old grandson, Samuel.  Under prior law, Samuel could, based on his life expectancy, take distributions over 55 years.  If the amount in the IRA at the time of Harold’s death was $1 million, Samuel’s first-year distribution would be $18,182 ($1,000,000/55).  Depending on Samuel’s other income, the IRA income could be taxed at a rather low tax bracket rate or a high tax bracket rate.  The amount remaining in Samuel’s inherited IRA would continue to grow over Samuel’s lifetime.  Under the CAA, however, Samuel must take all distributions from the inherited IRA within 10 years of Harold’s death.  As a result, Samuel will likely be placed into a much higher tax bracket.  Harold could avoid this result, for example, by leaving the IRA to the Rural Law Program at Washburn University School of Law. 

The provision does make sense from a policy standpoint given that the U.S. Supreme Court has held that inherited IRAs are not retirement accounts.  Clark v. Rameker, 134 S. Ct. 2242 (U.S. 2014).  However, the potential for a higher tax burden placed on the beneficiary will require additional estate planning and strategic Roth conversions during the account owner’s lifetime.  Drafters of trust instruments should review existing trusts for clients that contain “pass-through” trusts to ensure conformity with the new rule.  For trusts that don’t conform to the new rules, access to funds by heirs of IRA beneficiaries could be restricted and tax obligations could be large.

The provision applies to all qualified plans such as 401(k), 403(b) and 457(b) plans.  It also applies to ESOPs, cash balance plans, 401(a) plans (defined contribution) as well as lump-sum distributions from defined benefit plans, and IRAs. However, it does not apply to a spousal rollover. When the owner dies, their spouse may roll over their spouse’s IRA into their own IRA.

Extenders

The Congress allowed numerous tax provisions to expire at the end of 2017 and 2018.  The CAA addresses some of the expired provisions, restoring them retroactively and extending them through 2020.  Here’s a list of the more significant ones:

  • The provision excluding from income qualified principal residence debt that has been forgiven (up to $2 million; $1 million for married taxpayers filing separately) is restored for 2018 and 2019 and extended through 2020. R.C. §108(a)(1)(E as amended by §101(a) of the Disaster Act.  The provision also applies to qualified principal residence debt discharged via a binding written agreement entered into before 2021.  Disaster Act §101(b) amending I.R.C. §108(h)(2)
  • The deduction for mortgage insurance premiums is retroactively reinstated and extended through 2020. This provision is extended through 2020 for amounts paid or incurred after Dec. 31, 2017.  Disaster Act §102 amending I.R.C. §163(h)(3)(E)(iv)(l).   
  • The medical expense deduction floor is set at 7.5 percent for 2019 and 2020. Disaster Act §103, amending I.R.C. §213(f).
  • The tax code provision providing for a 3-year depreciation recovery period for race horses two years old or younger is extended for such horses placed in service before 2021. Disaster Act §114, amending I.R.C. §168(e)(3)(A)(i). 
  • The legislation restores the qualified tuition (and related expenses) deduction for 2018 and 2019 and extends it through 2020. Disaster Act §104, amending I.R.C. §222(e).
  • The work opportunity tax credit that employers can claim for hiring individuals from specific groups is extended through 2020. R.C. §51(c)(4), as amended by §143 of the Disaster Act. 
  • The employer tax credit for paid family and medical leave is extended through 2020. Disaster Act §142, amending I.R.C. §45S(i). 
  • The biodiesel fuel tax credit is extended through 2020. Disaster Act §121(a), amending I.R.C. §40A(g)
  • The tax credit for nonbusiness energy property (e.g., windows, doors, skylights, roofs, etc.) for personal residences is extended for tax years beginning after 2017 and before 2021. Disaster Act §123, amending I.R.C. §25C(g)(2). 
  • The tax credit for electricity produced from certain “renewable” resources is extended for qualified facilities constructed before January 1, 2021. Disaster Act §127(a), amending various subsections of I.R.C. §45(d).  For wind facilities the construction of which begins in calendar year 2020, the applicable credit is reduced by 40 percent. Disaster Act §127(c)(2)(A), amending I.R.C. §45(b)(5). 
  • The tax credit for manufacturers of energy-efficient residential homes is extended for homes acquired before January 1, 2021. Disaster Act §129, amending I.R.C. §45L(g). 

Other Provisions

The TCJA changed the rules for deducting losses associated with casualties and disasters.  The Disaster Act modifies those TCJA rules and provides that taxpayers impacted by a qualified disaster beginning January 1, 2018, and ending 60 days after the date of enactment, can make tax-favored withdrawals from retirement plans.  In addition, the modification provides for an automatic 60-day filing extension of all tax deadlines for those taxpayers affected by federally declared disasters that are declared after December 20, 2019. Disaster Act §205, amending I.R.C. §7508A,

The Disaster Act also modifies the contribution limits with respect to donations by businesses and individuals giving to provide relief to those affected by disasters.

The modification to the “kiddie-tax” contained in the Tax Cuts and Jobs Act (TCJA) is repealed effective January 1, 2020, but an election can be made to have the new rules apply to the 2018 and 2019 tax years.  This means that children’s unearned income will be taxed at their parents’ highest marginal tax rate rather than the rates applicable to trusts and estates, and the taxable income of a child attributable to earned income will be taxed under the rates for single individuals.  SECURE Act §501(a), amending I.R.C. §1(j)(4).   

What Wasn’t Addressed

There were several provisions in the TCJA that needed technical corrections.  Not the least of those was the need to clarify that qualified improvement property is 15-year property.  However, the nothing in the Omnibus legislation addresses this issue.  The Omnibus legislation also does not increase or repeal the $10,000 limit on deductions for state and local taxes for individuals.

Conclusion

The changes included in the various parts of the Omnibus legislation are significant, particularly with respect to the retirement provisions.  Most certainly, Roth IRAs will be an even more popular tax and retirement planning tool. 

A very merry Christmas to all!

December 24, 2019 in Estate Planning, Income Tax | Permalink | Comments (0)

Friday, December 20, 2019

2020 National Summer Ag Income Tax/Estate and Business Planning Seminar

Overview

Each summer for almost 15 years, I have conducted a national summer seminar at a choice location somewhere in the United States.  During some summers, there has been more than a single event.  But, with each event, the goal is to take agricultural tax, estate planning and business planning education and information out to practitioners in-person.  Over the years, I have met many practitioners that do a great job of representing agricultural producers and agribusinesses with difficult tax and estate/business/succession planning situations.  Because, ag tax and ag law is unique, the detailed work in preparing for those unique issues is always present.

The 2020 summer national ag tax and estate/business planning seminar – it’s the topic of today’s post.

Deadwood, South Dakota - July 20-21, 2020

Hold the date for the 2020 summer CLE/CPE seminar.  This coming summer’s event will be in Deadwood, South Dakota on July 20 and 21.  The event is sponsored by the Washburn University School of Law.  The Kansas State University Department of Agricultural Economics will be a co-sponsor.  The location is The Lodge at Deadwood.  The Lodge is relatively new, opening in 2009.  It is located just west of Deadwood on a bluff that overlooks the town.  You can learn more about The Lodge here: https://www.deadwoodlodge.com/hotel.  The Lodge has great conference facilities and also contains the Deadwood Grille featuring Western dining.  For families with children, The Lodge contains an indoor water playland.  There is also transportation from The Lodge to Main street in Deadwood where the shops and local attractions are located.  Deadwood is in the Black Hills area of western South Dakota.  Nearby is Mt. Rushmore, Crazy Horse, Custer State Park and Rapid City.  The closest flight connection is via Rapid City.  To the west is Devil’s Tower in Wyoming.  The Deadwood area is a beautiful area, and the weather in late July should be fabulous. 

Featured Speakers

On Day 1, July 20, joining me on the program will be Paul Neiffer.  Paul has been doing the summer seminars with me for several years now and is affiliated with CliftonLarsonAllen, LLP.  We enjoy working together to provide the best in ag tax education that you can find.  Also, confirmed as a Day 1 speaker is the honorable Judge Elizabeth Paris of the U.S. Tax Court.  She will provide an informative session on litigating a case before the U.S. Tax Court and the special rules and procedures of the court.  Judge Paris has decided several important ag cases during her tenure on the court, and is a great speaker.  You won’t want to miss her session.

I will lead off Day 2 with coverage of the most recent ag-related cases and rulings impacted farm and ranch estate and business planning.  Also joining me on Day 2 will be Prof. Jeffrey Jackson, a colleague of mine at Washburn University School of Law.  He will present a session on gun trusts for holding firearms and the unique issues that passing firearms at death can present.  Prof. Jackson will discuss what a gun trust is and how it works, what it cannot do, and client counseling with respect to passage of firearms by gift or at death.

Also making a presentation on Day 2 will be Marc Vianello.  Marc is a CPA and the managing member of Vianello Forensic Consulting, LLC.  He is an experienced financial professional with and intensive 30-year history as a forensic accountant and expert witness regarding damages in highly complex litigation, including breach of contract, intellectual property (patent, Lanham, trade secret, copyright), business valuation, franchise, agriculture, Qui Tam and class action, personal injury, employment, casualties, financial crimes, and all other types of income and valuation damages. Marc also has an extensive background regarding the computation of estate and gift tax discounts for lack of marketability.  Marc’s presentation will focus on how practitioners can utilize forensic accounting techniques and expert testimony to bolster a client’s position against the IRS on audit as well as in court.

The Day 1 and Day 2 speakers and agenda aren’t fully completed yet, but the ones mentioned above are confirmed.  An ethics session may also be added.    

Webcast

The two-day event will be broadcast live over the web.  The webcast will be handled by Glen McBeth, Instructional Technology at the Washburn Law School Law Library.  Glen has broadcast the last few summer seminars and does a tremendous job producing a high-quality webcast. 

Room Block

A room block at The Lodge will be established and you will be able to reserve your room as soon as the seminar brochure is finalized and registration is opened.  The room block will begin the weekend before the seminar begins so that you can arrive early and enjoy the weekend in Deadwood and the Black Hills area prior to the event if you’d like. 

Alumni Event

Washburn’s law school will also be holding an alumni event at The Lodge that corresponds with the summer seminar.  Presently, the plan is to have a social event for law school alumni and registrants of the summer seminar on Sunday evening, July 19.  That event will be followed the next day with a CLE seminar focusing on law and technology.  That CLE event will also be at The Lodge and will run simultaneously with Day 1 of the two-day summer seminar on July 20.  The summer seminar will continue on July 21.

Sponsorship

If your business is interested in sponsoring a breakfast, break or lunch, and having vending space at the conference, please let me know.  It’s a great event to interact with practitioners that represent the legal and tax needs of farmers and ranchers from across the country that are involved in many aspects of agriculture.

Conclusion

Please hold the date for the July 20-21 conference and, for law school alumni (as well as registrants for the two-day event), the additional alumni reception and associated CLE event.  It looks to be an outstanding opportunity for specialized training in ag tax and estate/business planning. 

December 20, 2019 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Friday, December 13, 2019

Is a Tenancy-in-Common Interest Eligible for Like-Kind Exchange Treatment?

Overview

The Tax Cuts and Jobs Act (TCJA) changed the like-kind exchange rules of I.R.C. §1031 such that only real estate can be exchanged in a tax-deferred manner.  Personal property trades no longer qualify for tax-deferred treatment if entered into after 2017.  But what if the real estate is not owned 100 percent outright by the taxpayer?  What if the taxpayer owns a fractional interest in real estate either for convenience or as part of a business entity?  In that situation, can the fractional interest be traded for other real estate with any gain on the transaction deferred under I.R.C. §1031?  Or, instead, is it possible that owning property in that manner could constitute a partnership with the result that the taxpayer’s “partnership” interest wouldn’t qualify for like-kind exchange treatment?

Fractional interests in real estate and qualification for gain deferral under I.R.C. §1031 – it’s the topic of today’s blog post. 

Like-Kind Exchange Basics

A like-kind exchange of real estate is a popular method to dispose of appreciated real estate without incurring tax currently.  I.R.C. §1031.  A tract of real estate can be traded for other real estate that the taxpayer will hold for business or investment purposes.  The rules are liberal enough that the exchange of the properties need not be simultaneous – the taxpayer has up to 45 days to identify the replacement property after the transfer of the relinquished property and must receive the replacement property within the earlier of 180 days after the transfer or by the extended due date of the return for the year of the transfer. 

Eligibility of Undivided Fractional Interests

In prior posts, I have looked at the issue of what constitutes “real estate” for purposes of the like-kind exchange rules of I.R.C. §1031.  In those posts, implied in the analysis was outright, full ownership of the taxpayer’s interest in the real estate that the taxpayer sought to exchange on a deferred basis.  But, what if the interest in real estate is a fractional interest such as a tenancy in common?  A tenancy-in-common is an arrangement where two or more people share ownership rights in real estate or a tract of land that can be commercial, residential or farmland/ranchland.  When two or more people own property as tenants-in-common, all areas of the property are owned equally by the group – they each own a physically undivided interest in the entire property.  In addition, the co-tenants may have a different share of ownership interests.  Also, each tenant-in-common is entitled to share with the other tenant the possession of the whole parcel and has the associated rights to a proportionate share of rents or profits from the property, to transfer the interest, and to demand a partition of the property.   When a tenant in common dies, the decedent’s interests in the property becomes part of the decedent’s estate and passes in accordance with the decedent’s will or trust, or state law if the decedent did not have a will or trust. 

A significant question is whether a tenancy-in-common ownership arrangement constitutes a partnership for tax purposes.  The question is important because the like-kind exchange rules don’t apply to exchanges of partnership interests – a partnership interest is not like-kind to a fee simple interest in real estate.  I.R.C. §1031(a)(2)(D).  Presumably, the exclusion of partnership interests also applies to multi-member LLC interests where the LLC is taxed as a partnership.   Under Treas. Reg. §1.761-1(a) and Treas. Reg. §301.7701-1 through 301.7701-3, a partnership for federal tax purposes does not include mere co-ownership of property where the owners’ activities are limited to keeping the property maintained, repaired, rented or leased.  However, the regulations point out that a partnership for federal tax purposes is broader in scope than the common law meaning of “partnership” and may include groups not classified by state law as partnerships.  

In 1997, the IRS issued a private letter ruling noting that, in some situations, a tenancy in common arrangement resulting in multiple owners holding an undivided fractional interest in real estate could result in a partnership such that the exchange of the owners’ interests would not qualify for like-kind exchange treatment.  Priv. Ltr. Rul. 974017 (Jul. 10, 1997).  The issuance of the ruling created a stir and the IRS, in 2000, indicate that it would further study the issue.  Rev. Proc. 2000-46, 2000-2 C.B. 438.  Later, in 2002, the IRS issued Rev. Proc. 2002-22, 2002-1 C.B. 733 setting forth 15 conditions (factors) indicating that an undivided co-ownership in rental real estate would not result in the creation of a federal tax partnership.  In essence, the factors point to the tenant-in-common owners not going beyond mere co-ownership of property to the point of engaging in business together.  The factors (e.g., “guidelines”) aren’t intended to be substantive rules and are not intended to be used for audit purposes. 

The factors (guidelines; conditions) set forth in Rev. Proc. 2002-22 are as follows:

  • Each co-owner must hold title as a tenant-in-common under local law;
  • The number of co-owners must be limited to no more than 35 persons;
  • The co-owners must not file a partnership or corporate tax return; conduct business under a common name; or execute an agreement identifying any or all of the co-owners as partners, shareholders or members of a business entity;
  • The co-owners may enter into a limited co-ownership agreement that may run with the land. These agreements may provide that a co-owner must offer its interest for sale to another co-owner at fair market value before exercising any right to partition;
  • The co-owners must unanimously approve the hiring of any manager; the sale or other disposition of the property; any leases of the property; or the creation or modification of a blanket lien;
  • Each co-owner must have the right to transfer, partition and encumber the co-owner’s undivided interest without the agreement of any person;
  • Upon the sale of the property, the net proceeds (after payment of liabilities) must be distributed to the co-owners;
  • Each co-owner must proportionally share in all revenues and costs generated by the property and all costs associated with the property pro-rata;
  • Each co-owner must share in all debt secured by blanket liens on the property;
  • A co-owner may issue an option to purchase its TIC interest, as long as the exercise price reflects the fair market value;
  • The activities of the co-owners must be limited to those customarily performed in connection with the maintenance and repair of rental real property;
  • The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually;
  • All leases must be bona fide leases for federal tax purposes. Rent must reflect the fair market value of the property;
  • The lender may not be a related person.; and
  • The amount of any payments to a “sponsor” must reflect the fair market value of the acquired co-ownership interest and may not depend on the income or profits derived from the property.

Private Letter Rulings

As noted above, one of the factors of Rev. Proc. 2002-22 is that a co-owner’s activities must be limited to those customarily performed in connection with the maintenance and repair of rental property and that the income from performing such activities is not unrelated business taxable income.   All of the activities of the co-owners and their affiliates concerning the property are taken into account, including the sponsor’s efforts to sell the tenancy-in-common interests in the property.  But, the activities of a co-owner or related person with respect to the property is ignored if the co-owner owns a tenancy-in-common interest for less than six months.  In Priv. Ltr. Rul. 200327003 (Mar. 7, 2003), however, the IRS determined that an undivided fractional interest in real estate qualified for like-kind exchange treatment and was not an interest in a business entity.  This ruling helped alleviate concerns about the imputation of activities of a sponsor.

In Priv. Ltr. Rul. 200513010 (Dec. 6, 2004), the IRS provided a good roadmap for real estate investors (and others) to follow when structuring fractional ownership arrangements.  The ruling was favorable to the taxpayer and detailed how to structure partition rights; co-owner purchase options; manager substation rights; and how a management company can properly operate without the arrangement being deemed to be a partnership. 

PMTA 2010-005 (Mar. 15, 2010) involved a situation where tenants-in-common had taken action to deal with a master tenant’s bankruptcy.  They appointed interim agents and there were temporary non-pro-rata contributions from some of the tenants-in-common.  The IRS concluded that the owners would not be treated as partners in a partnership for federal tax purposes. 

In 2016, the IRS issued additional guidance on a tenancy-in-common arrangement.  Priv. Ltr. Rul. 201622008 (Feb. 23, 2016).  The facts involved in the private ruling involved a co-ownership agreement between a landlord and a tenant and a management agreement that would become effective after the parties entered into a lease for the property at issue, and a call/put option for the lessee to buy a portion of the property.  The landlord owned a commercial office building via a single member limited liability company (LLC).  The tenant was to enter into a triple net lease with the LLC set at fair market value with the rental amount not tied to the income or profits derived from the property.  The transaction was incredibly complex, but the IRS determined that if the landlord/LLC  were to exercise the option and sell a tenancy-in-common interest to the tenant, the relations would not be considered to be a partnership, with the result that each a co-owner could sell his undivided interest in the property in a I.R.C. §1031 exchange because the conditions of Rev. Proc. 2002-22 had been satisfied. 

Accounting and Management

To avoid having a tenancy-in-common ownership arrangement be characterized as a partnership with the interests not eligible for like-kind exchange treatment, proper recordkeeping, accounting and management of the arrangement is essential.  Care should be taken not to account for the arrangement or manage it in the manner of a business entity.  Certainly, a partnership or corporate income tax return should not be filed, even though doing so might simplify reporting expenses and revenues of the arrangement.  

Election

A co-tenancy that is established for investment purposes (and not for trade or business purposes can elect to be excluded form partnership treatment.  I.R.C. §761(a)(1).  But, qualifying for the election can be difficult.  See Treas. Reg. 1.761-2.  The co-tenants must have chosen to be treated as a partnership pursuant to state partnership law and they must have limited involvement in the operation of the property (which might be the case with bare land ownership).  There also must be limited to no restrictions on the rights of co-owners to individually sell their interests, and there should not be any provision in the partnership agreement requiring a vote of a majority to transfer the asset.  In addition, each owner must be allocated a constant pro rata share of income and loss based on their share of ownership.  If these requirements can be satisfied, the election can be made by attaching a statement to the partnership return that is filed by the filing deadline for the partnership return for the year in which the partnership wants the election to be in place.  Whether a partnership agreement can be amended to satisfy the requirement so that an election can be made is an open question. 

Conclusion

Many tenancy-in-common arrangements exist in agriculture and elsewhere.  Avoiding partnership status so that a like-kind exchange can be achieved can be important in certain situations.  Knowing the IRS boundaries is beneficial. 

December 13, 2019 in Income Tax, Real Property | Permalink | Comments (0)

Tuesday, December 10, 2019

Tax Issues Associated With Restructuring Credit Lines

Overview

Last week the U.S. Tax Court held that MoneyGram is not a bank, which meant that it could not claim ordinary loss deductions associated with the write-off of a substantial amount of partially or wholly worthless asset-backed securities.  MoneyGram International, Inc. v. Comr., 153 T.C. No. 9 (2019).  Buried in the court’s opinion is a discussion of the “original issue discount” (OID) rules.  That discussion triggered a thought about farmers and their lines of credit. 

As 2019 comes to a close, some farmers and ranchers will have unpaid lines of credit remaining and may be asked or required by a lender to roll the existing credit line balance into the 2020 line of credit.  They may also be asked to pay some of the interest charge down.  If either of those events happens, what are the tax consequences?  It’s an important question that is often overlooked when making a determination of what to do with an existing line of credit.

The tax consequences of restructuring credit lines – that’s the topic of today’s blog post.

In General

For a loan that has fixed interest payable in one year or less, the interest is not deductible when there is a rollover of a remaining line of credit at year-end into the next year.  I.R.C. §1273(a)(2); Battelstein v. Internal Revenue Service , 631 F.2d 1182 (5th Cir. 1980), cert. den., 451 U.S. 938 (1981); Wilkerson v. Comr., 655 F.2d 980 (9th Cir. 1981), rev’g., 70 T.C. 240 (1978; IRS News Release 83-93 (Jul. 6, 1983). The result is the same if the taxpayer borrows funds from the same lender for the purpose of satisfying the interest obligation to that lender.  For a cash basis taxpayer to deduct interest, the payment must be in cash or a cash equivalent.  I.R.C. §163. The delivery of a promissory note isn't a cash equivalent but merely a promise to pay.   In Battelstein, the taxpayers were land developers embroiled in a bankruptcy proceeding. A lender agreed to loan the taxpayers more than three million dollars to cover the purchase of a tract of land. The lender also agreed to make future advances of the interest costs on the loan as the interest cost came due.  Indeed, the taxpayers never paid interest except by means of the advances. Each quarter, the lender would notify the taxpayer of the amount of interest currently due. The taxpayer would then send the lender a check in the same amount, and, on its receipt, the lender would send the taxpayer a check for the identical amount. The taxpayers deducted the interest amount as “paid” during the tax year, but the IRS and the appellate court disagreed.  There was no current payment of interest as I.R.C. §163(a) requires.   

Thus, where a lender withholds interest from the loan proceeds, the borrower generally is considered to have paid with a note.  That is not payment in cash or with a cash equivalent and does not give rise to a deduction.

So, what’s the point of this to a farmer or rancher that is dealing with credit issues?  The “take-home” lesson is that a taxpayer can’t deduct interest if funds are borrowed from the same lender that provided the original loan.  That’s true even if unrestricted control is maintained over the loan proceeds.  However, an interest deduction should be available if the taxpayer can show that the newly-borrowed funds weren't, in substance, the same funds used to pay the loan. To do that, of course, the taxpayer would have to establish that the taxpayer had sufficient other funds to pay the interest.  Likewise, a deduction is permitted when interest is paid with funds borrowed from another lender.  See, e.g., Davison v. Comr., 141 F.3d 403 (2d Cir. 1998), aff’g., 107 T.C. 35 (1996).  But, in reality, borrowing funds from another lender might be quite difficult for a financially troubled borrower. 

What’s the Issue With “Original Issue Discount”?

Original issue discount (OID) is a form of interest.  In U.S. financial markets, “commercial paper” refers to unsecured promissory notes issued by corporations with a fixed maturity of no more than 270 days.  Commercial paper is always issued at a discount to the face amount of the obligation. The discount is OID, and it represents unstated interest that the investor receives upon selling the instrument or when it is received as the face amount at maturity.  Thus, a debt instrument generally has OID when the instrument is issued for a price that is less than its stated redemption price at maturity.  OID is the difference between the stated redemption price at maturity and the issue price.  All debt instruments that pay no interest before maturity are presumed to be issued at a discount.

The general rule is that OID is taxed as ordinary income.  I.R.C. §1271(a)(4).  OID accrues over the term of the debt instrument, whether or not the taxpayer receives any payments from the issuer.  But, the OID rules generally do not apply to short-term obligations (those with a fixed maturity date of one year or less from date of issue).  See IRS Publication 550.  The one-year restriction is key.  So, if a farmer rolls over a 2019 loan into the line of credit for 2020, the OID rules may be triggered if the old loan does not become payable until more than a year after the original loan was taken out.  I.R.C. §§1272(a)(1); (a)(2)(C); 1273(a)(1).  In that event, the interest amount is spread over the loan’s term resulting in a portion of the interest being deductible in the year that the loan is rolled over. 

Consider the following example:

Kay O’Pectate borrowed $200,000 from Usurious State Bank on June 1, 2019 at 6 percent simple interest.  Interest and principle were due on December 1, 2019.  However, due to poor crop and livestock markets, Kay and the bank on December 1 agreed to defer the payments on the loan for another year – until December 1, 2020.  During that timeframe, interest would continue to accrue at 6 percent.  Because no payment is due on the renegotiated loan until after June 1, 2020, the OID rules apply.  Thus, under the loan that has been rolled over, the “issue price” is $200,000, and the “stated redemption price at maturity” is the $200,000 as of December 1, 2019, plus the half-year interest to that date of $6,000, plus the interest expected to December 1, 2020 of $12,000 for a total of $218,000.  Because the total amount due on December 1, 2020, exceeds the issue price of $200,000, there is OID of $18,000.  I.R.C. §1273(a)(1).  Thus, Kay could deduct, in 2019, the $6,000 of interest as OID through December 1 of 2019, plus one month of OID for December of 2019 (1/12 of $12,000) for a total interest deduction in 2019 of $7,000.  The balance of the OID, $11,000, would be deductible in 2020. 

The rollover caused the interest deduction to be spread out over 2019 and 2020.  That may or may not be advantageous to Kay.  The answer to that question depends on numerous factors particular to Kay.  The point is, however, that Kay should understand the consequences of rolling over her loan into the next year. 

Payment Allocation

For tax purposes, the OID rules require that payment be allocated first to OID, to the extent that OID has accrued as of the date the payment is due, and then to the payment of principal.  Treas. Reg. §1.1275-2(a).  So, if a farmer (or non-farm taxpayer for the matter) pays down principal late in the year, but leaves an amount of interest to be rolled over into the next year, the OID rules still apply. 

Conclusion

When working with a lender concerning credit lines, rarely does a discussion of the tax treatment of interest occur.  Note the problem of borrowing funds from the same lender to pay interest on an existing loan, and take into consideration the OID rules on a roll-over.  Always talk with your tax practitioner about how to maximize the tax benefit of restructuring loans and deducting interest.    

December 10, 2019 in Income Tax | Permalink | Comments (0)

Tuesday, November 26, 2019

Are Windbreaks Depreciable?

Overview

On many farms and ranches, windbreaks are used to minimize soil erosion and protect buildings and structures.  But, is a windbreak depreciable, or must its cost be capitalized and added to the basis of the land?  A depreciation deduction provides an immediate tax break, but adding the cost of a windbreak to the land basis is only beneficial upon eventual sale of the land. 

Depreciating or capitalizing windbreaks – it’s the topic of today’s post.

Depreciation Basics

Depreciation applies to property that is either tangible personal property (or is a certain type of real property) that is used in the taxpayer’s trade or business or for the production of income and has a determinable useful life of more than a year.  The depreciation rules have changed over the years, with the present system known as the Modified Cost Recovery System (MACRS).  MACRS is eight-class system that allows the cost of an asset to be depreciated or recovered over a period shorter than the asset's useful life.  All depreciable property fits into one of the eight depreciation classes with its cost recovered over 3, 5, 7, 10, 15, 20, 27 1/2 or 39 years.  Property gets assigned to these eight classes either by Congressional legislation or by the IRS.  For example, breeding hogs are classified as three-year property.  The five and seven-year categories apply generally to farm machinery and equipment. Single-purpose ag and horticultural structures along with trees and vines that produce nuts and fruits are also classified as ten-year property.  The 15-year category includes land improvements, including irrigation systems (at least the below-ground part such as wells) and some landscaping costs. 

What About Earthen Improvements?

Earthen improvements are generally not depreciable unless the taxpayer can establish that the earthen improvement is physically deteriorating and that, without maintenance, the improvement would become worthless.  See, e.g., Ekberg v. United States, No 711 W.D., 1959 U.S. Dist. LEXIS 4467 (D. S.D. Dec. 31, 1959).  In addition, expenses for maintaining such improvements should be deductible as repairs.  Common items on a farm that are included in the “land improvement” category include silage bunkers, concrete ditches, waterways, pond outlets and wells used for irrigation and livestock watering.  Relatedly, a permanent pasture (natural or seeded grassland that remains unplowed for many years) has been held to be depreciable.  See, e.g., Johnson v. Westover, No. 16527-WM, 1959 U.S. Dist. LEXIS 4249 (S.D. Cal. Mar. 19, 1955).  The court determined, based on the evidence, that the pasture should be replanted at the end of 10 years to maintain its economic usefulness.  At the time of purchase, the evidence showed that the pasture had a remaining life of five years.

But, what about a windbreak on a farm or a ranch?  Isn’t a windbreak an earthen improvement that is used in a farmer or rancher’s business?  As noted above, they are panted to reduce moisture evaporation and soil erosion.  Clearly, trees and vines that produce nuts and fruits are depreciable as ten-year property.  However, there is no specific MACRS category for trees (and bushes) planted as a windbreak that don’t also produce nuts and fruits.  In Everson v. United States, 108 F.3d 234 (9th Cir. 1997), the court ruled that the windbreak trees and bushes (Russian olive trees and Caragana bushes) that were planted in rows perpendicular to the wind by a prior owner of a 3,700-acre wheat farm were, in essence, part of the land and not depreciable because land does not have a determinable useful life – it doesn’t wear out (in theory).  See also, Blair v. Comr., 29 T.C. 1205 (1958).  The taxpayer couldn’t establish that the windbreak had a limited life or was associated with a depreciable asset.  In addition, the court noted that windbreaks are specifically listed in the definition of non-depreciable soil and water conservation expenses eligible for a deduction under I.R.C. §175.  If windbreaks were held to be depreciable, the court reasoned, the specific inclusion of windbreaks in I.R.C. §175(c) as a non-depreciable land improvement eligible for a deduction as a soil and water conservation expense would be rendered meaningless.  Thus, because the prior owner of the farm that incurred the cost of planting the windbreak could have deducted the cost of establishing the windbreak under I.R.C. §175, the taxpayer could not allocate part of the purchase price of the ranch to the windbreak and claim a depreciation deduction. 

More on Soil and Water Conservation Expense Deductibility

Soil and water conservation expenses that qualify under I.R.C. §175 must be paid or incurred for soil or water conservation purposes with respect to land used in farming, or for the prevention of erosion on farmland and be consistent with a soil conservation plan or an endangered species recovery plan. I.R.C. §§175(a); (c)(3)(A)(i).  Qualified expenses include various types of earth moving on farmland using in the business of farming (to produce crops, fruits or other ag products or the sustenance of livestock).  I.R.C. §175(c)(2)Expenses for leveling, conditioning, grading, terracing and contour furrowing are all eligible as are costs associated with the control and protection of diversion channels, drainage ditches, irrigation ditches, earthen dams, water courses, outlets and ponds.  Even the cost of eradicating brush and, as noted above, the planting of windbreaks is eligible.  I.R.C. §175(c)(1)Also included are drainage district assessments (and soil and water conservation district assessments) if such assessments would have been a deductible expense if the taxpayer had paid them directly.  I.R.C. §175 (c)(1)(B).

Conclusion

The IRS position is that windbreaks are inextricably associated with the land.  As such, the cost of a windbreak is to be added to the basis in the land.  In addition, a windbreak is specifically listed under I.R.C. §175 as a non-depreciable item the cost of which is eligible for deduction as a soil and water conservation expense.  An “organic” land improvement can be depreciated, however, when the taxpayer can prove that it wears out, or when it is associated with a depreciable asset in such a way that the land improvement is no longer useful to the taxpayer once the asset with which it is associated has completed its useful life.  For example, in Rudolph Investment Corp. v. Comr., T.C. Memo. 1972-129, the court allowed the taxpayer to depreciate earthen dams and earthen water storage tanks located on ranchland.  The taxpayer was able to establish that, as the result of erosion processes, the dams and storage tanks became filled-in over a period of approximately ten years, so that at the end of the ten-year period they ceased to have any ranch value.  In Everson, the taxpayer couldn’t establish a comparable situation for the windbreak.

November 26, 2019 in Income Tax | Permalink | Comments (0)

Thursday, October 31, 2019

Are Director Fees Subject to Self-Employment Tax?

Overview

An interesting question was posed to me at a recent tax seminar.  The question was whether director fees are subject to self-employment tax.  That question comes up because sometimes farmers, ranchers and others receive income for serving as a director of a farming or ranching business, an agricultural cooperative, an ag lender or other organization. 

Whether a director fee is subject to self-employment tax turns on whether the fee constitutes employee wages.  Making that determination turns on the facts and circumstances of the particular situation.

Director fees and self-employment tax – it’s the topic of today’s post.

Self-Employment Tax Basics

A self-employed individual is one who has net earnings from self-employment as defined by I.R.C. §1402(a).  “Net earnings from self-employment” means gross income derived from a trade or business that the taxpayer conducts (less associated deductions).  Id.  But, a “trade or business” for self-employment tax purposes does not include “the performance of services by an individual as an employee.”  I.R.C. §1402(c)(2). 

A corporate director, under the right set of facts, is not a corporate employee.  Treas. Reg. §31.3121(d)-1(b) specifies that, “Generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation. A director of a corporation in his capacity as such is not an employee of the corporation.”

On the self-employment tax issue, the IRS ruled in 1972, that director fees are self-employment income subject to self-employment tax.  Rev. Rul. 72-86, 1972-1 CB 273.  That is certainly the case if a “director” performs no services for the corporation.  But, what if some services are provided?  When does a “director” cross the line and grade over into “employee” status with payments received constituting wages?  If the fees constitute “wages” they aren’t subject to self-employment tax and there could be other implications. 

The Blodgett case

In Blodgett v. Comr., T.C. Memo. 2012-298, the petitioner served on a local bank board.  The board operated independently and represented members of the community that owned the bank.  The board supervised bank management but did not participate in daily bank operations. The bank provided liability coverage, life and disability insurance and retirement benefits, but not health insurance to the board members.  The petitioner was also vested in the bank’s retirement plan for board members.  He put in less than five hours a week on board member business and did not hold himself out as a contractor and did not claim any tax deductions for business expenses because the bank paid all expenses.  The bank issued him a Form 1099-MISC, Miscellaneous Income, reporting "nonemployee compensation" of $26,750 for his services.  He reported the amount on line 21 of his return as “other income” not subject to self-employment tax.  The IRS disagreed, asserting that the income was attributable to work the petitioner performed as an independent contractor and that self-employment tax was owed. 

The Tax Court agreed with the IRS and analyzed the facts based on a seven-factor test.  Those factors, set forth in Weber v. Comr., 103 T.C. 378 (1994), are: (1) extent of control maintained by the bank; (2) responsibility for providing work facilities; (3) the opportunity for the trustee to receive a profit or loss; (4) the ability of the bank to fire the trustee; (5) the trustee duties as part of the bank’s regular business activities; (6) the permanency of the bank-trustee relationship; and (7) the intent of the bank-trustee relationship.

Here's how the factors shook out in Blodgett:

Factors favoring employee status:

  • The bank provided the trustees with meeting rooms, office supplies, and other items necessary to fulfill their duties.
  • The trustees were paid for attending board meetings and did not have additional opportunities for profit or loss.
  • The petitioner had been reelected to his position for more than 10 consecutive three-year terms, but bank management was appointed for one-year terms.

Factors favoring nonemployee status:

  • The board of trustees operated independently from the bank’s management and were not subject to any meaningful control by the bank.
  • Only corporate members could terminate the trustees, and then only on a limited basis including by a vote of the members.
  • The trustees’ duties were primarily related to oversight with no involvement in daily bank operations.
  • Evidence showed that the bank had no intent to create and employer-employee relationship with the trustees and issued Forms 1099-Misc. instead of Forms W-2 to all of the trustees.

The court didn’t simply stack up the factors and see whether a majority of them favored employee or nonemployee status.  Instead, the court placed the most weight on how much control the bank exercised over the trustees and determined that the trustees were not employees and that self-employment tax was owed. 

The Burbach Case

In Burbach v. Comr., T.C. Memo. 2019-17, the petitioner was an engineer whose LLC business involved working with towns to determine the need for a public pool.  If it was determined that a pool had merit, the petitioner would plan and market the pool and organize fundraising for the construction of the pool.  Ultimately, he changed his business form from an LLC to two corporations – one to hold the operating assets of the business and another corporation to hold real estate.  With help from his tax advisor, the petitioner established a self-employed pension plan.  He funded the plan by taking “director fees” out of the operating entity which he then deposited into his personal checking account with subsequent transfers to his pension account.  He reported the director fees on Schedule C and claimed an offsetting deduction for the contributions to his self-employed retirement plan. 

The facts got tangled with respect to late-filed corporate returns and ultimately it was determined that the pension plan needed to be an employer-sponsored plan run through the operating entity because it had employees and also because all the compensation on which plan contributions were based was W-2 compensation that the corporation paid to the petitioner as an employee.  The plan was corrected retroactively with the operating entity as the plan sponsor including all eligible employees in the plan and including the amounts the petitioner received as director fees for plan purposes. 

The parties settled on the plan qualification issues, but the IRS claimed that the director fees the petitioner received were wages as remuneration for employee services.  As wages, the IRS argued, the petitioner couldn’t claim I.R.C. §404 pension plan deductions because he had no self-employment income. 

The Tax Court agreed with the IRS for the following reasons:

  • The petitioner was the operating entity’s sole shareholder and was involved hands-on in the company’s daily affairs.
  • While the petitioner was the operating entity’s only director, there was no evidence that he provided any director services. Instead, the services provided involved daily decisions concerning engineering, project management and marketing.
  • The petitioner had represented to the IRS when he and the operating entity applied for a compliance statement for the pension plan that he was providing services that were essentially employee services.

Consequently, the petitioner had no earnings from self-employment and I.R.C. §404(a)(8) barred him from claiming any deductions for contributions he had made to his Keogh-type pension plan for the tax years at issue.  Instead, he was an “employee” within the meaning of I.R.C. §401(c)(1) and the operating entity was his “employer” under I.R.C. §401(c)(4) by virtue of I.R.C. §404(a)(8). 

Note that the outcome in Burbach was different that the typical outcome with respect to directors’ fees.  While it’s a facts and circumstances determination, most often those facts indicate that directors’ fees are self-employment income.  Had that been the case in Burbach, the petitioner, as a corporate director, could have established a Keogh plan based on those fees.  See, e.g., I.R.C. §3121(d)(1); Treas. Reg. §31.3121(d)-1(b).  However, the petitioner provided more than minor services and was classified as an employee whose director fees were classified as wages. 

Conclusion

It’s not uncommon in rural areas for farmers, ranchers and others to serve on various corporate boards for which compensation is received.  It’s important to properly report the director fee income on the return.  That will turn on the classification of the relationship of the taxpayer to the entity involved.  Facts and circumstances of each situation are critical.  If the taxpayer is deemed to be an independent contractor with self-employment income, perhaps there are associated costs that can be deducted to help offset the income and self-employment tax.  Likewise, it may be possible to establish a pension plan.  But the facts must support the classification desired.

October 31, 2019 in Income Tax | Permalink | Comments (0)

Tuesday, October 29, 2019

Does the Sale of Farmland Trigger Net Investment Income Tax?

Overview

One of the new taxes created under Obamacare is a 3.8 percent tax on passive sources of income of certain individuals.  It’s called the “net investment income tax” and it took effect in January of 2013.  Its purpose was to raise about half of the revenue needed for Obamacare.  It’s a complex tax that can surprise an unsuspecting taxpayer – particularly one that has a one-time increase in investment income (such as stock).  But it can also apply to other sources of “passive” income, such as income that is triggered upon the sale of farmland.

But are farmland sales always subject to the additional 3.8 percent NIIT?  Are there situations were the sale won’t be subject to the NIIT?  These questions are the topic of today’s post.

Background

The NIIT is 3.8% of the lesser of (1) net investment income (NII); or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). I.R.C. §1411.  The threshold amount is not indexed for inflation.  For this purpose, MAGI is defined in Treas. Reg. §1.1411-2(c)(2).  For an estate or trust, the NIIT is 3.8% of the lesser of (1) undistributed NII; or (2) the excess of AGI (as defined in I.R.C. §67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins ($12,750 for 2019).  I.R.C. §1411(a)(2).   

What is NII? For purposes of the NIIT, net investment income (NII) is gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the NII tax doesn't apply. I.R.C. §1411(c)(1)(A)(i).  If the taxpayer either owns or is engaged in a trade or business directly or indirectly through a disregarded entity, the determination of character of income for NIIT purposes is made at the individual level.  Treas. Reg. §1.1411-4(b)(1).  If the income, gain or loss traces to an investment of working capital, it is subject to the NIIT.  I.R.C. §1411(c)(3).  Also, the NIIT applies to business income if the trade or business at issue is a passive activity.  I.R.C. §1411(c)(2)(A). But, if income is subject to self-employment tax, it’s not NII subject to the NIIT.  I.R.C. §1411(c)(6)

Sale of Farmland and the NIIT

Capital gain income can trigger the application of the NIIT. However, if the capital gain is attributable to the sale of a capital asset that is used in a trade or business in which the taxpayer materially participates, the NIIT does not apply. For purposes of the NIIT, material participation is determined in accordance with the passive loss rules of I.R.C. §469

If an active farmer sells a tract of land from their farming operation, the capital gain recognized on the sale is not subject to the NIIT. However, whether the NIIT applies to the sale of farmland by a retired farmer or a surviving spouse is not so easy to determine. There are two approaches to determining whether the NIIT applies to such sales – the I.R.C. §469(f)(3) approach and the I.R.C. §469 approach

I.R.C. §469(h)(3) approach.  I.R.C. §469(h)(3) provides that “a taxpayer shall be treated as materially participating in any farming activity for a taxable year if paragraph (4) or (5) of I.R.C. §2032A(b) would cause the requirements of I.R.C. §2032A(b)(1)(C)(ii) to be met with respect to real property used in such activity if such taxpayer had died during the taxable year.” The requirements of I.R.C. §2032A(b)(1)(C)(ii) are met if the decedent or a member of the decedent’s family materially participated in the farming activity five or more years during the eight years preceding the decedent’s death. In applying the five-out-of-eight-year rule, the taxpayer may disregard periods in which the decedent was retired or disabled.  I.R.C. §2032A(b)(4). If the five-out-of-eight year rule is met with regard to a deceased taxpayer, it is deemed to be met with regard to the taxpayer’s surviving spouse, provided that the surviving spouse actively manages the farming activity when the spouse is not retired or disabled.   I.R.C. §2032A(b)(5).

To summarize, a retired farmer is considered to be materially participating in a farming activity if the retired farmer is continually receiving social security benefits or is disabled; and materially participated in the farming activity for at least five of the last eight years immediately preceding the earlier of death, disability, or retirement (defined as receipt of social security benefits).

The five-out-of-eight-year test, once satisfied by a farmer, is deemed to be satisfied by the farmer’s surviving spouse if the surviving spouse is receiving social security. Until the time at which the surviving spouse begins to receive social security benefits, the surviving spouse must only actively participate in the farming operation to meet the material participation test. 

“Normal” I.R.C. §469 approach. A counter argument is that I.R.C. §469(h)(3) concerns the recharacterization of a “farming activity,” but not the recharacterization of a rental activity. Thus, if a retired farmer is no longer farming but is engaged in a rental activity, §469(h)(3) does not apply and the normal material participation tests under §469 apply. 

What are the material participation tests of I.R.C. §469?  As set forth in Treas. Reg. §1.469-5T, they are as follows:

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity  of any other individual (including individuals  who are not owners of interests in the activity) for such year;

(4) The  activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The above tests don’t apply to a limited partner in a limited partnership, and only one of the tests is likely to have any potential application in the context of a retired farmer to determine whether the taxpayer materially participated in the farming activity – the test of material participation for any five years during the ten years preceding the sale of the farmland. 

Clearly, the “normal” approach would cause more  transactions to be subject to NIIT.  It’s also the approach that the IRS uses, and it is likely the correct approach.

Sale of land held in trust.  When farmland that has been held in trust is sold, the IRS position is that only the trustee of the trust can satisfy the material participation tests of §469.   This is an important point because of the significant amount of farmland that is held in trust, particularly after the death of the first spouse, and for other estate and business planning reasons.  However, the IRS position has been rejected by the one federal district court that has ruled on the issue.  Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003).  The IRS did not appeal the court’s opinion, but continued to assert in in litigation in other areas of the country.  In a case from Michigan in 2014, the U.S. Tax Court in a full tax court opinion, rejected the IRS’s position.  Frank Aragona Trust v. Comm’r, 142 T.C. 165 (2014).    The Tax Court held that the conduct of the trustees acting in the capacity of trustees counts toward the material participation test as well as the conduct of the trustees as employees. The Tax Court also implied that the conduct of non-trustee employees would count toward the material participation test.  The court’s opinion makes it less likely that the NIIT will apply upon trust sales of farmland where an actual farming business is being conducted.

Conclusion

Obamacare brought with it numerous additional taxes.  One of those, the NIIT, applies to passive income of taxpayer’s with income above a certain threshold.  The NIIT can easily be triggered upon sale of particular assets that have been held for investment or other purposes, including farmland.  Some planning may be required to avoid its impact. 

 

October 29, 2019 in Business Planning, Income Tax | Permalink | Comments (0)

Wednesday, October 23, 2019

Recapture – A Dirty Word In Tax Code Lingo

Overview

In 1972, comedian George Carlin listed in a monologue the “Seven Words You Can Never Say on Television.”  He then proceeded to use all seven words multiple times.  The use of those words constitutes a violation of Federal Communications Commission standards and triggers a penalty.  In the tax world, there are also “dirty” words, and they are used to describe something that happens in tax that triggers a bad tax result for the taxpayer.  “Recapture” is one of those words.  It means that a tax benefit previously received must be given up – paid back. That “pay back” is often at ordinary income tax rates rather than the (often) more favorable capital gain rates.

Recapture in the context of depletion deductions previously claimed that is associated with oil and gas interests – it’s the topic of today’s post.

Recapture – What Is It?

At its core, recapture is the Code’s procedure for triggering income on a gain a taxpayer realizes upon the disposition of an asset that had previously provided a tax benefit, such as through depreciation.  Because depreciation can be deducted from ordinary income to reflect the wear-and-tear on an asset (an exhaustion factor) used in the taxpayer’s trade or business or for the production of income where the asset has a determinable useful life of more than one year, gain on the disposal of the asset (up to the taxpayer’s recomputed basis in the asset (see, e.g. I.R.C. §1016 and/or I.R.C. §1245(a)(2)(A)) must be reported as ordinary income.  It is not reported as capital gain in accordance with I.R.C. §1231.  Depreciation recapture attributable to tangible personal property is governed by I.R.C. §1245.  The provision governing recapture associated with real property is I.R.C. §1250.  For I.R.C. §1250 recapture purposes, the IRS refers to it as “additional depreciation” in IRS Pub. 544.  In I.R.S. Pub. 544, the IRS describes it as the portion of accumulated depreciation that exceeds straight line depreciation.  It is taxed at ordinary income rates to the extent of gain realized at a maximum of 37 percent (presently).  The portion corresponding to straight-line depreciation is “unrecaptured §1250 gain” and is taxed at a maximum rate of 25 percent.  Any remaining gain is long-term capital gain if the taxpayer had held the property for over a year, and is taxed at a maximum capital gain rate of 20 percent. 

Depletion Deduction Recapture

There’s another recapture section of the Code – I.R.C. §1254.  It’s titled, “Gain from disposition of interest in oil, gas, geothermal, and other mineral properties.”  While gain on the sale or exchange of natural resources is generally capital gain in nature via I.R.C. §1221 or I.R.C. §1222 or via the netting process of I.R.C. §1231, I.R.C. §1254 taxes as ordinary income the recapture of depletion deductions previously claimed when an oil or gas interest is disposed of in a taxable transaction.  Under I.R.C. §1254, the amount recaptured as ordinary income is the lesser of (1) the sum of the deductions for depletion under I.R.C. §611 that reduced the property’s adjusted basis, and the intangible drilling and development costs currently deducted under I.R.C. §263; or (2) the gain obtained by deducting the adjusted basis of the property from the amount realized.  I.R.C. §§1254(a)(1)(A),(B). 

Because I.R.C. §1254 applies to depletion that reduces adjusted basis, it applies to both percentage and cost depletion – to the extent either depletion approach reduced the adjusted basis of the subject property.  Thus, gain in excess of depletion previously allowed is taxed as ordinary income.  It also applies separately to each property of the taxpayer, if the taxpayer has more than a single property.  I.R.C. §614 defines “property” for this purpose.  Also, if the taxpayer only disposes of a portion of a property that is subject to I.R.C. §1254 depreciation recapture, rules governing partial dispositions can apply.  See I.R.C. §1254(a)(2); Treas. Reg. §1.1254-1(c). 

Consider the following example:

Suzy, in 2011, acquired a working interest in an oil and gas deposit.  Her original basis in the interest was $100,000.  During Suzy’s period of ownership, she was allowed (and claimed) $75,000 of depletion deductions.  Thus, her adjusted basis in the working interest is $25,000 in accordance with I.R.C. §1016(a)(2).  Suzy did not expense any intangible drilling and development costs.  Suzy later sells her working interest in the deposit in 2019 for $125,000 - its fair market value at the time of sale.  Suzy has realized gain of $125,000 less her adjusted basis of $25,000, or $100,000.  Applying I.R.C. §1254(a)(1), Suzy has recapture of the previously claimed depletion deductions of the lesser of $75,000 or $100,000.  Thus, $75,000 of the $100,000 gain is treated as ordinary income.  The remaining $25,000 gain is taxed as long-term capital gain in accordance with I.R.C. §1231

Other Rules on Recapture

As noted above, recapture is potentially triggered when the taxpayer’s interest is disposed of in a taxable transaction.  In other words, there must be a “disposition” of the asset before recapture is possible.  Some transactions do not constitute a “disposition” for purposes of recapture under I.R.C. §1254.  These include mortgaging the property (Treas. Reg. §1.1254-1(b)(3)(ii)(A)); any abandonment (unless the taxpayer recognizes income on the foreclosure of a nonrecourse debt) (Treas. Reg. §1.1254-1(b)(3)(ii)(B)); leasing or subleasing the property (Treas. Reg. §1.1254-1(b)(3)(ii)(C)); the termination or election of S corporation status (Treas. Reg. §1.1254-1(b)(3)(ii)(D)); including the property in a pooling or unitization arrangement (Treas. Reg. §1.1254-1(b)(3)(ii)(E)); the expiration or reversion of an operating mineral interest in whole or in part by the terms of the agreement (Treas. Reg. §1254-1(b)(3)(ii)(F)); or any conversion of an overriding royalty interest that at the grantor’s option (or at the option of a successor in interest) converts to an operating mineral interest after a certain amount of production.  Treas. Reg. §1.1254-1(b)(3)(ii)(G).  Also, when taxpayers exchange their interests in oil and gas partnerships for stock of a newly organized corporation, they don’t have any gain or loss except to the extent that their share of partnership liabilities exceed their basis.  In this situation, there is no recapture of intangible drilling costs.  Priv. Ltr. Rul. 8107099 (Nov. 21, 1980). 

If the disposition of the oil or gas (or geothermal) property is by gift, recapture is not triggered.  Treas. Reg. §1.1254-2(a)(1).  But if the transaction is a part gift/part sale transaction (typically utilized in estate planning situations and other transactions involving family members) recapture can apply to any gain that the transaction triggers.  Treas. Reg. §1.1254-2(a)(2).  The charitable deduction associated with a gift to a charitable organization of a working or operating interest in an oil or gas property must be reduced by the amount of any intangible drilling and development costs attributable to the donated interest that the donor previously deducted under I.R.C. §1254I.R.C. §170(e)(1)(A).   

As usual, a transfer on account of death does not trigger recapture.  Treas. Reg. §1.1254-2(b).  Also, if the disposition occurs as part of a like-kind exchange under I.R.C. §1031, the depreciation recapture taxed as ordinary income is limited to the “boot” (gain attributable to “unlike” property) involved in the exchange.  Treas. Reg. §1.1254-2(c).  On this last point, it appears to be implicit in the regulation that an interest in an oil and gas property constitutes real estate for purposes of I.R.C. §1031.  That’s an important point now that personal property is not eligible for tax-deferred treatment under I.R.C. §1031.

When a partnership disposes of an interest in oil and gas (or other natural resources), the amount treated as ordinary income is determined at the partner level.  Each partner recognizes as ordinary income the lesser of the partner’s I.R.C. §1254 costs with respect to the property disposed of, or the partner’s share of the amount (if any) by which the amount realized upon the sale, exchange, or involuntary conversion, or the fair market value of the property upon any other disposition, exceeds the adjusted basis of the property.  Treas. Reg. §1.1254-5(b)(1). 

Conclusion

Oil and gas taxation is a bit unique in many respects.  Depletion, while conceptually the same as depreciation, is nuanced.  The rules on recapture of the depletion deduction generally follow the rules for depreciation recapture.  That means if the rules are triggered, the result is not going to be a good one for the taxpayer.  Remember, “recapture” is one of the “dirty” words in tax.  Avoid it if you can.

October 23, 2019 in Income Tax | Permalink | Comments (0)

Monday, October 21, 2019

More on Cost Depletion – Bonus Payments

Overview

Last week’s post on cost depletion generated an interesting question from a reader concerning whether a bonus payment that a landowner receives upon signing an oil and gas lease agreement entitles the landowner to a cost depletion deduction on the payment.   That’s an important question.  The increased production of oil and gas on privately owned property in recent years means that an increasing number of landowners are receiving payments from oil and gas companies, including bonus payments.

The taxation of bonus payments associated with oil and gas leases – that’s the topic of today’s post.

Bonus payment

Character of the gain.  The lessee typically pays a lump-sum cash bonus during the initial lease term (pre-drilling) for the rights to acquire an economic interest in the minerals. This is the basic consideration that the lessee pays to the lessor (landowner) when the lease is executed. The lessor reports the bonus payment on Schedule E, Supplemental Income and Loss. It constitutes net investment income (NII) that is potentially subject to the additional 3.8 percent NII tax (NIIT) of I.R.C. §1411.  A bonus payment is generally categorized as ordinary income and not capital gain because it is not tied to production.  See, e.g., Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 588 Fed. Appx. 199 (3d Cir. 2014)

A bonus payment may be paid annually for a fixed number of years regardless of production. If the lessee cannot avoid the payments by terminating the lease, the payments are termed a lease bonus payable in installments. These payments are also consideration for granting a lease. They are an advance payment for oil, and each installment is typically larger than a normal delay rental.  A cash-basis lessee must capitalize such payments, and the fair market value (FMV) of the contract in the year the lease is executed is ordinary income to the lessor if the right to the income is transferable.  Rev. Rul. 68-606, 1968-2 CB 42.  However, if the bonus payments are made under a contract that is nontransferable and nonnegotiable, a cash-basis lessor can defer recognizing the payments until they are received.  See, e.g., Kleberg v. Comm’r, 43 BTA 277 (1941), non. acq. 1952-1 CB 5. 

Cost depletion?  Can a lessor claim cost depletion on a bonus payment?  This question came up in a Tax Court case in 2013.  In Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 558 Fed. Appx. 199 (3d Cir. 2014), the taxpayer owned a tract of land in Pennsylvania and entered into an oil and gas agreement with an oil and gas company.  The lease called for the taxpayer to receive a lease bonus payment upfront for entering into the lease agreement.  The taxpayer was also entitled to a royalty payment of 16 percent of the net profits of oil and gas extracted from the leased premises.  The bonus payment was not tied to extraction or production in any fashion.  It was purely an upfront payment made to induce the taxpayer to execute the lease agreement.  The taxpayer reported the bonus payment as long-term capital gain rather than ordinary income on the assertion that the transaction amounted to a sale of oil and gas.   On audit, the IRS disagreed, recharacterized the bonus payment as ordinary income and slapped a 20 percent accuracy-related penalty on top. 

The Tax Court agreed with the IRS, citing the classic U.S. Supreme Court case of Burnet v. Hamel, 287 U.S. 103 (1932).   On the sale/lease issue, the Tax Court taxpayer retained an economic interest in the oil and gas deposits that were the subject matter of the lease.  That was true, the Tax Court reasoned because under the lease the taxpayer was entitled to royalty payments computed as a percentage of net profits of oil and gas that were extracted from the property.  That meant that the taxpayer possessed an economic interest in the in-place minerals.  See, e.g., Kittle v. Comr., 21 T.C. 79 (1953).  Had the transaction been a sale, the Tax Court reasoned, there would have been an exchange of a set quantity of oil and gas for a particular price.   

The taxpayer also claimed that the bonus income was subject to percentage depletion.  Percentage depletion is a cost recovery method that provides a tax deduction for most natural resources.  Percentage depletion assigns a set percentage of depletion to the gross income derived from extracting fossil fuels, minerals, or other nonrenewable resources.   For oil and gas, the allowable statutory percentage depletion deduction is the lesser of net income or 15% of gross income. If net income is less than 15% of gross income, the deduction is limited to 100% of net income.  I.R.C. §613(b)(2).  The Tax Court disagreed with the taxpayer’s claim that percentage depletion applied.  I.R.C. §613A(d) bars percentage depletion from applying to lease bonus payments.  The payment must be tied to production for percentage depletion to apply.  See Treas. Reg. §1.613A-3(j). 

But the Tax Court did indicate that the taxpayer’s bonus payment could be eligible for cost depletion.  The Tax Court noted that cost depletion, in accordance with Treas. Reg. §1.612-3(a)(1), is tied to the taxpayer’s basis for depletion.  The amount of the deduction is dependent upon depletion basis, future expected royalties and the amount of the upfront bonus payment.  The taxpayer needed to establish all of these amounts to claim a deduction for cost depletion.  The taxpayer failed to do so.  The Tax Court also upheld the accuracy-related penalty.

Establishing Basis

The Dudek case makes it clear that the taxpayer must establish a basis in the minerals subject to an oil and gas lease agreement to be able to claim cost depletion.  That can be tricky when land is acquired that has an oil and gas deposit and purchase transaction combines both the land and the deposit together.  It is the position of the IRS that minerals do not have a separate cost basis unless the seller’s cost stipulated such an amount; or was the result of an estate tax valuation that contained the separate valuations; or the seller’s cost basis can be properly allocated in accordance with existing evidence at the time of the acquisition.  I.R.M. 4.41.1.2.1.2 (Dec. 3, 2013).  While the IRS has indicated that a taxpayer might be able to establish a separate value for the minerals based on the evidence, it clearly is the taxpayer’s burden to prove the basis allocated to the oil and gas (or other mineral) deposit.  See, e.g., Rev. Rul. 69-539, 1969-2 CB 141; Collums v. United States, 480 F. Supp. 864 (D. Wyo. 1979)That allocation might even be 100 percent of the taxpayer’s basis in the lease if a zero estimate of future royalties is reasonable (such as in a wildcat area).  See, e.g., Collums v. United States, 480 F. Supp. 864 (D. Wyo. 1979); but see Tech. Adv. Memo. 8532011 (May 7, 1985). 

Conclusion

Cost depletion can be confusing.  The Dudek opinion reiterates the long-standing ordinary income treatment of bonus payments associated with oil and gas leases.  It also points out that cost depletion can apply to the payments.  But work must be done to be able to claim cost depletion, and that burden is on the taxpayer. 

October 21, 2019 in Income Tax | Permalink | Comments (0)

Thursday, October 17, 2019

Bad Debt Deduction

Overview

When financial and economic conditions sour, one of the issues that can come up concerns the ability to collect on debts. Ag retail businesses are experiencing tougher credit relations with farm clients due to difficult times in some sectors of production agriculture.  Thus, a debt can turn into a “bad debt.”  That has tax consequences. An income tax deduction is allowed for debts which become worthless within the taxable year.   

What does it take to be able to deduct a bad debt?  Is there a tax difference between a business bad debt and a non-business bad debt? 

Distinguishing between business and non-business bad debts.  That’s the topic of today’s blog post.

Elements Necessary For Deductibility

Debtor-creditor relationship.  For a bad debt to be deductible, there must be a debtor-creditor relationship involving a legal, valid, and enforceable obligation to pay a fixed or determinable sum of money.  See, e.g., Meier v. Comm’r, T.C. Memo. 2003-94; Treas. Reg. §1.166-1(c).  In addition, the taxpayer must be able to show that it was the intent of the parties at the time the transaction was entered into to create that debtor-creditor relationship.  The requisite intent is established by showing that when the relationship was formed, the taxpayer had an actual expectation of repayment and intended to enforce the debt if necessary.  Thus, a deductible bad debt can derive from a loan made in the context of protecting the taxpayer’s investment if the purpose of making the loan was for business and their was intent to collect on the loan if necessary. 

While a formal loan agreement helps establish this intent, the lack of one will not absolutely bar the finding of a bona fide debt.  Conversely, the existence of paperwork documenting the transaction (such as a note) does not always mean that the transaction constitutes a bona fide debt stemming from a debtor-creditor relationship. 

Related party?  The fact that the debtor and creditor are related parties does not preclude a bad debt deduction.  The key is whether the loan that is now worthless was made for legitimate business purposes and arises from a debtor-creditor relationship and meets the other requirements as noted above.  However, the IRS tends to look more closely to debts involving related parties than those involving non-related parties. 

Classification of Bad Debts

For individuals and entities taxed as individuals, bad debts may be business bad debts or nonbusiness bad debts.  Corporations have only business bad debts.  Business bad debts are deducted directly from gross income while a nonbusiness bad debt of a non-corporate taxpayer is reported as a short-term capital loss when it becomes totally worthless.

So what is the distinction between a business bad debt and a nonbusiness bad debt?  A business bad debt relates to operating a trade or business and is mainly the result of credit sales to customers or loans to suppliers, clients, employers or distributors.  The loan transaction must have a relationship to the taxpayer’s trade or business.  Treas. Reg. §1.166-5(b).  According to the U.S. Supreme Court, the relationship of the loan transaction to the taxpayer’s trade or business is dependent upon whether the taxpayer’s “dominant motivation” for the loan was related to the taxpayer’s business.  United States v. Generes, 405 U.S. 93 (1972). In Generes, the Court concluded that the taxpayer's status as an employee was a business interest, but the taxpayer’s status as a shareholder was a nonbusiness interest.  But, this does not appear to be a blanket rule for every situation.  While the Court indicated that a business bad debt can arise from a loan transaction entered into to protect an employment status, source of income, a business relationship or to protect a business reputation, the Court also seemed to indicate that a shareholder can still experience a business bad debt if the loan transaction has a business purpose and otherwise meets the requirements of a business bad debt.  The facts are critical.

A taxpayer that is in the trade or business of lending money generally treats uncollectable loans as business bad debts. See, e.g., Henderson, 375 F.2d 36 (5th Cir. 1967); Serot v. Comr., T.C. Memo. 1994-532; aff’d. without pub. op., 74 F.3d 1227 (3d Cir. 1995); Owens v. Comr., T.C. Memo. 2017-157.  The cases cited also provide good guidance on how much loan activity is necessary for a taxpayer to be treated as being in the trade or business of lending money. 

Claiming the Deduction

A bad debt deduction may be claimed only if there is an actual loss of money or the taxpayer has reported the amount as income. A business bad debt may be totally worthless (no collection potential) or partially worthless.  I.R.C. §166(a)(1)-(2).  In any event, the allowed deduction for a bad debt does not include any amount that was deducted in a prior year at a time that the debt was only partially worthless.  Treas. Reg. §1.166-3(b).   

A bad debt is deductible when worthlessness can be established.  A nonbusiness bad debt must be wholly worthless in the year for which the deduction is claimed.  Cooper v. Comr., T.C. Memo 2015-191; Treas. Reg. §1.165-5(a)(2).  But, the actual tax year of worthlessness can sometimes be difficult to determine.  If the IRS, on audit, views worthlessness to have occurred in a year before the bad debt deduction was actually claimed, the applicable statute of limitation for seeking a refund or credit for a bad debt is seven years (rather than the normal three years).  I.R.C. §6511(d). 

But, a bad debt can’t be claimed if the taxpayer doesn’t have any records or activity to establish that the money transferred created an enforceable loan entered into for profit.  That can be a key point with many farming operations and loans between family members.  See, e.g., Vaughters v. Comr., T.C. Memo. 1988-276.  It’s critical to properly document the arrangement.

Conclusion

Careful tax planning can help maximize the tax benefit of a bad debt deduction and minimize the economic pain.  Today’s post covered the basics of bad debts, perhaps a future post can dig a little further.

October 17, 2019 in Income Tax | Permalink | Comments (0)

Monday, October 7, 2019

The Importance of Income Tax Basis “Step-Up” At Death

Overview

2013 marked the beginning of major law changes impacting estate planning.  Those changes were continued and, in some instances, enhanced by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017.  In particular, the “applicable exclusion amount” was enhanced such that (for deaths in 2019) the associated credit offsets the first $11.4 million in taxable estate value (or taxable gifts).  Consequently, the vast majority of estates are not impacted by the federal estate tax.  The “stepped-up” basis rule was also retainedI.R.C. §1014.  Under that rule, property included in the estate at death gets an income tax basis in the hands of the heirs equal to the property’s fair market value (known as “stepped-up” basis).  Much estate planning now emphasis techniques to cause property inclusion in a decedent’s estate at death to get the basis increase. 

What are the planning steps to achieve a basis increase?  What about community property?  These are the issues addressed in today’s post.

Basis “Step-Up” Considerations – First Things First

As noted above, under present law, the vast majority of estates do not face federal estate tax at death.  Thus, obtaining a basis increase for assets included in the gross estate is typically viewed as more important.  Consequently, an initial estate planning step often involves a comparison of the potential transfer tax costs with the income tax savings that would arise from a “step-up” in basis.  Unfortunately, this is not a precise science because the applicable exclusion adjusts be for inflation or deflation and could change dramatically depending on the whim of politicians. 

It’s also important to note that a basis increase is of no tax help to the owner of the property that dies.  The only way to capture the income tax benefits of the stepped-up basis adjustment is for the recipients of those assets to dispose of them in a taxable transaction. The degree of the benefit is tied to the asset.  Farm and ranch land may never be sold or may only be sold in the very distant future.  A basis adjustment at death is also beneficial if the asset involved is depreciable or subject to depletion.  An additional consideration is whether the asset involved is an interest in a pass-through entity such as a partnership or an S corporation.

Exceptions To “Stepped-Up” Basis

There are exceptions to the general rule of date- of-death basis.  For example, if the estate executor elects alternate valuation under I.R.C. §2032, basis is established as of the alternate valuation date (typically six months after death).  Also, if the estate executor elects special use valuation under I.R.C. §2032A, the lower agricultural use value of the elected property as reported on the federal estate tax return establishes the basis in the hands of the heirs.  For deaths in 2019, the maximum statutory value reduction for elected land is $1,160,000. 

In addition, for land subject to a qualified conservation easement that is excluded from the gross estate under I.R.C. §2031(c), a “carryover” basis applies to the property.  Also not receiving a basis increase at death is property that constitutes income in respect of a decedent (such as unrecognized interest on U.S. savings bonds, accounts receivable for cash basis taxpayers, qualified retirement plan assets, and IRAs, among other things).  There’s also a special basis rule that involves appreciated property that was gifted to the decedent within one year of death, where the decedent transferred the property back to the original donor of such property (or the spouse of the donor).  The donor receiving the property back will take as a basis the basis that the decedent had in the property immediately before the date of death. I.R.C. §1014(e).  The property basis won’t step-up to fair market value at the date of the decedent’s death.

Community Property Considerations 

The advantage of community property.  On the basis step-up issue, estates of persons living in community property states have an advantage over estates of persons domiciled in separate (common law) property states.  Under community property law, all assets acquired during marriage by either spouse, except gifts, inheritances, and assets acquired with separate property, are considered to be owned equally by the spouses in undivided interests.  The title of an asset is not definitive in terms of ownership in community property states like it is in common law states. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. 

The ownership portion of the couple’s community property that is attributable to the surviving spouse by virtue of I.R.C. §1014(b)(6) gets a new basis when the first spouse dies if at least one-half of the community property is included in the decedent’s estate for federal estate tax purposes.  This became the rule for deaths after 1947.  Restated differently, there is a basis adjustment of both the decedent’s and surviving spouse’s one-half of community property at death if at least one-half of the community property was included in the decedent’s gross estate under the federal estate tax rules – which would normally be the result.  The federal tax law considers the surviving spouse’s share to have come from the decedent.  The result is a 100 percent step-up in the basis of the property.  Conversely, in a common law property state, property that one spouse owns outright at death along with only 50 percent of jointly owned property is included in the estate of the first spouse to die (and receives a basis adjustment) unless the rule of Gallenstein v. Comr., 975 F.2d 286 (6th Cir. 1992) applies to provide a 100 percent basis step-up for property acquired before 1977.   

Community property spousal trusts.  Three common law property states, Alaska, South Dakota and Tennessee, authorize the creation of “community property trusts” for married couples that establish via the trust an elective community property system.  See, Alaska Stat. Ann. §34.77.100; Tenn. Code Ann. Ch. 35-17-101 – 35-17-108; S.D. Cod. Laws. Ch. 55-17-1 – 55-17-14.   In these states, married couples can classify property as community property by transferring the property to a qualifying trust.  

Under the Alaska provision (enacted in 1998), at least one trustee must be an individual who resides in Alaska or a trust company or bank with its principal place of business in Alaska.  The trust is irrevocable unless it provides for amendment or revocation.  Certain disclosures must be made for the trust to be valid, and the trust must contain specific language declaring that the property contained in the trust is to be community property.  Resident married couples can also execute an agreement to create community property for property that is not held in trust.

The Tennessee provision was enacted in 2010 and allows married couples to convert their property to community property by means of a “Community Property Trust.”  Again, the idea of the trust is to achieve a 100 percent basis step-up for all of the trust property at the death of the first spouse.  Comparable to the Alaska provision, at least one trustee must be an individual that resides in Tennessee or a company that is authorized to act as a fiduciary in Tennessee.   

Under the South Dakota law (enacted in 2016), property contained in “South Dakota Spousal Trust” is considered to be community property even if one spouse contributed more than 50 percent of the property to the trust.  At least one trustee must be a South Dakota resident, which could be one of the spouses.  S.D. Cod. Laws §§55-17-1; 55-3-41.  The trust must state that the trust property is intended to be community property and must specify that South Dakota law applies.  S.D. Cod. Laws §55-17-3.  Both spouses must sign the trust.  S.D. Cod. Laws §55-17-1.  Nonresidents can also utilize such a trust if a trustee is a qualified person that resides in South Dakota.  In addition, significant disclosures are required between the spouses and both must consent and execute the trust.  S.D. Cod. Laws §§55-17-11; 55-17-12.  The trust can be either revocable or irrevocable if the trust language allows for amendment or revocation.  S.D. Cod. Laws. §55-17-4. 

Transfer of farmland.  Can farmland that is owned in joint-tenancy, tenancy-by-the-entirety, or co-tenancy in a common law property state be transferred to a Community Property Trust created under the laws of these states and be treated as community property in order to achieve a full stepped-up basis at the death of the first spouse?  Normally the law of “situs” (e.g. the location of where land is located) governs the legal status of the land transferred to a trust that is administered in another state.  Neither the Alaska, South Dakota, nor Tennessee laws clearly address the legal nature of farmland that is transferred to such a trust from a common law property state, and there appears to be no caselaw or IRS rulings that address the question.  Thus, a preferable planning approach might be to transfer the out-of-state farmland to an entity such as a limited liability company or family limited partnership followed by a transfer of the interests in the entity to the trust.  Perhaps doing so would avoid questions concerning the property law and income tax basis issues associated with the out-of-state farmland.

The UDCPRDA.  Presently, sixteen states (Alaska; Arkansas; Colorado; Connecticut; Florida; Hawaii; Kentucky; Michigan; Minnesota; Montana; New York; North Carolina; Oregon; Utah; Virginia and Wyoming) have enacted the Uniform Disposition of Community Property Rights at Death Act (“UDCPRDA”).  The UDCPRDA specifies how property that was acquired while the spouses resided in a community property state passes at death if the spouses then reside in a common law property state.  The UDCPRDA preserves the community property nature of the property, unless the couple has taken some action to sever community property rights.  It does so by specifying that upon the death of the first spouse, one-half of the community property is considered the property of the surviving spouse and the other half is considered to belong to the deceased spouse.  This should achieve a full basis step-up due to the unlimited marital deduction of I.R.C. §2056, however there aren’t any cases or IRS rulings on the impact of the UDCPRDA on basis step-up under I.R.C. §1014(b)(6).

Other Techniques

The disparate treatment of community and common law property under I.R.C. §1014 has incentivized estate planners to come up with techniques designed to achieve a basis “step up” for the surviving spouse’s common law property at the death of the first spouse.

One way to achieve the basis increase is to give each spouse a power of appointment over the other spouse’s property which causes, on the death of the first spouse, the deceased’s spouse’s property to be included in the decedent’s estate by virtue of I.R.C. §2033 (if owned outright) and I.R.C.§2038 if owned in a revocable trust.  The surviving spouse’s property would also be included in the decedent’s estate by virtue of I.R.C. §2041. The power held by the first spouse to die terminates upon the first spouse’s death and would be deemed to have passed at that time to the surviving spouse.

Another technique involves the use of a joint exempt step-up trust (JEST).  In essence, both spouses contribute their property to the JEST that holds the assets as a common fund for the benefit of both spouses. Either spouse may terminate the trust while both are living, with the result that the trustee distributes half of the assets back to each spouse. If there is no termination, the joint trust becomes irrevocable upon the first spouse’s death. Upon the first spouse’s death, all assets are included in that spouse’s estate.  Upon the first spouse’s death, assets equal in value to the first spouse’s unused exclusion will be used to fund a bypass trust for the benefit of the surviving spouse and descendants. These assets will receive a stepped-up basis and will not be included in the surviving spouse’s estate.  Any asset in excess of the funding of the bypass trust will go into an electing qualified terminable interest property (QTIP) trust under I.R.C. §2056(b)(7).  If the first spouse’s share of the trust is less than the available exclusion, then the surviving spouse’s share will be used to fund a bypass credit shelter trust.  These assets will avoid estate taxation at the surviving spouse’s death.

The JEST technique comes with caution.  Because the surviving spouse (the donor) could revoke the joint revocable living trust at any time, the surviving spouse arguably has dominion and control over the trust assets during the year before and up to the time of the decedent spouse’s death.  That could mean that I.R.C. §1014(e) applies to disallow a basis increase in the surviving spouse’s one-half interest in the trust due to retained control over the trust assets within a year of death.  See, Priv. Ltr. Ruls. 9308002 (Nov. 16, 1992) and 200101021 (Oct. 2, 2000). 

Conclusion

For the vast majority of people, avoiding federal estate tax at death is not a concern.  Some states, however, do tax transfers at death and the exemption in those states is often much lower than the federal exemption.  But, achieving an income tax basis at death is of primary importance to many people.  Community property has an advantage on this point, and other planning steps might be available to receive a full basis step-up at death.  In any event, estate and income tax basis planning is a complex process for many people, especially those with farms and ranches and other small businesses that are trying to make a successful transition to the next generation.  Competent legal and tax counsel is a must.

October 7, 2019 in Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, October 2, 2019

Hobby Losses Post-2017 and Pre-2026 – The Importance of Establishing a Profit Motive

Overview

Court cases are many in which the IRS has asserted that the taxpayer is engaged in an activity without an intent to make a profit.  If the IRS prevails in its claim that the taxpayer’s activity is a hobby, deductions for losses from the activity are severely limited.  The tax result is even harsher as a result of the Tax Cuts and Jobs Act (TCJA). 

What does it take to be conducting an activity with a profit intent?  How did the TCJA change the impact of the “hobby loss” rules?  These are the topics of today’s blog post.

Tax Code Rules

What is a “hobby”?  A “hobby” under the Code is defined in terms of what it is not.  I.R.C. §183.  A hobby activity is essentially defined as any activity that a taxpayer conducts other than those for which deductions are allowed for expenses incurred in carrying on a trade or business or producing income.  I.R.C. §§162; 212.  The determination of whether any particular activity is a hobby activity or not is based on the facts and circumstances of each situation.  It’s a highly subjective determination.  But the Code provides a safe harbor.  I.R.C. §183(d).  Under the safe harbor, an activity that doesn’t involve horse racing, breeding or showing must show a profit for three of the last five years, ending with the tax year in question.  It’s two out of the last seven years for horse-related activities.  If the safe harbor is satisfied (either for horse activities or other activities, a presumption arises that the activity is not a hobby.  The safe harbor applies only for the third (or second) profitable year and all subsequent years within a five-year (or seven-year) safe-harbor period that begins with the first profitable year.  Treas. Reg. §1.183-1(c). 

The burden of proof.  Satisfaction of the safe harbor shifts the burden to prove that the activity is a hobby (i.e., lacks a profit motive) to the IRS.  But the IRS can rebut the for-profit presumption even if the safe harbor is satisfied – although it doesn’t tend to do so without extenuating circumstances.   

What about losses in early years?  As noted above, the safe harbor applies only after a taxpayer incurs a third profitable year within the five-year testing period.  That means that only loss years arising after that time (and within the five-year period) are protected.   Losses incurred in the first several years are not protected under the safe harbor.  It makes no difference whether the activity turns a profit in later years.

Postponing the safe harbor.  It is possible to postpone the application of the safe harbor until the close of the fourth tax year (or sixth (for horse activities) after the tax year the activity begins.  I.R.C. §183(e).   This is accomplished by making an election via Form 5213 to allow losses incurred during the five-year period to be reported on Schedule C.  Thus, if the activity shows a profit for three or more of the five years, the activity is presumed to not be a hobby for the full five-year period.  The downside risk of the election occurs if the taxpayer fails to show a profit for at least three of the five years.  If that happens, a major tax deficiency could occur for all of the years involved.  Thus, filing Form 5213 should not be made without thoughtful consideration.  For example, while the election provides more time to establish that an activity is conducted with a profit intent, it will also put the IRS on notice that an activity may be conducted without a profit intent.  It also extends the statute of limitations for a tax deficiency (and refund claims) associated with the activity.  See, e.g., Wadlow v. Comr., 112 T.C. 247 (1999).    

Showing a Profit Intent – Some Recent Cases

While the IRS is presently not aggressively auditing many returns involving farm-related activities, the hobby loss area involving ag activities is one of them.  So, what does it take to establish the necessary profit intent?  Some recent court decisions provide guidance. 

Cattle ranching activity deemed to be a hobby.  In Williams v. Comr., T.C. Memo. 2018-48, the petitioner grew up on the family ranch in the Texas panhandle.  He then went on to have a career as a chiropractor.  He also operated a publishing and research business and a gun shop. He sold his chiropractic practice and bought an 1,100-acre ranch in south-central Texas. He ran a feeder-stocker cattle operation on the ranch, employing two ranch workers to tend to the cattle. The petitioner also hired a bookkeeper to manage his various business activities and a CPA to do the tax work for his businesses. He put approximately six to eight hours a week into the cattle ranching activity, and also spent time in his other business ventures. He modified his cattle operation after encountering problems that were detrimental to the viability of the business. The petitioner’s publishing business showed an average profit of approximately $300,000 each year; the gun shop was approximately a break-even business; and the cattle business averaged Schedule F losses of about $100,000 annually over a 15-year period, never showing a profit in any year (although losses declined on average over time).

The IRS examined years 2011 and 2012 and disallowed the loss from the ranching activity on the basis that the petitioner did not engage in the activity with a profit intent. The Tax Court analyzed each of the nine factors under Treas. Reg. §1.183-2. Of the nine factors contained therein, only one favored the petitioner - he did not derive any personal pleasure from the cattle ranching activity. The Tax Court determined that the petitioner did not operate the ranch in a businesslike manner; had no formal education in animal husbandry; did not view the hours spent in the activity by the employees as attributable to the petitioner; did not have a reasonable expectation of appreciation of the value of the ranch’s assets (but the Tax Court ignored the building improvements and fences that were built); had no history of running comparable businesses profitably; and had substantial income from other sources that the losses from the ranching activity offset.

Horse activity was a hobby.  In Sapoznik v. Comr., T.C. Memo. 2019-77, the petitioners bought a horse in 2011 and participated in horse shows in 2014 and 2015. The horse was top-ten in its class nationally, and the petitioners hoped to be able to sell the horse for more than its purchase price. However, the lost more than $100,000 and sold the horse for what they paid for it. The petitioners deducted the $100,000 loss and the IRS rejected the deduction and assessed a penalty exceeding $6,000. The Tax Court agreed with the IRS that the activity was a hobby.  The Tax Court noted that the petitioners had not conducted the activity in a businesslike manner. They also had no written business plan and didn’t keep accurate books and records. They also made no changes in how they conducted the activity to reduce expenses or generate additional income, and they did not attempt to educate themselves on how to conduct the activity. They also did not rely on the activity as a major source of their income, and never came close to making a profit. 

Profit was “too gone for too long.” In Donoghue, et ux. v. Comr., T.C. Memo. 2019-71, the petitioners, sustained losses in their horse breeding/racing activity for almost 30 years without ever showing a profit. The husband was a computer programmer and his wife a retired paralegal and business executive. The wife had been a life-long horse enthusiast. They operated the activity via a partnership as a “virtual farm.” The IRS denied the loss deductions from the activity and the Tax Court agreed on the basis that the petitioners couldn’t satisfy the requirements of the regulations under I.R.C. §183. The Tax Court noted that the evidence clearly established that the petitioners didn’t operate the activity in a businesslike manner. They didn’t breed, race or sell any of their horses during the years at issue. While they had separate bank accounts and some records, the records were incomplete or inaccurate. While the petitioners had written business plans, the plans projected net losses and remained essentially unchanged from the original plans 30 years earlier. Also, their long string of unbroken losses was used to offset non-farm income, and the petitioners derived substantial personal pleasure from the activity. They left the “grueling aspects” of the activity to others that they paid, and there was no evidence that they sought expert advice concerning how to make a profit at the activity. Instead, they sought only general advice.

Golf course activity conducted for profit.  In one recent non-ag case, WP Realty, LLP v. Comr., T.C. Memo. 2019-120, a profit intent was found to be present.  The petitioner, a limited partnership, owned and operated a golf course. The limited partner and sole shareholder of the general partner was a real estate developer and developer of golf courses who created a nonprofit corporation to which he planned to donate the golf course at issue. The IRS approval of nonprofit status was conditioned on the corporation focusing only on charitable activities and distributing funds to a medical center. As a result, the golf course gave access to the corporation and members.  The corporation paid rent and members paid fees for golf rounds. The golf course was managed by an experienced manager. The manager kept complete books and records and maintained budgets for the course and facilities. Between 2001 and 2015, the golf course sustained losses which flowed through the petitioner to the limited partner. The golf course reported a net profit in 2016.

The IRS denied the loss deductions on the basis that the golf course was not engaged in its activity for profit. The Tax Court disagreed based on the nine factors of Treas. Reg. §1.183-2(b), a predominance of which favored the petitioner. The golf course was operated in a businesslike manner with complete and accurate books and records, and the records were used to determine when capital improvements should be made. Steps were also taken to make the golf course more profitable. In addition, the managers had extensive experience in the golf industry and in managing golf clubs. The Tax Court also noted that the limited partner had successfully developed two other golf clubs and did not derive substantial tax benefits from the passed-through losses. While a long history of losses was present, that factor was not enough to negate the petitioner’s actual and honest intent to make a profit. 

TCJA Change

The TCJA suspends miscellaneous itemized deductions for years 2018-2025.  Thus, deductions for expenses from an activity that is determined to be a hobby are not allowed in any amount for that timeframe.  I.R.C. §67(g).  But all of the income from the activity must be recognized in adjusted gross income.  That’s painful, and it points out the importance of establishing the requisite profit intent. 

Conclusion

Hobby activities involving agricultural activities (especially those involving horses) have been on the IRS radar for quite some time.  That’s not expected to change.  It’s also an issue that some states are rather aggressive in policing.  See, e.g., Howard v. Department of Revenue, No. TC-MD 160377R, 2018 Ore. Tax LEXIS 35 (Ore. Tax Ct. Mar. 16, 2018); Feola v. Oregon Department of Revenue, No. TC-MD 160081N, 2018 Ore. Tax. LEXIS 48 (Ore. Tax. Ct. Mar. 27, 2018).  It’s also not an issue that the U.S. Supreme Court is likely to review if the taxpayer receives an unfavorable opinion at the U.S. Circuit Court of Appeals level.  See, e.g., Hylton v. Comr., T.C. Memo. 2016-234, aff’d., No. 17-1776, 2018 U.S. App. LEXIS 35001 (4th Cir. 2018), cert. den., No. 18-789, 2019 U.S. LEXIS 966 (U.S. Sup. Ct. Feb. 19, 2019).

October 2, 2019 in Income Tax | Permalink | Comments (0)

Friday, September 27, 2019

The Family Limited Partnership – Part Two

Overview

In Tuesday’s Part One of a two-part series on family limited partnerships (FLPs), I looked at where an FLP might fit as part of a business or succession plan for a farm or ranch operation.  Today, in Part Two, I examine the relative advantages and disadvantages of the FLP form.

The pros and cons of the FLP – that’s the topic of today’s blog post.

Advantages of an FLP

Income taxation.  An FLP is generally taxed like a general partnership.  There is no corporate-level tax and taxes are not imposed on assets passing from the FLP to the partners (unlike an S corporation).  Thus, the FLP is not recognized as a taxpayer, and the income of the FLP passes through to the partners based on their ownership interest.  The partners report the FLP income on their individual income tax returns and must pay any tax owed.  Income is allocated to each partner to the extent of the partner’s share attributable to their capital (or pro rata share). 

This tax feature of the FLP can be an attractive vehicle if a transfer of interests to family members in a lower tax bracket is desired.  Transfers of FLP interests can also be made to minor children if they are competent to manage their own property and participate in FLP activities.  But, such transfers are typically made in trust on behalf of the minor.  Also, unearned income of children under age 18 (and in certain cases up to age 23) may be subject to the “kiddie tax” and thus be taxable at the parents’ income tax rate. 

Avoidance of transfer taxes.  Another advantage of an FLP is that it can help avoid transfer taxes - estate tax, gift tax and generation skipping transfer tax.  Transfer tax avoidance is accomplished in three ways: 1) by the removal of future asset appreciation; 2) the utilization of the present interest annual exclusion for gift tax purposes; and 3) the use of valuation discounts for both gift and estate tax purposes.  Of course, the federal estate and gift tax is not much concern for very many at the present time with the applicable exclusion amount set at $11.4 million for deaths in and gifts made in 2019.  But, the present high level of the exclusion is presently set to expire after 2025.  Depending on politics, it could be reduced before 2025.

Transfer of assets yet maintenance of control.  Another advantage of an FLP is that it allows the senior generation of the family to distribute assets currently while simultaneously maintaining control over those assets by being the general partner with as little as a 1% interest in the FLP.  This can allow the general partner to control cash flow, income distribution, asset investment and all other management decisions. 

But, a word of caution is in order.  I.R.C. §2036(a)(1) provides that a decedent’s gross estate includes the value of property previously transferred by the decedent if the decedent retained the possession or enjoyment of, or the right to the income from, the transferred property. I.R.C. §2036(a)(2) includes in the gross estate property previously transferred by the decedent if the decedent retained the right, either alone or in conjunction with any person, to designate the persons who are to possess or enjoy the transferred property or its income. Thus, pursuant to §2036(a)(2), the IRS may claim that because a general partner controls partnership distributions, a transferred partnership interest should be taxed in the general partner’s estate.

In the typical FLP scenario, the parents establish the FLP with themselves as the general partners and gift the limited partnership interests to their children. In this situation, if the general partners have the discretionary right to determine the amount and timing of the distributions of cash or other assets, rather than the distributions being mandatory under the terms of the partnership agreement, the IRS could argue that the general partners (who have transferred interests to the limited partners) have retained the right to designate the persons who will enjoy the income from the transferred property.  An exception exists for transfers made pursuant to a bona fide sale for adequate and full consideration.

Consolidation of family assets.  An FLP also keeps the family business in the family, with the limited partner interests restricted by the terms of the partnership agreement.  Such restrictions typically include the inability of the limited partner to transfer an FLP interest unless the other partners are first given the opportunity to purchase (or refuse) the interest.  This virtually guarantees that non-family members will not own any of the business interests.  These agreements (buy-sell agreements and rights of first refusal) must constitute a bona fide arrangement, not be a device to transfer property to family members for less than full and adequate consideration, and have arm’s length terms.  An agreement structured in this manner will produce discounts from fair market value for transferred interests that are subject to the agreement.

Provision for non-business heirs.  The FLP can also provide for children not in the family business and allow for an even distribution of the estate among all family members, farm and non-farm.  The limited partner interest of a non-farm heir can allow that heir to derive an economic benefit from the income distributions made from time to time without being involved in the day-to-day operation of the business. 

Asset protection.  The FLP can also serve as an asset protection device.  This is particularly the case for the limited partners.  A limited partner has no ownership over the assets contributed to the FLP, thus the creditor’s ability to attach those assets is severely limited.  In general, a court order (called a “charging order”) would be required to reach a limited partner interest, and even if the order is granted, the creditor only receives the right to FLP income to pay the partner’s debt until the debt is paid off.  The creditor still does not reach the FLP assets.  The limited partnership agreement and state law are crucial with respect to charging orders.  Also, a charging order could put a creditor in a difficult position because tax is owed on a partner’s share of entity profits even if they are not distributed.  Thus, a creditor could get pinned with a tax liability, but no income flowing from the partnership to pay the obligation.   However, a general partner does not receive the same creditor protection unless the general partner interest is structured as a corporation. 

Establishing a corporation as the general partner should be approached with care.  It cannot be established as merely a sham to avoid liability.  If it is, IRS and/or the courts could ignore it and pierce the corporate veil.  To avoid this from happening, the corporation must be kept separate from the FLP.  Funds and/or assets must not be commingled between the FLP and the corporation, and all formalities must be observed to maintain the corporate status such as keeping records and minutes, holding directors and shareholders’ meetings and filing annual reports. 

Other advantages.

  • The FLP can also provide flexibility because the FLP agreement can be amended by vote in accordance with the FLP agreement.    
  • Consolidation of assets. The assets of both the general and limited partners are consolidated in the FLP.  That can provide for simplification in the management of the family business assets which could lead to cost savings.  In addition, the management of the assets and related investments can be managed by professional, if desired. 
  • Minimization or elimination of probate. Assets may be transferred to the FLP and the ownership interests may be transferred to others, with only the FLP interest owned at death being subject to probate.  Upon death, the FLP continues to operate under the terms of the FLP agreement, ensuring continuity of the business without any disruption caused by death of an owner.  Relatedly, an FLP will also typically avoid the need for an ancillary probate (probate in the non-domiciliary state) at the FLP interest owner’s death.  Most states treat FLP interests as personal property even if the FLP owns real estate.  To the extent probate is avoided, privacy is maintained.
  • Partnership accounting rules. The rules surrounding partnership accounting, while complicated, are relatively flexible.
  • Ease of gifting. The FLP structure does provide a mechanism that can make it easier for periodic gifting to facilitate estate and tax planning goals.

Disadvantages of an FLP 

While there are distinct advantages to using an FLP in the estate and business succession planning context, those advantages should be weighed against potential drawbacks.  The disadvantages of using an FLP can include the following:

  • An FLP is a complex form of business organization that requires competent legal and tax consultation to establish and maintain. Thus, the cost of formation could be relatively higher than other forms of doing business.
  • Unlimited liability of the general partners. However, slightly over one-half of states have enacted legislation allowing the formation of a limited liability limited partnership (LLLP), which is typically accomplished by converting an existing limited partnership to an LLLP.  In an LLLP, any general partner has limited liability for the debts and obligations of the limited partnership that arise while the LLLP election is in place.  In addition, some states (such as California) that do not have a statute authorizing on LLLP will recognize LLLPs formed under the laws of another state.  Also, while Illinois does not authorize LLLPs by statute, it does allow the formation of an LLLP under the Revised Uniform Limited Partnership Act.   
  • Ineligibility of FLP members for many of the tax-free fringe benefits that employees are eligible for.
  • The gifts of FLP interests must be carefully planned to not trigger unexpected estate, gift or GSTT liability.
  • Establishing and FLP can be costly in terms of the legal work necessary to draft the FLP agreement, changing title to assets, appraiser fees, state and local filing fees, and tax accounting fees.
  • There could be additional complications in community property states. In community property states, guaranteed payments (compensation income) from an FLP are treated as community property.  However, FLP income distributed at the discretion of the general partner(s) is classified as separate property. 

Conclusion

The FLP can be a useful business organizational form for the farm or ranch business.  Careful considerations of the pros and cons of the entity choice in accordance with individual goals and objectives is essential.

September 27, 2019 in Business Planning, Income Tax | Permalink | Comments (0)