Wednesday, September 15, 2021
In the Part One of this series, I discussed the basics rules governing gifts made during life and the present interest annual exclusion. In Part Two, I expanded the present interest gifting discussion to gifts of entity interests and how to qualify the gifts for present interest exclusions. In today’s Part Three the attention turns to how to report gifts of interests in a partnership for tax purposes.
The tax reporting of gifted partnership interests – it’s the topic of today’s post.
Basic Rules Applied
Often no issues. From an income tax standpoint, the donee does not recognize income (or loss) on the value of gifted property. The gift, however, can trigger gift tax if the amount of the gift exceeds the present interest annual exclusion (presently $15,000 per donee, per year) or is not of a present interest of any amount. In that situation, Form 709 must be filed by April 15 of the year following the year in which the taxable gift was made. But, as noted in Part One, gift tax is often not due because the tax can be offset by unified credit. But remember, even if the credit is used to fully offset gift tax, Form 709 must be filed to show the amount of the taxable gift and the offsetting credit reducing the taxable amount to zero.
Valuing gifts for tax purposes. If gift tax is imposed, it is calculated on the fair market value (FMV) of the gifted property less the amount of debt (if any) from which the donor is relieved. Applying those principles in the partnership context, the fair market value of a partnership interest would need to be determined, as well as the donor’s share of any partnership liabilities. If the gifted partnership interest relieves the donor of more debt than the donor has income tax basis in the partnership interest, the excess is treated as an amount realized in a deemed sale transaction. In that event, the donor must recognize gain. Treas. Reg. §1.1001-2(a).
Gain Recognition on Gift of a Partnership Interest
For gifted partnership interests, gain recognition is common when the donor has a negative tax basis capital account. A partner’s tax basis capital account balance generally equals the amount of cash and tax basis of property that the partner contributes to the partnership, increased by allocations of taxable income to the partner, decreased by allocations of taxable loss to the partner, and decreased by the amount of cash or the tax basis of property distributed by the partnership to the partner. If the result of all of these adjustments is a negative amount, the partner has a negative tax basis capital account and is more likely to have gain recognition upon the gift of a partnership interest.
Note: For tax years ending on or after 2020 partnerships must report each partner’s capital account on a tax basis. For prior years, a partnership could report partner capital accounts on some other basis (such as GAAP) which limited the ability of the IRS to identify potentially taxable situations.
Depending on whether the “hot asset” rules of I.R.C. §751 apply, some of the gain could be taxed at ordinary income rates. IRC §751 requires recognition of gain from "hot assets" as ordinary income. Under §751(b), "hot assets" include unrealized receivables, substantially appreciated inventory and depreciation recapture. Any amount of capital gain triggered by the gifted partnership interest will be either short-term or long-term under the normal rules.
Frank has structured his farming operation as a general partnership. Assume that his tax basis capital account is negative $200,000 and his share of partnership liabilities is $300,000, and the FMV of his interest in the partnership assets is $400,000. For succession planning purposes, Frank wants to gift his partnership interest to his son, Fred. Frank needs to know both the gift tax and income tax consequences of gifting his partnership interest to Fred.
The amount of the taxable gift is the difference in the FMV of Frank’s share of the partnership assets and his share of partnership debt he is being relieved of. Thus, the amount of the gift is $100,000. Assuming that the gift qualifies for the present interest annual exclusion (see Part 2 of this series), the taxable gift would be $85,000. That amount could be fully offset by the estate and gift tax unified credit (assuming Frank has enough currently remaining) resulting in no gift tax liability. Form 709 would need to be filed by April 15 of the year following the year of the gift.
On the income tax side of things, the gift of the partnership interest relieved Frank of his share of partnership liabilities of $300,000. From that amount Frank subtracts the adjusted basis of his partnership interest – that’s Frank’s tax basis capital account value of negative $200,000 plus his share of partnership liabilities of $300,000. Thus, from the debt relief of $300,000, Frank subtracts $100,000. The result is that Frank has $200,000 of gain associated with a deemed sale of the partnership interest.
The amount of gain that Frank recognizes on the gift of the partnership interest is added to Frank’s basis in his interest for determining Fred’s basis. Fred then has a basis equal to the amount realized (the amount of debt relief) in the deemed sale. Treas. Reg. §1.1015-4(a). Fred’s tax basis capital account begins at zero, representing Frank’s negative capital account of $200,000 plus $200,000 gain recognized by Frank. Another way of looking at this is the tax basis of Frank’s share of the partnership assets was $100,000, plus Frank recognized gain of $200,000, reduced by Frank’s share of the partnership debt assumed by Fred of $300,000.
Note: One exception to the general rule of carryover basis is if the donor’s pays any gift tax on the gift. See I.R.C. §§742 and 1015.
Note: If the FMV of a partnership interest is less than the partner's basis at the time of the gift, for purposes of determining the donee's loss on a subsequent disposition, the donee's basis in the interest is the FMV of the partnership interest at the time of the gift. I.R.C. §1015(a).
Basis adjustment. If a gifting partner recognizes gain on the deemed sale of the partnership interest and the partnership had an I.R.C. §754 election in place, the partnership will need to adjust the basis of its assets to reflect the amount of the gain.
Transfer to family members. If a partnership interest is purchased by a family member, the transfer is subject to the family partnership rules of I.R.C. §704(e)(2). For this purpose, a “family member” is defined as the donor’s spouse, ancestors and lineal descendants and any trusts for the primary benefit of such persons. If the rules are triggered, the transfers is treated as if it was created by gift from the seller, and the fair market value of the purchased interest is considered to be donated capital. This rule is designed to bar the shifting of income and property appreciation from higher-bracket taxpayers to lower-bracket taxpayers by requiring income produced by capital to be taxed to the true owner of that capital. The rule is also designed to ensure that services are taxed to the person performing the services. If the IRS deems the rules to have been violated it may reallocate income between partners (or determined that a partner is not really a partner) for income tax purposes.
Valuation discounts. As noted in Part 2, gifts of partnership interests to family members are often subject to valuation discounts to reflect lack of marketability or minority interest. Thus, careful structuring of partnerships and transferring of partnership interests involving family members must be cautiously and carefully undertaken to avoid IRS objection.
Transitioning the farming or ranching business to the next generation is difficult from a technical perspective. But those difficulties should not prevent farm and ranch families from doing appropriate planning to ensure that a succession plan is in place to help assist the future economic success of the family business.
Friday, September 10, 2021
Proposed legislation that would decrease the federal estate tax exemption and the federal gift tax exemption is raising many concerns among farm and ranch families and associated estate and business planning issues. For farmers and ranchers desirous of keeping the family business intact for the next generation, questions about gifting assets and business interests to the next generation of owners now are commonplace.
Gifting assets before death – Part One of a series - It’s the topic of today’s post.
Federal Estate and Gift Tax - Current Structure
The current federal estate and gift tax system is a “coupled” system. A “unified credit” amount generates and “applicable exclusion” of $11.7 per individual for 2021. That amount can be used to offset taxable gifts during life or offset taxable estate value at death. It’s and “either/or” proposition. Any unused exclusion at the time of death can be “ported” over to the surviving spouse and added to the surviving spouse’s own applicable exclusion amount at death.
However, some gifts are not “taxable” gifts for purposes of using up the unified credit and, in turn, reducing the amount of asset value that can be excluded from federal estate tax at death.
Gifting – The Present Interest Annual Exclusion
Basics. “Present interest” gifts are not “taxable” gifts and do not reduce the donor’s unified credit. The present interest annual exclusion amount is a key component of the federal gift tax. I.R.C. §2503. The exclusion is presently $15,000 per donee, per year. That means that a donor can make gifts of up to $15,000 per year, per donee (in cash or an equivalent amount of property) without triggering any gift tax, and without any need to file Form 709 – the federal gift tax return.
Note: Spouses can elect split gift treatment regardless of which spouse actually owns the gifted property. With such an election, the spouses are treated as owning the property equally, thereby allowing gifts of up to $30,000 per donee. Also, under I.R.C. §2503(e), an unlimited exclusion is allowed for direct payment of certain educational and medical expenses. In effect, such transfers are not deemed to be gifts.
The exclusion “renews” each year and is not limited by the number of potential donees. It is only limited by the amount of the donor’s funds and interest in making gifts. Thus, the exclusion can be a key estate planning tool by facilitating the passage of significant value to others (typically family members) pre-death to aid in the succession of a family business or a reduction in the potential size of the donor’s taxable estate, or both. But, to qualify for the exclusion, the gift must be a gift of a present interest – the exclusion does not apply to future interests.
Note: A present interest gift is one that the recipient is free to use, enjoy, and benefit from immediately. A gift of a future interest is one where the recipient doesn't have complete use and enjoyment of it until some future point in time. “Strings” are attached to future interest gifts.
Gifts to minors. I.R.C. §2503(c) specifies that gifts to persons under age 21 at the time of the gift are not future interests if the property and the income from the gift “may be expended by, or for the benefit of, the donee before attaining the age of 21 years, and will to the extent not so expended, pass to the donee on his attaining the age of 21 years, and in the event the donee dies before attaining…age…21…, be payable to the estate of the donee or as he may appoint under a general power of appointment…”. This provision contemplates gifts to minors in trust with a trustee appointed to manage the gifted property on the minor’s behalf. But, to qualify as a present interest, the gift still must be an “outright” gift with no strings attached.
Whether gifts are present interests that qualify for the annual exclusion has been a particular issue in the context of trust gifts that benefit minors. In 1945, the U.S. Supreme Court decided two such cases. In Fondren v. Comr. 324 U.S. 18 (1945) and Comr. v. Disston, 325 U.S. 442 (1945), the donor created a trust that benefitted a minor. In Fondren, the trustee had the discretion to distribute principal and income for the minor’s support, maintenance and education and, in Disston, the trustee had to apply to the minor’s benefit such income “as may be necessary for…education, comfort, and support.” In both cases, the Court determined that the minor was not entitled to any amount of a “specific and identifiable income stream.” So, no present interest was involved. The gifts were determined to be future interests.
What if a transferee has a right to demand the trust property via a right to withdraw the gifted property from the trust? Is that the same as outright ownership such that the gifted property would qualify the donor for an annual exclusion on a per donee basis? In 1951, the U.S. Court of Appeals for the Seventh Circuit said “yes” in a case involving an unlimited timeframe in which the withdrawal right could be exercised without any time limit for exercising the right. Kieckhefer v. Comr., 189 F.2d 118 (7th Cir. 1951). But in 1952 the U.S. Court of Appeals for the Second Circuit said “no” because it wasn’t probable that the minor would need the funds. Stifel v. Comr., 197 F.2d 107 (2d Cir. 1952). In Stifel, the minor’s access to the gifted property was to be evaluated in accordance with how likely it was that the minor would need the funds and whether a guardian had been appointed.
The “breakthrough” case on the issue of gifts to minors and qualification for the present interest annual exclusion came in 1968. In that year, the U.S. Circuit Court of Appeals for the Ninth Circuit, in Crummey v. Comr., 397 F.2d 82 (9th Cir. 1968), allowed present interest annual exclusions for gifts to a trust for minors that were subject to the minor’s right to demand withdrawal for a limited timeframe without any need to determine how likely it was that a particular minor beneficiary would actually need the gifted property. Since the issuance of the Crummey decision, the “Crummey demand power” technique has become widely used to assure availability of annual exclusions while minimizing the donee’s access to the gifted property.
Gifting – The Income Tax Basis Issue
In general, property that is included in a decedent’s estate receives an income tax basis in the hands of the heir equal to the fair market value of the property as of the date of the decedent’s death. I.R.C. §1014(a)(1). However, the rule is different for gifted property. Generally, a donee takes the donor’s income tax basis in gifted property. I.R.C. §1015(a). These different rules are often a significant consideration in estate planning and business transition/succession plans.
With the current federal estate and gift tax exemption at $11.7 million for decedent’s dying in 2021 and gifts made in 2021, gifting assets to minimize or eliminate potential federal estate tax at death is not part of an estate or succession plan for very many. But, if a current proposal to reduce the federal estate tax exemption to $3.5 million and peg the gift tax exemption at the $1 million level would become law, then gifting to avoid estate tax would be back in “vogue.” However, legislation currently under consideration would change the basis rule with respect to inherited property. The proposal is to limit the fair market at death income tax basis rule to $1 million in appreciated value before death, and apply a “carry-over” basis to any excess. An exception would apply to farms and ranches that remain in the family and continue to be used as a farm or ranch for at least 10 years following the decedent’s death. Gifted property would retain the “carry-over” basis rule.
Another proposal would specify death as an income tax triggering event causing tax to be paid on the appreciated value over $1 million, rather than triggering tax on appreciated value when the heir sells the appreciated property. If any of these proposals were to become law, the planning horizon would have to be reevaluated for many individuals and small businesses, particularly farming and ranching operations.
Still another piece of the proposed legislation would limit present interest gifts to $10,000 per donee and $20,000 per donor on an annual (it appears, although this is not entirely clear) basis.
Note: At this time, it remains to be seen whether these proposed changes will become law. There is significant push-back among farm-state legislators from both aisles and small businesses in general.
Even if the rules change surrounding the exemption from federal estate tax and/or the income tax basis rule at death, and/or the timing of taxing appreciation in wealth, gifting of assets during life will still play a role in farm and ranch business/succession planning. A big part of that planning involves taking advantage of the present interest annual exclusion to avoid reducing the available federal estate tax exemption at death.
Wednesday, September 8, 2021
The courts continue to issue opinions involving important tax issues not only farmers and ranchers, but opinions on issues that impact a broader range of taxpayers. In today’s post I highlight a few of the recent developments involving dependency; conservation easements; the ability to deduct NOLs; whether the “Roberts Tax” is a tax; whether losses are passive; and the deductibility of theft losses.
Recent court developments in tax law – it’s the topic of today’s post
Taxpayer Caring for Brother’s Children Entitled to Child-Related Tax Benefits
Griffin v. Comr., T.C. Sum. Op. 2021-26
During the tax year in issue, the petitioner lived with and cared for her mother at the petitioner’s home. She received compensation for caring for her mother through a state agency. For more than one-half of the tax year, the petitioner also cared for her niece and nephews because their father (her brother) was a disabled single parent. The niece and nephews stayed with her overnight from mid-May to mid-August and on weekends during school closures and on holidays. While they were with her, she paid for their food, home utility use and entertainment. On her 2015 return she claimed dependency exemption deductions for the children and child tax credits as well as the earned income tax credit. On audit and during the examination, the brother provided a signed form 8332, but the petitioner did not attach it to her return. The IRS denied the dependency exemptions, the child tax credits and the earned income tax credit. The Tax Court, rejecting the IRS position, noted that the children stayed with the petitioner for more than one-half of the tax year and that the petitioner’s testimony was credible to establish that the children were “qualifying children” for purposes of I.R.C. §152. Because none of them had reached age 17 during the tax year, the petitioner was entitled to a child tax credit for each one. Also, because I.R.C. §32 uses the same definition of “qualifying child” as does I.R.C. §152, the petitioner was entitled to the earned income tax credit.
IRS Provides Deed Language for Conservation Easement Donations
CCA 202130014 (Jun. 16, 2021)
The IRS has noted that a deed language for a donated conservation easement to a qualified charity fails to satisfy the requirements of I.R.C. §170(h) if the deed contains language that subtracts from the donee’s extinguishment proceeds the value of post-donation improvements or the post-donation increase in value of the property attributable to improvements. Such language violates Treas. Reg. §1.170A-14(g)(6)(ii) unless, as provided in Treas. Reg. §1.170A-14(g)(6). The IRS has provided sample language adhering to Treas. Reg. §1.170A-14(g)(6)(ii) that would not cause the issue from arising on audit. The language specifically states that on any subsequent sale, exchange or involuntary conversion of the property subject to the easement, the done is entitled to a portion of the proceeds at least equal to the proportionate value of the perpetual conservation restriction.
NOL Not Available Due to Lack of Documentation
Martin v. Comr., T.C. Memo. 2021-35
The petitioners, a married couple, has NOLs from 1993-1997 (which could be carried back three years and forward 15 years) that were being used to offset income in 2009 and 2010. The petitioners provided their 1993 and 1994 tax returns, but the returns did not include a detailed schedule related to the NOLs. Based on the information provided, the Tax Court determined that the petitioners had, at most, an NOL of $782,584 in 1993 and $666,002 in 1992 or earlier. Consequently, $1,448,586 of the NOL had expired in 2008 and was not available to offset income in 2009 or 2010. Thus, the petitioners had a potential NOL of $257,125 for their 1994 return. The Tax Court pointed out that the petitioners bore the burden of substantiating NOLs by establishing their existence and the carryover amount to the years at issue. That requires a statement be include with the return establishing the amount of the NOL deduction claimed, including a detailed schedule showing how the taxpayer computed the NOL deduction. The petitioners also filed bankruptcy in 1998. The Tax Court determined that the $257,125 NOL for 1994 was zeroed-out in the bankruptcy. The petitioners provided some information from their 1997-2007 returns which seemed to show Schedule C losses for some years, but had no documentation. They claimed that the NOLs should be allowed because they had survived prior audits of their 20072008 and 2011-2012 returns. The Tax Court pointed out that each year stands on its own and the fact that the IRS didn’t challenge an item on a return in a prior year is irrelevant to the current year’s treatment. Due to the lack of documentation the Tax Court denied any NOL deduction for 2009 or 2010.
“Roberts Tax” is Not a Tax
In re Juntoff, No. 20-13035, 2021 Bankr. LEXIS 995 (Bankr. N.D. Ohio Apr. 15, 2021)
The court held that the “shared-responsibility” payment of Obamacare is not an income tax because it is not measured based on income or gross receipts. The court determined that it also was not an excise tax because an individual’s not purchasing minimum essential coverage was not a transaction. Thus, the payment was not on a transaction. Thus, the “Roberts Tax” was not a tax entitled to priority treatment in bankruptcy under 11 U.S.C. §507(a)(8). The court noted it’s disagreement with the holding in In re Szczyporski, No. 2:20-cv-03133, 2021 U.S. Dist. LEXIS 61628 (E.D. Pa. Mar. 31, 2021) on the same issue.
Losses Not Passive and Fully Deductible
Padda v. Comr., T.C. Memo. 2020-154
The petitioner, a married couple, worked full-time as physicians. They also owned and operated a pain management clinic. During 2008-2012, they also opened five restaurants and a brewery with a 50 percent partner in the same general location as their medical practices. Each restaurant and the brewery operated in a separate LLC. For the years 2010-2012, they deducted nonpassive losses of more than $3 million from these businesses. The IRS claimed that the losses were passive and, thus, nondeductible. The petitioners couldn’t substantiate their participation, but did have some records showing trips and time spent at the various locations. They were also able to obtain sworn statements from 12 witnesses about the petitioners’ involvement in the construction and operation on a daily basis over the years. The Tax Court found the witnesses credible. The Tax Court determined that the petitioners had satisfied the material participation requirement of Temp. Treas. Reg. §1,469-5T(a)(4) because their hours in the non-medical activities exceeded the 100 hours required for each one to be considered a significant participation activity and exceeded the 500-hour threshold. The Tax Court therefore rejected the IRS argument that the restaurants and brewery were passive activities. The claimed losses were currently deductible.
No Theft Loss Deduction
Torres v. Comr., T.C. Memo. 2021-66
The petitioner was the president, CEO and sole shareholder of an S corporation that he cofounded with Ruzendall. From about 2010 forward, Ruzendall was no longer a shareholder but continued to manage the S corporation’s books and records. The petitioner became ill in 2016 and was unable to work and relied on others to handle the taxes for the business. Upon a bookkeeper’s advice, Ruzendall was issues a Form 1099-Misc. for 2016 reporting $166,494 in non-employee compensation. In 2018, the petitioner sued Ruzendall for misappropriation of funds, alleging a loss from embezzlement. In 2019, an amended Form 1120-S was filed. The IRS denied a deduction for embezzlement and the alternative claim as a deduction for compensation. The Court looked to the definition of embezzlement under state law. One of the requirements is an intent to defraud. The taxpayer did not offer evidence the woman intended to defraud the company and denied the deduction. The Court also noted that even if a theft loss occurred it was discovered in 2017, not 2016 and, therefore, could only be deducted in the year of discovery. The Court also denied the taxpayer's alternate argument of a deduction for compensation, but on the taxpayer's claim he did not mention the woman was entitled to compensation. The Court denied the alternative argument.
There are so many relevant and key developments practically on a daily basis. I’ll be posting soon on where this fall’s tax update seminars will be held at and when online updates will be occurring.
Sunday, September 5, 2021
The Uniform Partnership Act defines a partnership as an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, §6. As an estate planning device, the partnership is generally conceded to be less complex and less costly to organize and maintain than a corporation. A general partnership is comprised of two or more partners. There is no such thing as a one-person partnership, but there is no maximum number of partners that can be members of any particular general partnership.
Sometimes interesting legal issues arise as to whether a particular organization is, in fact, a partnership. If there is a written partnership agreement, that usually settles the question of whether the arrangement is a partnership. Unfortunately, relatively few farm or ranch business relationships are based upon a written partnership agreement or, as it is expressed in some cases, a set of articles of partnership.
When does a partnership exist – it’s the topic of today’s post.
Informality Creates Questions
If there is no written partnership agreement, one of the questions that may arise is whether a landlord/tenant lease arrangement constitutes a partnership. Unfortunately, the great bulk of farm partnerships are oral. Because a partnership is an agreement between two or more individuals to carry on as co-owners a business for profit, a partnership generally exists when there is a sharing of net income and losses. See, e.g., In re Estate of Humphreys, No. E2009-00114-COA-R3-CV, 2009 Tenn. App. LEXIS 716 (Tenn. Ct. App. Oct. 28, 2009). This also tracks the U.S. Supreme Court’s definition of a partnership as the sharing of income and gains from the conduct of a business between two or more persons. Comr. v. Culbertson, 337 U.S. 733(1949). This rule has been loosely codified in I.R.C. §761, which also includes a “joint venture” in the definition of a partnership.
A crop-share lease shares gross income, but not net income because the tenant still has some unique deductions that are handled differently than the landlord's deductions. For example, the landlord typically bears all of the expense for building maintenance and repair, but the tenant bears all the expense for machinery and labor. Thus, there is not a sharing of net income, and the typical crop-share lease is, therefore, not a partnership. Likewise, a livestock share lease is usually not a partnership because both the landlord and the tenant will have unique expenses. But, if a livestock share lease or a crop-share lease exists for some time and the landlord and tenant start pulling out an increased amount of expenses and deducting them before dividing the remaining income, then the arrangement will move ever closer to partnership status. When the arrangement arrives at the point where there is a sharing of net income, a partnership exists.
This means that a partnership can exist in certain situations based on the parties’ conduct rather than intent. Does the form of property ownership constitute a partnership? By itself, the answer is generally “no.” See, e.g., Kan. Stat. Ann. §56a-202. Thus, forms of ownership of property (including joint ownership) do not by themselves establish a partnership “even if the co-owners share profits made by the use of the property.” See, e.g., Kan. Stat. Ann. §56a-202(c)(1). Also, if a share of business income is receive in payment of rent, a presumption that the parties would otherwise be in a partnership does not apply. See, e.g., Kan. Stat. Ann. §56a-202(c)(3)(iii).
Tax Code, Tax Court and IRS Views
The United States Tax Court, in Luna v. Comr., 42 T.C. 1067 (1964) set forth eight factors to consider in determining the existence of a partnership for tax purposes. In Luna, the Tax Court considered whether the parties in a business relationship had informally entered into a partnership under the tax Code, allowing them to claim that a payment to one party was intended to buy a partnership interest. To determine whether the parties formed an informal partnership for tax purposes, the Tax Court asked "whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise." The Tax Court listed non-exclusive factors to determine whether the intent necessary to establish a partnership exists.
The eight factors set forth in Luna are:
- The agreement of the parties and their conduct in executing its terms;
- The contributions, if any, which each party has made to the venture;
- The parties' control over income and capital and the right of each to make withdrawals;
- Whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income;
- Whether business was conducted in the joint names of the parties;
- Whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that they were joint ventures;
- Whether separate books of account were maintained for the venture;
- Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise
A recent Tax Court case is instructive on the application of the Luna factors. In White v. Comr., T.C. Memo. 2018-102, the petitioner was approached by his ex-wife, about forming a mortgage company and, along with their respective spouses, they orally agreed to work together in the real estate business in 2010 or 2011. The business was conducted informally, and no tax professionals were consulted. In 2011, the petitioner withdrew funds from his retirement account to support the business. The ex-wife and her new husband did not make similar financial contributions. Each of the “partners” handled various aspects of the business. The petitioner initially used his personal checking account for the business, until business accounts could be opened. Some accounts listed the petitioner as “president” and his wife as treasurer, but other business accounts were designated as “sole proprietorship” with the petitioner’s name on the account. The petitioner controlled the business funds and used business accounts to pay personal expenses and personal accounts to pay business expenses. Records were not kept of the payments. Business funds were also used to pay the ex-wife’s personal expenses.
The Tax Court applied the Luna factors and concluded that the business was not a partnership for tax purposes. The Tax Court determined that all but one of the Luna factors supported a finding that a partnership did not exist. To begin with, the parties must comply with a partnership. There was no equal division of profits; the parties withdrew varying sums from the business; the petitioner claimed personal deductions for business payments; the ex-wife and her new spouse could have received income from sources other than their share of the business income; and there was no explanation for how payments shown on the ex-wife’s return ended up being deposited into the business bank account.
Alternatively, the court concluded that even if a partnership existed, there was no reliable evidence of the partnership's total receipts to support an allocation of income different from the amounts that the IRS had determined by its bank deposits analysis.
When applying the Luna factors to typical farming/ranching arrangements, it is relevant to ask the following:
- Was Form 1065 filed for any of the years at issue (it is required for either a partnership or a joint venture)?
- Did the parties commingle personal and business funds?
- Were any partnership bank accounts established?
- Was there and distinct treatment of income and expense between business and personal expenses?
- How do the parties refer to themselves to the public?
- How do the parties represent themselves to the Farm Service Agency?
- Are the business assets co-owned?
An informal farming arrangement can also be dangerous from an income tax perspective. Often
taxpayers attempt to prove (or disprove) the existence of a partnership in order to split income
and expense among several taxpayers in a more favorable manner or establish separate ownership of interests for estate tax purposes. However, such a strategy is not always successful, as demonstrated in the following case. See, e.g., Speelman v. Comr., 41 T.C.M. 1085 (1981).
Liability and other Legal Concerns
Why all of the concern about whether an informal farming arrangement could be construed legally as a partnership? Usually, it is the fear of unlimited liability. Partners are jointly and severally liable for the debts of the partnership that arose out of partnership business. It is this fear of unlimited liability that causes parties that have given thought to their business relationship to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership.
The scenarios are many in which legal issues arise over the question of whether a partnership exists and gives rise to some sort of legal issue. For example, in Farmers Grain Co., Inc. v. Irving 401 N.W.2d 596 (Iowa Ct. App. 1986), the plaintiff extended credit to the defendant who was a tenant under an oral livestock share lease. Upon default of the loan, the defendant filed bankruptcy and the plaintiff tried to bind the landlord to the debt under a partnership theory. The court held that a partnership had not been formed where the landlord did not participate in the operation, no joint bank accounts were established, and gross returns were shared rather than net profits.
In Tarnavsky v. Tarnavsky, 147 F.3d 674 (8th Cir. 1998), the court determined that a partnership did exist where the farming operation was conducted for a profit, the evidence established that the parties involved intended to be partners and business assets were co-owned.
Oral business arrangements can also create unanticipated problems if one of the parties involved in the business dies. In In re Estate of Palmer, 218 Mont. 285, 708 P.2d 242 (1985), the court determined that a partnership existed even though title to the real estate and the farm bank account were in joint tenancy. As such, the surviving spouse of the deceased “partner” was entitled to one-half of the farm assets instead of the land and bank account passing to the surviving joint tenant.
Formality in business relationships can go along way to avoiding legal issues and costly court proceedings when expectations don’t work out as anticipated. Putting agreements in writing by professional legal counsel often outweighs the cost of not doing so.
Saturday, August 28, 2021
In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual. Clearly, if a farmer constructs a confinement building, places their own livestock in the building, provides all management and labor, and pays all expenses, the net profit from the activity will be subject to self-employment tax. But, what if the livestock production activity conducted in the confinement building is done so under a contract with a third party? Is the farmer’s net income from the activity subject to self-employment tax in that situation?
Livestock confinement buildings and self-employment tax – it’s the topic of today’s post.
Self-employment income is defined as “net earnings from self-employment.” The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402. In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates. I.R.C. §§1402(a)(1) and 1402(a)(1)(A). For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax if the operation constitutes a trade or business “carried on by such individual.” See, e.g., Rudman v. Comr., 118 T.C. 354 (2002). Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business. In general, to be subject to self-employment tax, an activity must be engaged in on a substantial basis with continuity and regularity.
Livestock Confinement Buildings and Contract Production
Does self-employment tax apply to the net income derived from livestock production activities conducted in a farmer’s confinement building pursuant to a contract with a third party? As with many tax answers, “it depends.”
The U.S. Tax Court provided guidance on the issue in 1995. In Gill v. Comr., T.C. Memo. 1995-328, a corporation that produced, processed and marketed chicken products bought breeder stock from primary breeders and placed them in farmer-owned buildings for 20 weeks. The placement of the chicks with individual farmers was done in accordance with production contracts. The petitioners (two different farmers) constructed broiler barns with the corporation’s assistance in obtaining financing and established that the petitioners had the ability to maintain their facilities. Each contract was for 10 years and the corporation paid the petitioners a fixed monthly amount tied to the space inside each building ($.045 per month/per square foot) that was supplemented over time to reflect inflation. The petitioners were required to perform certain maintenance items, inspections and general flock management responsibilities.
The petitioners did not report the income received under the contracts as subject to self-employment tax. They claimed that they did not materially participate in the production or the management of the production of the poultry in the barns that they leased to the corporation. As such, they claimed that the payments they received were excluded from the definition of “net earnings from self-employment” as “rents from real estate.”
The Tax Court disagreed. The Tax Court noted that the apparent intent of the Congress was to exclude from self-employment tax only those payments for use of space and, by implication, such services as are required to maintain the space in condition for occupancy. Thus, when a taxpayer performs additional services of a substantial nature that compensation for the additional services can be said to constitute a material part of the payment the made to the owner, the payment is income that is attributable to the performance of labor. It’s not incidental to the realization of return from a passive investment, and the payment is included in the computation of the taxpayer’s “net earnings from self-employment.” Applying the analysis to the facts, the Tax Court determined that the petitioners (and their children) performed each and every task necessary to raise the flocks of birds that the corporation delivered. This constituted material participation subjecting the contract payments to self-employment tax. The payments were not excluded from net earning from self-employment as “real estate rents.” See also Schmidt v. Comr., T.C. Memo. 1997-41.
Many ag production contracts like the ones at issue in Gill require the farmer/producer to perform substantial services in connection with the production of the livestock or poultry. Therein lies the problem. To avoid having the income subjected to self-employment tax, the farmer/building owner must not participate to a significant degree in the production activities or bear a substantial risk of loss.
So, are there any planning avenues to address the self-employment tax issue? One option may be to split the contractual arrangement into two separate agreements. One agreement would be strictly for the “rental” of the building with IRS Form 1099 issued for the rental income. Given the typical high capital costs for livestock confinement buildings, a return on capital shown as “rent” should not be unreasonable. A second agreement would be entered into providing for herd/flock management with the issuance of a separate Form 1099 for non-employee compensation or a Form W-2 for wages. These payments would be subject to self-employment tax or FICA tax.
Another approach was established by the Tax Court in 2017. In Martin v. Comr., 149 T.C. 293 (2017), the petitioners, a married couple, operated a farm in Texas. In late 1999, they built the first of eight poultry houses to raise broilers under a production contract with a large poultry integrator. The petitioners formed an S corporation in 2004, and set up oral employment agreements with the S corporation based on an appraisal for the farm which guided them as to the cost of their labor and management services. They also pegged their salaries at levels consistent with other growers. The wife provided bookkeeping services and the husband provided labor and management. In 2005, they assigned the balance of their contract to the S corporation. Thus, the corporation became the “grower” under the contract. In 2005, the petitioners entered into a lease agreement with the S corporation. Under the agreement, the petitioners rented their farm to the S corporation, under which the S corporation would pay rent of $1.3 million to the petitioners over a five-year period. The court noted that the rent amount was consistent with other growers under contract with the integrator. The petitioners reported rental income of $259,000 and $271,000 for 2008 and 2009 respectively, and the IRS determined that the amounts were subject to self-employment tax because the petitioners were engaged in an “arrangement” that required their material participation in the production of agricultural commodities on their farm.
The Tax Court determined that the “derived under an arrangement” language in I.R.C. §1402(a)(1) meant that a nexus had to be present between the rents the petitioners received and the “arrangement” that required their material participation. In other words, there must be a tie between the real property lease agreement and the employment agreement. The court noted the petitioners received rent payments that were consistent with the integrator’s other growers for the use of similar premises. That fact was sufficient to establish that the rental agreement stood on its own as an appropriate measure of return on the petitioners’ investment in their facilities. Similarly, the employment agreement was appropriately structured as a part of the petitioners’ conduct of a legitimate business. Importantly, the Tax Court noted that the IRS failed to brief the nexus issue and simply relied on the Tax Court to broadly interpret “arrangement” to include all contracts related to the S corporation. Accordingly, the Tax Court held that the petitioners’ rental income was not subject to self-employment tax.
Aside from the “two-check” approach, leases should be drafted to carefully specify that the landlord is not providing any services or participating as part of the rental arrangement. Services and labor participation should remain solely within the domain of the employment agreement. In addition, leases where the landlord is also participating in the lessee entity must be tied to market value for comparable land leases. See e.g., Johnson v. Comm'r, T.C. Memo. 2004-56. If the rental amount is set too high, the IRS could argue that the lease is part of “an arrangement” that involves the landlord’s services. See, e.g., Solvie v. Comm'r, T.C. Memo. 2004-55. If the lessor does provide services, a separate employment agreement should put in writing the duties and compensation for those services.
Whether self-employment tax is incurred or not will likely be determined by the extent of involvement the owner retains with regard to the confinement building. But, a word of caution. With the ability to claim substantial depreciation and large interest expense payments (associated with financing the confinement building), a loss could be created. Thus, classification of the arrangement as a rental activity with no self-employment tax may not be the best tax strategy. Instead, the preference might be to offset the loss against self-employment income. This last point raises a question. Can a taxpayer “change horses” mid-stream when the confinement building is sufficiently paid for such that interest expense is lower and, also, depreciation deductions have dropped significantly? Can the contract then be modified at that point so that self-employment tax is avoided?
Interesting tax planning questions.
Monday, August 16, 2021
On Friday, September 3, I will be hosting an “Ag Law Summit” at Nebraska’s Mahoney State Park. This one-day conference will address numerous legal and tax issues of current relevance. The conference will also be broadcast live online.
The Ag Law Summit – it’s the topic of today’s post.
Topics and Speakers
Proposed legislation and policy implications. The day begins with my overview of what’s happening with proposed legislation that would impact farm and ranch estate and business and income tax planning. Many proposals are being discussed that would dramatically change the tax and transfer planning landscape. From the proposed lowering of the federal estate tax exemption, to the change in the step-up basis rule at death, to changes in the rules governing gifts, there is plenty to discuss. But, the list goes on. What about income tax rates and exemptions? What about capital gain rates? There are huge implications if any of these changes are made, let alone all of them. What does the road forward for ag producers look like? What changes need to be made to keep the family farm intact? The discussion during this session should be intense!
State ag law update. Following my discussion of what is going on at the federal level, the discussion turns to the state level. Jeff Jarecki, an attorney with Jarecki Lay & Sharp P.C. out of Albion and Columbus, NE will team up with Katie Weichman Zulkoski to teach this session. Katie is a lawyer in Lincoln, NE that works in lobbying and government affairs. They will provide a NE legislative update specific to agriculture and review significant federal developments that impact agriculture – including the current Administration’s proposed 30 by 30 plan.
Farm succession planning. After the morning break. Dan Waters, a partner in the Lamson, Dugan & Murray firm in Omaha will get into the details of the mechanics of transitioning a farming/ranching business to subsequent generations. How do you deal with uncertainty in the factors that surround estate and business planning such as commodity prices, land values, taxation, and government programs? This session will examine various case studies and the use of certain tools to address the continuity question.
Luncheon. During the catered lunch, the speaker is Janet Bailey. Janet has been involved in ag and food policy issues for many years and has an understanding of rural issues. Her presentation will be addressed to legal and tax professionals that represent rural clients. How can you maintain a vibrant practice in a rural community? What other value does a rural practice bring to the local area? The session’s focus is on the importance of tax and legal professionals to small towns in the Midwest and Plains.
Special use valuation. If the federal estate tax exemption is reduced, the ability to value the ag land in a decedent’s estate at it’s value for ag purposes rather than fair market value will increase in importance. During this session, I will provide an overview of the key points involved in this very complex provision of the tax Code. What steps need to be taken now to ensure that the eventual decedent’s estate qualifies to make the special use valuation election on the federal estate tax return? How do farmland leases impact the qualification for the election and avoidance of recapture tax being imposed? Those are just a couple of the topics that will be addressed.
Ag entrepreneur’s toolkit. This final session for the day will cover the business and tax law feature of limited liability companies. The session is taught by Prof. Ed Morse of the Creighton University School of Law and Colten Venteicher, an attorney with the Bacon, Vinton, Venteicher firm in Gothenburg, Nebraska. They will address some of the practical considerations for how to properly use the LLC in the context of farm and ranch businesses.
The Summit will be broadcast online for those unable to attend in-person. Washburn Law is an NASBA CPE provider. The program will qualify in the taxes area for the minutes noted next to each presentation for both the online and in-person attendees. The goal of the Summit is tto continue providing good legal and tax educational information for practitioners with a rural client base. That will aid in the provision of excellent legal and tax services for those rural clients and will, in turn, benefit the associated rural communities.
We hope that you will join us either in-person or online for the Summit on September 3. For more information and to register, click here: https://www.washburnlaw.edu/employers/cle/aglawsummit.html
Thursday, August 5, 2021
I just returned from a speaking trip that took me through several states in the West. While many parts of Kansas have had plentiful rainfall this Spring and Summer, many parts of the West have not. Much of the West is struggling with drought and fire this summer and a smoky haze lingers over many areas.
Sometimes drought and other weather conditions can cause livestock owners to sell more livestock than normally would be sold in a particular year. When that happens, special tax rules can apply to address the additional income triggered by the excess sales.
Weather-related sales of livestock – it’s the topic of today’s post
There are two statutory deferral strategies available to defer the income from excess livestock sold over normal business practice if the sale was on account of a weather-related condition.
Involuntary conversion. If a farmer sells livestock (other than poultry) held for draft, dairy or breeding purposes in excess of the number that would normally be sold during the time period, the sale or exchange of the excess number may be treated as a nontaxable involuntary conversion if the sale occurs because of drought, flood, fire or other weather-related condition. I.R.C. §1033(e).
The livestock sold or exchanged must be replaced within two years after the year in which proceeds were received with livestock similar or related in service or use (in other words, dairy cows for dairy cows, for example), and be held for the same purpose that the animals given were held. Treas. Reg. §1.1033(e)-1(d). This is why, for example, dairy cows can be replaced with dairy cows, but they can’t be replaced with breeding animals. But, if the taxpayer can prove that it is not feasible to reinvest the proceeds in property similar or related in use, the proceeds can be reinvested in other property used for farming purposes (except real estate). Similarly, if it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into property that is not like-kind or real estate used for farming purposes. I.R.C. §1033(f).
The tax on the sale is triggered when the replacement animals are sold.
The two-year replacement period is extended to four years in areas designated as eligible for assistance by the federal government (i.e., by the President or any agency or department of the federal government). I.R.C. §1033(e)(2)(A). For example, if a farmer sells excess livestock in 2021, the replacement period begins in 2022 and runs through 2025.
Presumably, any livestock sales that occur before the designation of an area as eligible for federal assistance would also qualify for the extended replacement period if the drought, flood, or other weather-related conditions that caused the sale also caused the area to be so designated. The replacement property must be livestock that is similar or related in service or use to the animals disposed of. Also, the Treasury Secretary has the authority to extend, on a regional basis, the period for replacement if the weather-related conditions continue for more than three years. I.R.C. §1033(e)(2)(B).
Note: Notice 2006-82, I.R.B. 2006-39, 529, IRS specified that the replacement period will be extended until the end of the taxpayer’s first taxable year ending after the first “drought-free year” for the applicable region. “Drought-free year” means the first 12-month period that (1) ends on August 31; (2) ends in or after the last year of the taxpayer’s four-year replacement period; and (3) does not include any weekly period for which exceptional, extreme or severe drought is reported for any location in the applicable region. “Applicable region” is defined as the county that experienced drought conditions on account of which the livestock was sold or exchanged and all contiguous counties. “Exceptional, extreme or severe drought is to be determined by reference to U.S. drought monitor maps which are accessible at http://www.drought.unl.edu/dm/archive.html. IRS also publishes, by the end of September every year, a list of counties for which extreme or severe drought was reported during the preceding 12 months. For 2020, the IRS issued Notice 2020-74, 2020-41 IRB on September 22, 2020, providing guidance on the replacement period under IRC §1033(e).
The election to defer the gain is made by attaching a statement to the return providing evidence of the weather-related condition that caused the early sale, the computation of the gain realized, the number and kind of livestock sold and the number and kind of livestock that would have been sold under normal business practices. The election can be made at any time within the normal statute of limitations for the period in which the gain is recognized, assuming that it is before the expiration of the period within which the converted property must be replaced. Treas. Reg. §1.1033(e)-1(e). If the election is filed and eligible replacement property is not acquired within the applicable replacement period (usually four years), an amended return for the year in which the gain was originally realized must be filed to report the gain. But, if the animals are replaced, for the tax year in which the livestock are replaced, the taxpayer should include information with the return that shows the purchase date of the replacement livestock, the cost of the replacement livestock and the number and kind of the replacement livestock. The election must be made on the return for the first tax year in which any part of the gain from the sale is realized. It’s also very important for a taxpayer to maintain sufficient records to support the nonrecognition of gain.
Note: For livestock that are partnership property and are sold by the partnership, the election is the responsibility of the partnership. The partners do not individually make the election to defer recognizing the gain. Rosefsky v. Comm’r, 599 F.2d 515 (2d Cir. 1979).
If insurance proceeds are received that exceed the tax basis of the involuntarily converted animals, the excess is taxable gain that is also deferrable if an election is made to defer the gain and the livestock are replaced within the applicable timeframe. In that instance, the deferred amount is taxed at the time the replacement animals are sold.
Note: However, it may be advantageous from a tax standpoint for the rancher to report the gain on the animals in order to claim ordinary depreciation on the replacement animals.
Under I.R.C. §1033(a)(2)(C), the statutory period for the IRS to assess any deficiency for any tax year where part of the gain under the involuntary conversion rules is realized doesn’t expire before three years from the date the taxpayer notifies the IRS of the replacement of the converted property or of an intention not to replace. If there is a deficiency, the IRS may assess the deficiency for up to three years from the notification. This means that the general three-year statute of limitations is extended. The effect of this is that if a livestock owner doesn’t intend to replace the excess livestock when they are sold, the gain should be reported. This will avoid having to file an amended return in the future. Alternatively, the second provision – the one-year deferral provision could be utilized.
One-year deferral. Under the second provision, if farm and ranch taxpayers on the cash method of accounting are forced because of drought or other weather-related condition to dispose of livestock (raised or purchased animals that are held either for resale or for productive use) in excess of the number that would have been sold under usual business practices, they may be able to defer reporting the gain associated with the excess until the following taxable year. I.R.C. §451(g). In addition, the taxpayer's principal business must be farming in order to take advantage of this provision. In 1989, the IRS issued a very favorable ruling concerning what constitutes a farming business. Priv. Ltr. Rul. 8928050, April 18, 1989. In this ruling, a rancher had $121,000 a year gross income from ranching, and made $65,000 a year off the farm and it was determined that his principal business was farming where he devoted 750 to 1,000 hours per year to the ranch and his wife contributed about 300 hours. This ruling is a strong indication that taxpayers need not have all of their time on the farm in order to take advantage of this rule.
Deferral of income is limited to sales in excess of “usual business practices.” Also, an election for one-year deferral is valid if made during the application replacement period for the livestock under I.R.C. § 1033(e).
Note: The gain to be postponed is equal to the total income realized from the sale of all livestock divided by the total head sold, with that result multiplied by the excess number of head sold because of the weather-related condition. The excess is determined by comparing the actual number of head sold to those that would have been sold under usual business practices in the absence of the weather condition. It is common to use the taxpayer’s most recent three-year average in determining the number of livestock that would be sold under normal business practices. However, that is not the actual rule. Under Treas. Reg. §1.451-7(b) it is a facts circumstances test.
At the time the tax return is due for the year of the casualty, the livestock owner may not be sure of which election is the best one to make. In that event, a “protective” election can be made under I.R.C. §1033 for that tax year. If the livestock can be replaced within the applicable replacement period, the involuntary election can be revoked and the return for the casualty year can be amended to make the election to defer the gain for one year. In that instance, the return for the year after the casualty would also have to be amended to report the deferred gain.
Relatedly, a taxpayer can make an election under I.R.C. §451(g) until the four-year period for reinvestment of the property under I.R.C. §1033 expires. That means that if a livestock owner elects involuntary conversion treatment and fails to acquire the replacement livestock within the four-year period, the I.R.C. §451(g) election to defer the gain for one year can still be made. If that happens the livestock owner will have to file an amended return for the casualty year to make the I.R.C. §451(g) election and revoke the I.R.C. §1033(e) election, and the next year to report the gain deferred to that year.
These rules can be helpful for livestock owners dealing with drought and other weather-related conditions that have excess livestock sales. The two rules differ in terms of the type of livestock covered; the period within which to make the election; how the postponement works; the cause of the sale; whether a disaster need be declared; whether a repurchase of livestock is required; whether there is a carryover basis rule; and whether there is a replacement period.
Use the rule that works best for you.
Wednesday, August 4, 2021
Tax developments continue to occur in the courts, state agencies and the IRS. Today’s post addresses some of the developments that are relevant to rural landowners in addition to recurring issues that impact all taxpayers.
A potpourri of tax developments – it’s the topic of today’s post.
Assignment of Income Doctrine At Issue
Berry v. Comr., T.C. Memo. 2021-52
The petitioner and spouse owned 50 percent of an S corporation engaged in construction projects. They were also involved in drag racing. They reported the income and expenses of the racing operation on the S corporation’s books. The IRS took the position that the taxpayers merely assigned the income of the racing operation to the S corporation while in fact they were separate operations. The Tax Court upheld the IRS position that the income had to be reported on the taxpayers' personal return as other income. The S corporation also claimed an I.R.C. §179 deduction for the cost of a utility trailer and an excavator. The IRS also disallowed this deduction. The Tax Court determined that the petitioner failed to show that the trailer was used for business purposes. Instead, it was used to transport race cars. The I.R.C. §179 expense for the excavator was disallowed because all the S corporation could show with respect to the purchase was an undated bill of sale. The petitioner established that he made a cash withdrawal and purchased a money order for the purchase of the excavator, but failed to prove that the cash withdrawal was connected to the purchase.
Travel Expenses Not Deductible
West v. Comr., T.C. Memo. 2021-21
The petitioner lived in Georgia, but worked in Louisville, Kentucky as a nurse. She deducted over $30,000 in travel-related expenses traveling between Kentucky and Georgia. The IRS denied the deductions and the Tax Court agreed. The Tax Court determined that the petitioner’s tax home was Kentucky. She had no business ties in Georgia and her job in Kentucky was not temporary. The petitioner also rented an apartment in Kentucky, filled prescriptions there and registered her car in Kentucky. The Tax Court noted that those facts further indicated that Kentucky was the petitioner’s tax home.
Payment For Water Right is Business Expense.
Priv. Ltr. Rul. 202129001 (Apr. 21, 2021)
The IRS, in a private ruling, determined that a contractually obligated payment for part of the cost of acquiring a water right was an ordinary expense. The right, IRS determined, was used to mitigate environmental damage from a tract of real estate, not improve it. Also, because the water right was used to combat groundwater draw down was a business expense, the taxpayer was eligible to deduct the payment for tax purposes.
Study Hours Don’t Count Toward 750-Hour test
The petitioners, a married couple, sustained losses on rental properties from 2008-2010 and deducted them as non-passive losses on the basis that the wife was a real estate professional in accordance with I.R.C. §469(c)(7). As such, she had to put more than 50 percent of the personal services that she performed for any given year into real property trades or businesses in which she materially participated, and perform more than 750 hours of services during the tax year in real property trades or businesses in which she materially participated. The trial court determined that the wife did not satisfy the 750-hour test because it was not permissible to count her hours spent during 2008-2009 studying for her real estate license. The appellate court affirmed on this point, and also affirmed the trial court’s finding that the wife failed to meet the 750-hour test in 2010 because the time spent working on the couple’s personal properties could not count toward the required 750 hours to be spent on real property trades or businesses.
Alimony Deduction Tied To Former Spouse
Berger v. Comr., T.C. Memo. 2021-89
The petitioners, a married couple paid their former son-in-law to visit their grandchildren and deducted the amounts as “alimony.” The IRS denied the deduction and the Tax Court affirmed on the basis that the deduction belongs exclusively to the former spouse, the petitioners’ daughter. The Tax Court noted that alimony obliges the former spouse, not anyone else that makes payments on behalf of an ex-spouse. The Tax Court also held that the petitioners could not deduct amounts allegedly as business expenses as rent for a greenhouse related to a cannabis business due to a lack of evidence that the amounts were spent on a business.
Solar Power Generation Taxed Assessed as “Farmland”
2021, A5434, eff. Jul. 9, 2021
New Jersey law now provides that land on which a dual-use solar energy project is constructed and approved is eligible for farmland assessment, subject to certain conditions. To receive farmland assessment, a dual-use solar energy project must: (1) be located on unpreserved farmland that is in operation as a farm in the tax year for which farmland assessment is applied for; (2) in the tax year preceding the construction, installation, and operation of the project, the acreage used for the dual-use solar energy project must have been valued, assessed, and taxed as land in agricultural or horticultural use; (3) be located on land that continues to be actively devoted to agricultural and horticultural use, and meets the income requirements set forth in state law for farmland assessment; and (4) have been approved by the state Department of Agriculture. In addition, no generated energy from a dual-use solar energy project is considered an agricultural or horticultural product, and no income from any power sold from the dual-use solar energy project is considered income for the purposes of eligibility for farmland assessment. To be eligible, the owner of the unpreserved farmland must obtain the approval of the Department of Agriculture, in addition to any other approvals that may be required pursuant to federal, state or local law, rule, regulation, or ordinance, before the construction of the dual-use solar energy project.
Corporate Payment of Personal Expenses Not Deductible
Blossom Day Care Centers, Inc. v. Comr., 2021 T.C. Memo. 86
The petitioner paid for personal expenses of its officers and their family members via credit cards issued in the petitioner’s name. The cards were also used to pay officers (and family members) personal credit card, and family members continued to make personal purchases on the petitioners’ cards even during periods when they were not employees of the petitioner. The IRS disallowed the deductions, and the Tax Court agreed. The petitioner also recorded the personal expenditures as a “Note Receivable from Officers” in multiple entries on the corporate books and maintained a running balance, indicating the personal nature of the expenses. The Tax Court also disallowed the petitioner’s I.R.C. §45A tax credit (Indian tax credit) because the petitioner was owned 51 percent by an Indian.
Hoop Buildings are Farm Machinery and Equipment in Missouri
MDOR Priv. Ltr. Rul. No. LR 8152 (Jun. 29, 2021)
A taxpayer sold hoop buildings that are designed and used for livestock production. The buildings are of a permanent nature and can be used in multiple livestock production cycles. The Missouri Department of Revenue (MDOR) determined that is a buyer used a hoop building exclusively, solely, and directly for raising livestock for ultimate sale at retail, the hoop building constitutes "farm machinery and equipment" exempt from sales and use tax under Mo. Rev. Stat. §144.030(2)(22). In addition, the MDOR concluded that the mere fact that the purchaser ultimately attaches the system to a wood or concrete foundation does not make the hoop building subject to sales and use tax. But, MDOR determined that the taxpayer's sales of hoop buildings would not be exempt from sales and use tax as farm machinery and equipment if they are used for purposes such as grain, hay, and other commodity storage, feed rations storage, sand, salt and gravel storage, and storage of equipment and machinery. The MDOR reasoned that hoop buildings used for grain storage are not used in the production of crops. Grain storage is not an agricultural purpose under Mo. Rev. Stat. §144.030.2(22). Neither is the storage of machinery and equipment.
These are some recent state and federal developments touching upon legal issues that farmers, rancher and rural landowners face. Some of the developments have also been more general in nature. Today’s post has been a “heads-up” on just a few.
Saturday, July 31, 2021
An issue that is problematic for many taxpayers that find themselves under audit with the IRS are the potential litigation and administrative costs if the matter were to end up in court. The IRS knows this and, as a result, sometimes asserts a tenuous position in situations where the amount in controversy is not enough to make it worth the taxpayer challenging the IRS position.
When can a taxpayer recover litigation costs against the IRS – it’s the topic of today’s post.
Tax Code Requirements
Under I.R.C. §7430, a taxpayer can receive an award of litigation costs in cases against the United States that involve the determination of any tax, interest or penalty. To be eligible to recover litigation costs, a taxpayer must satisfy four requirements: 1) be the “prevailing party”; 2) have exhausted available administrative remedies within the IRS; 3) not have unreasonably protracted the proceeding; and 4) make a claim for “reasonable” costs. The taxpayer must satisfy all four requirements. See, e.g., Minahan v. Comr., 88 T.C. 492 (1987). The decision to award fees is within the discretion of the Tax Court. That means any decision denying attorney fees to a prevailing taxpayer is reviewed under an abuse of discretion standard.
Note. Under the Tax Court’s rules, a party seeking to recover reasonable litigation costs must file a timely motion in the proper manner. U.S. Tax Court Rules, Title XXIII, Rule 231(a).
Exhaustion. Litigation costs will not be awarded unless the court determines that the prevailing party has exhausted available administrative remedies within the IRS. I.R.C. § 7430(b)(1). For example, when a conference with the IRS Office of Appeals is available to resolve disputes, a party is deemed to have exhausted administrative remedies only by participating in the conference before filing a Tax Court petition or requesting a conference (even if it isn’t granted) before the IRS issues a statutory notice of deficiency. See, e.g, Veal-Hill v. Comr., 812 Fed. Appx. 387 (7th Cir. 2020).
Unreasonable protraction. To be rewarded litigation costs, the taxpayer must not unreasonably protract the proceeding. I.R.C. §7430(b)(3). In Estate of Lippitz, et al. v. Comr., T.C. Memo. 2007-293, the petitioner sought innocent spouse relief and the IRS conceded the case. The petitioner sought to recover litigation costs and the IRS objected. The Tax Court largely rejected as meritless an IRS argument that the petitioner was otherwise disqualified from recovery due to her unreasonable protraction of proceedings. The dispute involved tax deficiencies from 1980-1985 stemming from the now-deceased spouse’s assignment of income to various trusts. The IRS based its argument on the taxpayer's failure to comply with an almost 20-year old summons that the taxpayer had no reason to know about concerning the couple’s joint liability until the IRS later “resurrected” it in 2003.
Prevailing party. Perhaps the requirement that is the most complex and generates the most litigation is that the taxpayer must be the “prevailing party.” A taxpayer can be a “prevailing party” only if the taxpayer satisfies certain net worth requirements or “substantially prevails” with respect to the amount in controversy on “the most significant issue or set of issues presented. I.R.C. §7430(c)(4)(A). An application to recover an award for fees and other expenses must be filed with the court within 30 days of the final judgment in the case. 28 U.S.C. §2412(d)(1)(B).
The net worth requirement is incorporated into the “prevailing party” requirement and specifies that a taxpayer’s net worth must not exceed $2 million. I.R.C. §7430(c)(4)(A)(ii). For this purpose, “net worth” is determined on the basis of the cost of acquisition of assets under generally accepted accounting principles (GAAP) rather than the fair market value of assets. See, e.g, Swanson v. Commissioner, 106 T.C. 76 (1996); see also H.R. Rept. No. 96-1418, 96th Cong., 2d Sess. 15 (1980). Depreciation is taken into account. Also, notes receivable are taken into account under GAAP. The acquisition cost of a note exchanged for cash is the amount of cash received in exchange for the note. If the interest on the note is unstated, it is recorded in the books as having value in an amount that reasonably approximates the fair value of the note.
A taxpayer cannot meet the prevailing party requirement, however, if the IRS takes a position with respect to the taxpayer’s return that is “substantially justified.” In other words, a taxpayer can’t “substantially prevail” if the IRS position is substantially justified.
For the IRS, a substantially justified position is one that has a reasonable basis in fact – one that is supported by sufficient relevant evidence that a reasonable mind might accept as adequate to support a conclusion. See Pierce v. Underwood, 487 U.S. 552 (1988). Reasonableness is based on the facts of the case and legal precedent. Maggie Management Co. v. Comr., 108 T.C. 430 (1997). The IRS position must also have a reasonable basis in law – the legal precedent must substantially support the IRS position based on the facts of the case. The courts have interpreted this standard as requiring sufficient relevant evidence that a reasonable mind might accept as adequate to support a conclusion. See, e.g., Pierce v. Underwood, 487 U.S. 552 (1988). Thus, the IRS could take a position that is substantially justified even if it is incorrect if a reasonable person could believe it to be correct. See, e.g., Maggie Management Co. v. Comr., 108 T.C. 430 (1997). Likewise, the IRS position could be substantially justified where only factual issues are in question. See, e.g., Bale Chevrolet Co. v. United States, 620 F.3d 868 (8th Cir. 2010). Also, the IRS concession of a case or an issue doesn’t mean that its position was unreasonable. It’s merely a factor for consideration.
What the IRS does at the administrative level have no bearing on whether its litigating position is substantially justified. The administrative process and the court process are two separate matters. I.R.C. §7430 distinguishes between administrative and judicial proceedings. See, e.g., Pacific Fisheries, Inc. v. United States, 484 F.3d 1103 (9th Cir. 2007). IRS conduct occurring after the petition is filed is all that matters. This means that the IRS can create a multitude of problems for a taxpayer, justified or not, at the administrative level and fees cannot be recovered because the conduct occurred pre-petition. That is the case even if the IRS conduct during the administrative process caused the litigation. See, e.g., Friends of the Benedictines in the Holy Land, Inc. v. Comr., 150 T.C. 107 (2018).
All of this means that the bar is set rather low for the IRS to establish a litigating position that is substantially justified. Conversely, the bar is set high for a taxpayer to be a “prevailing party” to be able to recover litigation costs.
Note. An exception exists for a “qualified offer.” A qualified offer is one that is made pre-trial. If the taxpayer makes such an offer and the IRS rejects it and the taxpayer goes on to win at the Tax Court, the taxpayer can be compensated for litigation fees that are incurred after the offer was made. I.R.C. §§7430(c)(4)(B)(i); 7430(c)(4)(E)(i).
The Tax Court recently issued an opinion in a case involving the issue of whether the petitioner was entitled to litigation fees. In Jacobs v. Comr., T.C. Memo. 2021-51, the petitioner had been a trial lawyer with the U.S. Department of Justice before becoming a full-time professor at a university in Washington, D.C. During this time, he was also an adjunct professor at another university in Washington, D.C., and a “Visiting Scholar” at yet another university for three months on the West Coast. He ultimately became a professor at a second West Coast university. On his tax returns for these years (2014 and 2015), he claimed $54,000 Schedule C deductions related to payments for meals and lodging for his Visiting Scholar position, the business use of his home, bar association dues and other professional fees, and travel expenses. The IRS audited the returns and denied the deductions.
After a tortured appeals process involving the Taxpayer Advocate Service, the U.S. Treasury Inspector General for Tax Administration, and four IRS Appeals offices, the IRS offered the petitioner a settlement proposal allowing most of the claimed deductions. The petitioner confirmed receipt of the settlement offer, but didn’t respond further. Five months later, the IRS Appeals Office turned the matter over to the IRS Chief Counsel’s Office to prepare the case for trial. At a Tax Court status conference a few days later, the IRS Chief Counsel conceded the case in its entirety and filed a stipulation of settled issues a couple of weeks later.
The petitioner then filed a motion for $32,000 of litigation costs. Those costs included fees for expert witnesses and lawyers. The IRS objected to the motion on the basis that its position in the Tax Court proceedings at the time the answer was filed (that the petitioner was not entitled to the deductions) was substantially justified.
The Tax Court noted that the petitioner bore the burden to establish that his expenses were deductible as ordinary and necessary business expenses under I.R.C. §162 and were not associated with the taxpayer’s activities as an employee. See, e.g., Weber v. Comr., 103 T.C. 378 (1994), aff’d., 60 F.3d 1104 (4th Cir. 1995). The Tax Court determined that a reasonable person could have concluded that a reasonable person could have concluded that the petitioner had not satisfied this burden by the time the IRS filed its answer. Accordingly, the Tax Court denied the petitioner’s motion for litigation costs.
The Jacobs case, although a negative result for the petitioner, is instructive on how difficult it is for a taxpayer to recover litigation costs from the IRS. It’s also an example of how the IRS can create an administrative “nightmare” for the taxpayer causing the taxpayer to ring up thousands of dollars of fees and costs with no hope of recovering those expenses. Litigation fees are only awarded for “litigation” – matters that happen after the IRS files its answer to the taxpayer’s Tax Court petition.
Many taxpayers would conclude that the system is “rigged.” Indeed, the present statutory construct allows the IRS to continue to assert positions with little basis in law when the amount in controversy is less than the anticipated attorney fees without much risk of being challenged in court.
Saturday, July 17, 2021
Three recent court cases touch on issues that often face clients. One involves the tricky issue of what is a taxpayer’s “tax home.” Another case involves the issue of unforeseen circumstances as an exception to the two-year ownership and usage requirement for the principal residence gain exclusion provision. The final case for discussion today involves the deduction for gambling losses, and a rather unique set of facts.
Recent tax decisions in the courts – it’s the topic of today’s blog post.
Tax “Home” At Issue
Geiman v. Comr., T.C. Memo. 2021-80
An individual’s “tax home” is the geographical area where the person earns the majority of their income. The location of the permanent residence doesn’t matter for this purpose. The tax home is what the IRS uses to determine whether travel expenses for business are deductible. It’s the taxpayer’s regular place of business – the general area where business or work is located.
This distinction between a taxpayer’s personal residence and their tax home often comes into play for those that have an indefinite work assignment(s) that last more than a year. In that situation, the place of the assignment becomes the taxpayer’s tax home. That means that the taxpayer can’t deduct any business-related travel expenses. This points out another key distinction – the costs of traveling back and forth from the tax home for business are deductible, but commuting expenses associated from home to work are not.
That brings us to Mr. Geiman, the petitioner in this case. He was a licensed union journeyman electrician who owned a trailer home and a rental property in Colorado. His membership in his local union near his home gave him priority status for jobs in and around that area. When work dried up in the area near his home, he traveled to jobs he could obtain through other local unions. As a result, he spent most of 2013 working jobs in Wyoming and elsewhere in Colorado. On his 2013 return, he claimed a $39,392 deduction for unreimbursed employee business expenses – meals; lodging; vehicle expenses (mileage); and union dues. He also claimed a deduction of $6,025 for “other” expenses such as a laptop computer, tools, printer and hard drive. The petitioner claimed a home mortgage interest deduction on the 2013 return for the Colorado home. He voted in Colorado, his vehicles were registered there, and he received his mail at his Colorado home. The IRS disallowed the deductions.
The Tax Court noted that a taxpayer can deduct all reasonable and necessary travel expenses “while away from home in pursuit of a trade or business” under I.R.C. §162(a)(2). As noted above, a taxpayer’s “tax home” for this purpose means the vicinity of the taxpayer’s principal place of business rather than personal residence. In addition, when it differs from the vicinity of the taxpayer’s principal place of employment, a taxpayer’s residence may be treated (as noted above) as the taxpayer’s tax home if the taxpayer’s principal place of business is temporary rather than indefinite. If a taxpayer cannot show the existence of both a permanent and temporary abode for business purposes during the tax year, no deductions are allowed.
The Tax Court cited three factors, based on Rev. Rul. 73-529, 1973-2 C.B. 37, for consideration in determining whether a taxpayer has a tax home – (1) whether the taxpayer incurred duplicative living expenses while traveling and maintaining the home; (2) whether the taxpayer has personal and historical connections to the home; and 3) whether the taxpayer has a business justification for maintaining the home. Upon application of the factors, the Tax Court held that the petitioner’s tax home was his Colorado home for 2013. His work consisted of a series of temporary jobs, each of which lasted no more than a few months. That meant that he did not have a principal place of business in 2013. He paid a mortgage on the Colorado home, and had significant personal and historical ties to the area of his Colorado home where he had been a resident since at least 2007. Also, his relationship with the local union near his Colorado home gave him a business justification for making his home where he did in Colorado. Thus, the Tax Court concluded that the petitioner was away from home for purposes of I.R.C. §162(a)(2), allowing him to deduct business-related travel expenses.
But, Geiman had a problem. He didn’t keep good records of his expenses. Ultimately, the Tax Court said what he had substantiated could be deducted. Thus, the Tax Court allowed substantiated meal expenses which were tied to a business purpose to be deducted. The Tax Court also allowed lodging expenses to be deducted to the extent they were substantiated by time, place and business purpose for the expense. The Tax Court also allowed a deduction for business mileage at the IRS rate where it was substantiated by starting and ending point – simply using Google maps was insufficient on this point. The Tax Court also allowed the petitioner’s claimed deductions for union and professional dues, but not “other expenses” for lack of proof that they were incurred as an ordinary and necessary business expense. The end-result was that the Tax Court allowed deductions totaling approximately $7,500.
Unforeseen Circumstances Exception to Two-Rule Home Ownership Rule At Issue
United States v. Forte, No. 2-:18-cv-00200-DBB, 2021 U.S. Dist. LEXIS (D. Utah Jun. 21, 2021)
Upon the sale of the principal residence, a taxpayer can exclude up to $500,000 of the gain from tax. That’s the limit for a taxpayer filing as married filing jointly (MFJ). For a single filer, the limit is $250,000. I.R.C. §121(b)(1-2). To qualify for the exclusion, the taxpayer must own the home and use it as the taxpayer’s principal residence for at least two years before the sale. I.R.C. §121(a). If the two-year requirement can’t be met, a partial exclusion is possible and there are some exceptions that can, perhaps, apply. For example, if the taxpayer’s job changed that required the taxpayer to move to a new location, or health problems required the sale, those are recognized exceptions to the two-year rule. There’s also another exception – an exception for “unforeseen” circumstances. I.R.C. §121(b)(5)(C)(ii)(III). The unforeseen circumstances exception was at issue in a recent case.
In this case, the defendants, a married couple, bought a home in 2000 and lived there until 2005 when they sold it. They put about $150,000 worth of furniture in the home. In 2003, they bought a lot with the intent to build a home. They took out a loan an began construction on the home. They also did not get paid the full contract amount for the 2005 home sale and couldn’t collect fully on the seller finance notes. They experienced financial trouble in 2005, but moved into the new home in December of 2005 and purchased an adjacent lot for $435,000 with the intent to retain a scenic view from their new home.
After moving into their new home, the defendants sought to refinance the loan to a lower interest rate, but were unable to do so due to bad credit. Thus, a friend helped them refinance by allowing them to borrow in his name. They then executed a deed conveying title to the friend. A trust deed named the friend as Trustor for the defendants as beneficiaries. The friend obtained a $1.4 million loan, kept $20,000 of the proceeds and used the balance to pay off the defendants’ loans. The defendants made the mortgage payments on the new loan. In 2006, they also executed a deed for the adjacent lot in the friend’s favor. In 2007, the friend signed a quitclaim deed conveying the home’s title to the defendants. The loan on the home went into default, and the defendants then transferred title to an LLC that they owned. They then sold the home and the adjacent lot for $2.7 million later in September of 2007 and moved out.
An IRS agent filed a report allowing a basis increase in the initial home for the furniture that was sold with that home, and determined that the defendants could exclude $458,333 of gain on the 2007 sale of the new home even though they had not lived there for two years before the sale. Both the IRS and the defendants challenged the agent’s positions and motioned for summary judgment. The defendants claimed that they suffered unexpected financial problems requiring the sale before the end of the two-year period for exclusion of gain under I.R.C. §121. As such, the defendants claimed that they were entitled to a partial exclusion of gain for the period that they did own and use the home.
The court noted that the defendants’ motion for summary judgment required them to show that there was no genuine issue of material fact that the home sale was not by reason of unforeseen circumstances. The court denied the motion. A reasonable jury, the court determined, could either agree or disagree with the agent’s report. While the defendants were experiencing financial problems in 2005 before moving into the new home, the facts were disputed as to when they realized that they would not be able to collect the remaining $695,000 of holdbacks from the buyers of the first home. The court also denied the defendants’ motion that they were entitled to a basis increase for the cost of the furniture placed in the initial home. The defendants failed to cite any authority for such a basis increase.
Drug-Induced Gambling Losses Disallowed
Mancini v. Comr., No. 19-73302, 2021 U.S. App. LEXIS 19362 (9th Cir. Jun. 29, 2021), aff’g., T.C. Memo. 2019-16
All gambling winnings are taxable income. Unless a taxpayer is in the trade or business of gambling, and most aren’t, it’s not correct to subtract losses from winnings and only report the difference. But, a taxpayer that’s not in the trade or business of gambling can list annual gambling losses as an itemized deduction on Schedule A up to the amount of winnings. But, to get around the limitations, can a gambling loss be characterized as casualty loss? This last point was at issue in this case.
The petitioner was diagnosed with Parkinson’s disease in 2004 and began taking prescription medicine to help him control his movements. Over time, the medication dosage was increased. The petitioner had been a recreational gambler, but in 2008 he began gambling compulsively. By the end of 2010 he had drained all of his bank accounts and almost all of his retirement savings. In 2009, he started selling real estate holdings for less than fair market value and used the proceeds to pay his accumulated gambling debt. In 2010, his doctor took him off his medication and his compulsive gambling ceased along with his compulsive cleanliness, and suicidal thoughts. The medication he had been on was known to lead to impulse control disorders, including compulsive gambling.
On his 2008-2010 returns he reported gambling winnings and also deducted gambling losses to the extent of his winnings. He later filed amended returns characterizing the gambling losses as casualty losses. While the Tax Court determined that the compulsive gambling was a likely side effect of the medication, the Tax Court agreed with the IRS that the gambling losses were not deductible under I.R.C. §165. Also, the gambling losses over a three-year period failed the “suddenness” test to be a deductible casualty loss. In addition, the Tax Court found that the petitioner had failed to adequately substantiate the losses. On appeal, the appellate court affirmed.
Tax Court cases with good discussion of issues of relevance to many never cease to keep rolling in.
Thursday, July 15, 2021
The second of the two national conferences on Farm/Ranch Income Tax and Farm/Ranch Estate and Business Planning is coming up on August 2 and 3 in Missoula, Montana. A month later, on September 3, I will be conducting an “Ag Law Summit” at Mahoney State Park located between Omaha and Lincoln, NE.
Upcoming conferences on agricultural taxation, estate and business planning, and agricultural law – it’s the topic of today’s post.
The second of my two 2021 summer conferences on agricultural taxation and estate/business planning will be held in beautiful Missoula, Montana. Day 1 on August 2 is devoted to farm income taxation, with sessions involving an update of farm income tax developments; lingering PPP and ERC issues (as well as an issue that has recently arisen with respect to EIDLs); NOLs (including the most recent IRS Rev. Proc. and its implications); timber farming; oil and gas taxation; handling business interest; QBID/DPAD planning; FSA tax and planning issues; and the prospects for tax legislation and implications. There will also be a presentation on Day 1 by IRS Criminal Investigation Division on how tax practitioners can protect against cyber criminals and other theft schemes.
On Day 2, the focus turns to estate and business planning with an update of relevant court and IRS developments; a presentation on the farm economy and what it means for ag clients and their businesses; special use valuation; corporate reorganizations; the use of entities in farm succession planning; property law issues associated with transferring the farm/ranch to the next generation; and an ethics session focusing on end-of life decisions.
If you have ag clients that you do tax or estate/business planning work for, this is a “must attend” conference – either in-person or online.
For more information about the Montana conference and how to register, click here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html
On September 3, I will be holding an “Ag Law Summit” at Mahoney St. Park, near Ashland, NE. The Park is about mid-way between Omaha and Lincoln, NE on the adjacent to the Platte River and just north of I-80. The Summit will be at the Lodge at the Park. On-site attendance is limited to 100. However, the conference will also be broadcast live over the web for those that would prefer to or need to attend online.
I will be joined at the Summit by Prof. Ed Morse of Creighton Law School who, along with Colten Venteicher of the Bacon, Vinton, et al., firm in Gothenburg, NE, will open up their “Ag Entreprenuer’s Toolkit” to discuss the common business and tax issues associated with LLCs. Also on the program will be Dan Waters of the Lamson, et al. firm in Omaha. Dan will address how to successfully transition the farming business to the next generation of owners in the family.
Katie Zulkoski and Jeffrey Jarecki will provide a survey of state laws impacting agriculture in Nebraska and key federal legislation (such as the “30 x 30” matter being discussed). The I will address special use valuation – a technique that will increase in popularity if the federal estate tax exemption declines from its present level. I will also provide an update on tax legislation (income and transfer taxes) and what it could mean for clients.
The luncheon speaker for the day is Janet Bailey. Janet has been deeply involved in Kansas agriculture for many years and will discuss how to create and maintain a vibrant rural practice.
If you have a rural practice, I encourage you to attend. It will be worth your time.
For more information about the conference, click here: https://www.washburnlaw.edu/employers/cle/aglawsummit.html
The Montana and Nebraska conferences are great opportunities to glean some valuable information for your practices. As noted, both conferences will also be broadcast live over the web if you can’t attend in person.
Friday, July 9, 2021
The IRS has finally issued guidance on how farm taxpayers are to handle carryback elections related to farm net operating losses (NOLs) in light of all of the legislative rule changes in recent years.
Handling farm NOLs – it’s the topic of today’s post
The Tax Cuts and Jobs Act (TCJA) limited the deductibility of an NOL arising in a tax year beginning after 2017 to 80 percent of taxable income (computed without the NOL deduction). Under the TCJA, no NOL carryback was allowed unless the NOL related to the taxpayer’s farming business. A farming NOL could be carried back two years, but a taxpayer could make an irrevocable election to waive the carryback. The 80 percent provision also applied to farm NOLs that were carried back for NOLs generated in years beginning after 2017. Under the TCJA, post-2017 NOLs do not expire.
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) suspended the 80 percent limitation for NOLs through the 2020 tax year. The suspension applies to all NOLs, farm or non-farm, arising in tax years beginning in 2018-2020. The CARES Act also removed the two-year carryback option for farm NOLs and replaced it with a five-year carryback for all NOLs arising in a tax year beginning after 2017 and before 2021. Under the carryback provision, an NOL could be carried back to each of the five tax years preceding the tax year of the loss (unless the taxpayer elected to waive the carryback). That created an issue – some farmers had already carried back an NOL for the two-year period that the TCJA allowed.
The COVID-Related Tax Relief Act (CTRA) of 2020 amended the CARES Act to allow taxpayers to elect to disregard the CARES Act provisions for farming NOLs. This is commonly referred to as the “CTRA election.” Under the CTRA election, farmers that had elected the two-year carryback under the TCJA can elect to retain that carryback (limited to 80 percent of the pre-NOL taxable income of the carryback year) rather than claim the five-year carryback under the CARES Act. In addition, farmers that previously waived an election to carryback an NOL can revoke the waiver.
The CTRA also specifies that if a taxpayer with a farm NOL filed a federal income tax return before December 27, 2020, that disregards the CARES Act amendments to the TCJA, the taxpayer is treated as having made a “deemed election” unless the taxpayer amended the return to reflect the CARES Act amendments by the due date (including extensions of time) for filing the return for the first tax year ending after December 27, 2020. This means that the taxpayer is deemed to have elected to utilize the two-year carryback provision of the TCJA.
On June 30, 2021, the IRS issued Rev. Proc. 2021-14, 2021-29 I.R.B. to provide guidance for taxpayers with an NOL for a tax year beginning in 2018-2020, all or a portion of which consists of a farming loss. The guidance details how the taxpayer can elect to not apply certain NOL rules of the CARES Act, and how the CTRA election can be revoked. Rev. Proc. 2021-14 is effective June 30, 2021.
Affirmative election. The Rev. Proc. specifies that a taxpayer with a farming NOL, other than a taxpayer making a deemed election, may make an “affirmative CTRA election” to disregard the CARES Act NOL amendments if the farming NOL arose in any tax year beginning in 2018-2020. An affirmative election allows the farm taxpayer to carryback a 2018-2020 farm NOL two years instead of five years. To make an affirmative election, the taxpayer must satisfy all of the following conditions:
- The taxpayer must make the election on a statement by the due date, including extensions of time, for filing the taxpayer’s Federal income tax return for the taxpayer’s first tax year ending after December 27, 2020. This means that for calendar year individuals and C corporations, the date is October 15, 2021.
- The top of the statement must state: "The taxpayer elects under § 2303(e)(1) of the CARES Act and Revenue Procedure 2021-14 to disregard the amendments made by § 2303(a) of the CARES Act for taxable years beginning in 2018, 2019, and 2020, and the amendments made by § 2303(b) of the CARES Act that would otherwise apply to any net operating loss arising in any taxable year beginning in 2018, 2019, or 2020. The taxpayer incurred a Farming Loss NOL, as defined in section 1.01 of Rev. Proc. 2021-14 in [list each applicable taxable year beginning in 2018, 2019, or 2020]."
Note. The election is all-or-nothing. The taxpayer must choose either the two-year farm NOL carryback provision for all loss years within 2018-2020, or not.
- The taxpayer attaches a copy of the statement to any original or amended federal income tax return or application for tentative refund on which the taxpayer claims a deduction attributable to a two-year NOL carryback pursuant to the affirmative election.
For taxpayers that follow the Rev. Proc. and make an affirmative election, the Rev. Proc. specifies that the 80 percent limitation on NOLs will apply to determine the amount of an NOL deduction for tax years beginning in 2018-2020, to the extent the deduction is attributable to NOLs arising in tax years beginning after 2017. In addition, the CARES Act carryback provisions will not apply for NOLs arising in tax years beginning in 2018-2020.
Deemed election procedure. In §3.02 of the Rev. Proc., the IRS sets forth the procedure for a taxpayer to follow to not be treated as having made a deemed election. For taxpayers that made a deemed election under the CARES Act, the election applies unless the taxpayer amends the return the deemed election applies to reflecting the CARES Act amendments by due date specified in the Rev. Proc. Also, for taxpayers that made a deemed election under the CARES Act and IRS rejected the two-year carryback claims, Rev. Proc. 2021-014 establishes the steps the taxpayer may take to pursue those claims. Those steps require the taxpayer to submit complete copies of the rejected applications or claims, together with income tax returns for the loss year(s). The top margin of the first page of a complete copy of each application or claim should include, “Deemed Election under Section 3.02(2) of Rev. Proc. 2021-14.” The Rev. Proc. states that resubmission of previously rejected claims should be sent by the Rev. Proc. due date.
Note. The taxpayer is not treated as having made a deemed election if the taxpayer subsequently files an amended return or an application for tentative refund by the due date of the Rev. Proc.
For a taxpayer that elected not to have the two-year carryback period apply to a farming NOL incurred in a tax year beginning in 2018 or 2019, the Rev. Proc. specifies that the taxpayer may revoke the election if the taxpayer made the election before December 27, 2020, and makes the revocation on an amended return by the date that is three years after the due date, including extensions of time, for filing the return for the tax year the farming NOL was incurred. If the NOL is not fully absorbed in the five-year earlier carryback year, the balance carries forward to the fourth year back and subsequent years in the carryback period until it is fully absorbed. The taxpayer may also amend the returns for the years in the five-year carryback period, if needed, to utilize the benefits of I.R.C. §1301 (farm income averaging).
Note. A statement must be attached to the return to revoke the prior election to waive the carryback period. The statement must read as follows: “Pursuant to section 4.01 of Rev. Proc. 2021-14 the taxpayer is revoking a prior I.R.C. §172(b)(1)(B)(iv) or I.R.C. §172(b)(3) election to not have the two-year carryback period provided by I.R.C. §172(b)(1)(B)(i) apply to the farm NOL, as defined in section 1.01 of Rev. Proc. 2021-14, incurred in the taxable year.”
Area of uncertainty. What remains unclear after the issuance of Rev. Proc. 2021-14 is whether the affirmative CTRA election can be made to use the two-year carryback if a farmer had previously waived the five-year carryback. The Rev. Proc. is not clear on this point.
Example. Hamilton Beech is a calendar year farmer. He sustained a farming NOL in 2019. 2017, however, was a good year financially and Hamilton wanted to use the TCJA two-year carryback provision so that he could use the 2019 NOL to offset the impact of the higher tax brackets on his taxable income for 2017. Unfortunately, the CARES Act (enacted into law on March 27, 2020) eliminated the two-year carryback provision leaving Hamilton with the choice of either carrying the 2019 NOL to 2014 or forgoing the five-year carryback. 2014 was a low-income year for Hamilton. Thus, Hamilton elected to waive the five-year NOL carryback provision on his 2019 return that he filed after March 27, 2020 (but before December 27, 2020) and the attached statement made reference to I.R.C. §172(b)(3) and not I.R.C. §172(b)(1)(B)(iv).
Because Hamilton filed his 2019 return after March 27, 2020, and before December 27, 2020, uncertainty exists concerning his ability to make an affirmative election under the Rev. Proc. to disregard the CARES Act five-year NOL carryback provision. If he can, he would be able to use the two-year carryback rule to offset his higher income in 2017. One approach for Hamilton would be for him to amend his 2019 return, citing Rev. Proc. 2021-14, Section 3.01 and state that he has met the conditions of Section 3.01(2).
Note. The taxpayer must also attach a statement to an amended return for the loss year, that states at its top: “Pursuant to section 4.01 of Rev. Proc. 2021-14, the taxpayer is revoking a prior I.R.C. §172(b)(1)(B)(iv) or I.R.C. §172(b)(3) election not to have the two-year carryback period provided by I.R.C. §172(b)(1)(B)(i) apply to the Farming Loss NOL, as defined in section 1.01 of Rev. Proc. 2021-14, incurred in the taxable year.”
Mixed NOLs. If a taxpayer has an NOL that is a mixture of farm and non-farm activities, the portion of the NOL that is attributable to the farming activity may be carried back either two or five years consistent with the guidance of the Rev. Proc. The non-farm portion of the NOL may not be carried back two years. Also, the election to waive the carryback period is all-or-nothing. It is not possible to separately waive a farm NOL carryback from a non-farm NOL.
The Congress has made tax planning with farm NOLs difficult in recent years with numerous rule changes. The recent guidance from the IRS, though issued late, is helpful on several points.
Monday, June 28, 2021
The U.S. Tax Court has issued several interesting and important decisions in recent days. Among other matters, the Tax Court has addressed when cost of goods sold can be deducted; when basis reduction occurs as a result of debt forgiveness; the requirements for a theft loss deduction; and the substantiation required for various deductions.
Recent Tax Court cases of interest – it’s the topic of today’s post.
To Recover Cost of Goods Sold, Taxpayer Must Have Gross Receipts From Sale of Goods
BRC Operating Company LLC v. Comr., T.C. Memo. 2021-59
During tax years 2008 and 2009, the petitioner paid about $180 million to acquire minerals and lease interests in West Virginia, Pennsylvania, Ohio and Kentucky. The petitioner planned to explore for, mine and produce natural gas for sale. On Form 1065, the petitioner reported, as costs of goods sold, estimated drilling costs for natural gas exploration and mining in the amount of $100 million for tax year 2008 and $60 million for tax year 2009 and passed those amounts through to investors. However, the petitioner did not drill (except for two test wells), receive drilling services from third parties or receive drilling property during these years. In addition, the petitioner didn’t report any gross receipts or sales during these years that were attributable to the sale of natural gas. The IRS fully disallowed the amounts claimed for costs of goods sold on the basis that the petitioner had failed to satisfy the “all-events” test and the economic performance requirement of I.R.C. §461(h)(1).
The Tax Court upheld the IRS determination, noting that the petitioner conceded that the drilling of the test wells was irrelevant and that it had not received any income from the wells. Thus, it was inappropriate to characterize the passed-through amounts as costs of goods sold in the amount of $100 million for 2008 and $60 million in 2009 for drilling costs for natural gas mining. There were no gross receipts for natural gas for either 2008 or 2009. There were no receipts from the sale of goods to offset by costs.
The Timing of Basis Reduction Associated With Discharged Debt
Hussey v. Comr., 156 T.C. 12 (2021)
In 2009 the petitioner purchased 27 investment properties on which he assumed outstanding loans totaling $1,714,520. By 2012 he was struggling to make payments on the loans. He sold 16 of the properties in 2012, with 15 of them being sold at a loss. After the sales, the lender restructured the the debt and issued a Form 1099-C for each property sold at a loss evidencing the amount of debt forgiven. The petitioner sold additional investment properties in 2013 at a loss. The lender again restructured the debt, but didn’t issue Form 1099-Cs for 2013. In late 2015, the lender noted that $493,141 was the remaining amount to be booked as a loan loss reserve recovery as of October 25, 2015.
After filing an initial return for 2012, the petitioner filed Form 1040X for 2012 on January 14, 2015. The Form 4797 attached to the amended return stated that petitioner had sold 17 properties for a loss totaling $613,263. On Form 982 petitioner reported that he had excludable income of $685,281 "for a discharge of qualified real property business indebtedness applied to reduce the basis of depreciable real property" (i.e., the debt discharged from the lender). On October 15, 2014, the petitioner filed Form 1040 for 2013. On Form 4797 included with that return, petitioner reported that in 2013 he had sold six investment properties and his primary residence (which was also listed as an investment property) for a loss totaling $499,417 ($437,650 for the investment properties and $61,767 for his primary residence). On October 15, 2015, the petitioner filed Form 1040 for 2014. The petitioner reported a net operating loss carryforward of $423,431 from 2013. On Form 982 petitioner reported he had excludable income of $65,914 from a discharge of qualified real property business debt. A Form 1099-C showed that the petitioner received a discharge of debt of $65,914 from the 2014 sale of his primary residence (the same residence reported as sold in his 2013 tax return). The IRS disallowed the loss deductions claimed on petitioner’s 2013 Form 4797. For 2014, the IRS disallowed the loss carryover deduction from 2013.
The issue was whether the basis reduction as a result of the debt discharge occurred in 2012 or 2013. Also, at issue was whether there was any debt discharge in 2013. The Tax Court, in a case of first impression, laid out the statutory analysis. The Tax Court noted that, in general, a taxpayer realizes gross income under I.R.C. §61(a)(11) when a debt is forgiven. But, under I.R.C. §108(a)(1)(D), forgiveness of qualified real property business debt is excluded from income. However, the taxpayer must reduce basis in the depreciable real property under I.R.C. §108(c)(1)(A). I.R.C. §1017 requires the reduction of basis to occur at the beginning of the tax year after the year of discharge. But, I.R.C. §1017(b)(3)(F)(iii) provides that in the case of property taken into account under I.R.C. §108(c)(2)(B) which is related to the exclusion for qualified real property business debt, the reduction of basis occurs immediately before the disposition of the property (if earlier than the beginning of the next taxable year).
The Tax Court reasoned that because the petitioner received a discharge of qualified real property debt and sold properties in 2012, he was required to reduce his bases in the disposed properties immediately before the sales of those properties in 2012. The Tax Court rejected the taxpayer’s arguments that because the aggregated bases in his unsold properties in 2012 exceeded the discharged amount, he did not need to reduce his bases until 2013. The Tax Court noted instead that selling properties from the group triggered I.R.C. §1017(b)(3)(F)(iii) with respect to the bases of the properties sold regardless of the remaining bases in the properties not sold.
Note. The key point of the case is that the basis reduction rule associated with the forgiveness of qualified real property debt is an exception to the general rule that basis reduction occurs in the year following the year of debt discharge.
No Deductible Theft Loss Associated With Stock Purchase
Baum v. Comr., T.C. Memo. 2021-46.
The petitioners, a married couple, bought corporate stock from a third party’s mother after the third party “encouraged” them to do so. The petitioners lost money on the stock and deducted the losses as theft losses on the basis that they were defrauded in the purchase based on false pretenses. The IRS denied the deductions.
Under state (CA) law, theft by false pretenses requires that the defendant to have made a false pretense or representation to the owner of property with the intent to defraud the owner of that property, and that the owner transferred the property to the defendant in reliance on the representation. Here, the Tax Court noted, the petitioners did their own investigation, confirming the information presented to them. They also provided records of communications between them and the promoter about the investments. But they failed to provide specific evidence that the third party’s representations were false or that they were made with the intent to defraud. The Tax Court held that the taxpayers failed to prove the elements for theft by false pretenses and that there was no reasonable prospect of recovery. Accordingly, the Tax Court upheld the IRS position.
Deductions Fail For Lack of Substantiation
Chancellor v. Comr., T.C. Memo. 2021-50
It’s a well-known principle that deductions are a matter of legislative grace. For a taxpayer to take advantage of that grace, the deductions must be substantiated. This grace isn’t freely bestowed. It’s also important to properly categorize deductions. Some reduce gross income to adjusted gross income, while others are of the “below-the-line” type that reduce adjusted gross income to taxable income. Most of the business-related deductions are “above-the-line” while most of those that are non-business are below-the line. There are also substantiation requirements that apply, and another rule that can come into play when the taxpayer doesn’t have the proper documentation to substantiate deductions – the “Cohan” rule (named after entertainer George M. Cohan). The Cohan rule allows the Tax Court to guess at the correct amount of a deduction for a taxpayer when the taxpayer can show that expenses were actually incurred and meet the legal requirement for the deduction being claimed. But, the Cohan rule can be wiped-out by a statute that has very specific substantiation requirements. One such statute is I.R.C. §274(d).
In this case, the petitioner reported approximately $40,000 of income on her 2015 return and claimed about $33,000 of deductions. The deductions included Schedule A deductions of $6,500 for charitable donations and $4,500 for sales taxes. Schedule C deductions were claimed for meals and entertainment; car and truck expense; utilities for a home office; legal fees; advertising; and “other” expenses. The IRS disallowed all of the Schedule C deductions and the Schedule A deductions for charity and sales taxes.
The Tax Court determined that the petitioner could not meet the specific receipt substantiation requirements for the cash donations to charity under I.R.C. §170(f) or for sales taxes. However, the Tax Court could use the sales tax tables to substantiate the sales tax deduction. The Tax Court determined that the petitioner could not satisfy the heightened substantiation deduction requirements of I.R.C. §274(d) or §280A for the Schedule C (business-related) deductions. Claimed deductions associated with the petitioner’s home office, advertising, legal and post office expense could be estimated under the Cohan rule. For those expenses, the petitioner could show some expenditures that were connected to the legal requirements for the particular deduction.
Note. The case is a good one for how the Tax Court sorted out the various types of deductions in terms of the applicable substantiation rules, and whether or not the Cohan rule would apply.
These recent Tax Court decisions are a continuing illustration of the interesting and important issues that are seemingly constantly before the court.
Monday, June 7, 2021
The U.S. legal system has a long history of allowing debtors to hold specified items of property exempt from creditors (unless the exemption is waived). This, in effect, gives debtors a “head start” in becoming reestablished after suffering economic reverses. But, how extensive is the list of exempt property, and does it include federal and state refunds.
The ability (or not) to treat tax refunds as exempt from creditors in bankruptcy – it’s the topic of today’s post.
Bankruptcy Exemptions – The Basics
Typically, one of the largest and most important exemptions is for the homestead. Initially even the exempt property is included in the debtor's estate in bankruptcy, but the exempt assets are soon returned to the debtor. Only nonexempt property is used to pay the creditors.
Each of the 50 states has developed a unique list of exemptions available to debtors. 18 states and the District of Columbia allow debtors to choose between their state exemptions or the federal exemptions. The remaining states have chosen to “opt-out” of the federal exemptions. Under the 2005 Bankruptcy Act, to be able to utilize a state’s exemptions, a debtor must have resided in the state for 730 days preceding the bankruptcy filing. If the debtor did not reside in any one state for 730 days immediately preceding filing, then the debtor may use the exemptions of a state in which the debtor resided for at least 180 days immediately preceding filing. If those requirements cannot be met, the debtor must use the federal exemptions.
Tax Refunds as Exempt Property – The Moreno Case
Each state’s statutory list of exempt assets in bankruptcy will determine the outcome of whether tax refunds are exempt. But, a recent case involving the state of Washington’s exemption list is instructive on how other states might approach the matter.
Facts of Moreno. In In re Moreno, No. 20-42855-BDL, 2021 Bankr. LEXIS 1262 (Bankr. W.D. Wash. May 11, 2021), the debtor filed Chapter 7 (liquidation) bankruptcy in late 2020. The debtor then filed her 2020 federal income tax return on January 28, 2021, and later received a tax refund of $10,631.00. That refund was made up of $572 of withheld taxes; $2,800 of a “Recovery Rebate Credit” (RRC); $1.079 of an Additional Child Tax Credit (ACTC); and $5,500 of an Earned Income Tax Credit (EITC). The bankruptcy trustee sought to include almost all of the debtor’s tax refund in the bankruptcy estate, excluding only 0.3 percent of the total amount ($31.89) based on the debtor’s Chapter 7 filing being December 30, 2020 (i.e., only one day of 2020 fell after the date the debtor filed bankruptcy).
Timing of filing. The debtor claimed that the tax refund arose post-petition because she filed the return post-petition. Consequently, the debtor claimed, the tax refund was not property of the bankruptcy estate. The court disagreed, noting that under 11 U.S.C. §541(a)(1), the bankruptcy estate includes all legal or equitable interests of the debtor in property as of the date the case commences. Based on that, the court determined that the debtor had obtained an interest in the tax refund as she earned income throughout 2020. Thus, the tax refund for the prepetition portion of the tax year were rooted in her prepetition earnings and were property of the bankruptcy estate regardless of the fact that she had to file a return to receive the refund.
RRC. The debtor used the state’s list of exemptions and the trustee conceded that certain portions of the debtor’s prorated tax refund were exempt. Specifically, the trustee did not dispute the debtor's right to retain the full RRC in the amount of $2,800. 11 U.S.C. §541(b)(11), enacted December 27, 2020, specifically excluded the RRC from the debtor’s bankruptcy estate.
Withheld taxes. The debtor filed an amended Schedule C on which she claimed that $572 of her 2020 refund attributable to withheld tax was exempt under state law. The trustee disagreed and the debtor failed to explain how state law applied to withheld taxes. However, the trustee conceded that amount was exempt as personal property (up to a dollar limitation). Rev. Code Wash. §6.15.010(1)(d)(ii). This same part of the state exemption statute, the trustee concluded, entitled the debtor to an additional exemption of $2,630, the balance allowable as exempt personal property after allowing the debtor to exempt $370 in cash and checking accounts.
ACTC and EITC. As for the part of the refund attributable to the ACTC and the EITC, the debtor claimed that it was exempt under Rev. Code Wash. §6.15.010(1)(d)(iv) as any past-due, current or future child support “that is paid or owed to the debtor” or as “public assistance” under Rev. Code Wash. §74.04.280 and 74.04.005. The trustee claimed that the ACTC was encompassed by the remaining “catch-all” exemption for personal property of Rev. Code Wash. §6.15.010(1)(d)(ii). However, the court noted that if the catch-all provision didn’t apply to the ACTC, it could be applied to the debtor’s other debts to the benefit of the debtor. Thus, the court needed to determine whether both the ACTC and the EITC were exempt under state law.
The Court first concluded that neither the ACTC nor the EITC portions of the tax refund constituted “child support” under RCW § 6.15.010(1)(d)(iv). Instead, the court determined that the plain meaning of “child support” refers to payments legally required of parents. That was not the case with neither the ACTC nor the EITC. The court likewise concluded that the credits were not “public assistance” as defined by Rev. Code Wash. §§ 74.04.280 and 74.04.005. Based on state law, the court noted, the credits would have to be “public aid to persons in need thereof for any cause, including…federal aid assistance.” Rev. Code Wash. §74.04.005(11). The court determined that the credits, under this statute, could only possibly be exempt as “federal aid assistance” which is defined under Rev. Code Wash. § 74.04.005(8) to include “[T]he specific categories of assistance for which provision is made in any federal law existing or hereafter passed by which payments are made from the federal government to the state in aid or in respect to payment by the state for public assistance rendered to any category of needy persons for which provision for federal funds or aid may from time to time be made, or a federally administered needs-based program.”
The court determined that the state definition of “federal aid and assistance” applied to assistance in the form of monetary payments from the federal government to needy persons, but did not describe federal tax credits. Instead, tax credits are paid by the federal government directly to taxpayers. However, the court also noted that the statutory definition also included “federal aid assistance” and any “federally administered needs-based program.” As such, it was possible that the credits could be exempt as “assistance” from a “federally administered needs-based program.” On this point, the court noted that there was no statutory language nor legislative history associated with the credits indicating that they were part of a federally administered needs-based program. In addition, there was no caselaw on point that provided any light on the subject. However, disagreeing with the trustee’s objection to the categorization of any federal tax credit as a federally administered needs-based program, the court relied on court opinions from other states construing similarly worded state statutes to conclude that both the ACTC and the EITC were “federally administered needs-based programs” exempt from bankruptcy under Rev. Code Wash. §74.04.280. See In re Farnsworth, 558 B.R. 375 (Bankr. D. Idaho 2016); In re Hardy, 787 F.3d 1189 (8th Cir. 2015); In re Hatch, 519 B.R. 783 (Bankr. S.D. Iowa 2014); In re Tomczyk, 295 B.R. 894 (Bankr. D. Minn. 2003).
The Moreno case, even though it involved the particular language of one state’s exemption statute, provides good insight as to how bankruptcy courts in other states would analyze the issue of whether federal tax credits (and other tax benefits) are exempt from a debtor’s bankruptcy estate.
Monday, May 31, 2021
The donation of a permanent conservation easement on farm or ranch land can provide a significant tax benefit to the donor. The rules are complex and must be carefully complied with to obtain the tax benefits that are possible – qualified farmers and ranchers can deduct up to 100 percent of their income (i.e., the contribution base). For others, the limit is 50 percent of annual income.
But, the IRS has a history of auditing returns claiming deductions for conservation easements, and winning in court on the issue. But, is the tide starting to turn with respect to one of the IRS “arrows” it uses to attack conservation easement deductions?
The trouble with permanent conservation easement donations and current litigation on the “extinguishment” regulation – it’s the topic of today’s post.
The donation of a permanent conservation easement is accomplished via a transaction that involves a legally binding agreement that is voluntarily entered into between a landowner and qualified charity – some form of land trust or governmental agency. Under the agreement, the landowner allows a permanent restriction on the use of the donated land so as to protect conservation characteristics associated with the tract. See I.R.C. §170(h). But, all of the applicable tax rules must be precisely complied with in order to generate a tax deduction. This is one area of tax law where a mere “foot-fault” can be fatal.
The key to securing a tax deduction for the donation of a permanent conservation easement is the proper drafting of the easement deed (as well as an accurate and detailed appraisal of the property). That’s the instrument that conveys the legal property interest of the easement to the qualified charity (qualified land trust, etc.). This document must be drafted very precisely. For example, the donor must not reserve rights that are conditioned upon the donee’s consent. This is termed a deemed consent provision and it will cause the donated easement to fail to be a perpetual easement – one of the requirements to get a charitable contribution deduction. See Treas. Regs. §§1.170A-14(e)(2); 1.170A-14(g)(1); 1.70A-14(g)(6)(ii).
The IRS also takes the position that the perpetuity requirement is not met if a mortgage on the property is not subordinated. For instance, in Palmolive Building Investors, LLC v. Comr., 149 T.C. 380 (2017), a charitable deduction was denied because the mortgages on the property were not subordinated to the donated façade easements as Treas. Reg. §1.170A-14(g)(2) requires. In addition, the deed at issue stated that the mortgagees had prior claims to extinguishment proceeds. That language violated the requirement set forth in Treas. Reg. §1.170A-14(g)(6)(ii). A savings clause in the deed did not cure the defective language because the requirements of I.R.C. §170 must be satisfied at the time of the easement is donated.
The caselaw also supports the IRS position that development rights and locations for development cannot be reserved on the property subject to the easement if it changes the boundaries for the easement. In other words, the IRS position is that the easement deed language must place a perpetual encumbrance on specifically defined property that is fixed at the time of the grant. However, if the easement only allows the boundary of potential development to be changed on a portion of a larger parcel that is subject to the easement restrictions and neither the acreage of potential development nor the easement is enhance, the perpetuity requirement remains satisfied. See, e.g., Bosque Canyon Ranch II, L.P. v. Comr., 867 F.3d 547 (5th Cir. 2017); Treas. Reg. §1.170A-14(f).
Another problem with easement deeds that the IRS watches for is whether the deed language allows the donor and donee to mutually agree to amend the deed. If this reserved right is present, the IRS takes the position that the easement is not perpetual in nature and does not satisfy the perpetuity requirement of I.R.C. §170(h)(2)(C). But, there is an exception. Amendment language is allowed if any subsequent transfer by the donee (via amendment language in the deed) facilitates the conservation purpose of the original transfer to the donee organization. Treas. Reg. 1.170A-14(c)(2); see also Butler v. Comr., T.C. Memo. 2012-72.
The Extinguishment Regulation
Another requirement of securing a charitable deduction for a donated conservation easement is that the charity must be absolutely entitled to receive a portion of any proceeds received on account of condemnation or casualty or any other event that terminates the easement. Treas. Reg. §1.170A-14(g)(6). This is required because of the perpetual nature of the easement. But, exactly how the allocation is computed is difficult to state in the easement deed. The basic point, however, is that the allocation formula cannot result in what a court (or IRS) could deem to be a windfall to the taxpayer. See, e.g., PBBM-Rose Hill, Ltd. v. Comr., 900 F.3d 193 (5th Cir. 2018); Carroll v. Comr., 146 T.C. 196 (2016). In addition, the allocation formula must be drafted so that it doesn’t deduct from the proceeds allocable to the donee an amount that is attributable to “improvements” that the donor makes to the property after the donation of the permanent easement. If such a reduction occurs, the IRS presently takes the position that no charitable deduction is allowed because the specific requirements of the proceeds allocation formula are not satisfied. This seems counter-intuitive, but it is an IRS audit issue with respect to donations of permanent conservation easements.
If the donee acquires the fee simple interest in the real estate that is subject to the easement, the donee’s ownership of both interests would merge under state law and thereby extinguish the easement. This, according to the IRS, would trigger a violation of the perpetuity requirement. Consequently, deed language may be included to deal with the merger possibility. But, such language is problematic if it allows the donor and donee to contractually agree to extinguish the easement without a court proceeding. Leaving merger language out of the easement deed would seem to result in the IRS not raising the merger argument until the time (if ever) the easement interest and the fee interest actually merge.
Litigation on the extinguishment regulation. The Tax Court has decided a couple of cases recently involving the extinguishment regulation. In Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020), various investors created the petitioner in 2007 and bought 143 cares on a mountain near Chattanooga, Tennessee for $1.7 million. The following year, the petitioner donated 106 acres to a qualified land trust as a permanent conservation easement and claimed a $9.5 million deduction. The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution. That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement.
The IRS denied the charitable deduction for violating the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6), because the qualified land trust was not entitled to a proper proportionate share of proceeds if the easement were acquired through eminent domain at some future date. On the contrary, the easement language in the deed had the effect of allocating to the petitioner all of the value of any land improvements made after the easement was donated. The full Tax Court agreed with the IRS position on the allocation issue, and also upheld the validity of the regulation on the basis that the extinguishment regulation had been properly promulgated and did not violate the Administrative Procedure Act (APA). The full Tax Court also determined that the construction of I.R.C.§170(h)(5), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).
In a related memorandum opinion, Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made. It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed. However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable.
The Tax Court again upheld its proportionate value approach in a case where the deed granting the easement reduced the donee’s share of the proceeds in the event of extinguishment by the value of improvements (if any) that the donor made. Smith Lake, LLC v. Comr., T.C. Memo. 2020-107. As such, the petitioner had not satisfied the perpetuity requirement of I.R.C. §170(h)(5)(A). The Tax Court upheld the validity of the regulation and the petitioner’s claimed deduction was denied.
Litigation continues at the appellate court. The petitioner in the Oakbrook case has appealed the Tax Court’s opinion to the U.S. Circuit Court of Appeals for the Sixth Circuit, claiming that the Treasury violated the APA in creating the extinguishment regulation by not soliciting comments and failing to reasonably interpret the underlying statute. The petitioner latched onto the Judge Holmes’ dissent in the full Tax Court opinion, that determined that the IRS had not properly considered public comments as the APA required. Judge Holmes viewed the majority interpretation as having the future effect of denying many more charitable deductions associated with conservation easements. The petitioner is also claiming on appeal that the deed language satisfied the perpetuity requirement, and that the petitioner shouldn't be liable to "predict and compensate the donee for hypothetical events outside of the donor's control." The petitioner is also claiming that the IRS arguments concerning the deed language relating to the perpetuity requirement weren’t raised at the Tax Court level and should be barred on appeal. The petitioner also claims that the deed language has been commonly used for over 30 years, and, as such, the current IRS position is contrary to the Congressional purpose of the statute to incentivize conservation.
It will be interesting to see how the Oakbrook case is decided at the Sixth Circuit. A decision is expected by the end of summer. Thousands of permanent conservation easement donations hang in the balance.
Friday, May 21, 2021
The first of two summer conferences focusing on agricultural taxation and farm/ranch estate and business planning sponsored by Washburn Law School is coming up soon on June7-8. The live presentation will be at the Shawnee Lodge and Conference Center near West Portsmouth, Ohio. Attendance may also be online because we will be broadcasting the conference live.
This year’s conference includes a component focusing on the farm economy. I want to focus on that presentation for today’s article. Understanding ag economics is critical to a complete ability to represent a farmer or rancher in tax as well as estate/business planning.
The farm economy and the upcoming Ohio conference – it’s the focus of today’s post.
The Ag Economy
As is well known the general economy is struggling. Of course, the struggles are related to the economy trying to recover from the various state-level shut-downs. But what about the ag economy? Understanding the economics that farm and ranch clients are dealing is critical for tax practitioners and those that advise farmers and ranchers on estate and business planning matters.
So, what are the key points concerning the farm economy right now that planners must understand?
Net farm income. For starters U.S. net farm income was higher in 2020 than it was in 2019. When government payments are included, net farm income was 46 percent higher than in 2019 representing the fourth highest amount for any year since 1970. That’s good news for ag producers, rural communities and the practitioners that represent them. However, it’s also important to understand that 38 percent of the total amount was from government payments and not the private marketplace. That’s also a record – and not a good one. What government giveth, government can taketh away.
Earlier this year, USDA projected net farm income to drop eight percent compared to 2020. But, even with that drop, net farm income would still be 21 percent higher than the 2000-2019 average. So far this year grain prices for the major row-crop commodities (corn, soybeans and wheat) have been soaring. These prices have been driven by strong export demand, tight stocks, weather concerns in South America and the U.S. economy coming out of the various state-level shutdowns.
Cattle market. So far this year, the cattle market has shown improved beef demand as restaurants reopen and exports have been strong. There is also a smaller 2021 calf crop. However, there are challenges on the processing side of the equation with capacity issues and higher feed prices presenting difficulties. In addition, drought in cattle country will always be a concern.
Dairy. As for the dairy industry, demand is showing greater strength and dairy prices are increasing. This can also be a resulting impact of the loss of numerous dairy farms in recent years that lowers production. However, feed cost is wiping out all of the impact of higher dairy prices.
Exports. In 2020, total ag exports were also seven percent higher than they were in 2019. U.S. ag exports to China alone were 91 percent higher in 2020 than they were in 2019, with total ag exports to China being higher in 2020 than at any point during the Obama Administration (or any prior Administration). China is a critically important market for U.S. ag producers. China has approximately 20 percent of global population but only seven percent of the world’s arable land. China must import food from elsewhere. The Trump Administration got serious with China’s global trade conduct, imposed tariffs and other sanctions against it to the benefit of U.S. agriculture. Whether this pattern continues is an open question.
So far in 2021, total U.S. ag exports are up 24 percent compared to last year. A large part of that is due to the increased level of exports to China. But, there are numerous other ag export markets around the world to keep an eye on.
Accounting. What about the farm balance sheet? How is it looking. For starters, U.S. farmland values continue to hold steady if not slightly higher. The primary influencers of land values are commodity prices, government support programs, the supply of land, interest rates and inflation in the general economy. Shocks to one or more of those factors could impact land values significantly.
Farm working capital has seen four straight years of increases after reaching a low point in 2016. However, total farm debt continues to inch upward the U.S. farm debt to asset ratio is at its highest point in about 12 years (though still far below where it was during the height of the farm debt crisis of the 1980s. Overall, farm balance sheets (especially for crop producers) have improved primarily because of higher government payments, higher commodity prices and strong land values.
Prognosticating the Future
What does the future hold for the agricultural sector in the U.S.? For starters, there is a different administration consisting largely of retreads that have been in the bureaucratic swamp for decades. They love to regulate economic activity. While taxpayer dollars may still flow to the sector, that doesn’t mean it will be to support traditional and “ad hoc” farm programs. It’s more likely that taxpayer dollars will flow to support “food stamps” (remember, a record number of people were on food stamps the last time the current USDA Secretary held the position) and “rural development” and conservation programs. Of course, with taxpayer dollars flowing to support conservation activities on farms and ranches comes regulation of private property.
The next Farm Bill comes up in 2023. What will be the focus of the debate? Of course, much depends on the outcome of the 2022 mid-term elections. Will there be an examination of the existing farm programs and how they apply to large farms compared to smaller ones? Will there be an even greater focus on the environment? Will the “waters of the United States” (WOTUS) rule be revisited yet again? What about efforts to regulate carbon? What about the illegal immigration issue and the current policy fostering a wide-open border? What about ethanol production? Recently, the Iowa Governor was quoted as saying, “Every day under normal circumstances hunger is a reality for one in nine Iowans.” Iowa prides itself is being the nation’s leader in ethanol production. In light of that, let the Governor’s quote sink-in. Also, recall where the current USDA Ag Secretary is from.
As noted above, ag trade and exports is in a rather good spot right now. There was an emphasis on bilateral rather than multilateral trade agreements. Will that continue? Probably not. It’s likely that there will be an emphasis on rejoining various multilateral trade agreements. What will be the impact on U.S. ag? What about China? It now has more leverage on trade deals with the U.S.
There are always external factors and policies that bear on the bottom-line of agricultural producers. What are those going to be? In 2015, the Congress passed, and the President signed into law, a $305 billion infrastructure bill. Now, the present (old) Administration is at it again wanting to spend taxpayer dollars on “infrastructure.” I guess that’s an admission that the 2015 bill didn’t work – or maybe the new push for another bill is just an attempt to throw money around to potential voters.
Another factor influencing farmers and ranchers is tax policy. The potential for increased income and capital gain rates, the removal of “stepped-up” basis at death, higher estate and gift tax rates coupled with lower exemptions, and a higher corporate tax rate is significant.
In the general economy, inflation and unemployment are lurking. Fuel (and other input) prices are up in some places by 50 percent since the beginning of the year – a significant input cost for ag producers. That, coupled with record taxpayer dollars flowing into the sector are being capitalized into higher food prices. Providing lower-income people with non-taxable cash has caused them not to seek jobs and has caused unemployment to be higher than what it otherwise would be. The economy is presently characterized by a high level of job openings and high unemployment at the same time. Let that sink in.
As the Congress tosses around trillion-dollar spending bills, it represents spending money that the government doesn’t have. So, the government just makes more by printing it (or borrowing it). The influx of money in the economy makes the dollars that are already there worth less. Remember, the promise was that “no one making less than $400,000 would have their taxes go up.” Ok, but the money you have in your pocket is worth less. Same difference? Not quite. Inflation deals more harshly with lower-income persons than it does with someone of greater wealth and with higher income. Even without factoring in the rise in fuel and food prices, inflation was at 4.2 percent in April, the sharpest spike since 2008.
What do these external factors mean for agriculture? Any one of them can be bad. A combination of them can be really bad. Now is not the time to be buying more things on credit. It’s time to be prudent with the income that is presently there. Pay-off debt. Tidy-up estate plans. Righten the “ship” and get ready. The ride could get rough.
Join us at the Ohio conference either in person or via the online simulcast and join in the discussion. You don’t want to miss this one. For more information and to register, you can click here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html
Wednesday, May 12, 2021
My article last month on the use of the revocable trust in an estate plan generated many nice comments. You can read that article here: https://lawprofessors.typepad.com/agriculturallaw/2021/04/the-revocable-living-trust-is-it-for-you.html. I also received several questions concerning what happens from an income tax standpoint when the grantor of the trust dies. After answering those questions, I thought it might be a good idea to write an article on it for the blog.
What are the income tax impacts of a revocable trust when the grantor dies – it’s the topic of today’s post.
Income Tax Issues for the Year of Death
When the grantor of a revocable trust dies, the trust assets are not impacted. The trust continues according to its terms and, as mentioned in last month’s article, the assets contained in the trust are not included in the decedent’s probate estate. For income tax purposes, the trust is required to obtain a taxpayer identification number (TIN). That’s the case even if the trust had obtained a TIN during the grantor’s lifetime. Treas. Reg. §301.6109-1(3)(i)(A). That means that the trustee will likely have to establish new accounts for the trust with banks and other financial institutions with which the trust does business.
For the year of the grantor’s death, all tax items must be allocated between the grantor and the trust for the pre-death and post-death periods. This requires the trustee to establish some type of system to make sure that the proper amounts of income, loss, deduction, credit, etc., are allocated appropriately in accordance with the trust’s method of accounting.
Returns and Reporting Issues
When the grantor of a revocable trust dies, the trust is no longer a grantor trust. Thus, all tax-related activity of the trust that occurred before the grantor’s death during the year of death must be reported on the grantor’s final income tax return. Upon the grantor’s death, the trust becomes a separate taxpayer (from the grantor’s estate) with a calendar year as its tax year. I.R.C. §644(a). Because of this separate taxpayer status, the grantor’s estate will also have to obtain a TIN and report tax items separately from those of the trust.
Note: If the terms of the trust require all of the trust income to be distributed annually but not trust corpus, the trust is a “simple” trust. If not, the trust is a “complex” trust.
Note: The grantor’s estate can elect either a fiscal year or a calendar year for tax reporting purposes. When a grantor dies late in the year, it may be beneficial for the executor of the grantor’s estate to elect a fiscal year. That may provide some ability to use tax-deferral techniques for the estate or the beneficiaries and can allow the executor more time to deal with administrative duties concerning the estate.
One technique that can help simplify tax filings after the grantor dies is for the trustee to work with the administrator of the grantor’s estate in considering whether to make an I.R.C. §645 election. The election can be used for certain revocable trusts, and has the effect of treating the trust as part of the decedent’s estate. I have written about the I.R.C. §645 election here: https://lawprofessors.typepad.com/agriculturallaw/2020/11/merging-a-revocable-trust-at-death-with-an-estate-tax-consequences.html. To recap that article, the election can reduce the number of separate income tax returns that will have to be filed after the grantor’s death. The irrevocable election is made via Form 8855.
A Sec. 645 election makes available several income tax advantages that would not otherwise be available in a separate trust tax filing. I detailed those in my article linked above that I wrote last fall, but for our purposes here, while the election is in force (two years if no federal estate tax return is required to be filed; other deadlines apply if a Form 706 is required (See Treas. Reg. §1.645-1(f)) income and deductions are reported on a combined basis – all trust income and expense is reported on the estate’s income tax return. The one exception is for distributable net income (DNI). DNI is computed separately. The combined reporting on the estate’s income tax return might be on a fiscal year instead of the calendar year-end that is required for trusts.
When the election period terminates, the “electing trust” is deemed to be distributed to a new trust. That’s a key point to understand. The new trust must use the calendar year for reporting purposes. As a result, the trust beneficiaries might receive two Schedule K-1s if the co-electing estate files on a fiscal year.
If the decedent’s estate was large enough to require the filing of Form 706, the assets in the revocable trust are aggregated and reported on Schedule G. They are not listed separately. Part 4 should be answered, “yes.” In addition, a verified copy of the trust should be attached to Form 706.
Complexity of Farm Estates
A decedent’s estate is a separate entity for income tax purposes. In general, an estate’s net income, less deductions for the value of property distributed to heirs, is taxed to the estate. The distributions are taxed to the heirs in the calendar year which includes the last day of the estate fiscal year during which the distributions were made. When these principles are applied to the unique aspects of a farmer’s estate, problems (and opportunities) arise. A farmer’s estate has numerous attributes that require specialized application of the general principles of estate income taxation. Those include the seasonal nature of the business with bunching of income and expense in different times of the year; a complex mix of land and depreciable property that is subject to recapture; inventory; common use of income tax deferral due techniques; the problem of establishing income tax basis in property; determining accurate property inventories; and unique capital gain holding periods for certain assets.
A revocable trust is a common and often beneficial part of the estate plan of a farmer or rancher. But, understanding the tax issues when the trust grantor dies is important. Likewise, fitting the tax aspects a revocable trust that are triggered by the grantor’s death with the overall complexity of an agricultural estate is crucial.
Monday, May 10, 2021
In late March, a group of five Democrat Senators from northeastern states introduced the “Sensible Taxation and Equity Promotion (STEP) Act. Similar legislation has been introduced into the U.S. House, also from an East Coast Democrat. These bills, combined with S.994 that I wrote about last time, would make vast changes to the federal estate and gift tax system, have a monumental impact on estate planning for many – including farm and ranch families – and would also make significant income tax changes. The STEP Act also has a retroactive effective date of January 1, 2021. That makes planning to avoid the impacts next to impossible. Today’s focus will be on the provisions of the STEP Act.
The key components of the STEP Act and its impacts and planning implications – it’s the topic of today’s post.
Income Tax Provisions
Before addressing the STEP Act’s provisions, it’s important to remember other proposals that are on the table. Those include an income tax rate increase on taxable income exceeding $400,000 (actually about $450,000) by setting the rate at 39.6 percent. Also, for these taxpayers, the itemized deduction tax benefit is capped at 28 percent. That makes deductions less valuable. In addition, the PEASE limitation of three percent would be restored. This limitation reduces itemized deductions by three percent of adjusted gross income (AGI) over a threshold, up to 80 percent of itemized deductions. Also, proposed is a phase-out of the qualified business income deduction (QBID) of I.R.C. §199A. The phaseout of the QBID would impact many taxpayers with AGI less than $400,000.
The STEP Act is largely concerned with capital gains and trusts. The STEP Act applies the 39.6 percent rate to capital gains exceeding $1,000,000. Passive gains exceeding this threshold would be taxed at 43.4 percent after adding in the additional 3.8 percent net investment income tax of I.R.C. §1411 created by Obamacare. An additional $500,000 exclusion is provided for the transfer of a personal residence ($250,000 for a taxpayer with single filing status). Also, outright charitable donations of appreciated property are excluded, but (apparently) not transfers to charitable trusts), and some assets held in retirement accounts.
From an estate planning standpoint, if this provision were to become law a “lock-in” effect would occur to some extent – taxpayers would simply hold assets until death to receive the basis adjustment at death equal to the asset’s fair market value (I.R.C. §1014). Unless, of course, the “stepped-up” basis rule is eliminated.
Note: Planning strategies such as charitable remainder trusts (maybe), appropriate timing of the harvesting of gains and losses and similar techniques can be used to keep income under the $1 million threshold. Also, especially for high-income taxpayers residing in states with relatively high income tax rates, a tax minimization strategy has been the use of the incomplete non-grantor trust (ING). An ING is a self-settled, asset protection trust that allows a grantor to fund the trust without incurring gift tax while also achieving non-grantor status for income tax purposes. The typical structures is to establish the trust is a state without an income tax with the grantor funding the ING with appreciated assets having a low basis. The ultimate sale of the trust assets thereby avoids state income tax. The IRS has announced that it is studying INGs and will not issue any further rulings concerning them. Rev. Proc. 2021-3, 2021-1, IRB 140, Sec. 5.
The Step Act also proposes new I.R.C. §1261 which, under certain circumstances, imposes income recognition on gains at the time an asset is transferred to a trust. Under this provision, gain recognition occurs at the time of a transfer to a non-grantor trust, as well as a grantor trust if the trust assets (corpus) will not be included in the grantor’s estate. If the corpus will be included in the grantor’s estate at death, there apparently is no gain until a triggering event occurs. Proposed I.R.C. §1261(b)(1)(A).
Note: The lack of clarity of the STEP Act’s language concerning transfers to grantor trusts creates confusion. Seemingly the relinquishment of all retained powers under I.R.C. §2036 would mean that the trust corpus would not be included in the grantor’s estate, and the transfer to trust would be an income recognition event. It simply is not clear what the STEP Act’s language, “would not be included” means.
Apparently, a transfer to a non-grantor marital trust is not an income recognition event. Proposed I.R.C. §1261(c)(2). Similarly, a transfer qualified disability trust or cemetery trust does not trigger gain recognition. As noted above, the language is unclear whether a transfer in trust to a charity is excluded from recognition. However, a transfer to a natural person that is other than the transferor’s spouse is taxed at the time of the transfer.
Assets that are held in a non-grantor trust would be deemed to be sold every 21 years. That will trigger gain to the extent of unrealized appreciation every 21 years, with the first of these “trigger dates” occurring in 2026.
The STEP Act also requires annual reporting for trusts with more than $1 million of corpus or more than $20,000 of gross income. The reporting requires providing the IRS with a balance sheet and an income statement, and a listing of the trustee(s), grantor(s) and beneficiaries of the trust.
Note: The built-in gain on an asset that is transferred during life either outright to a non-spouse or to a type of trust indicated above cannot be spread over 15 years. However, the transfer of illiquid property (e.g., farmland) to a non-grantor trust that is not otherwise excluded is eligible for installment payments over 15 years, with interest only needing to be paid during the first five years. If the tax on the appreciated value is caused by death, the tax can be paid over 15 years by virtue of I.R.C. §6166.
Grantor trusts – sales and swaps. An important estate planning technique for higher wealth individuals in recent years designed to reduce potential estate tax involves the sale or gifting of assets to a grantor trust. The goal of such a transaction is to make a completed transfer for federal estate and gift tax purposes, but retain enough powers so that the transfer is incomplete for income tax purposes. This is the “intentionally defective grantor trust” (IDGT) technique. The result of structuring the transaction in this manner is that the future appreciation of the assets that are sold to the trust is removed from the grantor’s estate, and the grantor remains obligated for the annual income tax liability. Of course, the trust could reimburse the grantor for that tax obligation. Thus, the grantor ends up with a tax-free “gift” to the trustee of the trust’s income tax liability. This allows the trust assets to grow without loss of value to pay taxes.
The IRS blessed the IDGT technique in Rev. Rul. 85-13, 1985-1 C.B. 184. In the Ruling, the IRs determined that the grantor’s sale of the asset to the trust did not trigger income tax – the grantor was simply “selling” to himself. The irrevocable, completed nature of the transfer to the trust coupled with grantor trust status for income tax purposes is done by particular trust drafting language. Also, that language can be drafted to allow the grantor to “swap” low basis assets in the trust with assets having a higher basis. This allows the “swapped-out” asset to receive a basis increase at the time of the grantor’s death by virtue of inclusion in the grantor’s estate. I.R.C. §1014.
Under the STEP Act, a sale to a grantor trust might be treated as a transfer in trust. If that is what the language means, then Rev. Rul. 85-13 is effectively repealed. It also appears that swaps to a grantor trust would be treated that same as a sale. If this is correct, IDGTs as a planning tool are eliminated.
GRATs. One popular estate planning technique for the higher-valued estates has been the use of a grantor-retained annuity trust (GRAT). With this approach, the grantor transfers assets to a trust in return for an annuity. As the trust assets grow in value, any value above the specified annuity amount benefits the grantor’s heir(s) without being subject to federal gift tax. However, under the STEP Act, a transfer to a grantor trust is taxable if all of the transferred assets are not included in the grantor’s estate. But, if all of the assets transferred to a grantor trust are included in the grantor’s estate, the transfer to the trust is not a taxable event.
This language raises a couple of questions. One of the characteristics of a GRAT is that it can be drafted to make a portion taxable. In that case, it is not completely includible in a decedent’s estate. Likewise, if property is transferred into a GRAT and the transferor dies during the GRAT’s term and the I.R.C. §7520 rate rises, then less than all of the corpus of the GRAT is included in the decedent’s estate. See Treas. Reg. §20.2036-1, et seq. This would appear to mean that, under the STEP Act, the transfer to the GRAT would be a taxable event. It is also unclear whether the use of a disclaimer in the context of a GRAT will eliminate this potential problem.
Estate Tax Deduction
Income taxes that the STEP Act triggers would be deductible at death as an offset against any estate tax that is due on account of the taxpayer’s death.
The Constitutional Issue
As noted above, the STEP Act carries a general effective date of January 1, 2021. It is retroactive. If that retroactive provision were to hold, many (if not all) planning options that could presently be utilized will be foreclosed. But is a retroactive tax provision constitutional?
To be legal, a retroactive tax law change can satisfy the constitutional due process requirement if it is rationally related to a legitimate purpose of government. Given the enormous amount of spending that the Congress engaged in during 2020 to deal with the economic chaos caused by various state governors shuttering businesses, a "legitimate purpose" could be couched in terms of the “need” to raise revenue. See, e.g., Pension Benefit Guaranty Corporation v. R.A. Gray & Co., 467 U.S. 717 (1984); United States v. Carlton, 512 U.S. 26 (1994); In re Fifield, No. 04-10867, 2005 Bankr. LEXIS 1210 (Bankr. D. Vt. Jun. 20, 2005). That’s the case even though historic data indicate that government revenues rarely increase in the long-term from tax increases – particularly the type of tax increases that are presently being proposed.
Will the STEP Act become law as proposed? Probably not. But, combined with S. 994 the two proposals offer dramatic changes to the rules surrounding income tax, as well as federal estate and gift tax. With the proposal to basically double the capital gains tax rate, it could be a good idea to intentionally trigger what would be a gain under the STEP Act. Doing so would at least remove those assets from the transferor’s estate. In general, “harvesting” gains now before a 39.6 percent rate applies could be a good strategy. Also, estate plans should be reexamined in light of the possible removal of the fair market value basis rule at death. Consideration should be given to donating capital gain property to charity, setting up installment sales of property, utilizing the present like-kind exchange rules and making investments in qualified opportunity zones.
Is all planning basically eliminated for 2021? I don’t know. There simply is no assurance whether transfers made to lock in the existing federal estate and gift tax exemption, utilize valuation discounts, etc., will work. If the STEP Act is enacted, perhaps one strategy that will work would be to gift cash (by borrowing if necessary). If the STEP Act is not enacted, then utilizing grantor trusts with sales and swaps could be an effective technique to deal with a much lower exemption.
One key to estate planning is to have flexibility. The use of disclaimer language in wills and trusts is one way to provide flexibility. Coupled with a rescission provision, disclaimer language included in documents governing transactions completed in 2021 might work…or might not. It’s also possible that such a strategy could work for estate and gift tax purposes, but not for income tax purposes.
Another technique might be to set up an installment sale of assets to a marital trust for the spouse’s benefit that gives the spouse a power of appointment and entitles the spouse to lifetime income from the entire interest payable at least annually (basically a QTIP trust for the spouse (see I.R.C. §2523(e)). The STEP Act indicates that such a transfer would not be a gain recognition event – marital trusts are excluded so long as the spouse is a U.S. citizen. The surviving spouse would be given the power to appoint the entire interest and it could be exercised in favor of the surviving spouse or the estate of the surviving spouse. No person other than the surviving spouse could have any power to appoint any part of the interest to any person other than the surviving spouse. With a disclaimer provision the surviving spouse could disclaim all interest in the trust if the STEP Act is not enacted (or is enacted but becomes effective after the transfer by installment sale). The disclaimer would then shift the assets into a trust for the surviving spouse’s heirs. There are other techniques that could be combined with this approach to then add back the spouse. If the STEP Act is enacted, the assets could remain in the marital trust and not trigger gain recognition. The point is that the disclaimer adds tremendous flexibility (until disclaimers are eliminated – but the drafters of the STEP Act haven’t figured that out yet).
Also, I haven’t even discussed the proposed American Families Plan yet. On that one, Secretary Vilsack’s USDA put out an incredibly misleading press release titled, “The American Families Plan Honors America’s Family Farms.” In it, the USDA claims that the proposed changes to the federal estate tax would apply to only two percent of farms and ranches. That’s true as long as the family continues to own the farm and is materially participating in the farming operation. What the USDA didn’t mention is that the American Families Plan eliminates many income tax deductions and will increase the federal income tax bill for practically all farmers and ranchers.
Presently, there is considerable uncertainty in the income tax and estate/business planning environment. Also, the next shift in the political winds could wipe-out all of these proposed changes (if enacted) and the rules will swing back the other direction.
There’s never a dull moment. I can’t emphasize enough how important it is to attend (either in-person or online) this summer’s national conference on farm income tax and estate/business planning. It’s imperative to get on top of these issues. For more information on those conferences click here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html and here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxaugust.html
Saturday, May 1, 2021
May 1, 2021 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Friday, April 30, 2021
Periodically on this blog, I summarize recent cases of interest to those involved in agriculture and tax practitioners in general. Today is one of those days.
Recent court developments of interest – it’s the topic of today’s post.
Defendant’s Removal of Trees Within Conservation Easement Not a Nuisance
Cergnul v. Bradfield, 2021 Ind. App. Unpub. LEXIS 295 (Ind. Ct. App. Apr. 9, 2021)
The developers of a subdivision agreed to record a conservation easement twenty feet wide along two boundaries of the subdivision after complaints by local farmers. The conservation easement’s purpose was to preserve the visual aesthetic for residents who enjoyed the rural setting. Although the restrictive covenants that were recorded did not reference the conservation easement, the developer recorded a final plat that explicitly referred to the conservation easement. The defendant purchased a lot in the subdivision and proceeded to remove some trees and brush from within the conservation easement. The defendant had reviewed the restrictive covenants, which had not been updated after the final plat was recorded. The defendant also had met with a representative of the subdivision’s homeowner’s association, who advised the defendant that he could clear the trees and brush so long as he did not change the grade of the land. The plaintiff was an adjoining neighbor outside the subdivision who sought damages for the loss of quiet enjoyment of his property.
The trial court found that the plaintiff lacked standing to challenge the activity within the conservation easement. Further, the trial court noted that the plaintiff failed to demonstrate that he had been denied a property right. On appeal, the plaintiff argued that although he lacked standing to enforce the conservation easement, he was entitled to damages to address a nuisance. The plaintiff noted that the developers had set aside a conservation easement pursuant to state law and that the defendant’s conduct amounted to nuisance per se. The appellate court noted that the conservation easement enabling statute did not provide the plaintiff with a private right of enforcement. Alternatively, the plaintiff argued that the defendant’s conduct created a nuisance per accidens as the right to the quiet enjoyment of his property had been destroyed. The appellate court noted that whether the defendant’s conduct qualified as a nuisance per accidens depended on whether his conduct would cause actual physical discomfort to a person of ordinary sensibilities. The appellate court found that the plaintiff failed to show any such evidence, and as a result, affirmed the trial court’s decision and denied the nuisance damages sought by the plaintiff.
No Attorney-Client Privilege For Communications Between Trustee and Attorney
In re Estate of McAleer, No. 6 WAP 2019, 2021 Pa. LEXIS 1524 (Pa. Sup. Ct. Apr. 7, 2021)
The decedent created a revocable trust and named his son as the sole trustee. The trust named the son and his two step-brothers as beneficiaries. In 2014, the trustee filed a first and partial accounting of the trust. A step-brother objected and the trustee hired two separate law firms to respond to the step-brother’s objections. After an evidentiary hearing, the probate court dismissed the objections. During the court process, additional filings indicated that about $124,000 of trust funds had been expended from the trust for attorney’s fees and costs through 2015. The step-brothers then filed a petition to determine the reasonableness of the fees. In early 2016, the trustee filed a second and final accounting to which the step-brothers also objected. The trustee claimed that he had no obligation to provide the step-brothers with copies of billing invoices because they were protected by attorney-client privilege. The probate court disagreed and ordered the trustee to forward the unredacted invoices to the step-brothers withing 30 days. The trustee disclosed the invoices, but filed an interlocutory appeal on the issue of the attorney invoices.
The state Supreme Court upheld the probate court’s ruling, noting that the assertion of privilege requires sufficient facts be established to show that the privilege has been properly invoked. According to the state Supreme Court, the trustee had not established those facts. The state Supreme Court also held that the privilege didn’t apply because the interests the privilege protected conflicted with “weightier obligations” – the fiduciary duty of the trustee to provide information to the beneficiaries outweighed the privilege. This was especially the case because the attorney fees were paid from the trust.
Will Authorized Court To Review Sale/Transfer of Farmland
In re Estate of Burge, No. 19-1881, 2021 Iowa App. LEXIS 214 (Iowa Ct. App. Mar. 17, 2021)
The decedent left her estate to her three children and six grandchildren. Two of her children sought to probate the will as executors. One of the executors died shortly after, and his wife participated in the proceedings as the executor and sole beneficiary of his estate. The will distributed a lump sum to the now deceased son if he “is surviving on the death of the survivor” of the decedent. The will distributed half of the remainder to the three children in equal shares and the other half to the six grandchildren in equal shares. The decedent’s will also granted four grandchildren an option to purchase all of her farmland. If they chose to exercise this option, the will directed them to pay a penalty if they sold the farmland within 15 years. The will also had a provision that offered one of the decedent’s children, the remaining executor, to receive his share of the estate in farmland, provided that he could agree upon a division with the grandchildren. Both the grandchildren and the executor exercised their option to purchase the farmland.
The first proposed contract filed by the executor to purchase the farmland was rejected by the trial court because some of the beneficiaries did not participate in negotiations or agree to the terms. The executor filed a second proposed contract to transfer the decedent’s farmland to himself and the four grandchildren. The trial court approved this contract but included direction that if the executor continued with the exercise of his option, he would not be entitled to his residuary share of the estate. Two of the four grandchildren and the executor appealed, and argued that the trial court should not have removed them as residue beneficiaries. The executor also argued that the trial court should have excluded his deceased brother’s wife as a beneficiary.
The appellate court held that since the deceased son survived the decedent, the deceased son’s wife was entitled to his share of the estate as the sole beneficiary. The two grandchildren argued that the executor had the sole right to sell the real estate without court oversight, because the will provided an unrestricted power of sale. The appellate court disagreed and noted that the decedent’s will contained numerous provisions on the sale in her will, namely that the court could resolve any dispute as to the reasonableness of the terms and conditions of the sale. The two grandchildren also argued that the first proposed contract was binding and that the trial court was bound to accept it without modification. The appellate court noted that the first proposed contract did not provide for the executor’s share of the farmland, and the farmland sale/transfer was subject to the terms and conditions in the will and court review for reasonableness.
FBAR Penalties Not Subject to “Full Payment” Rule
Mendu v. United States, No. 17-cv-738-T, 2021 U.S. Claims LEXIS 537 (Fed. Cl. Apr. 7 2021)
The plaintiff was assessed approximately $750,000 of “willful” Foreign Bank and Financial Account (FBAR) penalties. Such penalties can reach up to 50 percent of the highest account balance of the foreign account. He paid $1,000 of the penalty amount and then sued in the U.S. Court of Federal Claims under the Tucker Act to recover the $1,000 as an illegal exaction. The IRS counterclaimed, seeking the entire judgment of $750,000 plus interest. The plaintiff moved to dismiss his complaint on the basis that the court lacked jurisdiction over the illegal exaction claim on the basis of Flora v. United States, 362 U.S. 145 (1960). Such dismissal would nullify the court’s jurisdiction over the counterclaim of the IRS. Under Flora, in accordance with 28 U.S.C. §1346(a)(1), a taxpayer seeking to file a federal tax claim in federal court (other than the U.S. Tax Court) must pay the full amount of the tax before filing suit. However, the plaintiff claimed that 28 U.S.C. §1346(a)(1) only applied to “internal revenue taxes” and claims related to “internal revenue laws.” The petitioner noted that Bedrosian v. United States, 912 F.3d 144 (3d Cir. 2018) hinted that FBAR penalties may fall within the reach of 28 U.S.C. §1346(a).
The court, in ruling for the plaintiff, flatly rejected the Bedrosian decision in holding that FBAR penalties are not subject to the Flora rule because they are not internal revenue laws or internal revenue taxes. The court noted that FBAR penalties are contained in Title 31 of the U.S. Code rather than Title 26 (the Internal Revenue Code), and that this placement was intentional. Title 31, the court noted, has as its purpose, the regulation of private behavior rather than the purpose of being a charge imposed for the purpose of raising general revenue. In addition, the court concluded that FBAR penalties are unlike civil penalties in that they contain no statutory cross-reference that equate “penalties” with “taxes.” The court also reasoned that the if the full payment rule didn’t apply to FBAR penalties there wouldn’t be any concern that the collection of FBAR penalties would be seriously impaired because they are enforced via a civil action to recover a civil penalty. That meant that there were no administrative collection procedures for FBAR penalties with which a partial payment illegal exaction claim would interfere. Thus, the court concluded that the Congress did not intend to subject FBAR penalty suits to the full payment rule.
There’s always action in the courts and with the IRS. That’s especially true this tax season which continues…