Tuesday, May 14, 2019
This summer Washburn Law School is sponsoring its summer national ag tax and estate and business planning conference in Steamboat Springs, Colorado on August 13-14. The event will be held at the beautiful Steamboat Grand Hotel, and is co-sponsored by the Department of Agricultural Economics at Kansas State University and WealthCounsel. Registration is now open for the two-day event, and onsite seating is limited to the first 100 registrants. However, the event will be live streamed over the web for those who can’t make it to Steamboat.
Key Ag Tax and Planning Topics
The QBID. As we historically have done at this summer event, we devote an entire day to ag income tax topics and an entire second day to planning concepts critical to farm and ranch families. Indeed, on Aug. 13, myself and Paul Neiffer will begin the day with a dive back into the qualified business income deduction (QBID) of I.R.C. §199A and take a look at the experience of the past filing season (that largely continues uninterrupted this year). For many clients, returns were put on extension in hopes that issues surrounding the QBID, or the DPAD/QBID for patrons of cooperatives would get resolved. Plus, software issues abounded, and the IRS issued conflicting (and some incorrect) information concerning the QBID. In addition, the season began with errors in Pub. 225, the Farmers’ Tax Guide. Some states even piggy-backed the IRS errors for state income tax purposes and coupling. That made matters very frustrating.
On the QBID discussion, we will take a close look at the rental issue. That seems to be a rather confusing matter for many practitioners. Is there an easy way to separate rental situations so that they can be easily analyzed? We will break it down as simply as possible and explain when to use the safe-harbor – it’s probably not nearly as often as you think. What is an I.R.C. §162 trade or business activity? How do the passive loss rules interact with the QBID?
For farmers that are patrons of ag cooperatives, how is the DPAD/QBID to be calculated? What information is needed to properly complete the return? Where does what get reported? My experience so far this tax season in seminars is that it is taking me about three hours just to recap and review the QBID and go through practitioner questions that came in during tax season and share how they were answered. The discussion has been great, and at the end of the discussion, you will have a better handle on how the QBID works for your clients. Is it really as complicated as it seems?
Selected ag topics. After a brief break following the QBID discussion, we will get into various ag-related tax topics and how the changes brought about by the TCJA impact ag returns. What were the problem areas of applying the new rules during the filing season? What are the key tax issues that farm and ranch clients are presently facing. Currently, disaster issues loom large in parts of the Midwest and Plains. Also, Farm Bill-related issues associated with CCC loans and the impact on the PLC/ARC decision are important. What about how losses are to be treated and reported? Those rules have changed. Depreciation rules have also been modified. But, is it always in a client’s best interests to maximize the depreciation deduction? What about trades? The reporting of personal property trades has changed dramatically. How do those get reported now? What are the implications for clients?
Cases and Rulings
Of course, the day wouldn’t be complete without going through the key rulings and cases from the prior year. There are always many important developments in the courts and with the IRS. Some are even amusing! It’s always insightful to learn from the mistakes of others, and from others that are blazing the trail for others to follow. We will work through all of the key ag-related cases and rulings from the past 12-18 months.
We will have specific session focusing on depreciation, the passive loss rules (and how to report on the return); ag disasters; and the 2018 Farm Bill. Day 1 will be a full day.
Ag Estate and Business Planning
On August 14, we turn our attention to planning concepts for the farm and ranch family. Joining me on Day 2 will be Stan Miller, the founder of WealthCounsel, LLC. In addition to providing estate and business planning education, WealthCounsel, LLC also provides drafting software. In addition, Timothy O’Sullivan joins the Day 2 teaching team. Tim has a longstanding practice in Wichita, Kansas, where he focuses on estate planning and the administration of trusts and estates.
Recent developments. Day 2 begins with a rapid summary of the development that impact estate and business planning. For most clients, the issue is not tax avoidance given the presently high levels of the applicable exclusion. Rather, the issue is including property in the estate to achieve a stepped-up basis. I will go through recent developments impacting the basis planning issue and other developments impacting charitable giving as well as retirement planning.
Other issues. Tim O’Sullivan will devote a session to dealing with family disharmony and how to keep it from cratering a good estate plan. Tim will also have a separate session on incorporating good long-term care planning into the overall family estate and business plan. This is a very important topic for many farm and ranch families – particularly those that want to keep the family business in tact for future generations. I will have separate sessions on charitable giving; planning for second (and subsequent) marriages; and common estate planning mistakes. To round out Day 2, Stan Miller will devote a session to techniques that can professionals can implement to preserve family held farms and ranches for future generations. This will be a timely topic given the many variables that farmers and ranchers must handle to help their operations continue to be successful.
For more information about the event and to register, click here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
A room block for the conference is available at the Steamboat Grand Hotel and is accessible from the page at the link provide above or here: https://group.steamboatgrand.com/v2/lodging-offers/promo-code?package=49164&code=WASH19_BLK
If you can’t attend, the conference is live streamed. Information about signing up for the live streaming is also available on the first link provided above.
Conservation Easement Seminar
I will also be presenting at another CLE/CPE event in Steamboat on Monday, August 12 immediately preceding our two-day conference. That event is sponsored by the Colorado Cattlemen’s Agricultural Land Trust, the Eagle Valley Land Trust, and the Yampa Valley Land Trust, and focuses on the legal, real estate and tax issues associated with conservation easement donations. I will provide more information about that event as it becomes available.
This two-day seminar is a high-quality event this summer in a beautiful location. If you are in need of training on ag tax and planning related issues, this is the event for you. In addition, the full day on conservation easements preceding the two-day conference is an excellent opportunity to dig into a topic that IRS is looking at closely. It’s important to complete these transactions properly and this conference will lay out the details as to how to do it properly.
I hope to see you either in-person in Steamboat Springs later this summer or via the web. It will be a great event for your practice!
Tuesday, April 30, 2019
A good number of the readers of this blog are tax practitioners. As a result, during tax season, significant developments tend to go unnoticed if they don’t directly impact client tax prep work currently. With today’s post, I take a brief look at what happened in federal tax while the tax season was raging on.
Some current developments in federal tax – that’s the topic of today’s post.
Obamacare Individual Mandate
For those of you who attended a tax seminar that I did last year, you heard me discuss the pending litigation concerning the constitutionality of Obamacare. Because Chief Justice Roberts hinged the Constitutionality of the law on the individual mandate (contained in I.R.C. §5000A) being a tax and, therefore, within the taxing authority of the Congress, if that tax is eliminated the law becomes Constitutionally suspect. National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012). At least that’s the argument that I mentioned was being made in court and that we could expect a federal court decision on that issue. The reason for the court challenge, of course, was because of the elimination by the Tax Cuts and Jobs Act (TCJA) of the individual mandate “tax” effective for months beginning after 12/31/18. Indeed, that opinion came out in late 2018 before the tax season began in Texas v. United States, No. 4:18-cv-00167-O, 2018 U.S. Dist. LEXIS 211547 (N.D. Tex. Dec. 14, 2018). The court noted that the payment was distinct from the individual mandate and determined that the individual mandate was no longer constitutional as of 1/1/2019 because it would no longer trigger any tax. In addition, because the individual mandate was the linchpin of the entire law, the provision could not be severed from the balance of the law. As a result, the court reasoned, as of January 1, 2019, Obamacare no longer has any constitutional basis and is invalidated as unconstitutional. The case is on appeal.
Since this ruling in December, two other courts have determined that the individual mandate is a tax. In re Cousins, No. 18-10739, 2019 Bankr. LEXIS 1156 (Bankr. E.D. La. Apr. 10, 2019), held that the provision was a tax for purposes of the bankruptcy Code. The Bankruptcy Code, in accordance with 11 U.S.C. §1328(a), allows a debt to be discharged unless it is listed as a priority claim in 11 U.S.C. §507(a). Priority taxes cannot be discharged, but a penalty amount is dischargeable. In this case, the debtors (a married couple) filed a proof of claim that included a $2,085 mandate assessment which the debtors claimed was dischargeable as a penalty. The IRS disagreed, citing National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012) in which the U.S. Supreme Court concluded that the assessment was a tax for constitutional purposes and cited the Bankruptcy Code in making its determination. The court also found that refusing to purchase health insurance and instead paying an assessment didn't constitute an "unlawful act," which was a strong indication that the individual mandate was not a penalty. In addition, the legislative history implied that the individual mandate was a tax since Congress referred multiple times to how it would raise revenue, the court said. Thus, the assessment was a nondischrgeable tax and was entitled to priority under 11 U.S.C. §507(a)(8) and the court denied the debtors’ objection to the IRS claim. The same result was reached in United States v. Chesteen, No. 18-2077, 2019 U.S. Dist. LEXIS 29346 (E.D. La. Feb. 25, 2019).
IRS Provides “Guidance” on How Farm Income Averaging Interacts With the QBID
In an item posted to its website shortly after the tax filing deadline, the IRS attempted to provide guidance on the Qualified Business Income Deduction (QBID) and a farmer (or fisherman) that makes an election under I.R.C. §1301 to average income. Under a farm income averaging election, a farm taxpayer’s income tax liability is the sum of the I.R.C. §1 tax computed on taxable income reduced by “elected farm income” (EFI) plus the increase in tax imposed by I.R.C. §1 that would result if taxable income for the three prior years were increased by an amount equal to one-third of the EFI. The IRS has stated that "[i]n figuring the amount [of the]... Qualified Business Income Deduction, income, gains, losses, and deductions from farming or fishing should be taken into account, but only to the extent that deduction is attributable to your farming or fishing business and included in elected farm income on line 2a of Schedule J (Form 1040)."
This appears to be saying that if an income averaging election is made, the taxpayer must use EFI to calculate the QBID. With the “guidance,” the IRS appears to be attempting to construe I.R.C. §199A(c)(3)(A)(ii) in this situation. The IRS may need to issue a further clarification. Elected Farm Income May Be Used To Figure Qualified Business Income Deduction, IRS Website, Apr.19, 2019
S Corporations and the Self-Employed Health Insurance Deduction
Just a few days ago, the IRS confirmed the position that many tax practitioners believed was correct with respect to S corporations and the deduction for self-employed health insurance. I.R.C. §1372 says that, for purposes of applying the provisions of the I.R.C. that relate to employee fringe benefits, an S corporation is treated as a partnership. Likewise, any 2 percent (as defined in I.R.C. §318 as owning more than two percent of the corporate stock) S corporation shareholder is treated as a partner in the partnership in accordance with I.R.C. §1372. An S corporation can deduct the cost of accident and health insurance premiums that the S corporation pays for or furnishes on behalf (i.e., reimburses) of its 2 percent shareholders. The two percent shareholders must include the amounts in gross income in accordance with Notice 2008-1, 2008-2 IRB 251 (i.e., the S corporation reports the amounts as wages on the shareholder’s W-2) provided that the shareholder meets the requirements of I.R.C. §162(l) and the S corporation establishes the plan providing medical care coverage.
Under the facts of C.C.A. 2019012001 (Dec. 21, 2019), a taxpayer owned 100 percent of an S corporation which employed the taxpayer’s family member. The family member is a two-percent shareholder under the attribution rules of I.R.C. §318. The S corporation provides a group health plan for all employees, and the amounts paid by the S corporation under the plan are included in the family members gross income. Provided the requirements of I.R.C. §162(l) are satisfied, the IRS determined that the family member could claim a deduction for the amounts the S corporation paid. Thus, the family member could convert what might be a nondeductible expense (because of either the 10 percent floor for medical expenses or because the family member takes the standard deduction) into an above-the-line deduction.
SALT Deduction Guidance
In early April, the IRS provided guidance on how the $10,000 limitation on the deduction of state and local taxes (SALT) under the TCJA and I.R.C. §280A work in conjunction with each other. For a taxpayer with SALT deductions at or exceeding $10,000, or who chooses to take the standard deduction, none of the SALT relating to the taxpayer’s business use of the home are treated as expenses under I.R.C. §280A(b). However, expenses relating to the taxpayer’s exclusive use of a portion of the taxpayer’s personal residence for business purposes remain deductible under I.R.C. §280A(b) or (c) or under another exception to the general rule of disallowance in I.R.C. §280A. The same rationale applies to other deductions that are subject to various limitations or disallowances, including home mortgage interest and casualty losses. For instance, interest on a mortgage balance exceeding the acquisition debt limitations becomes an I.R.C. §280A(c) limited expense when claiming a home office deduction. IRS Program Manager Technical Advice 2019-001 (Dec. 7, 2018).
Ministerial Housing Allowance
In mid-March, the appellate court issued it’s decision on the Constitutionality of the ministerial housing allowance of I.R.C. §107(2) that excludes from gross income a minister's rental allowance paid to the minister as part of compensation for a home that the minister owns. The plaintiff, an atheist organization, challenged the constitutionality of the provision. The trial court agreed, but the appellate court reversed. The appellate court noted that while the exclusion of housing provided for the convenience of the employer provision was not made available to ministers of the gospel, the Congress soon provided an exclusion for church-provided ministerial housing as well as the cash allowance provision of I.R.C. §107(2) at issue in this case. The appellate court determined that the provision was simply an additional provision providing tax exemption to employees that having a work-related housing requirement. The appellate court viewed a categorial exemption for ministers as requiring much less government “entanglement” in religion than lumping ministers under the general employer-provided housing exclusion of I.R.C. §119. The appellate court also noted the long history of tax exemption for religious organizations, and deemed this long history of significance and that I.R.C. §§107(1)-(2) continued that history. Gaylor, et al., v. Mnuchin, No. 18-1277 (7th Cir. Mar. 15, 2019), rev’g., Gaylor v. Mnuchin, 16-cv-215-bbc, 2017 U.S. Dist. LEXIS 165957 (W.D. Wisc. Oct. 6, 2017).
That’s just a bit of what happened in federal tax during tax season while many of you had your head down plowing through this trying tax season.
Friday, April 26, 2019
This summer, Washburn University School of Law will be sponsoring a two-day Farm and Ranch Tax and Estate/Business Planning Seminar in Steamboat Springs, CO. The event will be on August 13-14 at the Steamboat Grand Hotel. This seminar presents an extensive, in-depth coverage and analysis of tax and estate/business problems and issues involving farm and ranch clients over two-days. Attendance can either be in-person or via online over the web.
In today’s post, I outline the coverage of the topics at the seminar and the presenters as well as related information about registering. Steamboat Springs – Summer of 2019!
Topics and Speakers
On Day 1 (August 13), Paul Neiffer (CPA with CliftonLarsonAllen and author of the FarmCPA blog) will be presenting with me. We will start the day with a discussion of the I.R.C. §199A (QBI) deduction. Many issues surfaced during the 2018 tax filing season concerning the QBI deduction. The IRS produced contradictory statements concerning the deduction and the tax software companies also struggled to keep the software up with the developments. During this opening session, Paul and I will walk through QBI deduction issues as applied to farm and ranch clients and address many questions with detailed answers – a very real “hands-on” approach that is practitioner-friendly.
During the next session on Day 1, I Paul and I will take two hours to cover a potpourri of selected farm income tax topics. Those issues that are the present “biggies” will be addressed as well as current issues that practitioners are having with the IRS involving ag clients.
After lunch on Day 1, I will highlight some of the most important recent cases and rulings for farm and ranch taxpayers, and what those developments mean as applied on the farm and in the farm economy. Any new legislation will also be addressed, whether it’s income tax or other areas of the law (such as bankruptcy) that impact ag clients.
We will then devote an hour to common depreciation issues and how the rules have changed and are to be applied post-TCJA. What are the best depreciation planning techniques? We will work through the answers.
Following the afternoon break, I will dive into the passive loss rules. What do they mean? How do they apply to a farm client? How do they interact with the QBI deduction? What is a real estate professional? How to the grouping rules work? These questions (and more) will be answered and numerous examples will show how the rules work in various contexts.
Day 1 finishes out with Paul covering tax and planning issues associated with the 2018 Farm Bill and the choices farm clients have and how the new rules work. I will then cover the tax rules associated with ag disasters and casualties. There are many of those issues for clients that will show up during the 2019 tax filing season, especially for farm/ranch clients in the Midwest and Plains states.
On Day 2, our focus turns to farm and ranch estate and business planning. I will begin the day with an update of the key recent developments that impact the estate and succession planning process. What were the key cases of the past year? What about IRS rulings and pronouncements? I will cover those and show you how they apply to your clients.
Day 2 then continues with a key session on how to use estate planning concepts to minimize family disharmony. This session is presented by Tim O’Sullivan with Foulston Siefken LLP in Wichita, KS. Tim has a broad level of experience in estate planning and the handling of decedent’s estates. This is a “must attend” session for estate planners and deals with a topic that is often overlooked as an element in putting together a successful estate and business transition plan.
After the morning break on Day 2, I will cover the tax and legal issues associated with the use of trusts. Trusts are an often-used tool for farm and ranch clients, but what is the correct type for your client? The answer to that question is tied to the facts. Also, can a state tax a trust beneficiary or the trust itself if there isn’t any physical connection with the state? It’s an issue presently before the U.S. Supreme Court. By the time of the seminar, we will likely have an answer to that question.
How does the TCJA impact charitable giving? What are the new charitable planning techniques? What factors are important? I will address these questions and more in the session leading up to lunch.
After the lunch break on Day 2, I will deal with an unfortunate, but important topic- what is appropriate estate and business planning in second marriage situations? If the plan doesn’t account for this issue, significant disruptions can occur, and expectations may not be met. This is an important session dealing with a topic that tends to be overlooked.
I will then provide a breather from some heavy topics with a lighter (and fun) one – what are common estate and business planning mistakes? What classic situations have you dealt with in your practice over the years? Mistakes are frequent, but some seem to occur over and over. Can they be identified and prevented? That’s the goal of this session.
Tim O’Sullivan then returns for another session. This time, Tim does a deep dig into long-term health care planning. How can farm and ranch assets and resources be preserved? What are the applicable rules? What if only one spouse needs long-term care? Should assets be transferred? If so, to whom? This is a very important session designed to give you the tools you need for your long-term care planning toolbox.
Day 2 finishes with a key session by Stan Miller on how estate and business planning concepts can be used to help make sure the family farm survives for families that want it to survive as a viable economic unit. Stan is a founder of WealthCounsel, LLC and a principal in the company. Stan has a long background in estate and business planning. He is also a partner with ILP + McChain Miller Nissman in Little Rock, Arkansas. This session is a great capstone session for the day that will bring the day’s discussion together and get down to how the concepts discuss throughout the day can be used to help the farming and ranching business of a client survive the ups and downs of the economy, as well as family situations.
The seminar will be held on Tuesday and Wednesday, August 13-14 at the Steamboat Grand Hotel, in Steamboat, Colorado. It is co-sponsored by the Kansas State University Department of Agricultural Economics and WealthCounsel, LLC. You can find more registration information here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
On another note, on Monday, August 12, also in Steamboat, I will be participating in another seminar (also in Steamboat Springs) sponsored by the Colorado Cattlemen’s Agricultural Land Trust, the Eagle Valley Land Trust, and the Yampa Valley Land Trust. Half of the day will concern legal issues associated with conservation land trusts. The other half of the day will address real estate issues associated with conservation land trusts. These issues are very important in many parts of the country in addition to Colorado. As further details are provided, I will pass those along. This all means that there will be three full days of tax and legal information available this coming August in Steamboat Springs.
As I noted above, the seminar can be attended either in-person on online via the web. Registration will open up soon, so get your seat reserved. Steamboat Springs, CO is a beautiful area on the western slope of the Colorado Rockies.
Hope to see you there!!
Wednesday, April 24, 2019
Recently, it was reported that astronomers captured the first ever images of a black hole – an abyss they say that is so deep that not even light can escape it. Tax law has its own “black-hole.” It has to do with tax refund claims. But, an appellate court has found light coming from this tax “black- hole.” In addition, the manner in which the appellate court decided the case may shed light on how courts could construe unclear statutory provisions of the Tax Cuts and Jobs Act (TCJA).
Refund claims and statutory construction – these are the topics of today’s post.
The Tax Court has jurisdiction to determine the amount of any overpayment of tax if the taxpayer paid the amount to be refunded within a “look-back” period. I.R.C. §6512(b)(3)(B). That “look-back” period is specified as three years after the return was filed or two years after payment. I.R.C. §6511(b)(2). Wait too long to file or pay and it may be too late. In addition, the flush language (language not accompanied by a number or letter and is flush against the margin) at the end of I.R.C. §6512(b)(3)(B) says that, “In a case described in subparagraph (B) where the date of the mailing of the notice of deficiency is during the third year after the due date (with extensions) for filing the return of the tax and no return was filed before such date, the applicable period under subsections (a) and (b)(2) of [I.R.C. §6511] shall be 3 years.”
Confused? Let’s take a look at how this provision was applied in a recent case.
In Borenstein v. Comr., No. 17-3900, 2019 U.S. App. LEXIS 9650 (2d Cir. Apr. 2, 2019), rev’g., 149 T.C. 263 (2017), the taxpayer’s return for 2012 was due on April 15, 2013. At the taxpayer’s request, she received a six-month extension of time to file the return. That made the due date October 15, 2013. But, she still had to pay. When an extension of time to file is granted, that doesn’t extend the time to pay. Thus, she made several tax payments for 2012 totaling $112,000 that were all deemed to be made on April 15, 2013 in accordance with I.R.C. §6513. However, she didn’t file the return by October 15, 2013. In fact, she didn’t file a return for the next 22 months. That got the attention of the IRS. IRS then sent the taxpayer a statutory notice of deficiency (SNOD) on June 19, 2015, for her 2012 return. She then filed her 2012 return on August 29, 2015. On that return, she reported a tax liability of $79,559. The IRS agreed that the $79,559 was the taxpayer’s correct tax liability and that she had overpaid by $32,441. But, the kindler, gentler IRS said it was so sorry that it couldn’t issue her a credit or refund of the $32,441 because she made the overpayment outside the applicable look-back period tied to the SNOD. According to the IRS, the parenthetical phrase "with extensions" contained in the statute modified "due date." That meant, according to the IRS, the "due date (with extensions) for filing the return of tax" was October 15, 2013, pursuant to the automatic extension that the taxpayer received to file her 2012 return. Thus, the "third year" after that date, the IRS said, began on October 15, 2015. However, the IRS mailed the SNOD on June 19, 2015 – during the second year and not the third year "after the due date (with extensions) for filing the return." In addition, the IRS claimed, the last sentence of I.R.C. §6512(b)(3) did not apply. In essence, the parties were arguing over what “with extensions” means in I.R.C. §6512(b)(3) in terms of whether the Tax Court had jurisdiction to authorize a refund to the taxpayer.
The Tax Court, agreeing with the IRS, trotted out the statutory language of I.R.C. §6512(b)(3), which says the Tax Court has jurisdiction to order a refund of overpayments made during the three years immediately preceding the mailing of the notice of deficiency (i.e., a three‐year look‐back period) if the taxpayer failed to file a return before the mailing of the notice of deficiency and “the date of the mailing of the notice of deficiency is during the third year after the due date (with extensions) for filing the return of tax.” The Tax Court held that “(with extensions)” was unambiguous and modified only “due date” and had the effect of delaying by six months the beginning of the “third year after the due date.” The flush language and it’s three-year look-back period didn’t apply. That meant that there were only two years remaining from the date the SNOD was issued. Thus, the taxpayer’s overpayment was outside the two-year look-back by two months and the Tax Court determined it didn’t have jurisdiction to order the refund. Remember, there was no question the taxpayer was entitled to the refund. The IRS was taking the position that the Tax Court couldn’t order the IRS to issue the refund and the Tax Court agreed. The tax black-hole!
On appeal, the U.S. Court of Appeals for the Second Circuit reversed. The appellate court held that “with extensions” in I.R.C. §6512(b)(3) extended by six months the “third year after the due date.” Thus, the look-back period was three years rather than two and the Tax Court had jurisdiction to order the refund. Importantly, the appellate court said that I.R.C. §6512(b)(3) was unclear and, as a result, legislative history should be examined. That history, the appellate court determined, was in the taxpayer’s favor and that uncertain statutory language should be resolved against the government. The flush language, the appellate court noted, was intended to increase the Tax Court’s jurisdiction to order refunds to taxpayers that didn’t file a return before the mailing of the SNOD. No more black-hole.
Application to the TCJA?
Does Borenstein have any application to the tax provisions contained in the TCJA. It could. As noted, the appellate court said that uncertain tax provisions are to be construed against the government. There are more than a few unclear provisions in the TCJA. Even the IRS is struggling to come up with consistent interpretations of various TCJA provisions. In addition, there is very little legislative history concerning the bulk of the TCJA provisions. That could ultimately work in taxpayers’ favor if future courts construing TCJA provisions take the same position on statutory construction as did the appellate court in Borenstein.
The refund black-hole issue has been the subject of a couple of cases decided in recent months. At least in the Second Circuit the black-hole has disappeared. That’s Connecticut, New York and Vermont. The Borenstein decision is persuasive authority, but not binding, on the IRS outside the Second Circuit.
Monday, April 22, 2019
Last week’s post on the self-rental rule of Treas. Reg. §1.469-2T(f)(6) generated a lot of interest. As noted in that post, the self-rental rule bars a taxpayer with passive losses from artificially creating passive income from another activity to offset the passive losses. One way to potentially do this is to self-rent property. Questions were raised as to the rule’s application to S corporations. In addition, there were additional questions raised as to how the rule applied with respect to the net investment income tax (NIIT) of I.R.C. §1411 and whether self-rentals are eligible for a qualified business income deduction (QBID) under I.R.C. §199A.
Digging a bit deeper on the self-rental rule – it’s the topic of today’s post.
In general. In prior posts last year and earlier this year, I wrote on the various aspects of the QBID. The QBID was created under the Tax Cuts and Jobs Act and is effective for tax years beginning after 2017 and before 2026. The QBID is a 20 percent deduction for noncorporate taxpayers against qualified business income (QBI). QBI is the net amount of items of income, gain, deduction and loss with respect to a trade or business. A qualified trade or business is any trade or business other than a specified service trade or business (SSTB) or the business of performing services as an employee. An SSTB is a trade or business involving performance of services in the field of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. Taxpayers who own an SSTB may still qualify for the deduction if a taxpayer’s taxable income (for 2019) does not exceed $321,400 for a married couple filing a joint return, or $160,700 for all other taxpayers except that married filing separate taxpayers have a $160,725 threshold.
Rental activities. To be eligible for the QBID, a rental activity must rise to the level of trade or business in accordance with I.R.C. §162. That is a different (and more stringent) standard than that utilized for purposes of the passive loss rules of I.R.C. §469, and it requires regularity and continuity in the activity. There are many decided cases involving the issue of whether a trade or business exists under the I.R.C. §162 standard with the courts utilizing numerous factors such as the type and number of properties rented; how involved the taxpayer is in the business; whether any ancillary services are provided under the lease and, if so, the type; and, the type of the lease. These factors are also listed in the preamble to the I.R.C. §1411 regulations.
In August of 2018 QBID proposed regulations were released. The proposed regulations defined “self-rentals” as a “trade or business.” Thus, the income from a self-rental will qualify for the QBID if the self-rental is being leased through a passthrough business that is under “common control.” Common control is necessary to combine rentals with other business activities and is defined when the same person or group, directly or indirectly own 50% or more of each trade or business.
Seth Poole is the sole owner of an S corporation that is engaged in manufacturing widgets. Seth also owns an office building that he holds in his single member limited liability company (LLC). The LLC leases the office building to the S corporation under a triple-net lease (a lease agreement where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees such as rent, utilities, etc.). Because the office building is leased between entities that are under common control, and the S corporation is carrying on a trade or business, the triple-net lease activity qualifies as eligible for the QBID.
The “takeaway” from the proposed regulations was that self-rentals between entities that are under common control can produce a significant QBID.
In mid-January of 2018, the Treasury released the QBID final regulations. Issued along with those final regulations was Notice 2019-07 providing safe harbor rules for rental activities on the trade or business issue. In essence, to qualify for the safe harbor, a rental real estate activity is a QBI-qualifying trade or business under I.R.C. §199A if the taxpayer provides at least 250 hours of services during the tax year. But, it is important to remember that the safe-harbor is just that – a safe-harbor. A rental activity can qualify as an I.R.C. §162 trade or business without meeting the safe harbor requirements if the facts and circumstances support such a finding.
Under the final regulations, a self-rental constitutes an I.R.C. §162 trade or business for QBID purposes if the rental involves commonly controlled entities (either directly or via attribution under I.R.C. §§267(b) or 707(b)) where the self-rental income is not received from a C corporation. The final regulations also bar taxpayers from shifting SSTB income to non-SSTB status by using a self-rental activity where property or services are provided to an SSTB by a trade or business with common ownership. Under the rule, a portion of the trade or business that provides property to the commonly owned SSTB is treated as part of the SSTB with respect to the related parties if there is at least 50 percent common ownership.
A group of CPAs own a building. They lease 80 percent of the building space to the CPA firm and 20 percent of the building to an unrelated chiropractor. The 20 percent would be classified as non-SSTB income while the 80 percent would be treated as SSTB income. The general rule is that a rental real estate trade or business is not treated as an SSTB, subject to the taxable income limitations. However, that rule changes if there is common ownership exceeding 50 percent. If there is, the rental income attributable to the commonly controlled SSTB is treated as if it were SSTB income.
Even though the passive loss rules of I.R.C. §469 don’t specify that they apply to S corporations, the Tax Court has held that the self-rental rule applies to rentals by S corporations. In Williams v. Comr., T.C. Memo. 2015-76, the taxpayers (a married couple) owned 100 percent of an S corporation and 100 percent of a C corporation. The husband worked full-time for the C corporation during 2009 and 2010, and materially participated in its activities. Neither of the taxpayers materially participated in the S corporation or the rental of commercial real estate to C corporation. They also were not engaged in a real estate trade or business. In 2009 and 2010, the S corporation leased commercial real estate to the C corporation so that the C corporation could use it in its business. For those years, the S corporation had net rental income that the taxpayers reported as passive income on Schedule E which they then offset with passive losses. The IRS disagreed and recharacterized the rental income as non-passive under the self-rental rule.
In upholding the IRS position, the Tax Court determined that passthrough entities are subject to I.R.C. §469 (which included the taxpayers’ S corporation) even though not specifically mentioned by the statute. They did not need to be mentioned, the Tax Court reasoned, because they were not taxpayers. The Tax Court also rejected the taxpayers’ argument that the self-rental rule didn’t apply because the S corporation did not participate in the C corporation’s trade or business. It was enough that the husband personally provided material participation in the C corporation’s business to trigger the application of the self-rental rule. The rental income from the lease was non-passive.
The 3.8 percent NIIT applies to taxpayer’s with passive income that exceeds $250,000 on a joint return ($125,000 married filing separately; $200,000 for other filing statuses). Generally, the passive loss rules apply in determining whether an I.R.C. §162 trade or business is passive for NIIT purposes. Thus, if a taxpayer has rental income from an activity in which the taxpayer materially participates, the NIIT will not apply. But, what about the self-rental recharacterization rule? Treas. Reg. §1.1411-5(b)(2) specifies that, “To the extent that any income or gain from a trade or business is recharacterized as “not from a passive activity” by reason of . . . §1.469-2(f)(6), such trade or business does not constitute a passive activity . . . with respect to such recharacterized income or gain.”
Thus, if the self-rental recharacterization rule applies, it will cause the trade or business at issue to not be passive for NIIT purposes only with respect to the recharacterized income or gain. Treas. Reg. §1.1411-5(b)(2)(iii). When gross rental income is treated as not being derived from a passive activity because of a grouping a rental activity with a trade or business activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business. Thus, the NIIT would not apply. Treas. Reg. §1.1411-4(g)(6)(i).
For purposes of the NIIT, the self-rental rule is applied on a person-by-person basis. Thus, there can be situations involving multiple owners in a rental entity where some will be subject to the NIIT and others who will not be subject to the NIIT based on individual levels of participation in the activity.
The self-rental rules involve numerous traps for the unwary. For taxpayers with such scenarios, seeking competent tax counsel is a must.
Thursday, April 18, 2019
In recent weeks, I have written a couple of posts on various aspects of the passive loss rules contained in I.R.C. §469. Indeed, over the past two years, I have written six posts on the various aspects of the passive loss rules and their application to farm and ranch taxpayers. With today’s post, I add to those numbers by examining another aspect of the passive loss rules and how it applies to a common tax and business planning technique of farmers and ranchers – renting the farm/ranch land to the farm/ranch operating entity.
The “self-rental” limitation of the passive loss rules – it’s the topic of today’s post.
Passive Loss Rules - Basics
As noted in prior posts, to deduct passive losses (the amount by which the taxpayer’s aggregate losses from all passive activities for the tax year exceed aggregate income from those activities), an investor must have passive income. Stated another way, a passive activity loss can only offset passive income (with a few exceptions). The rule makes it quite difficult for a taxpayer to deduct passive losses unless they have another activity that is generating passive income.
Avoiding Passive Losses
Materially participate. There are two ways to approach the limitation of passive loss rules. One is to not be engaged in passive activities. A passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not materially participate. I.R.C. §469(c). Under the general rule, rental activities are passive. I.R.C. §469(c)(2). But, as noted in prior posts, there are exceptions. In addition, the activity is not a passive activity if the taxpayer is involved in it on a basis that is regular continuous and substantial. Basically, the taxpayer has to be involved in the daily management of the activity for a sufficient amount of time. The regulations provide seven tests for material participation. Treas. Reg. §1.469-5T(a)(1)-(7).
Create passive income and the risk of recharacterization. The other approach is be involved in activity that generates passive income that could then be offset by passive losses from another activity. Indeed, when the passive loss rules became law, there was immediate interest in creating what came to be known as passive income generators (PIGs). These are investment activities that throw off passive income, allowing the investor to match the passive income from the activity against passive losses. The IRS anticipated this and published regulations in the mid-1980's that recharacterized, or gave the IRS the power to recharacterize, passive income as non-passive income which was ineligible to offset passive losses. This became known as the “slaughter of pigs.” There are ten categories of recharacterization.
Bare land leases. One recharacterization rule applies to bare land leases. Treas. Reg. §1.469-2T(f)(3). Under this recharacterization rule, net income from a rental activity is considered not from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Id. The rule converts both net rental income and any gain on disposition from passive income to portfolio income (i.e., income from investments, dividends, interest, capital gains). But, the recharacterization rule only applies if there is net income from the rental activity. If there is a loss, the loss remains passive.
Example: Dr. Sawbones owns interests in multiple limited partnerships that have suspended losses. In an attempt to use those losses, Sawbones bought farmland for $400,000. $100,000 of the purchase price was allocated to fences, tile lines, grain bins and other depreciable property. Sawbones cash leased the land to his cousin via a cash rent lease in an attempt to generate passive income that he could offset with the suspended passive losses. However, because only 25 percent of the unadjusted basis is attributable to depreciable property, the cash rent income is recharacterized (for passive loss rule purposes) as portfolio income and will not offset the suspended passive losses from the limited partnerships. However, if the cash rent produces a net loss after taxes, interest and depreciation, the loss is a passive loss. This is not the result that Sawbones was hoping to achieve. The regulation has been upheld as valid. See, e.g., Wiseman v. Comr., T.C. Memo. 1995-303.
Self-rentals. Farmers and ranchers sometimes structure their businesses in multiple entities for estate and business planning (and tax) purposes. Such a structure may involve the individual ownership of the land that is then rented to the operating entity that the landlord also has an ownership interest in. Alternatively, the land may be held in some type of non-C corporation entity and rented to the operating entity. If the land lease does not involve the landlord’s material participation and the rental amount is set at fair market value (or slightly less), self-employment tax is avoided on the rental income even though the landlord materially participates in the operating entity as an owner. See Martin v. Comr., 149 T.C. 293 (2017). However, it’s also a classic self-rental situation that trips another recharacterization rule for passive loss purposes. Under this rule, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates. Treas. Reg. §1.469-2(f)(6). But, just like the recharacterization rule mentioned above for bare land leases, recharacterization only applies if there is net income from the self-rental activity. If a loss occurs, the loss remains passive. While an exception exists for rentals in accordance with a written binding contract entered into before February 19, 1988, that lease must have been a rather long-term lease at the time it was entered into for the grandfathering provision to still apply. Treas. Reg. §1.469-11(c)(1)(ii). It’s not possible to renew or draft an addendum to the original lease and come within the exception. See, e.g., Krukowski v. Comr., 114 T.C. 366 (2000), aff’d., 239 F.3d 547 (7th Cir. 2002). It also applies to S corporations. Williams v. Comr., No. 15-60341, 2016 U.S. App. LEXIS 1756 (5th Cir. Feb. 5, 2016), aff’g., T.C. Memo. 2015-76.
Example: For estate and business planning purposes, Mary put most of her farmland in an entity that she is the sole owner and employee of. Mary continued to own her livestock buildings, a machine shed and additional farmland, and rented them to the entity under a cash lease. Mary reported the rental income on Schedule E (Form 1040). However, because the rental income is derived from a business in which Mary materially participates, she cannot carry the rental income to Form 8582 (the passive activity loss Schedule) within her Form 1040. Instead, the net rental income is treated as coming from a non-passive activity. Mary will have to carry the net rental income from Schedule E directly to page one of her Form 1040. If Mary has passive losses from other sources, she will not be able to use those losses to offset the rental income.
It’s not possible to make a grouping election to overcome the self-rental regulation. See, e.g., Carlos v. Comr., 123 T.C. 275 (2000). As I noted in a prior post on the passive loss rules, a taxpayer can make an election to group multiple rentals as a single activity for passive loss rule purposes if the rental activities represent an appropriate economic unit. Treas. Reg. §1.469-4(c). But, even with such a grouping election the self-rental rule will still apply.
Example: Bill and Belinda are married and file a joint return. They own two tracts of farmland and cash lease each tract to the farming entity (an S corporation) that they own and operate. One of the tracts generates cash rental income of $200,000. The other tract produces an $80,000 loss. On their Schedule E for the tax year, they group the two tracts together as a single activity with the result that the net rental income reported is $120,000. Under the self-rental regulation, the IRS could separate the two rental tracts with the result that the $200,000 of income from one tract is recharacterized as non-passive and the $80,000 loss remains passive and cannot offset the $200,000 income. The $80,000 loss will be a suspended passive activity loss on Form 1040.
One option might be for Bill and Belinda to group the land rental activity that produces a loss with their operating entity. They can do that if the rental activity is “insubstantial” in relation to the business activity. Treas. Reg. §1.469-4(d)(1). In addition, they could group the rental activity that produced a loss with the operating entity (business activity) if they each have the same percentage ownership in the operating entity that they do in the rental activity. Such a grouping will result in the rental activity loss not being passive if they materially participate in the operating entity.
One more point on grouping – can a self-rental be grouped (“aggregated”) with the farming entity to maximize an I.R.C. §199A deduction? I.R.C. §199A is the new 20 percent deduction available for sole-proprietors and pass-through businesses on qualified business income. The answer is that as long as the farming entity and the land rental are part of a common group and have the same tax year, the rent will be aggregated with the farm income. That can optimize the use of the 20 percent deduction.
The passive loss rules are tricky. The cases are legion. Rentals are tricky, and the IRS can recharacterize rental activities to eliminate hoped-for passive income generators. Make sure you understand how the rules apply.
Wednesday, April 10, 2019
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.
The IRS has a history of not showing a great deal of appreciation for the provision. After all, the donor is getting a significant tax deduction and can still farm or graze the property, for example. So, the technical requirements must be paid close attention to and strictly complied with.
Now legislation has been introduced that would eliminate the tax deduction associated with the donation of permanent conservation easements via a syndicated partnership. In addition, the IRS recently designated syndicated conservation easement transactions as being on its list of the “Dirty Dozen” tax scams of 2019.
The trouble with permanent conservation easement donations – it’s the topic of today post.
Permanent Conservation Easement Donations
In general. 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.
IRS Concerns. 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).
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. 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 F3d 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.
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.
Syndicated Easement Donations
The IRS has also been aggressive at auditing donated conservation easements accomplished via a syndicated partnership. These transactions involve either an individual or an entity buying undeveloped property and then transferring it to a partnership. Partnership interests are then sold to “investors.” After the land appreciates in value, the partnership donates a conservation easement on the land to a qualified land trust with the charitable deduction flowing to the investors. This strategy made it on the 2019 IRS list of the “Dirty Dozen” tax scams and the Congress is taking action to eliminate the technique. In the U.S. Senate, The “Charitable Conservation Easement Program Integrity Act of 2019” has been introduced to end syndicated partnership easement donations. It also contains provisions that are effective retroactively and bars deductions when the value of the associated property has appreciated in value more than 2.5 times the initial investment.
I.R.C. §170(h) has been around for almost 40 years. It was enacted with the purpose of incentivizing landowners who wanted to bar development on their land and simultaneously provide a conservation benefit. It wasn’t designed with the intent that it become a profit-making venture. But, in recent years inappropriate and unsupportable property valuations have raised IRS and court scrutiny. In addition, the technical requirements for the deed language are very detailed and must be followed precisely. But, done correctly (and not via a syndicated partnership) the donation of a permanent conservation easement can provide substantial conservation benefits and a tax break for donors.
With the donation of permanent conservation easements it’s wise to remember that, “pigs get fat, but hogs get slaughtered.
Monday, April 8, 2019
Recently, I devoted a blog post to the benefits of a farming or ranching operation from the utilization of a cost segregation study. https://lawprofessors.typepad.com/agriculturallaw/2019/03/cost-segregation-study-do-you-need-one-for-your-farm.html. That post generated a great deal of nice comments and input and a request for another post looking at the risks of using a cost segregation study. Indeed, in 2018, the IRS issued a Chief Counsel Advice (CCA) discussing when the preparers of cost segregation studies could be subjected to penalties.
Issues and risks associated with cost segregation studies – that’s the topic of today’s post.
As pointed out in my prior post, cost segregation is the practice of taking a large asset (such as a building) and splitting its structural component parts into a group or groups of smaller assets that can be depreciated over shorter lives. See Treas. Reg. §1.48-1(e)(2)(provides guidance on the definition of a “structural component”). A primary emphasis of a cost segregation study is to classify assets as depreciable personal property rather than as depreciable real estate (or classify depreciable personal property (e.g., structures) separate from non-depreciable real estate). In tax lingo, the studies often result in the construction of rather detailed lists of individual assets that distinguish I.R.C. §1245 property with shorter depreciable recovery periods from I.R.C. §1250 property that has a longer recovery period. See, e.g., Hospital Corporation of America & Subsidiaries, 109 T.C. 21 (1997), acq. and non-acq. 1999-35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763. But see, Amerisouth XXXII, Ltd. v. Comr., T.C. Memo. 2012-67 (involving residential rental property). This technique will generate larger depreciation deductions in any particular tax year. The Tax Cuts and Jobs Act (TCJA) of late 2017, at least indirectly, makes the practice of cost segregation more beneficial by providing for the immediate expensing of up to $1 million ($1,020,000 for 2019) of most personal property that is found on a farm or ranch, and also by allowing first-year 100 percent “bonus” depreciation on used (in addition to new) assets. These changes make it more likely that a cost segregation study will provide additional tax benefits.
Because of the additional depreciation incentives included in the TCJA, the “placed-in-service” date of an asset is of primary importance. When is an asset deemed to be placed in service for depreciation purposes? The answer is when the asset is in a condition or state of readiness and availability for a specifically assigned function such as use in the taxpayer’s trade or business. See Treas. Reg. §1.167(a)-11(e)(1)(i); see also Treas. Regs. §§1.46-3(d)(1)(ii) and 1.46-3(d)(2); Von Kalinowski v. Comr., 45 F.3d 438 (9th Cir. 1994), rev’g. T.C. Memo. 1993-26. In practice, the determination of when an asset is placed in service is highly fact-dependent. In addition, the answer to the question can turn on the type of asset that is involved. As applied to commercial buildings, for example, the IRS tends to use the date on a certificate of occupancy as a factor in determining the placed-in-service date of the building or a portion of the building. But, in Stine, LLC v. United States, No. 2:13-03224, 2015 U.S. Dist. LEXIS 9850 (W.D. La. 2015), the court held that the two buildings of a retail operation at issue in the case were placed in service in the year when they were ready and available to store equipment and contained racks, shelving and merchandise. The court viewed it as immaterial that the certificates of occupancy for the buildings did not allow public access until the next year. The placed-in-service date was important in Stine because the taxpayer sought to have the buildings placed in service in 2008 (rather than 2009) to be eligible to deduct Gulf Opportunity Zone bonus depreciation on the buildings. The IRS issued a non-acquiescence in Stine. A.O.D. 2017-02 (Apr. 10, 2017). The IRS said that it will continue to litigate the placed-in-service issue on the basis of its position that a retail store isn’t placed in service until it is open for business.
IRS Audit Approach
The IRS has posted to its website a very detailed audit technique guide (ATG) concerning cost segregation studies. See https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-table-of-contents. The guide is useful in terms of the information it provides practitioners concerning its view on what constitutes a properly conducted cost segregation study. In the ATG, IRS auditors are advised to closely scrutinize cost segregation studies that are conducted on a contingency fee basis. The IRS believes that such fee structures incentivize the maximization of I.R.C. §1245 costs through “aggressive legal interpretations” or by inappropriate cost or estimation techniques. As a result, firms performing cost segregation studies may be better off billing the work based on the size of the project plus out-of-pocket expenses. Auditors are also advised to conduct in-depth reviews of cost segregation studies to determine the appropriateness of property depreciation classifications and determine if there are any land or non-depreciable land improvements that the study has classified as depreciable property. This could be a particularly important issue for cost segregation studies involving farm and ranch taxpayers.
In the ATG, IRS examiners are to closely look at the classification of I.R.C. §1245 and I.R.C. §1250 property. On this distinction, taxpayer records and documentation are critical. IRS will look to see whether a building component designated as I.R.C. §1245 can actually be used for other pieces of equipment. If it can, it will likely be classified as part of the building. The ATG also notes that IRS examiners can use sales tax records of the taxpayer as guidance on the proper allocation between I.R.C. §1245 and §1250 property. Other key points on the I.R.C. §1245/I.R.C. §1250 distinction involve whether the cost segregation study used cost estimates or actual cost records or a residual approach to determine the actual cost of I.R.C. §1245 items. What IRS is looking for is whether the cost of I.R.C. §1245 property has been set too high.
Another specific area of examination involves when depreciable and non-depreciable property are acquired in combination for a lump sum. The ATG points out to examiners that the basis for depreciation cannot exceed an amount which bears the same proportion to the lump sum as the value of the depreciable property at the time of the acquisition bears to the value of the entire property at that time. See Treas. Reg. §1.167(a)-5. Thus, examiners are to look at the fair market values of the properties at the time of acquisition. The fair market value of the land is to be based on its highest and best use as vacant land even if it has improvements on it. Thus, the ATG states that it is not correct for a cost segregation study to estimate land value by subtracting the estimated value of improvements from the lump sum acquisition price. Doing so, according to the IRS, results in an overstatement of the basis of depreciable improvements.
The ATG instructs examiners to reconcile total project costs (in terms of cost basis) in the taxpayer’s records with the total project costs in the cost segregation study. Thus, the IRS can be expected to request a copy of the taxpayer’s general ledger data. A key question will be whether costs that should have been in the taxpayer’s building account, for example, are showing up in another account or were expensed. Likewise, the ATG states that examiners should see if costs associated with site preparation, grading and land contouring have been properly (in the IRS view) allocated to land basis rather than being allocated to the overall building cost.
Preparer and Aiding and Abetting Penalties?
In 2018 the IRS issued a CCA taking the position that the preparers of cost segregation studies could be subjected to penalties. CCA 201805001(Oct. 26, 2017). The CCA involved a set of facts where an engineer/consultant prepared a cost segregation study without having any direct role in preparing tax returns. The engineer/consultant simply provided the completed study to the taxpayer so that the taxpayer could use it in the preparation of the taxpayer’s returns. The cost segregation study divided a 39-year property into component parts, many of which were assigned five-year MACRS lives. On audit, the IRS disagreed with the structural building components being classified as five-year property. Simply correcting the improper classification on the taxpayer’s returns was not enough. The IRS took the position that I.R.C. §6701 could serve as the basis for penalties against the study’s preparer for aiding and abetting the understatement of tax liability. The IRS position was that the engineer/consultant, by preparing the cost segregation study, was aiding or advising in the preparation of the taxpayer’s return. That satisfied I.R.C. §6701(a)(1). Accordingly, the engineer/consultant either knew or had reason to know that the study would be used “in a material matter relative to the IRC.” That satisfied I.R.C. §6701(a)(2). In addition, the IRS argued that the engineer/consultant had actual knowledge that the cost segregation study would result in an “understatement of the tax liability of another person” under I.R.C. §6701(a)(3). This last point is important. If the preparer of a cost segregation study knows that the study inflates depreciation deductions that will result in an understated tax liability, liability is present given that the fist two elements of potential liability under I.R.C. §6701 are practically presumed present.
The IRS determined that the engineer/consultant was liable for the $1,000 penalty for aiding and abetting the misstatement of individual tax forms. Had a misstated corporate form been involved, the penalty would have been $10,000. However, the IRS took the position that the $1,000 penalty should be imposed multiple times because the cost segregation study contributed to five returns misstating income as a result of the classification of 39-year property as five-year property. Why the IRS didn’t take the position that six $1,000 penalties should be imposed was not clear. Five-year MACRS property results in six-years of depreciation deductions (one-half year’s depreciation in each of year one year six under the one-half year convention). The IRS cited In re Mitchell, 977 F.2d 1318 (9th Cir. 1992) to support its position that multiple penalties should be imposed.
The favorable depreciation rules contained in the TCJA certainly create incentives for the greater use of cost segregation studies. In addition, care should be taken by the preparer(s) of a cost segregation study. The recent CCA indicates that the IRS is looking to establish that a study author has actual knowledge (under the preponderance of the evidence standard) that the study would result in an understatement of tax liability. See, e.g., Mattingly v. United States, 924 F.2d 785 (8th Cir. 1991). Actual knowledge must be shown. If a cost segregation study is prepared in accordance with the general guidance of Hospital Corporation of America & Subsidiaries, penalties should be avoided. But, ambiguities will very likely exist on the distinction between I.R.C. §1245 and I.R.C. §1250 property.
As Sergeant Esterhaus would say, ”Let’s be careful out there.”
Wednesday, March 27, 2019
While farm and ranch land is typically the largest-valued asset for the business, there may be items of significant value associated with the land. The land is not depreciable, but structures associated with the land are. From a depreciation standpoint, that means that there may be opportunities to allocate costs to personal property or land improvements that are depreciable. How is this allocation accomplished? One approach is to utilize a cost segregation study.
Agricultural cost segregation studies – that’s the topic of today’s post.
Cost Segregation Study – The Basics
A cost segregation study involves the combination of accounting and engineering concepts and techniques to identify costs associated with buildings and other structures and tangible personal property. The identification and allocation of costs to these items allows accelerated depreciation deductions to be available with the result that taxes can be reduced and cash flow for the business increased. Land is not depreciable and farm buildings are depreciated over 20 years.
When it comes to buildings, often a farmer will allocate the majority (if not all) of the cost of acquiring or constructing a building to real property. By doing so, the farmer may be overlooking the chance to allocate costs to personal property that has a shorter depreciation period than the 20 years over which a farm building is depreciated, and/or to depreciable land improvements. For example, the structural components of a building are often depreciable over 5-7 years. This would include such items as walls, windows, HVAC systems, plumbing and wiring. Land improvements are generally depreciable over 15 years.
For many taxpayers, the focus of a cost segregation study may be exclusively on a building. This is often the case, for example, for a commercial business. But, for a farmer, a cost segregation study has a broader application to examine whether depreciable items of personal property aren’t mistakenly lumped in with real property. As applied to farm buildings, a study will see if such things as parsing out the electrical wiring associated with a dairy parlor or a sow feeding system is possible. For fruit and vegetable farming operations, specialized equipment might be involved or there might also be some type of cooling system involved for a particular space or structure.
But, it’s not just buildings that need to be examined when it comes to ag. The farmland must also be looked at to account for improvements that have been made to the land for farming purposes. Land is not depreciable, but improvements to the land used in farming can be. These improvements include such things as pumps and wells that have been installed for irrigation purposes; fences; stock-watering ponds; earthen dams; soil conservation terraces; roads; fences and gates; drainage ditches and; water diversion channels.
Benefits of a Cost Segregation Study
Why conduct a cost segregation study? Depending on the situation, the tax savings that will enhance after-tax cash flow could be worth it. For example, assume that a farm building is acquired along with the purchase of a farm. If the farm was purchased for $500,000 and 100,000 was allocated to the farm building, that $100,000 would be depreciated over 20 years at five percent annually. In other words, the taxpayer could claim a $5,000 deduction annually attributable to the building. But, it may be the case that more of the cost can be allocated to depreciable property with shorter depreciable lives. If so, the depreciation deductions associated with the building and the items in the building will be enhanced. Breaking items out like this can also make it easier to make a partial asset disposition election and aid in deducting removal costs.
A “look-back” cost segregation study may also be used to identify missed deductions from prior years. To claim these deductions Form 3115 (application for a change in accounting method) must be filed with the IRS to claim these “catch-up” deductions on the current year return without filing amended returns. This can also be beneficial in certain circumstances in dealing with the limitations on deducting losses under the post-2017 rules.
Breaking out and identifying items that are depreciable personal property from real estate may also have a property tax benefit. In some states, farm personal property is not taxed for real estate purposes. Thus, if the items of depreciable personal property are broken out with a value assigned to them, real estate taxes may drop.
Another potential benefit of a cost segregation study is that it could result in a greater ability to take advantage of certain aspects of the Tax Cuts and Jobs Act (TCJA) of 2017. Under the TCJA, at least temporarily, first-year bonus depreciation is 100 percent and can apply to both new and used qualified property. In addition, I.R.C. §179 has been increased to $1,000,000 (and indexed), and the phase-out also increased. Thus, property that is reclassified into a category that qualifies for either bonus or expense-method depreciation will generate tax savings. As noted above, there may also be a benefit in dealing with losses.
Is a cost segregation study right for you? It depends on the situation. However, it might be worth having the conversation with your tax professional for a determination of whether it would be beneficial in your particular situation. A cost-segregation study is not cost-free. So, the question is whether the benefits will outweigh the costs. It’s just another consideration when it comes to tax planning for the farm or ranch. Depending on your situation and the type of farming operation that you have, it may be worthwhile. Have you thought about it?
Monday, March 25, 2019
Upon death, particularly the death of the surviving spouse, the estate executor may need to dispose of the decedent’s personal residence. When that happens, numerous tax considerations come into play. There are also some planning aspects to handling the personal residence.
The sale of the personal residence after death – that’s the topic of today’s post.
Income Tax Basis Issues
Upon death, the executor may face the need to dispose of the decedent’s personal residence. The starting point to determining any tax consequences of the disposition involves a determination of income tax basis. If the residence was included in the decedent’s gross estate, the tax basis will be determined in accordance with fair market value as of the date of the decedent’s death under the willing buyer-willing seller test. I.R.C. §1014. That is based largely on sales of comparable properties, and requires more than a simple market analysis by a real estate agent.
If the decedent was the first of the two spouses to die, a determination of how the residence was titled at death will need to be made. For a residence held in joint tenancy or tenancy in common, only the value of the decedent’s share of the residence will be included in the decedent’s estate and receive a basis step-up to fair market value. Id. In common-law property states where the residence is owned in joint tenancy between the spouses, the property is treated at the first death as belonging 50 percent to each spouse for federal estate tax purposes. I.R.C. § 2040(b). This is known as the “fractional share” rule. Thus, one-half of the value is taxed at the death of the first spouse to die and one-half receives a new income tax basis. However, in 1992 the Sixth Circuit Court of Appeals applied the “consideration furnished rule” to a husband-wife joint tenancy involving farmland. Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992). The result was that the entire value of the land acquired before 1977 was included in the estate of the first spouse to die. That meant that the full value was subject to federal estate tax, but was covered by the 100 percent federal estate tax marital deduction. The entire property received a new income tax basis which was the objective of the surviving spouse. Other federal courts have reached the same conclusion.
If the residence is community property, the decedent’s entire interest will receive a basis step-up to fair market value. If the residence is held in joint tenancy with rights of survivorship, the decedent’s interest passed by the survivorship designation to the designated survivor.
If a surviving spouse sells the marital home shortly after the first spouse’s death, the survivor will often realize a loss largely due to the expenses incurred with respect to the sale. If the survivor realizes a gain, then, the survivor is eligible for the $250,000 exclusion of gain. I.R.C. §121. That exclusion is a maximum of $500,000 if the sale occurs within two years of the first spouse’s death.
Residence Held in Trust
A revocable trust is a common estate planning tool. If the decedent’s personal residence was held in a revocable trust and passed to the surviving spouse upon the first spouse’s death under the terms of the trust to continue to be held in trust, the house receives a full step-up (or down) in basis to the current fair market value at the death of the surviving spouse. If the house is distributed outright to a beneficiary (or beneficiaries) and then the beneficiary immediately sells the home, a loss generally will be a nondeductible personal loss unless the home is first converted to a rental property before it is sold. This is a key point that may require some planning to allow for rental use for a period of time before sale.
If the residence must be sold by the estate or trust to pay debts or to satisfy cash distributions to beneficiaries, any loss on the sale might be deductible. That loss could potentially offset other income of the trust or estate, or it could flow through to the beneficiaries. However, the IRS position is that an estate or a trust cannot claim such a loss unless the residence is a rental property or is converted to a rental property before it is sold. This position has not been widely supported by the courts which have determined that a trust or estate can claim such a loss if no beneficiaries use the home as a residence after the decedent’s death and before it is sold. It is important to get good tax counsel on this issue. It’s an issue that comes up not infrequently.
The sale of the personal residence after death presents numerous tax issues. With a modest level of planning, negative tax consequences can be avoided and helpful tax provisions can be taken advantage of.
Wednesday, March 13, 2019
Last April I devoted a post to the general grouping rules under I.R.C. §469. https://lawprofessors.typepad.com/agriculturallaw/2018/04/passive-activities-and-grouping.html Those rules allow the grouping of passive investment activities with other activities in which the taxpayer materially participates. Thus, for example, an investor in an ethanol plant might be able to group the losses from that investment with the taxpayer’s farming activity. Grouping may make it more likely that the taxpayer can avoid the passive loss rules and fully deduct any resulting losses.
But, there’s another grouping rule – one that applies to a taxpayer that has satisfied the tests to be a real estate professional and it’s only for purposes of determining material participation in rental activities. This election is an all-or-nothing election – either all of the taxpayer’s rental activities are aggregated or none of them are.
The aggregation election for real estate professionals – that’s the focus of today’s post.
Real Estate Professional
In last Thursday’s post, https://lawprofessors.typepad.com/agriculturallaw/2019/03/passive-losses-and-real-estate-professionals.html I detailed the rules under I.R.C. §469 pertaining to a real estate professional. To qualify as a “real estate professional” two test must be satisfied: (1) more than 50 percent of the personal services that the taxpayer performs in trades or business for the tax year must be performed in real property trades or businesses in which the taxpayer materially participates; and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. I.R.C. §469(c)(7). If the two tests are satisfied, as noted above, the rental activity is no longer presumed to be passive and, if material participation is present, the rental activity is non-passive. I.R.C. §469(c)(7)(A)(i).Another way of putting is that once the tests of I.R.C. §469(c)(7) are satisfied it doesn’t necessarily mean that rental losses are non-passive and deductible, it just means that the rental losses aren’t per se as passive under I.R.C. §469(c)(2). See, e.g., Gragg v. United States, 831 F.3d 1189 (9th Cir. 2016); Perez v. Comr., T.C. Memo. 2010-232. An additional step remains – the taxpayer must materially participate in each separate rental activity (if there are multiple activities).
Note: The issue of whether a taxpayer is a real estate professional is determined on an annual basis. See, e.g., Bailey v. Comr., T.C. Memo. 2001-296. In addition, when a joint return is filed, the requirements to qualify as a real estate professional are satisfied if either spouse separately satisfies the requirements. I.R.C. §469(c)(7)(B).
Is Separate Really the Rule?
As noted above, if a taxpayer has multiple rental activities, the taxpayer must materially participate in each activity. That can be a rather harsh rule. But, there is an exception. Actually, there are two. If material participation test cannot be satisfied, the taxpayer can use a relaxed rule of active participation. I.R.C. §469(i). That rule allows the deduction of up to $25,000 of losses (subject to an income phase-out). In addition, the taxpayer can make an election to aggregate all of the rental activities that the taxpayer is involved in for purposes of meeting the material participation test. Treas. Reg. §1.469-9(g)(1). This aggregation election is available to a taxpayer that has satisfied the requirements to be a qualified real estate professional under I.R.C. §469(c)(7). See, e.g., C.C.A. 201427016 (Jul 3, 2014).
Points on aggregation. Aggregation only applies to the taxpayer’s rental activities. Activities that aren’t rental activities can’t be grouped with rental activities. In addition, it’s only for purposes of determining whether the material participation test has been met. Because the election only applies to rental activities, time spent on non-rental activities won’t help the taxpayer meet the material participation test for the rental activities. This makes the definition of a “rental activity” important. I highlighted the designated rental activities in last Thursday’s post. One of them is that the real estate must be used in a rental activity rather be realty that is held in the taxpayer’s trade or business where the average period of customer use for the property is seven days or less. Temp. Treas. Reg. §1.469-1T(e)(3)(ii); see also Bailey v. Comr., T.C. Memo. 2001-296.
By election only. Aggregation is accomplished only by election. Treas. Reg. §1.469-9(g)(3). It’s not enough to simply list all of the rental activities of the taxpayer in a single column on Schedule E. In Kosonen v. Comr., T.C. Memo. 2000-107, the petitioner owned seven residential rental properties. As of the beginning of 1994, he had non-deductible suspended losses of $215,860 from his properties. He put in almost 1,000 hours in rental activities in each of 1994 and 1995. On this 1994 return, he listed each rental property and loss separately on Schedule E and reported a combined loss of $56,954 on line 42 of Schedule E – the line where a taxpayer that is materially participating in rental activities reports net income or loss from all rental activities. He also reported the loss on line 17 of Form 1040 and subtracted it from other income to compute his adjusted gross income. He also filed Form 8582 to report the $56,954 loss. However, he didn’t attach an aggregation statement to the return noting that he was electing to treat his rental real estate activities as a single activity. He also didn’t combine his 1994 Schedule E rental real estate losses with his previously suspended losses. The IRS noted that had a proper election been made that the petitioner would have satisfied the material participation requirement. But, the IRS took the position that an election had not been made and as a result the material participation requirement had to be satisfied with respect to each separate activity. Because he could meet the material participation test in any single activity by itself, the IRS asserted, the resulting losses were suspended and couldn’t offset active income. The Tax Court agreed with the IRS. While the form of his entries on the return were consistent with an aggregation election, the Tax Court held that his method of reporting net losses as active income was not clear notice of an aggregation election. The fact that the IRS had not yet issued guidance on how to make an aggregation election didn’t eliminate the statutory requirement to aggregate, the Tax Court concluded.
Attached statement. To satisfy the statutory election requirement, the election statement attached to the return should clearly state that an election to aggregate rental activities is being made via I.R.C. §469(c)(7)(A) and that the taxpayer is a qualifying taxpayer in accordance with I.R.C. §469(c)(7)(B).
Late election relief. It is possible to make a late election via an amended return. In Rev. Proc. 2011-34, 2011-24 I.R.B. 875, the IRS said a late election can be made in situations where the taxpayer has filed returns that are consistent with having made the election. In that event, the late election applies to all tax years for which the taxpayer is seeking relief. The late election is made by making the election in the proper manner as indicated above as an attachment to the amended return for the current tax year. The attachment must identify the tax year(s) for which the late election is to apply, and explain why a timely election wasn’t initially made. The opportunity to make a late election is important. See, e.g., Estate of Ramirez, et al. v. Comr., T.C. Memo. 2018-196.
Binding election. The aggregation election cannot be revoked once it is made – it is binding for the tax year in which it is made and for all future years in which the taxpayer is a qualifying real estate professional. If intervening years exist in which the taxpayer was not a qualified real estate professional, the election has no effect in those years and the taxpayer’s activities will be evaluated under the general grouping rule of Treas. Reg. §1.469-4. Treas. Reg. §1.469-9(g)(1).
Years applicable. If the election hasn’t been made in a year during which the taxpayer was a qualified real estate professional, it can still be made in a later year. But, the election is of no effect if it is made in a year that the taxpayer doesn’t satisfy the requirements to be a real estate professional. Treas. Reg. §1.469-9(g)(1). In other words, the election may be made in any year in which the taxpayer is a qualifying taxpayer for any tax year in which the taxpayer is a qualifying taxpayer. In addition, the failure to make the election in one year doesn't bar the taxpayer from making the election in a later year. Treas. Regs. §§1.469-9(g)(1) and (3).
Revocation. While the aggregation election is normally binding, the aggregation election can be revoked for a year during which the taxpayer’s facts and circumstances change in a material way. If that happens, the election can be revoked by filing a statement with the original tax return for that year. According to the regulations, the statement must provide that the I.R.C. §469(c)(7)(A) election is being revoked and describe the material change in the taxpayer’s factual situation that justifies the revocation. Treas. Reg. §1.469-9(g)(3).
Rental real estate activities held in limited partnerships. What happens if the taxpayer makes the election to aggregate all real estate rental activities but not all of the taxpayer’s interests in real estate activities are held individually by the taxpayer? The regulations address this possibility and use an example of an interest in a rental real estate activity held by the taxpayer as a limited partnership interest. Treas. Reg. §1.469-9(f)(1). The result is that the effect of the aggregation election doesn’t necessarily apply in this situation. Instead, the taxpayer’s combined rental activities are deemed to be a limited partnership interest when determining material participation and the taxpayer must establish material participation under one of the tests that apply to determine the material participation of a limited partner contained in Treas. Reg. 1.469-5T(e)(2). Treas. Reg. §1.469-9(f)(1). But, there is a de minimis exception that applies if the taxpayer’s share of gross rental income from all limited partnership interests in rental real estate is less than 10 percent of the taxpayer’s share of gross rental income from all of the taxpayer’s interests in rental real estate for the tax year. In this situation, the taxpayer can determine material participation by using any of the tests for material participation in Treas. Reg. §1.469-5T(a) that apply to rental real estate activities. Treas. Reg. §1.469-9(f)(2). This is also the rule if the taxpayer has an interest in a rental real estate activity via an LLC. An LLC interest is not treated as a limited partnership interest for this purpose. Thus, the taxpayer can use any of the seven tests for material participation contained in Treas. Reg. §1.469-5T(a). See, e.g., Garnett v. Comr., 132 T.C. 368 (2009); Hegarty v. Comr., T.C. Sum. Op. 2009-153; Newell v. Comr., T.C. Memo. 2010-23; Thompson v. Comr., 87 Fed. Cl. 728 (2009), acq. in result only, A.O.D. 2010-002 (Apr. 5, 2010); Chambers v. Comr., T.C. Sum. Op. 2012-91.
It should be noted that in its 2017-2018 Priority Guidance Plan, the IRS stated that it planned to finalize regulations under I.R.C. §469(h)(2). That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. Those regulations were initially issued in temporary form and became proposed regulations in 2011. Until the IRS takes action to effectively overturn the Tax Court decisions via regulation, the issue will boil down (as it has in the Tax Court cases referenced above) to an analysis of a particular state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership.
Effect on losses. The aggregation election also impacts the handling of losses. Once the aggregation election is made, prior year disallowed passive losses from any of the aggregated real estate rental activities can be used to offset current net income from the aggregated activities regardless of which activity produces the income or prior year loss. At least this is the position take in the preamble to the regulations. See Preamble to T.D. 8645 (Dec. 21, 1995). This is the result even if the disallowed prior year losses occurred in tax years before the aggregation election was made. Treas. Reg. §1.469-9(e)(4).
Any suspended losses remain suspended until substantially all of the combined activities (by virtue of the election) are disposed of in a fully taxable transaction. This would be an issue if a rental real estate activity with a suspended loss is aggregated with other rental real estate activities. Those suspended losses would not be deductible until the entire aggregated activity (now treated as a single activity) is disposed of. Thus, depending on the amount of the suspended losses at issue, it may not be a good idea to make the aggregation election in this situation. Likewise, it also may not be a good idea to make the aggregation election if the taxpayer has positive net income from rental real estate activities and passive losses from activities other than rental real estate activities. If the election is made in this situation, the rental activities won’t be passive, and the taxpayer won’t be able to use the losses from the other passive activities to offset the income from the rental real estate activities. The losses could then end up being suspended and non-deductible until the entire (combined) activity is disposed of.
The aggregation election is an election that is available only for real estate professionals and can make satisfying the material participation test easier. That can allow for full deductibility of losses from rental real estate activities. But, the terrain is rocky. Good tax advice and planning is essential.
Monday, March 11, 2019
Earlier in the year I devoted a blog post to a few current developments in the realm of agricultural law and taxation. That post was quite popular with numerous requests to devote a post to recent developments periodically. As a result, I take a break from my series of posts on the passive loss rules to feature some current developments.
Selected recent developments in agricultural law and taxation – that’s the topic of today’s post.
While economic matters remain tough in Midwest crop agriculture and dairy operations all over the country and the projection is for the third-lowest net farm income in the past 10 years, it hasn’t resulted in an increase in Chapter 12 bankruptcy filings. For the fiscal year ended September 30, 2018, filings nationwide were down 8 percent from the prior fiscal year. However, the number of filing is still about 25 percent higher than it was in 2014. The filings, however, are concentrated in the parts of the country where traditional row crops are grown and livestock and dairy operations predominate. For example, according to the U.S. Courts and reports filed by the Chapter 12 trustees, the states comprising the U.S. Circuit Court of Appeals for the Eighth Circuit (Midwest and northern Central Plains) show a 45 percent increase in Chapter 12 filings when fiscal year 2018 is compared to fiscal year 2017. The Second Circuit (parts of the Northeast) is up 38 percent during the same timeframe. Offsetting these numbers are the Eleventh Circuit (Southeast) which showed a 47 percent decline in filings during fiscal year 2018 compared to fiscal year 2017. The far West and Northwest also showed a 41 percent decline in filings during the same timeframe.
USDA data indicates some rough economic/financial data. Debt-to-asset ratios are on the rise and the debt-service ratio (the share of ag production that is used for ag payments) is projected to reach an all-time high. The current ratio for farming operations is projected to reach an all-time low (but this data has only been kept since 2009). Unfortunately, the U.S. is very good at infusing agriculture with debt capital. In addition, there are numerous tax incentives for the seller financing of farmland. In addition, federal farm programs encourage higher debt levels to the extent they artificially reduce farming risk. This accelerates economic vulnerability when farm asset values decline.
Recent case. A recent Virginia case illustrates how important it is for a farmer to comply with all of the Chapter 12 rules when trying to get a Chapter 12 reorganization plan confirmed. In In re Akers, 594 B.R. 362 (Bankr. W.D. Va. 2019), the debtor owed three secured creditors approximately $350,000 in addition to other unsecured creditors. Two of the secured creditors and the trustee objected to the debtor’s proposed reorganization plan. At the hearing on the confirmation of the reorganization plan, it was revealed that the debtor had not provided any of the required monthly reports. As a result, the court denied plan confirmation and required the debtor to put together an amended plan. The debtor subsequently submitted multiple amended plans, and all were denied confirmation because of the debtor’s inaccurate financial reporting and miscalculation of income and expense. In addition, the current proposed plan was not clear as to how much the largest creditor was to be paid. The creditor had foreclosed, and some payments had been made but the payments were not detailed in the plan. The court denied plan confirmation and denied the debtor’s request to file another amended plan and dismissed the case. The court was not convinced that the debtor would ever be able to put together an accurate and manageable plan that he could comply with, having already had five opportunities to do so.
A recent Iowa case illustrates the need for ag producers to put business agreements in writing. In Quality Egg, LLC v. Hickmans’s Egg Ranch, Inc., No 17-1690, 2019 Iowa App. LEXIS 158 (Iowa App. Ct. Feb. 20, 2019), the plaintiff, in 2002, entered into an oral contract to sell eggs to the defendant via a formula to determine the price paid for the eggs. The business relationship continued smoothly until 2008, when the plaintiff received a check from the defendant that it determined to be far short of the amount due on the account. Notwithstanding the discrepancy, the parties continued doing business until 2011. In 2014, the plaintiff filed sued to recover the amount due, claiming that the defendant purchased eggs on an open account, and still owed about $1.2 million on that account. The defendant counter-claimed, asserting that the transaction did not involve an open account but simply an oral contract to purchase eggs that had been modified in 2008. Consequently, the defendant claimed that the disputed amount was roughly $580,000, based on the modified oral contract.
The trial court jury found that the ongoing series of transactions for the sale and purchase of eggs was an “open and continuous account” at the time of the short pay, yet still found for the defendant. The plaintiff appealed, asserting that the trial court had erred by allowing oral testimony used to prove the existence of a modified oral contract in violation of the statute of frauds. The appellate court remanded for a new trial on the issue, and the second jury trial in 2017 again found for the defendant. The plaintiff again appealed, asserting the statute of frauds as a defense. The plaintiff also asserted that the trial court had failed to instruct the jury on an open account, depriving the jury of the ability to decide the specific elements of its open account claim. The trial court provided only jury instructions on the elements of the breach of contract counter-claim brought by the defendant. On the statute of frauds issue, the appellate court noted that the defendant had admitted written correspondence, checks, and credit statements to support the oral testimony at trial in support of the oral testimony. Thus, the statute of frauds was not violated. However, on the open account jury instruction issue, the appellate court found that the instructions given were improper because the plaintiff’s burden was to prove its claim of money due on an open account, not to disprove an assertion from the defendant of an amended oral contract. The appellate court found that the instructions never mentioned an open account or discussed an open account in any way, and because of that, the jury was never able to render a proper verdict on the plaintiff’s claim. Accordingly, the appellate court concluded that the jury instructions were insufficient and reversed and remanded for a new trial limited to the open-account claim.
Get it in writing!
The qualified business income deduction (QBID) continues to bedevil the tax software programs. It’s the primary reason that the IRS extended the March 1 filing deadline to April 15. The IRS also released a draft Form 8995 to use in calculating the QBID for 2019 returns. But, the actual calculation of the QBID is not that complicated. The difficult part is knowing what is QBI and whether the specified service trade or business limits apply. No worksheet is going to help with that. Understand the concepts! Also, the IRS now says that a PDF attachment of the safe harbor election for rental activities must be combined with the e-filed return. In addition, the election must be signed under penalty of perjury. As I see it, this is just another reason to not use the QBID safe harbor election if you don’t have to.
The U.S. Senate is finally working on tax extender legislation that will extend provisions that expired at the end of 2017. The legislation would extend those expired provisions for two years, 2018-2019. The Senate Finance Committee has released a summary of the proposed bill language: https://www.finance.senate.gov/imo/media/doc/Tax%20Extender%20and%20Disaster%20Relief%20Act%20of%202019%20Summary.pdf
Court says that “Roberts tax” is a non-dischargeable priority claim in bankruptcy. United States v. Chesteen, No. 18-2077, 2019 U.S. Dist. LEXIS 29346 (E.D. La. Feb. 25, 2019). The debtor filed Chapter 13 bankruptcy. The IRS filed a proof of priority claim for $5,100.10, later amending the claim to $5,795.10 with $695 of that amount being an excise tax under I.R.C. §5000A as a result of the debtor’s failure to maintain government mandated health insurance under Obamacare. The debtor object to the $695 amount being a priority claim that could not be discharged, and the bankruptcy court agreed, finding that the “Roberts Tax” under Obamacare was not a priority claim, but rather a dischargeable penalty in a Chapter 13 case. On appeal, the appellate court reversed. The appellate court noted that the creditor bore the burden to establish that the Roberts Tax was a priority claim and noted that it was the purpose and substance of the statute creating the tax that controlled whether the tax was a tax or a penalty. The appellate court noted that a tax is a pecuniary burden levied for the purpose of supporting government while a monetary penalty is a punishment for an unlawful act or omission. On this point, the appellate court noted that Chief Justice Roberts, in National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012), upheld the constitutionality of Obamacare on the basis that the “shared responsibility payment” was a tax paid via a federal income tax return and had no application to persons who did not pay federal income tax. The appellate court noted that the amount was collected by the IRS and produced revenue for the government. It also did not punish an individual for any unlawful activity and, the appellate court noted, the IRS has no criminal enforcement authority if a taxpayer failed to pay the amount.
Court says that the IRS can charge for PTINs.In 2010 and 2011, the Treasury Department developed regulations that imposed certain requirements that an individual had to comply with to be able to prepare tax returns for a fee - a person had to become a “registered tax return preparer.” These previously unregulated persons had to pass a one-time competency exam and a suitability check. They also had to (along with all other preparers) obtain a Preparer Tax Identification Number (PTIN) and paying a user fee to obtain the PTIN. The plaintiff class challenged the authority of the government to require a PTIN and charge a fee for obtaining it. The IRS claimed that the regulations were necessary for the need to oversee tax return preparers to ensure good service. I.R.C. §6109(a)(4), in existence prior to the regulations at issue, requires a preparer to provide identification and state that the preparer’s social security number shall be used as the required identification. The regulations at issue, however, required preparers to obtain (at a fee paid to the Treasury) a PTIN as the identifying number. Preparers without a PTIN could no longer prepare returns for a fee. The IRS argued that by creating the PTIN requirement, it had created a “thing of value” which allowed it to charge a fee, citing 31 U.S.C. §9701(b). However, the plaintiffs claimed that the PTIN requirements are arbitrary and capricious under the Administrative Procedure Act or, alternatively is unlawful as an unauthorized exercise of licensing authority over tax return preparers because the fee does not confer a “service or thing of value.”
The trial court determined that the IRS can require the exclusive use of a PTIN because it aids in the identification and oversight of preparers and their administration. However, the trial court held that the IRS cannot impose user fees for PTINs. The trial court determined that PTINs are not a “service or thing of value” because they are interrelated to testing and eligibility requirements and the accuracy of tax returns is unrelated to paying a PTIN fee. Steele v. United States, 260 F. Supp. 3d 52 (D. D.C. 2017). A prior federal court decision held that the IRS cannot regulate tax return preparers (Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2014), thus charging a fee for a PTIN would be the equivalent of imposing a regulatory licensing scheme which IRS cannot do. The trial court determined that prior caselaw holding that the IRS can charge a fee for a PTIN were issued before the Loving decision and are no longer good law.
On appeal, the appellate court vacated the trial court’s decision and remanded the case. The appellate court determined that the IRS does provide a service in exchange for the PTIN fee which the court defined as the service of providing preparers a PTIN and enabling preparers to place the PTIN on a return rather than their Social Security number and generating and maintaining a PTIN database. Thus, according to the appellate court, the PTIN fee was associated with an “identifiable group” rather than the public at large and the fee was justified on that ground under the Independent Offices Appropriations Act. The appellate court also believed the IRS claim that the PTIN fee improves tax compliance and administration. The appellate court remanded the case for further proceeding, including an assessment of whether the amount of the PTIN fee unreasonable exceeds the costs to the IRS to issue and maintain PTINs. Montrois, et al. v. United States, No. 17-5204, 2019 U.S. App. LEXIS 6260 (D.C. Cir. Mar. 1, 2019), vac’g,. and rem’g., Steele v. United States, 260 F. Supp. 3d 52 (D. D.C. 2017).
Sanders (and Democrat) transfer tax proposals. The Tax Cuts and Jobs Act (TCJA) increased the exemption equivalent of the federal estate and gift tax unified credit to (for 2019) $11.4 million. Beginning for deaths occurring and for gifts made in 2026, the $11.4 million drops to the pre-TCJA level ($5 million adjusted for inflation). That will catch more taxpayers. This is, of course, if the Congress doesn’t change the amount before 2026. S. 309, recently filed in the Senate by Presidential candidate Bernie Sanders provides insight as to what the tax rules impacting estate and business planning would look like if he (or probably any other Democrat candidate for that matter) were ever to win the White House and have a compliant Congress. The bill drops the unified credit exemption to $3.5 million and raises the maximum tax rate to 77 percent (up from the present 40 percent. It would also eliminate entity valuation discounts with respect to entity assets that aren’t business assets, and impose a 10-year minimum term for grantor retained annuity trusts. In addition, the bill would require the inclusion of a grantor trust in the estate of the owner and would limit the generation-skipping transfer tax exemption to a 50-year term. The present interest gift tax exclusion would also be reduced from its present level of $15,000.
These are just a snippet of the many developments in agricultural taxation and law recently. Of course, you can find more of these developments on the annotation pages of my website – www.washburnlaw.edu/waltr. I also use Twitter to convey education information. If you have a twitter account, you can follow me at @WashburnWaltr. On my website you will also find my CPE calendar. My national travels for the year start in earnest later this week with a presentation in Milwaukee. Later this month finds me in Wyoming. Also, forthcoming soon is the agenda and registration information for the ag law and tax seminar in Steamboat Springs, Colorado on August 12-14. Hope to see you at an event this year.
On Wednesday, I resume my perusal of the rental real estate exception of the passive loss rules. I get a break on the teaching side of things this week – it’s Spring Break week at both the law school and at Kansas State University.
Thursday, March 7, 2019
Tuesday’s post was the first installment in a series of blog posts on the passive loss rules of I.R.C. §469. In that post, I noted that under I.R.C. §469, a taxpayer is limited in the ability to use losses from passive activities against income from a trade or business that the taxpayer is engaged in. In that post, I noted that a passive activity includes trades and businesses in which the taxpayer does not materially participate. Active participation provides a limited ability to deduct losses.
While a rental activity is normally treated as “per se” passive by presumption, if the taxpayer is deemed to be a “real estate professional” then the presumption is overcome, and the taxpayer will be treated as non-passive if the taxpayer materially participates in the rental activity.
The rule that rents are presumed to be passive is also a concern because of the Net Investment Income Tax (NIIT). I.R.C. §1411. The NIIT imposes an additional tax of 3.8 percent on passive income, including passive rental income.
The real estate professional test of the passive loss rules – that’s the topic of today’s post.
History and Basics of the Rule
As noted in Tuesday’s post, the passive loss rules of I.R.C. §469 became effective for tax years beginning after December 31, 1986. As originally enacted, a passive activity was defined to include any rental activity regardless of much the taxpayer participated in the activity. This barred rental activities from being used to shelter the taxpayer’s income from other trade or business activity. Rental activities could often produce a tax loss particularly due to depreciation deductions while the underlying property simultaneously appreciated in value. The rule was particularly harsh on real estate developers with multiple development projects. One project would be developed and sold while another project would be rented out. In this situation, the developer had two activities - one that was the taxpayer’s trade or business activity (non-passive); and one that was a rental activity (passive). This produced a different result, for example, from what a farmer would achieve if the farmer lost money on the livestock side of the business while making money on the crop portion. In that situation, the livestock loss would offset the crop income.
To address this perceived inequity, the Congress amended the passive loss rules to provide a narrow exception to the per se categorization of rental activities as passive. Under the exception, a “real estate professional” that materially participates in a rental activity is not engaged in a passive activity. I.R.C. §469(c)(7). Thus, rental activities remain passive activities unless the taxpayer satisfies the requirements to be a real estate professional.
To be a real estate professional two tests must be satisfied: (1) more that 50 percent of the personal services that the taxpayer performs in trades or business for the tax year must be performed in real property trades or businesses in which the taxpayer materially participates; and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. I.R.C. §469(c)(7). If the two tests are satisfied, as noted above, the rental activity is no longer presumed to be passive and, if material participation is present, the rental activity is non-passive. I.R.C. §469(c)(7)(A)(i).
The issue of whether a taxpayer is a real estate professional is determined on an annual basis. See, e.g., Bailey v. Comr., T.C. Memo. 2001-296.
What is a Real Property Trade Or Business?
To qualify for the real estate professional exception, the taxpayer must perform services in a real property trade or business. Obviously, production agriculture involves farm and ranch land. This raises a question as to the types of business associated with farming and ranching that could be engaged in a real property trade or business for purposes of the passive loss rules. Under I.R.C. §469(c)(7)(C), those are: real property development; redevelopment construction; reconstruction; acquisition; conversion; rental; operation; management; leasing; or brokerage.
Mortgage brokers and real estate agents present an interesting question as to whether they are engaged in a real estate trade or business. In general, a mortgage broker is not deemed to be engaged in a real property trade or business for purposes of the passive loss rules. That’s the outcome even if state law considers the taxpayer to be in a real estate business. What the courts and IRS have determined is that brokerage, to be a real estate business, must involve the bringing together of real estate buyers and sellers. It doesn’t include brokering financial instruments. See, e.g., Guarino v. Comr., T.C. Sum. Op. 2016-12; C.C.A. 201504010 (Dec. 17, 2014). The definition of a real estate trade or business also does not include mortgage brokering. See, e.g., Hickam v. Comr., T.C. Sum. Op. 2017-66. But, if a licensed real estate agent negotiates real estate contracts, lists real estate for sale and finds prospective buyers, that is likely enough for the agent to be deemed to be in a real estate trade or business for purposes of the passive loss rules. See, e.g., Agarwal v. Comr., T.C. Sum. Op. 2009-29.
A licensed farm real estate appraiser might also be determined to be in a real estate trade or business if the facts are right. See, e.g., Calvanico v. Comr., T.C. Sum. Op. 2015-64. A real estate appraisal business involves direct work in the real estate industry. But, associated services that are only indirectly related to the trade or business of real estate (such as a service business associated with real estate) would not seem to meet the requirements of I.R.C. §469(c)(7). Indeed, this is the position the IRS has taken in its audit technique guide for passive activities. See IRS Passive Activity Loss Audit Technique Guide at www.irs.gov/pub/irs-mssp/pal.pdf
What about a taxpayer that works for a farm management company? The services of a farm management company are a bit different than a real estate management company that is engaged in the real estate business. See, e.g., Stanley v. United States, No. 5:14-CV-05236, 2015 U.S. Dist. LEXIS 153166 (W.D. Ark. Nov. 12, 2015), nonacq., A.O.D. 2017-07 (Oct. 16, 2017). But, perhaps services performed that directly relate to the real estate business would count – putting together rental arrangements, managing the leases, dealing with on-farm tenant housing, etc. Economic related services such as cropping and livestock decisions would seem to not be real estate related. In any event, the taxpayer would need to be at least a five percent owner of the farm management company for the taxpayer’s hours to count toward the I.R.C. §469(c)(7) tests. I.R.C. §469(c)(7)(D)(ii); Treas. Reg. §1.469-9(c)(5).
Importantly, a real property trade or business can be comprised of multiple real estate trade or business activities. Treas. Reg. §1.469-9(d)(1). This implies that multiple activities can be grouped together into a single activity. That is, indeed, the case. Treas. Reg. §1.469-4 allows the grouping of activities that represent an “appropriate economic unit.” Under that standard, non-rental activities cannot be grouped with rental activities. Treas. Reg. §1.469-9(g) allows a real estate professional to group all interests in rental activities as a single activity. If this election is made, the real estate professional can add all of their time spent on all of the rental activities together for purposes of the 750-hour test.
In Chief Counsel Advice 201427016 (Apr. 28, 2014), the IRS stated that the Treas. Reg. §1.469-9(g) aggregation election “is relevant only after the determination of whether the taxpayer is a qualifying taxpayer.” Thus, whether a taxpayer is a real estate professional for purposes of the passive loss rules is not affected by an election under Treas. Reg. §1.469-9(g). In other words, the election under Treas. Reg. 1.469-9(g) has no bearing on the issue of whether a taxpayer qualifies as a real estate professional – puts in more than 750 hours in real estate activities and satisfies the 50 percent test. See also Miller v. Comr., T.C. Memo. 2011-219. But, grouping can make it easier for the taxpayer to meet the required hours test of I.R.C. §469(c)(7) and be deemed to be materially participating in the activity.
Regroupings are not allowed in later years unless the facts and circumstances change significantly, or the initial grouping was clearly not appropriate. Treas. Reg. §1.469-9(d)(2).
The IRS has taken the position that only an individual can be a real estate professional for purposes of the passive loss rules. C.C.A. 201244017 (Nov. 2, 2012). That’s important as applied to trusts. Much farm and ranch land that is rented out is held in trust. That would mean that the only way the trust rental income would not be passive is if the trustee, acting in the capacity as trustee, satisfies the tests of I.R.C. §469(c)(7). The one federal district court that has addressed the issue has rejected the IRS position. Mattie Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003). The Tax Court agrees.
In Frank Aragona Trust v. Comr., 142 T.C. 165 (2014), a trust incurred losses from rental activities which the IRS treated as passive. The trust had six trustees – the settlor’s five children and an independent trustee. One of the children handled the daily operation of the trust activities and the other trustees acted as a managing board. Also, three of the children (including the one handling daily operations) were full-time employees of an LLC that the trust owned. The LLC was treated as a disregarded entity and operated most of the rental properties. The trust had essentially no activity other than the rental real estate. The IRS, in treating the losses as passive said that the trustees were acting as LLC employees and not as trustees. The Tax Court disagreed with the IRS position, finding that the trust materially participated in the rental real estate activities and that the losses were non-passive. The trustees, the Tax Court noted, managed the trust assets for the beneficiaries, and if the trustees are individuals and work on a trade or business as part of their duties, then their work would be “performed by an individual in connection with a trade or business.” Thus, a trust, rather than just the trustees, is capable of performing personal services.
The Tax Court’s position in Frank Aragona Trust could be particularly important in agriculture. A great deal of leased farm ground is held in trust. The trust will be able to meet the material participation standard via the conduct of the trustees. That will allow full deductibility of losses. In addition, the trust income will not be subjected to the additional 3.8 percent tax of I.R.C. §1411.
The real estate professional exception to the per se rule that rental activities are passive is an important one. The issue may occur quite often in agricultural settings. In the next post on Monday, we will dig a little further on the passive loss rules.
Tuesday, March 5, 2019
The passive loss rules have a substantial impact on farmers and ranchers and investors in farm and ranch land. Until 1987, it was commonplace for non-farm investors to purchase agricultural real estate and run up losses which were used to offset the investor's wage or other income. However, the Congress stepped-in and enacted the passive loss rules in 1986. I.R.C. §469. Those rules reduce the possibility of offsetting passive losses against active income unless the taxpayer materially participates in the activity.
A look at the passive loss rules and material participation – that’s the topic of today’s post.
The Basic Concept
The passive loss rules apply to activities that involve the conduct of a trade or business and the taxpayer does not materially participate in the activity or in rental activity on a basis which is regular, continuous and substantial. If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains).
For farmers, the passive loss rules are likely to come into play in situations where the farmer is a passive investor in a separate business venture apart from the farming operation. In that case, the losses from the venture cannot be used to offset the income from the farming operation. The rules also get invoked when a non-farmer loses money in an activity that is a purported farming activity.
Unless an investor or other individual can meet one of two critical tests, the passive loss rules apply. The first of these tests is the test of material participation. If an individual can satisfy the material participation test, then passive losses can be deducted against active income. If, for example, a physician is materially participating in a farming or ranching activity, the losses from the farming or ranching activity can be used as a deduction against the physician's income from the practice of medicine.
Does an agent’s activity count? An investor is treated as materially participating in an activity only if the person “is involved in the operation of the activity on a basis which is regular, continuous, and substantial.” I.R.C. §469(h)(1). In determining whether an individual taxpayer materially participates (or actively participates), the participation of the taxpayer's spouse is taken into account, whether or not they file a joint income tax return. In addition, while the statute refers to material participation by the taxpayer, it does not specifically bar imputation of the services of an agent or specifically embrace the rules of the self-employment tax statute (I.R.C. § 1402), which does bar the ability of a taxpayer to impute the of an agent. However, a Committee Report and the regulations state that activities of an agent are not attributed to an individual taxpayer and the individual must personally perform sufficient services to establish material participation. Indeed, an individual’s own participation is not taken into account if a paid manager participates in the activity and someone else performs services in connection with management of the activity which exceed the amount of service performed by the taxpayer. See, e.g., Robison v. Comm’r, T.C. Memo. 2018-88.
Satisfying material participation. Farm and ranch taxpayers can qualify as materially participating if they materially participated for five or more years in the eight-year period before retirement or disability. In addition, the material participation test is met by surviving spouses who inherit qualified real property from a deceased spouse if the surviving spouse engages in “active management.” C corporations are treated as materially participating in an activity with respect to which one or more shareholders, owning a total of more than 50 percent of the outstanding corporate stock, materially participates. Treas. Reg. §1.469-1T(g)(3)(i)(A). In other words, the corporation must be organized such that at least one shareholder materially participates, and the materially participating shareholders own more than 50 percent of the corporate stock. Estates and trusts, except for grantor trusts are treated as materially participating (or as actively participating) if a fiduciary meets the participation test. See, e.g., Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003); Aragona Trust v. Comr., 142 T.C. 165 (2014).
Regulations. In February 1988, the IRS issued temporary regulations specifying the requirements for the material participation test. Treas. Reg. 1.469-5T. These regulations have great relevance, especially for tenants renting agricultural real estate from the local physician, veterinarian or lawyer or any other non-farm investor. The temporary regulations lay out seven tests for material participation.
Under the first test, an individual is considered to be materially participating if the individual participates in the activity for more than 500 hours during the year. Treas. Reg. §1.469-5T(a)(1). This is a substantial amount of time; almost ten hours per week. In fact, this is more time than some tenants put into the operation on an annual basis. As a result, this test is exceedingly difficult for most investors to satisfy.
The second test involves situations where an individual's participation is less than 500 hours, but constitutes “substantially all of the participation” in the activity by all individuals during the year. Treas. Reg. §1.469-5T(a)(2). In other words, if the investor puts in less than 500 hours annually in the farming or ranching operation, but substantially all of the involvement comes from the investor, the material participation test will be satisfied. However, the investor cannot meet this test if there is a tenant involved, because a tenant will probably put more time in than the investor. Consequently, this test also tends to be difficult to meet.
Under the third test, an individual is considered to be materially participating if the individual puts more than 100 hours per year into the activity and the individual's participation is not less than that of any other individual. Again, if there is a tenant, this test is nearly impossible to meet because of the likelihood that the tenant will put more hours into the activity than the investor. Treas. Reg. §1.469-5T(a)(3).
The fourth test involves “significant participation.” An individual is treated as materially participating in significant participation activities if the individual's aggregate participation activities for the year exceed 500 hours. Treas. Reg. §1.469-5T(a)(4). A “significant participation activity” is a trade or business activity in which the individual participates for more than 100 hours for the taxable year. This is an aggregate test. For example, let us assume that an investor owns a farm, two fast food restaurants, and a convenience store. This rule permits an aggregation of all of those together, provided the investor puts in more than 100 hours in each activity. If the investor spends more than 100 hours in each activity, then each activity can be aggregated to see if the 500-hour test has been met. Thus, if an investor puts more than 100 hours into a farm activity, more than 100 hours into, for example, convenience store, and more than 100 hours into each of several restaurants, the total hours may exceed 500.
Under the fifth test the individual is treated as materially participating if the individual materially participated in the activity for any five of the ten taxable years immediately preceding the taxable year. Treas. Reg. §1.469-5T(a)(5). The idea behind this rule is that substantial involvement over a lengthy period indicates that the activity was probably the individual's principal livelihood. This is a very useful test for a retired farmer who has had several years of involvement.
The sixth test is for individuals involved in personal service activities. An individual is treated as materially participating in a personal service activity for a taxable year if the taxpayer materially participated in the activity for any three taxable years preceding the taxable year in question. This is a test solely for personal service activities. Treas. Reg. §1.469-5T(a)(6). Thus, it is a rule that can be used by taxpayer’s engaged in accounting, law practice, medicine and other professional services.
The seventh and final test is a “facts and circumstances” test. Treas. Reg. §1.469-5T(a)(7). This is the rule under which most farm investors try to qualify, and it requires that the taxpayer participate in the activity during the tax year on a basis that is regular, continuous and substantial. What a taxpayer does for any other purpose (such as material participation for Social Security purposes), does not count for purposes of the material participation test of I.R.C. §469. Treas. Reg. §1.469-5T(b)(2)(i). In addition, the facts and circumstances test cannot be satisfied unless the taxpayer participates more than 100 hours in the activity during the year as a threshold requirement. Treas. Reg. §1.469-5T(b)(2)(iii). Also, as noted above, if the taxpayer is represented by a paid manager, the taxpayer’s own record of involvement does not count. Treas. Reg. §1.469-5T(b)(2)(ii)(A). Thus, the involvement of a paid farm manager eliminates the possibility of the investor counting his or her own hours of participation.
Active participation. Farm landlords receiving crop share rent will likely have difficulty in satisfying any of the tests for material participation. However, if a taxpayer fails to meet the material participation test, there is a fallback test of active participation if the taxpayer owns at least 10 percent of the value of the interests in the rental activity and is not a corporation. I.R.C. §469(i). Active participation requires less than the material participation test, and allows the taxpayer to deduct up to $25,000 each year in losses from a rental real estate activity.
The IRS position is that a crop-share lease is a joint venture and not a rental real estate activity. Treas. Reg. § 1.469-1T(e)(3)(viii), Example (8). Thus, according to the IRS, a crop-share landlord will not qualify under the active participation test.
The active participation test is unavailable to taxpayers with adjusted gross income in excess of $150,000. As adjusted income exceeds $100,000, the $25,000 amount is phased-out over a $50,000 adjusted gross income (determined without regard to passive activity losses) range.
The passive loss rules are important in agriculture. While they operate to bar passive losses from offsetting passive income, material (or active) participation can suffice to allow full deductibility of losses. In the next post, we will dig deeper into the passive loss rules.
Friday, March 1, 2019
Donations to charity can provide a tax deduction for the donor. Normally, the tax deduction is tied to the value of the property donated to a qualified charity. That’s an easy determination if the gift is cash. But what if the gift consists of property other than cash? How is that valued for charitable deduction purposes?
Valuing non-cash gifts to charity – that’s the topic of today’s post.
When a charitable contribution of property other than money is made, the amount of the contribution is generally the fair market value (FMV) of the donated property at the time of the donation. Treas. Reg. §1.170A-1(c)(1). What is FMV? It’s “the price at which the property would change hands between a willing buyer and seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Treas. Reg. §1.170A-1(c)(2). Sometimes FMV is relatively easy to determine under this standard. Other times, it’s not as easy – especially if the non-cash gift is a unique asset. In that situation, the IRS has two approaches to arrive at FMV: the comparable sales method; and the replacement value of the donated property. In a relatively recent Tax Court case, these valuation approaches to a substantial non-cash donation to charity were on display.
In Gardner v. Comr., T.C. Memo. 2017-165, the petitioner was a big-game hunter that had been on numerous safaris and other big-game hunts around the world. In one two-year period he had been on over 20 safaris. Like many big-game hunters, he provided the meat from his kills to the local community and then had taxidermists prepare the hide for eventual display in the “trophy room” of his home. Some of the displays were full body mounts, others were wall hangings or rugs. These types of displays are the most attractive and desirable in the hunting business. His trophy room was, at one point, featured in a hunting publication, “Trophy Rooms Around the World.”
Ultimately, the petitioner downsized his collection by donating 177 of the “less desirable” pieces in his collection to a charity (an ecological foundation). None of the donated specimens were of “record book” quality. Before making the donation, he had the donated specimens appraised. Based on that FMV appraisal, he claimed a charitable deduction of $1,425,900. That figure was derived from his appraiser’s computation of the replacement cost of each donated item – what it could cost him to replace each item with an item of similar quality. Replacement cost was computed by projecting the out-of-pocket expenses for the petitioner to travel to a hunting site; take part in a safari; kill the animal; remove and preserve the carcass; ship the carcass to the U.S.; and pay for taxidermy services to prepay the specimen for display. The petitioner’s appraiser gave every one of the donated items a quality rating of “excellent” for specimen quality and taxidermy quality. For provenance, the appraiser listed the items as “meager.” The appraiser, however, did not provide any evidence for the rational of why he utilized the replacement cost approach.
On audit, the IRS valued the donated specimens at $163,045 based on their expert’s report. The expert appraiser for the IRS had been a licensed taxidermist for more than 30 years and was a certified appraiser specializing in taxidermy items. He characterized the donated items as mostly “remnants and scraps” of a trophy collection – what’s left over after mounting an animal or “what’s left over when you’re done mounting an animal.” He testified that there was an active market among taxidermists for such items to either complete projects or mount them for their own collections. That market, the IRS expert noted, has been expanded by the internet and allowed a ready determination of market value. Indeed, the IRS expert found 504 comparable sales transactions via traditional auctions and internet auction sites. This wasn’t the situation, the IRS expert asserted, where world-class trophy mounts were involved with a thin to non-existent market (which would support the use of the replacement cost approach). Thus, based on the comparable sale approach, the IRS arrived at the $163,045 value.
The matter ended up in the Tax Court, and the Tax Court first noted that it had previously determined how to value hunting specimens donated to charity in 1992. In Epping v. Comr., T.C. Memo. 1992-279, the Tax Court reasoned that if an active market exists, the general rule is to use comparable sales to arrive at a value of the donated property. The Epping case involved “an assortment of animal mounts, horns, rugs, and antlers.” The Tax Court in that case determined that there was an active market in hunting specimens with substantial comparable sales.” However, the Tax Court also noted that replacement cost is appropriate when the donated property is unique, and no evidence of comparable sales exists. Thus, to be able for a taxpayer to use replacement cost to value the donated items, the taxpayer must show that there is no active market for the comparable items and that there is a correlation between the replacement cost and FMV. That’s a tough hurdle to clear in many situations.
In the present case, the Tax Court, was persuaded by the IRS expert’s testimony that the 177 donated items were neither of “world-class” nor museum quality. Instead, the Tax Court agreed that they were mostly “remnants, leftovers, and scraps” of the petitioner’s collection. In addition, the Tax Court noted that the petitioner’s own testimony indicated that he wanted to “downsize” his collection by getting rid of unwanted items. The Tax Court also noted that photographs of the specimens provided by his expert indicated that the donated specimens were not high quality, and none were of record-book quality. In addition, the Tax Court noted that the IRS expert had established an active market for items similar to those the petitioner donated. Thus, the Tax Court determined that the specimens were commodities rather than collectibles and would be appropriately valued based on the market price for similar items – the IRS approach. To further support the use of the comparable sales approach, the Tax Court concluded that the petitioner did not really attempt to challenge the IRS expert’s data and didn’t introduce any evidence of market prices for comparable items. The petitioner failed to prove that the FMV of the 177 donated items exceeded the $163,045 value that the IRS established.
Valuing non-cash charitable gifts can be tricky. Establishing FMV of the donated property must be backed up with sufficient evidence that supports the valuation approach. Truly unique items that lack a ready market may be able to be valued under the replacement cost approach. A good appraiser goes a long way to making that determination. As the Tax Court stated, “To paraphrase Ernest Hemingway, there is no hunting like the hunting for tax deductions.”
Thursday, February 21, 2019
The Tax Code allows for the exclusion of the value of meals and lodging that an employer provides to an employee. Of course, certain conditions must be satisfied for the exclusion to apply. The basic idea is the providing of meals and lodging to an employee must be on the business premises, for the convenience of the employer and as a condition of employment for the value to not be included in the employee’s wages. For farms and ranches in remote areas, this is a particularly attractive fringe benefit for C corporations.
But, a recent IRS Technical Advice Memorandum puts a new twist on the meals side of the equation. It involves the presence of meal delivery services.
The exclusion of meals from an employees wages and meal delivery services – that’ s the topic of today’s post.
Meals and Lodging – The Basics
The value of meals and lodging furnished on the business premises for the employer's convenience and as a condition of employment are not taxable income to the employee (and the employee’s spouse and dependents) and are deductible by the employer if they are provided in-kind. I.R.C. § 119. This tax treatment is available only for meals and lodging furnished to employees, not tenants. See Weeldreyer v. Comm’r, T.C. Memo. 2003-324; Schmidt v. Comm’r, T.C. Memo. 2003-325; Tschetter v. Comm’r, T.C. Memo. 2003-326; Waterfall Farms, Inc. v. Comm’r, T.C. Memo. 2003-327. Likewise, the value of meals and lodging furnished on the business premises for the convenience of the employer are not wages for FICA and FUTA purposes.
As an employer-provided fringe benefit, the meals and lodging arrangement is available only to an individual who is an employee of a C corporation. Owners of other entities cannot take advantage of this fringe benefit. For instance, sole proprietors and partners in a partnership do not have the necessary employee status to qualify for the fringe benefit. Also, I.R.C. §1372 bars S corporation employees who own, directly or indirectly, more than 2 percent of the outstanding stock from receiving tax-free fringe benefits, including the I.R.C. §119 meals and lodging fringe benefit. In addition, with respect to S corporations, the I.R.C. §318 attribution rules apply in determining who considered to be an S corporation shareholder.
Focus on Meals
Meals that are provided to employees during working hours without the furnishing of lodging must be furnished for substantial non-compensatory business reasons of the employer. Examples include emergency call situations, employer business activity that permits on a short meal break, and insufficient eating facilities in the vicinity of the employer’s premises. Treas. Reg. §1.119-1(a)(2).
A significant question is whether the value of groceries furnished to an employee that the employee then prepares into meals is eligible for the exclusion. The IRS claims that it is not. Rev. Rul. 77-806. However, the courts have ruled that either the employer or the employee may prepare the groceries into meals, as long as the arrangement otherwise meets the requirements of I.R.C. §119. Jacobs v. Comm’r, 493 F.2d 1294 (3d Cir. 1974); Harrison v. Comm’r, T.C. Memo. 1981-211. The issue is not settled. Some courts have held that groceries are included under the definition of meals, but other courts and the IRS have ruled that the value of groceries is not meals and is includible in an employee's gross income.
Under a 1997 provision, the cost of meals furnished on the business premises for the convenience of the employer is fully deductible as a de minimis fringe benefit. Under legislation passed in 1998, if more than one-half of the employees to whom meals are provided on the employer's premises are provided for the convenience of the employer, then all of the meals are treated as furnished for the employer's convenience, and the value of the meals is excludible from the employee's income and is deductible by the employer. I.R.C. §119(b)(4). But, there can’t be a cash allowance for meals. If the allowance constitutes compensation, it’s included in the employee’s gross income. See, e.g., Priv. Ltr. Rul. 9801023 (Sept. 30, 1997).
Remoteness. As noted above, for meals to be excluded from an employee’s wages, the meals must be provided as a condition of employment, and be for the employer’s convenience and furnished on the employer’s business premises. I.R.C. §119(a)(1). The requirements seem to be easier for remotely located farms and ranches. In those situations, its often not feasible for employees to go to town for meals. That makes the argument easier that it’s necessary for the employee to eat on the premises – it’s for the employer’s convenience and as a condition of employment.
The litigated cases reveal that the remote location of the business is a significant factor in excluding meals from an employee’s wages. In a 1966 Wyoming case, Wilhelm v. United States, 257 F. Supp. 16 (D. Wyo. 1966), the taxpayers owned a ranch in a remote location several miles from the nearest town. The taxpayers transferred the ranch, ranch-house and all of the equipment to the corporation and attempted to live in the house tax free. The corporation also bought the food and treated it as a deductible expense. The IRS challenged the practice. The Federal District Court for the District of Wyoming ruled against the IRS and noted that the ranch was a grass ranch that put up very little hay and required constant attention by persons experienced in grass ranch requirements to keep cattle alive. The court also noted that during snowstorms the cattle needed to be fed daily, needed to be moved, waterholes had to be kept open, and the cattle had to be protected against the hazards of being trapped or falling into ravines. The court felt that the employees had no other choice but to accept the facilities furnished by the corporate employer, and that the food and lodging were furnished to the employees not only for the convenience of the employer, but that they were indispensable in order to have the employees on the job at all times.
The Wilhelm case was a very important decision, but it also raised the question of how a court would view the situation if the corporation were located in a less remote area. In 1971, the United States Court of Appeals for the 9th Circuit addressed this issue in the context of a grape and crop farming operation in Caratan v. Commissioner, 442 F.2d 606 (9th Cir. 1971). In Caratan, the corporation was located within a ten-minute drive from a residential area of a nearby town. Company policy required supervisory and management personnel to reside on the farm. Company-owned lodging was supplied free of charge for this purpose. The court, in ruling against the IRS, held that the issue was not the remoteness of the corporation, but whether there was a good business reason to require the employees to remain on the premises. The court indicated that the nature of the farming enterprise would determine the reasonableness of requiring employees to reside on the premises rather than the location of the corporation from the nearest town. Whether corporate business required around the clock work such as is the case with a grain drying operation, a farrow-to-finish operation, a dairy or a cattle ranch with characteristics similar to the ranch involved in the Wilhelm case was the real issue.
Historically, cash grain operations have had the greatest difficulty in successfully excluding the cost of lodging and meals provided by the corporation to employees. The IRS has difficulty in accepting the fact that grain farmers simply cannot lock up their machinery after the fall harvest, return the next spring and expect it to still be there. The IRS does not put much weight on security, and they think there is no reason why a grain farmer cannot live in town if all that occurs is the planting, cultivating and harvesting of a crop. On the other hand, livestock ventures or those that are irrigating or drying grain typically have had better success against an IRS challenge. For example, taxpayers were successful in one case involving only a grain operation with the emphasis on grain drying as a reason to be on the premises on a continuing basis. Johnson v. Comm’r, T.C. Memo. 1985-175; compare with J. Grant Farms, Inc. v. Comm’r, T.C. Memo. 1985-174.
Recent Tech Advice Memo. If Caratan stands for the proposition that remoteness is not the issue, the most recent IRS development on employer-provided meals supports that position. In Tech. Adv. Memo. 201903017 (Jan. 18, 2019), an employer provided meals to employees and an IRS examining agent sought guidance on whether the meals were excludible from the employees’ income. The National Office of IRS determined that the value of the meals was not excludible because of the employer’s goals of providing a secure business environment for confidential business discussions; innovation and collaboration; for employee protection due to unsafe conditions surrounding the business premises; and for improvement of employee health; and because of the shortened meal period policy. The National Office determined that the employer’s reasons weren't substantial non-compensatory business reasons as I.R.C. §119 requires. However, the IRS National Office determined that to the extent the taxpayer provided meals so that employees were available to handle emergency outages, the value of those meals were excludible from income under I.R.C. §119. Likewise, snacks provided to employees were excludible as a de minimis fringe.
But, there’s a new twist to the TAM. In the TAM, the IRS noted the increasing presence of meal delivery services. The IRS noted that such services have become more prevalent, and that they tend to undermine the argument that an employee must take their meals on the business premises due to insufficient time to leave the premises for meals. See, e.g., Treas. Reg. §1.119-1(a)(2)(ii)(c).
Perhaps the issue of meal delivery services is not that big of an issue for farms and ranches that are truly remotely located in areas that meal delivery services don’t reach. I.R.C. §119 and the associated Treasury Regulations, of course, don’t mention meal delivery services. Likewise, there is no caselaw discussing meal delivery services either. But, in any event, the TAM may be an indication that the IRS will be more likely to raise questions about employer-provided meals in the future. The availability of a meal delivery service is now a new consideration. And remember, on the employer side of the equation, beginning in 2018, the 100 percent deduction for amounts incurred and paid for the provision of food and beverages associated with operating a business dropped to 50 percent. After 2025, the employer deduction is gone.
Friday, February 15, 2019
If you missed last week’s seminar/webinar, I covered the status of extender legislation, technical corrections, tax software issues and, of course, issues with the qualified business income deduction and the associated transition rule applicable to agricultural cooperatives and their patrons.
If you’d like to view the video and get my 25-page technical outline, you can click here: https://vimeo.com/ondemand/2019taxfilingupdate
An update on where things sit in the midst of tax season – that’s the topic of today’s post.
Where Art Thou Technical Correction and Extender Legislation?
On January 2, 2019, the House Ways and Means Committee released a draft technical corrections bill that sought to correct “technical and clerical” issues in the Tax Cuts and Jobs Act (TCJA). However, the newly constituted Ways and Means Committee with a Democratic majority is reported to be unlikely to take up the draft according to a staffer who made the comment at a conference in Washington, D.C. on January 29.
As for extender legislation, nothing has been enacted as of today to extend provisions for 2018 that expired at the end of 2017. Extender legislation was introduced in early December, but then the bill was revised with the extender provisions stripped-out. In mid-January Sen. Grassley, the chair of the Senate Finance Committee, said that he wanted to push an extender bill through, but there haven’t been any hearings scheduled yet. On February 14, he said that he would push for a retroactive extension of expired tax credits that would last for two years (2018 and 2019).
There are numerous individual, business and energy-related provisions that await renewal, including the following:
- Above-the-line deduction for certain higher-education expenses, including qualified tuition and related expenses, under R.C. §222.
- The treatment of mortgage insurance premiums as qualified residence interest under I.R.C. §163(h)(3)(E).
- The exclusion from income of qualified canceled mortgage debt income associated with a primary residence under I.R.C. §108(a)(1)(E).
- 7-year recovery for motorsport racing facilities under I.R.C. §168(i)(15).
- Empowerment zone tax incentives under I.R.C. §1391(d)(1)(A).
- 3-year depreciation for race horses two years or younger under I.R.C. §168(e)(3)(A)(i).
- The beginning-of-construction date for non-wind facilities to claim the production tax credit (PTC) or the investment tax credit (ITC) in lieu of the PTC under I.R.C. §45(d) and §48(a)(5).
- The credit for construction of energy efficient new homes under I.R.C. §45L.
- The energy efficient commercial building deduction under I.R.C. §179D.
- Alternative fuel vehicle refueling property credit under I.R.C. §30C(g).
- Incentives for alternative fuel and alternative fuel mixtures under I.R.C. §6426(d)(5) and §6427(E)(6)(c).
- Incentives for biodiesel and renewable diesel under I.R.C. §40A(a); I.R.C. §6426(e)(3); and I.R.C. §6427(e)(6)(B).
New Items for 2019
While the TCJA generally applies beginning with tax years effective after 2017, there are some unique provisions that change for 2019. These include the following:
- Medical expenses become more difficult to deduct. For 2018, itemizers could deduct medical expenses to the extent they exceeded 7.5% of the taxpayer’s adjusted gross income (AGI). For 2019, the "floor" beneath medical expense deductions increases to 10%. R.C. §213(f).
- Big shift in the alimony tax rules. For payments required under divorce or separation instruments that are executed after Dec. 31, 2018, the deduction for alimony payments is eliminated, and recipients of affected alimony payments will no longer have to include them in taxable income. The rules for alimony payments also apply to payments that are required under divorce or separation instruments that are modified after Dec. 31, 2018, if the modification specifically states that the new-for-2019 treatment of alimony payments (not deductible by the payer and not taxable income for the recipient) applies. R.C. §§215; 71.
- Shared responsibility payment is history. Obamacare generally provides that individuals must have minimum essential coverage (MEC) for health care, qualify for an exemption from the MEC requirement, or make an individual shared responsibility payment (i.e., pay a penalty) when they file their federal income tax return. The TCJA reduced the individual shared responsibility payment to zero for months beginning after Dec. 31, 2018. I.R.C. §5000A(c). However, the I.R.C. §4980H “employer mandate” (also known as an employer shared responsibility payment, or ESRP) remains on the books. The employer mandate general provides that an employer that employed an average of at least 50 full-time employees, including full-time equivalent employees, on business days during the preceding calendar year is required to pay an assessable payment if: (i) it doesn't offer health coverage to its full-time employees; and (ii) at least one full-time employee purchases coverage through the Marketplace and receives an I.R.C. §36B premium tax credit.
- Liberalized rules for hardship distributions from 401(k) plans. R.C. §401(k) plans may provide that an employee can receive a distribution of elective contributions from the plan on account of hardship (generally, because of an immediate and heavy financial need of the employee; and in an amount necessary to meet the financial need). Under Treas. Reg.§1.401(k)-1(d)(3)(iv)(E), an employee who receives a hardship distribution cannot make elective contributions or employee contributions to the plan and to all other plans maintained by the employer, for at least six months after receipt of the hardship distribution. The IRS has modify the regulation to delete the six-month prohibition on contributions and to make “any other modifications necessary to carry out the purposes of” I.R.C. §401(k)(2)(B)(i)(IV). The revised regs are to apply to plan years beginning after Dec. 31, 2018.
- There are other tax changes starting in 2019. For example, the debt-equity documentation regulations apply to issuances in 2019; the accelerated phaseout of the tax credit for wind facilities continues; and many tax-exempt organizations face eased donor disclosure requirements. Also, while not brand new for 2019, the election out of 100% bonus depreciation into 50 percent bonus is not available unless the tax year includes September 27, 2017.
Final I.R.C. §199A Regulations
Deductions. While I have addressed the final qualified business income deduction (QBID) regulations in prior posts, software issues remain. One lingering issue involves how to handle business-related deductions. The final regulations are consistent with the proposed regulations on the treatment of the self-employed health insurance deduction and retirement plan contributions. Prop. Treas. Reg. §1.199A-1(b)(4) defines QBI as the net amount of qualified items of income, gain, deduction and loss with respect to a trade or business as determined under the rules of Prop. Treas. Reg. §1.199A-3(b). The above-the-line adjustments for S.E. tax, self-employed health insurance deduction and the self-employed retirement deduction are examples of such deductions.
The basic starting point is that QBI is reduced by certain deductions reported on the return that the business doesn’t specifically pay, including the deduction for one-half of the self-employment tax, the self-employed health insurance deduction, and retirement plan contributions. The self-employed health insurance deduction may only “apply” to Schedule F farmers because, with respect to partnerships and S corporations, it is actually a component of either shareholder wages for an S corporation shareholder or guaranteed payments to a partner and, thus, may not reduce QBI. The self-employed health insurance deduction should not be removed from an S-corporate owner on their individual return because it has already been removed on Form 1120-S. Do not deduct it twice. If QBI were reduced by the amount of the I.R.C. §162(l) deduction on the 1040, QBI would be (incorrectly) reduced twice. In other words, QBI should not be reduced by the self-employed health insurance from the S corporation or the partnership. The deduction for the S corporation shareholder is allocated to the wage income, and the deduction for the partner is from the guaranteed payment. The one-half self-employment tax deduction for the partner is allocated between guaranteed payments (if any) and that portion of the K-1 allocated income associated with QBI. Some tax software programs are not treating this properly. Watch for updates, such as a box to check on the self-employed health insurance screen.
The final regulations also clarify that the deduction for contributions to qualified retirement plans under I.R.C. §404 is considered to be attributable to a trade or business to the extent that the taxpayer’s gross income from the trade or business is accounted for when calculating the allowable deduction, on a proportionate basis. See Prop. Treas. Reg. §1.199A-3(b)(vi). When an S corporation makes an employer contribution to an employer-sponsored retirement plan, that contribution, itself, reduces corporate profits. Thus, there is less profit on which the QBID can potentially apply. Thus, for some S corporation owners, a contribution to an employer-sponsored retirement plant will effectively result in a partial deduction, but still subject the entire contribution, plus all future earnings, to income tax upon distribution. The final regulations make clear that sole proprietors and partners must also “back-out” these amounts from business profits before applying the QBID. This rule will make 401(k)s with a Roth-style option more valuable.
The final regulations do not address how deductions for state income tax imposed on the individual’s business income or unreimbursed partnership expenses are to be treated. The final regulations also don’t mention whether the deduction for interest expense to a partnership interest or an S corporation interest is business related.
Some tax software is presently reducing QBI passed through from an S corporation or partnership by the I.R.C. §179 amount which is passed through separately. Other tax software allows the practitioner to either include or exclude the I.R.C. §179 amount. A suggested approach is to always exclude it at the entity level because it is not known if it can be deducted on the taxpayer’s personal return. Operating properly, tax software should calculate QBI with a reduction for the I.R.C. §179 deduction at the individual level.
Fiscal year entities. The final regulations in January put an earlier report to rest that had surfaced in November of 2018. The problem that was reported to be the case did not materialize. Instead, under the final regulations, for purposes of determining QBI, W-2 wages, and the unadjusted basis in assets of qualified property, if an shareholder/partner/member receives any of these items from a passthrough entity having a fiscal year beginning in 2016 and ending before December 31, 2017, the items are treated as having been incurred by the individual during the individual's 2017 taxable year. No QBID would be available. On the other hand, if an individual receives any of these items from a passthrough entity that has a fiscal year beginning in 2017 and ending in 2018, the items are treated as having been incurred by the taxpayer during the individual’s 2018 tax year. That means the items may be taken into account in determining the individual’s QBID for 2018.
During the webinar/seminar on Feb. 8, I also covered the transition rule that bridges the gap between the original QBID cooperative rule and the “fix” that occurred in March of 2018. My detailed outline associated with the seminar goes through the various computations that might be encountered. Of course, under the transition rule, a farmer’s calculation of their QBID for 2018 does not include grain sold to a cooperative if the cooperative accounted for those sales when calculating its domestic production activities deduction (DPAD) under former I.R.C. §119 on its 2018 return. That means that a tax preparer is going to need certain information from the cooperative to prepare the patron’s return properly. And, yes, in spite of what some tax software companies are saying the 2018 Form 8903 is available via the IRS website (Dec. 2018 version).
For further elaboration on these points and you can read up on my lecture outline and slide presentation associated with the Feb. 8 seminar/webinar. I also went into detail on how to handle farm rentals with various scenarios. That issue still seems to bedevil practitioners. Again, you can access the video (no CE credit for not watching it live), my lecture outline and slides here: https://vimeo.com/ondemand/2019taxfilingupdate
Tuesday, February 5, 2019
Last summer, the U.S. Supreme Court decided South Dakota v. Wayfair, 138 S. Ct. 2080 (2018), where the court upheld South Dakota’s ability to collect taxes from online sales by sellers with no physical presence in the state. That decision was the latest development in the Court’s 50 years of precedent on the issue, and I wrote on the issue here: https://lawprofessors.typepad.com/agriculturallaw/2018/06/state-taxation-of-online-sales.html
Does the Supreme Court’s opinion mean that a state can tax trust income that a beneficiary receives where the only contact with the state is that the beneficiary lives there? It’s an issue that is presently before the U.S. Supreme Court. It’s also the topic of today’s post – the ability of a state to tax trust income when the trust itself has no contact with the taxing state.
The “Nexus” Requirement
Article I, Section 8 of the U.S. Constitution says that, “The Congress shall have the power...to regulate commerce…among the several states…”. That is a rather clear statement – the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States.” As I pointed out in the blog post on the Wayfair decision last summer, a state tax will be upheld when applied to an activity that meets several requirements: the activity must have a substantial nexus with the state; must be fairly apportioned; must not discriminate against interstate commerce, and; must be fairly related to the services that the state provided. Later, the U.S. Supreme Court said that a physical presence was what satisfied the substantial nexus requirement.
The physical presence requirement to establish nexus was at issue in Wayfair and the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. But, the key point is that the “substantial nexus” must be present. Likewise, the other three requirements of prior U.S. Supreme Court precedent remain – the tax must be fairly apportioned; it must not discriminate against interstate commerce, and; it must be fairly related to services that the state provides. In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce. The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – limited application (based on transactions or dollars of sales); not retroactive; the state was a member of the Streamlined Sales and Use Tax Agreement; the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden.
Taxing an Out-Of-State Trust?
The U.S. Supreme Court has now decided to hear a case from North Carolina involving that state’s attempt to tax a trust that has no nexus with the state other than the fact that a trust beneficiary is domiciled there. Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 789 S.E.2d 645 (N.C. Ct. App. 2016), aff'd., 814 S.E.2d 43 (N.C. 2018), pet. for cert. granted, No. 18-457, 2019 U.S. LEXIS 574 (U.S. Sup. Ct. Jan. 11, 2019). The trust at issue, a revocable living trust, was created in 1992 with a situs of New York. The primary beneficiaries were the settlor’s descendants. None of the descendants lived in North Carolina at the time of the trust’s creation. The trust was divided into three separate trusts in 2002, one for each of the settlor’s children. The beneficiary of one of the sub-trusts was a North Carolina resident at that time. The trustee was replaced in 2005 with a successor trustee who resided in Connecticut. North Carolina tax returns were filed for tax years 2005-2008 for the accumulated trust income, that was distributed to the beneficiaries, including the non-North Carolina beneficiaries. In 2009, the trust filed a claim for a refund of North Carolina taxes in an amount slightly exceeding $1.3 million. The trust claimed that N.C. Gen. Stat. §105-160.2, which assesses tax on the amount of taxable income of the estate or trust that is for the benefit of a North Carolina resident, was unconstitutional on due process and Commerce Clause grounds. The defendant denied the claim, and the hearing officer later dismissed the case for lack of jurisdiction.
The trial court dismissed the request for injunctive relief with respect to the refund claim, but denied the defendant’s motion to dismiss the constitutional claims. The trial court then granted summary judgment for the trust on the constitutional claim and ordered the defendant to refund the taxes paid on its accumulated income.
On appeal, the appellate court affirmed. The appellate court determined that the trust failed to have sufficient minimum contacts (as required by the Due Process Clause) with North Carolina to subject the trust to North Carolina income tax. The court cited both International Shoe Co. v. Washington, 326 U.S. 310 (1945) and Quill Corp. v. North Dakota, 504 U.S. 298 (1992) to support its position on this point. The trust did not have any physical presence in the state during the tax years at issue, contained no North Carolina property or investments, had no trust records that were created or kept in North Carolina, and the place of trust administration was not in North Carolina. Basing the imposition of state tax on a beneficiary’s domicile, by itself, did not establish sufficient minimum contacts with the state to satisfy the Due Process Clause and allow North Carolina to tax a non-North Carolina trust. The appellate court held that Brooke v. Norfolk, 277 U.S. 27 (1928) was controlling. In that case, a Maryland resident created a testamentary trust with a Maryland situs for a Virginia beneficiary. Virginia assessed tax on the trust corpus, but the Court held the assessment to be unconstitutional.
On further review, the state Supreme Court affirmed, also noting that a key to the case was that the trust beneficiary did not receive trust distributions during the years at issue. As such, the North Carolina statute violated the Due Process Clause of the U.S. Constitution.
The North Carolina Supreme Court’s decision was delivered 13 days before the U.S. Supreme Wayfair decision, and was based on the controlling U.S. Supreme Court decision at that time – Quill. Consequently, the North Carolina Department of Revenue, based on Wayfair, sought U.S. Supreme Court review. On January 11, 2019, the U.S. Supreme Court agreed to hear the case.
State taxation of trusts varies greatly from state to state in those states that have a state income tax. A trust’s situs in a state certainly permits that state to subject the trust to the state’s income tax as a resident. But, a trust may be tied to a state in other ways via a grantor, trustee, assets, or a beneficiary. In addition, whether a trust is a revocable or irrevocable trust can make a difference. For instance, the Illinois definition of “resident” includes “an irrevocable trust the grantor of which was domiciled in this State at the time such trust became irrevocable.” 35 ILCS/1501(A)(20)(D); see also, Linn v. Department of Revenue, 2 N.E.3d 1203 (Ill. Ct. App. 2013). Indeed, a trust may have multiples states asserting tax on the trust’s income.
However, due process requires that before a state can tax a trust’s income, the trust must have a substantial enough connection (e.g., nexus) with the state. How the U.S. Supreme Court decides the North Carolina case in light of its Wayfair decision will be interesting. It’s a similar issue but, income tax is involved rather than sales or use tax. In my post last summer (noted above) I discussed why that difference could be a key distinction. In addition, while a trust could be subject to state income tax based on its residency, the trust has grantors and trustees and beneficiaries and assets that can all be located in different states – and can move from state-to-state (at least to a degree).
The U.S. Supreme Court decision will have implications for trust planning as well as estate and business planning. Siting a trust in a state without an income tax (and no rule against perpetuities) is looking better each day.
Thursday, January 24, 2019
As noted on Tuesday’s post, the Treasury issued final regulations for the qualified business income deduction (QBID) under I.R.C. §199A on January 18. This provision, of course, provides for a 20 percent deduction on business income received by a sole proprietor or member of a pass-through entity. On Tuesday, I discussed how the final regulations affected rental situations for farmers and ranchers and also how the final rules dealt with aggregation.
In today’s post, I look at numerous other issues associated with I.R.C. §199A and the final regulations that are important to farmers and ranchers
The rest of the story, so to speak, concerning the QBID final regulations and farmers and ranchers – that’s the topic of today’s post.
Proposed regulations. Under the proposed regulations, carryover losses that were incurred before 2018 and that are now allowed in years 2018-2025 will be ignored in calculating qualified business income (QBI) for purposes of the QBID. This is an important issue for taxpayers that have had passive losses that have been suspended under the passive loss rules. While this loss allocation rule is generally favorable, clarification was needed on a couple of points. For instance, could a taxpayer also ignore pre-2018 suspended losses for purposes of the Excess Business Loss rule under I.R.C. §461(l)?
Final regulations. The final regulations, consistent with the regulations issued under former I.R.C. §199, provide that any losses that are disallowed, suspended, or limited under I.R.C. §465 (passive loss rules) §704 and I.R.C. §1365 (or any other similar provision) are to be used on a first-in, first-out basis.
In addition, the final regulations clarify that an NOL deduction (in accordance with I.R.C. §172) is generally not considered to be in connection with a trade or business. Excess business losses (the amount over $500,000 (mfj)) are not allowed for the tax year. However, an Excess Business Loss under I.R.C. §461(l) is treated as an NOL carryover to the next tax year where it reduces QBI in that year. The carry forward becomes part of the taxpayer's NOL carryforward in later years. There is no mention whether this amount gets retested under I.R.C. §461(j) (involving subsidized farming losses). Under prior law, those disallowed losses retained their character in a later tax year. That is no longer the case and it appeared that the NOL generated under I.R.C. §461(l) would not be subject to other loss limitation provisions.
Included and Excluded Items
QBI includes net amounts of income, gain, deduction, and loss with respect to any qualified trade or business. I.R.C. §199A(c). Business-related items that constitute QBI include ordinary gains and losses from Form 4797; deductions that are attributable to a business that is carried on in an earlier year; the deduction for self-employed health insurance under I.R.C. §162(l); and the deductible portion of self-employment tax under I.R.C. §164(f). The final regulations affirm this. Treas. Reg. §1.199A-3(b)(1)(vi). The reduction of QBI for self-employed health insurance, for an S corporation shareholder or partner occurs at the entity level. It is removed for an S corporation, for example on Form 1120-S. It should not be deducted twice. If QBI were reduced by the amount of the I.R.C. §162(l) deduction on Form 1040, QBI would (incorrectly) be reduced twice.
The final regulations also clarify that the deduction for contributions to qualified retirement plans under I.R.C. §404 is considered to be attributable to a trade or business to the extent that the taxpayer’s gross income from the trade or business is accounted for when calculating the allowable deduction, on a proportionate basis.
The final regulations do not address how deductions for state income tax imposed on the individual’s business income or unreimbursed partnership expenses are to be treated. The final regulations also don’t mention whether the deduction for interest expense to a partnership interest or an S corporation interest is business related. Guaranteed payments for the use of capital in a partnership are not attributable to the partnership’s business, unless they are properly allocable to the recipient’s qualified trade or business (not likely). Also excluded from QBI are amounts that an S corporation shareholder receives as reasonable compensation or amounts a partner receives as payment for services under I.R.C. §§707(a) or (c).
Proposed regulations. The proposed regulations appeared to take the position that gain that is “treated” as capital gain is not QBI. Prop. Treas. Reg. 1.199A-3(b)(2)(ii)(A). This interpretation would exclude I.R.C. §1231 gain (such as is incurred on the sale of breeding livestock) from being QBI-eligible. But, it could also be argued that is an incorrect interpretation of the relevant Code provisions. It also is arguably inconsistent with the purpose of the QBID statute. I.R.C. §1222(3) defines long-term capital gain as the gain from the sale or exchange of a capital asset held for more than one year, if and to the extent the gain is taken into account in computing gross income. I.R.C. §1231(a)(1) treats the I.R.C. §1231 gains as long-term capital gain. I.R.C. §199A(a)(2)(B) neither modifies nor makes any other specification. Also, I.R.C. §1222(11) defines “net capital gain” as the excess of the net long-term capital gain for the year over the net short-term capital loss. None of the other provisions on I.R.C. §1222 mention I.R.C. §1231. Simply because, as the proposed regulations state, gain is “treated as” capital gain does not make it capital gain. Rather, “treated as” should be read in a manner that the tax on I.R.C. §1231 gain is computed in the same manner as capital gain. I.R.C. §1231 reflects gain on the disposition of a business asset. As such, the argument is, I.R.C. §1231 gain should be QBI because the purpose of I.R.C. §199A is to provide a lower tax rate on business income. Losses from the sale of short-term depreciable assets (Part II of Form 4797) should not reduce QBI if I.R.C. §1231 gains (Part 1 of Form 4797) are present.
Final regulations. So how did the final regulations deal with this issue? The final regulations remove the specific reference to I.R.C. §1231 and provide that any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss, including any item treated as one of these under any Code provision, is not taken into account as a qualified item of income, gain, deduction or loss. That’s comprehensives. It’s basically any item that is reported on Schedule D plus qualified dividends. Qualified dividends are specifically included in the term “capital gain” by reference to I.R.C. §1(h).
Proposed regulations. The proposed regulations provided that “brokering” is limited to trading securities for a commission or a fee. Prop. Treas. Reg. §199A-5(b)(2)(x). Clarification was needed to ensure that brokering of commodities did not constitute a specified service trade or business (SSTB). An SSTB is eligible for the QBID, but under a different set of rules that apply to non-SSTB businesses (such as farms and ranches). For instance, the concern was that under the proposed regulations a person who acquired a commodity (such as wheat or corn for a hog farm), and transported it to the ultimate buyer might improperly be considered to be dealing in commodities. This would have resulted in the income from the activity treated from an SSTB. None of the commodity income would have been eligible for the QBID for a high-income taxpayer.
Final regulations. This is also an important issue for private grain elevators. A private grain elevator generates income from the storage and warehousing of grain; it also generates income from the buying and selling of grain. Is the private elevator’s buying and selling of grain “commodity dealing” for purposes of I.R.C. §199A? If it is, then a significant portion of the elevator’s income will not qualify for the QBID. Clarification was needed to distinguish that these various services involved do not constitute an SSTB making the income non-QBI.
The final regulations clarify that the brokering of agricultural commodities does not constitute an SSTB and does so by pointing to I.R.C. §954.
The final regulations specify that the IRS may provide for methods of computing taxable wages. Simultaneously with the release of the final regulations, the IRS issued Rev. Proc. 2019-11. The Rev. Proc. notes that it applies only for QBID purposes, and recites the W-2 wages definition from the proposed regulations. Thus, statutory employees that a have a Form W-2 with Box 13 marked are not W-2 wages for QBID purposes. Also, wages paid in-kind to agricultural labor are not eligible W-2 wages, but wages paid to children under age 18 are. I explained this distinction in an earlier post that you can read here: https://lawprofessors.typepad.com/agriculturallaw/2018/08/the-qualified-business-income-deduction-and-w-2-wages.html.
The proposed regulations set forth three methods for computing W-2 wages – unmodified box method; modified box 1 method; and the tracking wages method. The Rev. Proc. also provided special rules to use for a short tax year which requires the use of the tracking wages method.
Multiple Trades Or Businesses
The final regulations follow the approach of the proposed regulations concerning a taxpayer that has multiple trades and businesses. Items of QBI that are properly allocable to more than a single trade or business must be allocated among the several trades or businesses to which they are attributed using a reasonable method based on the facts. That method is to be consistently applied each year. The same concept applies for individual items.
Income Tax Basis
Proposed regulations. Under I.R.C. §199A, higher income taxpayers compute their QBID in accordance with a wages/qualified property (QP) limitation. The amount of QP that is used in the limitation is tied to the what is known as the “unadjusted basis in assets” (UBIA). However, the proposed regulations raised some questions about UBIA that needed clarified.
For instance, Prop. Treas. Reg. §1.199A-4(b), Example 3, needed modified. When a tax-free contribution of property to a corporation is involved, the transferor’s unadjusted basis should continue to be the UBIA. The placed-in-service date would be the date that the transferor originally placed the property in service. I.R.C. §351 should simply be viewed as a continuation of the taxpayer’s holding. The only difference is that the asset is being held via the S corporation. Indeed, the tax attributes of the contributed asset remain unchanged. Likewise, the transferor’s depreciation history with respect to the contributed asset carries into the S corporation. Thus, the unadjusted basis should also carry into the corporation.
Final regulations. The final regulations clarify that the UBIA of property received in either an I.R.C. §1031 or 1033 exchange is the UBIA of the relinquished property. In addition, the placed-in-service date of the replacement property is the service date of the relinquished property. Similar concepts apply for transfers that are governed by I.R.C. §§351, 721 and 731.
The final regulations also take the position that property contributed to a partnership or S corporation under the non-recognition rules retains the UBIA of the contributor. In addition, an I.R.C. §743(b) adjustment is QP to the extent of an increase in fair market value over original cost. For entities, the UBIA is measured at the entity level, and the property must be held by the entity as of the end of the entity’s tax year. As for a decedent’s estate, the fair market value of property that is received from a decedent pegs the UBIA and the new depreciation period (for purposes of the computation of the limitation) is reset as of the date of the decedent’s death.
The final regulations specify that a non-grantor trust that is established for “a primary purpose” of avoiding income tax under I.R.C. §199A will be considered to be aggregated with trust settlor/grantor for QBID purposes. In addition, distributable net income (DNI) transferred from a non-grantor trust to a beneficiary is treated as having been received by the beneficiary. This could lead to an increase in the creation of non-grantor, irrevocable, complex trusts.
The final regulations also did not place any limitation on the use of irrevocable trusts that are considered to be owned by the beneficiary(ies). See I.R.C. §678. However, this does not necessarily mean that there should be a rush to create irrevocable trusts. The IRS, supported by the courts, often view the substance of a transaction as more controlling than form when it believes that the entity was created primarily for tax avoidance purposes. See, e.g., Helvering v. Gregory, 293 U.S. 465 (1935).
Under the final regulations, a veterinarian is engaged in the provision of health care and, therefore, is an SSTB. But, no clarity was given as to the treatment of insurance salesmen – they are often statutory employees However, the final regulations do contain a three-year lookback period on the reclassification of workers from employee (W-2) status to independent contractor (Form 1099) reporting. Employees do not have QBI, but independent contractors can.
The final regulations are effective upon being published in the Federal Register. But, in general, a taxpayer can rely on either the final or proposed regulations for tax years that end in 2018. Some parts of the final regulations apply to tax years ending after December 22, 2017, or to tax years ending after August 16, 2018. However, these situations apply to the anti-abuse rules, including the anti-abuse rules that apply to trusts.
Tuesday, January 22, 2019
Last August, the Treasury issued proposed regulations under I.R.C. §199A that was created by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017. REG-107892-18 (Aug. 8, 2018). The proposed regulations were intended to provide taxpayers guidance on planning for and utilizing the new 20 percent pass-through deduction (known as the QBID) available for businesses other than C corporations for tax years beginning after 2017. It expires for years beginning after 2025. While some aspects of the proposed regulations are favorable to agriculture, other aspects created additional confusion, and some issues were not addressed at all (such as the application to agricultural cooperatives).
A public hearing on the final regulations was held in Washington, D.C. on October 16, 2018 and the Treasury released the final QBID regulations on January 18, 2019. The final regulations provide much needed guidance on several key points.
Today’s post does not provide an overview of the 199A provision (for that background information you can read my prior post here https://lawprofessors.typepad.com/agriculturallaw/2018/01/the-qualified-business-income-qbi-deduction-what-a-mess.html and here https://lawprofessors.typepad.com/agriculturallaw/2018/03/congress-modifies-the-qualified-business-income-deduction.html. What I am focusing on today is the impact of the final regulations on farm and ranch businesses - that’s the topic of today’s post.
Multiple businesses. The proposed regulations did provide a favorable aggregation provision that allows a farming operation with multiple businesses (e.g., row-crop; livestock; etc.) to aggregate the businesses for purposes of the QBID. This was, perhaps, the best feature of the proposed regulations with respect to agricultural businesses because it allows a higher income farming or ranching business to make an election to aggregate their common controlled entities into a single entity for purposes of the QBID. This is particularly the case with entities having paid no wages or that have low or no qualified property. Entities with cash rental income already qualified the income as QBI via common ownership (common ownership is required to aggregate) Once the applicable threshold for 2018 ($157,500 for a single filer; $315,000 for a married filing joint return) is exceeded, the taxpayer must have qualified W-2 wages or qualified property basis to claim the QBID. Aggregation, in this situation, may allow the QBID to be claimed (assuming the aggregated group has enough W-2 wages or qualified property).
Proposed regulations. Common ownership is required to allow the aggregation of entities to maximize the QBID for taxpayers that are over the applicable income threshold. Prop. Treas. Reg. §1.199A-4(b). “Common ownership” requires that each entity has at least 50 percent common ownership. But, the common ownership rule does not require every person involved to have an ownership in every trade or business that is being aggregated, or that you look to the person’s lowest percentage ownership. For example, person A could have a 1 percent ownership interest in entity X and a 99 percent ownership interest in entity Y, and an unrelated person could have the opposite ownership (99 percent in x and 1 person in Y) and the entities would have common ownership of 100 percent (the group of people have 50 percent or more common ownership).
But, there was a potential snag with the definition, and it concerned a family attribution rule that could pose issues for farming operations involving family members with multiple generations. The proposed regulations limited family attribution to just the spouse, children, grandchildren and parents. See Prop. Treas. Reg. §1.199A-4(b)(3). In other words, the proposed regulations limited common ownership to lineal ancestors and descendants. Excluded were siblings – which are often involved in farming and ranching businesses. One way to plan around the lack of sibling attribution, for example, was to have one child own 100 percent of one business and another child of the same parent own 100 percent of another business. In that situation, the parent is deemed to have 100 percent ownership of both businesses even though there is no sibling attribution. The two businesses could be aggregated, even though there is no sibling attribution, as long as at least one parent is alive.
The proposed regulations were also unclear concerning whether (for taxpayers over the applicable income threshold) it mattered if the entities are on a calendar or fiscal year-end. In order to elect to aggregate entities together, the proposed regulations required all of the entities in a combined group must have the same year-end, and none can be a C corporation. But, rental income paid by a C corporation in a common group could be QBI if the C corporation was part of that combined group. If this reading were correct, that meant that the rental income could qualify as QBI. That interpretation is beneficial to farming and ranching businesses – many are structured with multiples entities, at least one of which is a C corporation.
Final regulations. Fortunately, the final regulations provide that siblings are included as related parties via I.R.C. §§267(b) and 707(b). Including siblings in the definition of common ownership for QBID purposes will be helpful upon the death of the senior generation of a farming or ranching operation. In addition, the final regulations retain the 50 percent test and clarify that the test must be satisfied for a majority of the tax year, at the year-end, and that all of the entities of a combined group must have the same year-end.
The final regulations also specify that aggregation for 2018 can be made on an amended return. The aggregation election can be made in a later year if it was not made in the first year.
Rental Activities – What’s Business Income?
One of the big issues for farmers and ranchers operating as sole proprietorships or as a pass-through entity is whether land rental income constitutes QBI. The proposed regulations confirmed that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity. That’s particularly the case if the rental is between “commonly controlled” entities. But, the proposed regulations could also have meant that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID. If that latter situation were correct it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID. Thus, clarification was needed on the issue of whether the rental of property, regardless of the lease terms will be treated as a trade or business for aggregation purposes as well as in situations when aggregation is not involved. That clarification is critical because cash rental income may be treated differently from crop-share income depending on the particular Code section involved. See, e.g., §1301.
Proposed regulations. The proposed regulations also contained an example of a rental of bare land not requiring any cost on the landlord’s part. See Prop. Treas. Reg. §1.199A-1(d)(4), Example 1. This seemed to imply that the rental of bare land to an unrelated third party qualifies as a trade or business. Another example in the proposed regulations also seemed to support this conclusion. Prop. Treas. Reg. §199A-1(d)(4), Example 2. Apparently, this means that a landlord’s income from passive triple net leases (a lease where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement) should qualify for the QBID. But, existing caselaw is generally not friendly to triple net leases being a business under I.R.C. §162. Clarification on this point was also needed.
Unfortunately, the existing caselaw doesn’t discuss the issue of ownership when it is through separate entities and, on this point, the Preamble to the proposed regulations created confusion. The Preamble says that it's common for a taxpayer to conduct a trade or business through multiple entities for legal or other non-tax reasons, and also states that if the taxpayer meets the common ownership test that activity will be deemed to be a trade or business in accordance with I.R.C. §162. But, the Preamble also stated that "in most cases, a trade or business cannot be conducted through more than one entity.” So, if a taxpayer has several rental activities that the taxpayer manages, the Preamble raised a question as to whether those separate rental activities can’t be aggregated unless each rental activity is a trade or business. It also raised a question as to whether the Treasury would be making the trade or business determination on an entity-by-entity basis. If so, triple net leases might not generate QBI. But, another part of the proposed regulations extended the definition of trade or business beyond I.R.C. §162 in one circumstance when it referred to “each business to be aggregated” in paragraph (ii). Prop. Treas. Reg. §1.199A-4(b)(i). This would appear to mean that the rental of property would be treated as a trade or business for aggregation purposes. See Prop. Treas. Reg. §199A-1(b)(13).
Final regulations. So how did the final regulations deal with the issue of passive lease income? For starters, the bare land rent example in the proposed regulations was eliminated. Unfortunately, no further details were provided on the QBI definition of trade or business. That means that each individual set of facts will be key with the relevant factors including the type of rental property (commercial or residential); the number of properties that are rented; the owner’s (or agent’s) daily involvement; the type and significance of any ancillary services; the terms of the lease (net lease; lease requiring landlord expenses; short-term; long-term; etc.). Certainly, the filing of Form 1099 will help to support the conclusion that a particular activity constitutes a trade or business. But, tenants-in-common that don’t file an entity return create the implication that they are not engaged in a trade or business activity.
The final regulations clarify (unfortunately) that rental paid by a C corporation cannot create a deemed trade or business. That’s a tough outcome as applied to many farm and ranch businesses and will require some thoughtful discussions with tax/legal counsel about restructuring rental agreements and entity set-ups. Before the issuance of the final regulations, it was believed that land rent paid by a C corporation could still qualify as a trade or business if the landlord could establish responsibility (regularity and continuity) under the lease. Landlord responsibility for mowing drainage strips (or at least being responsible for ensuring that they are mowed) and keeping drainage maintained (i.e., tile lines), paying taxes and insurance and approving cropping plans, were believed to be enough to qualify the landlord as being engaged in a trade or business. That appears to no longer be the case.
Notice 2019-7. Along with the release of the final regulations, the IRS issued Notice 2019-7. The Notice is applicable for tax years ending after December 31, 2017 and can be relied upon until the final Revenue Procedure is published. The Notice provides tentative guidance and a request for comments on the sole subject of when and if a rental activity (termed as a “rental real estate enterprise) will be considered to be an active trade or business. The Notice also provides a safe harbor. While real estate rented or leased under a triple net lease is not eligible under the safe harbor (unless common control allows it), a taxpayer who has an active business of entering into and selling triple net leases may still be considered to be sufficiently active to qualify as a trade or business under existing case law.
The Notice defines a triple net lease to include an agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance in addition to rent and utilities, and includes leases that require the tenant to pay common area maintenance expenses, which are when a tenant pays for its allocable portion of the landlord’s taxes, fees, insurance, and maintenance activities which are allocable to the portion of the property rented. The definition seems to leave open the ability to avoid triple net lease status by having the tenant be responsible for some portion of the maintenance, taxes, fees, insurances, and other expenses that would normally be payable by a landlord. However, failure to meet the safe harbor does not fully preclude the lease from generating QBI.
Note: For landowners receiving annual “wind lease” income for aerogenerators on their farmland, even though the income is received as part of a common controlled group, the actual income is not paid by any member of the controlled group. It is essentially triple net lease income with no services provided by the farmer (or spouse). This income will not be QBI, given the inability of the landowner to provide “services” under the lease agreement.
An individual may rely on the safe harbor, as well as a partnership or S-corporation that owns the applicable interest in the real estate that is leased out (such as farmland). As noted above, the final regulations take the position that the lessor entity must be a pass-through entity (or a sole proprietorship) that owns the real estate directly or through another entity that is disregarded for income tax purposes. Rent that is paid by a C corporation doesn’t count.
Each individual taxpayer, estate or trust can elect to treat each separate property as a separate enterprise, or all similar properties as a single enterprise, for purposes of applying the safe harbor rules, except that commercial and residential real estate cannot be considered as part of the same enterprise for testing purposes. In other words, all commercial rents can be netted as one single enterprise, and all residential rentals can be netted as another enterprise. But, real estate that is under a triple net lease, and real estate used as a residence by the taxpayer cannot be part of an aggregated enterprise for testing purposes because they cannot qualify to be included in the safe harbor.
The Notice specifies that for each separate enterprise, certain requirements must be satisfied each year for the enterprise’s income to be eligible for the safe harbor:
- Maintenance of separate books and records to reflect the income and expenses for each enterprise.
- Aggregate records for properties that are grouped as a single enterprise.
- Contemporaneous records (similar to auto logs) of time reports, logs, etc., with respect to services performed and the party performing the services with respect to tax years beginning January 1, 2019. The requirement is inapplicable to 2018 returns or fiscal year filers for years ending before 2020.
- For tax years 2018 through 2022, 250 or more hours of “rental services” must be performed to qualify the property for the safe harbor in each calendar year. Rental services include time spent by owners, employees, agents, and independent contractors of the owners, which can include management and maintenance companies who have personnel who keep and provide contemporaneous records. Rental services also include advertising to rent or lease properties; negotiating and executing leases; verifying tenant information; collecting rent; daily management and repairs; buying materials and supervising employees and independent contractors.
The safe harbor requirements will most likely be easier to satisfy by taxpayers having multiple properties, and cannot be used by a taxpayer that rents their personal residence(s) out for part of the year. While most rental house scenarios, cash rents and crop shares won’t qualify for the safe harbor, they may qualify under common control without regard to any hour requirement, or they can still generate QBI based on the overall facts and circumstances.
Thursday’s post will continue the discussion of the impact of the final QBI regulations on farming and ranching businesses. In that post, I will look a little further into the trade or business issue, discuss W-2 wages, and examine how the final regulations address the unadjusted basis in assets (UBIA) issue for QBI purposes. In addition, I will comment on numerous miscellaneous provisions, including the treatment of capital gains and the deductions that reduce QBI, just to name a couple. Also, I will take a look at how the final regulations treat commodity transactions, and how they apply to trusts and estates.