Monday, May 15, 2023
SCOTUS Dismisses Pork Case – Case Not Properly Plead
Overview
In a huge blow to pork producers (and consumers of pork products) nationwide, the Supreme Court of the United States (Court) has affirmed the U.S. Court of Appeals for the Ninth Circuit which upheld California’s Proposition 12 against a constitutional challenge. The Supreme Court dismissed the case without getting to the merits. But, in dismissing the case, the Court produced five opinions including one plurality opinion. Proposition 12 requires any pork sold in California to be raised in accordance with California’s housing requirements for hogs. This means that U.S. hog producers will need to ensure that their production facilities must satisfy California’s requirements for the resulting pork products to be sold to California consumers.
Each state sets its own rules concerning the regulation of agricultural production activities. So, how can one state override other states’ rules? Involved in the case was a claim involving the judicially-created doctrine known as the dormant Commerce Clause.
The dormant Commerce Clause, hogs and the SCOTUS and the ability of a state to dictate ag practices in other states – it’s the topic of today’s post.
Background
The Commerce Clause. Article I Section 8 of the U.S. Constitution provides in part, “the Congress shall have Power...To regulate Commerce with foreign Nations and among the several states, and with the Indian Tribes.” The Commerce Clause, on its face, does not impose any restrictions on states in the absence of congressional action. However, the U.S. Supreme Court has interpreted the Commerce Clause as implicitly preempting state laws that regulate commerce in a manner that disrupts the national economy. This is the judicially-created doctrine known as the “dormant” Commerce Clause.
The “dormant” Commerce Clause. The dormant Commerce Clause is a constitutional law doctrine that says Congress's power to "regulate Commerce ... among the several States" implicitly restricts state power over the same area. In general, the Commerce Clause places two main restrictions on state power – (1) Congress can preempt state law merely by exercising its Commerce Clause power by means of the Supremacy Clause of Article VI, Clause 2 of the Constitution; and (2) the Commerce Clause itself--absent action by Congress--restricts state power. In other words, the grant of federal power implies a corresponding restriction of state power. This second limitation has come to be known as the "dormant" Commerce Clause because it restricts state power even though Congress's commerce power lies dormant. Willson v. Black Bird Creek Marsh Co., 27 U.S. 245 (1829). The label of “dormant Commerce Clause” is really not accurate – the doctrine applies when the Congress is dormant, not the Commerce Clause itself.
Rationale. The rationale behind the Commerce Clause is to protect the national economic market from opportunistic behavior by the states - to identify protectionist actions by state governments that are hostile to other states. Generally, the dormant Commerce Clause doctrine prohibits states from unduly interfering with interstate commerce. State regulations cannot intentionally discriminate against interstate commerce. If they do, the regulations are per se invalid. See, e.g., City of Philadelphia v. New Jersey, 437 U.S. 617 (1978). Also, state regulations cannot impose undue burdens on interstate commerce. See, e.g., Kassel v. Consolidated Freightways Corp., 450 U.S. 662 (1981). Under the “undue burden” test, state laws that regulate evenhandedly to effectuate a local public interest are upheld unless the burden imposed on commerce is clearly excessive in relation to the local benefits.
The Court has never held that discrimination between in-state and out-of-state commerce, without more, violates the dormant Commerce Clause. Instead, the Court has explained that the dormant Commerce Clause is concerned with state laws that both discriminate between in-state and out-of-state actors that compete with one another, and harm the welfare of the national economy. Thus, a discriminatory state law that harms the national economy is permissible if in-state and out-of-state commerce do not compete. See, e.g., General Motors Corp. v. Tracy, 117 S. Ct. 811, 824-26 (1997). Conversely, a state law that discriminates between in-state and out-of-state competitors is permissible if it does not harm the national economy. H.P. Hood & Sons, Inc. v. Du Mond, 336 U.S. 525 (1949).
California Proposition 12 Litigation
In 2018, California voters passed Proposition 12. Proposition 12 bans the sale of whole pork meat (no matter where produced) from animals confined in a manner inconsistent with California’s regulatory standards. Proposition 12 established minimum requirements on farmers to provide more space for egg-laying hens, breeding pigs, and calves raised for veal. Specifically, the law requires that covered animals be housed in confinement systems that comply with specific standards for freedom of movement, cage-free design, and minimum floor space. The law identifies covered animals to include veal calves, breeding pigs and egg-laying hens. The implementing regulations prohibit a farm owner or operator from knowingly causing any covered animal to be confined in a cruel manner, as specified, and prohibits a business owner or operator from knowingly engaging in the sale within the state of shell eggs, liquid eggs, whole pork meat or whole veal meat, as defined, from animals housed in a “cruel manner.” In addition to general requirements that prohibit animals from being confined in a manner that prevents lying down, standing up, fully extending limbs or turning around freely, the measure added detailed confinement space standards for farms subject to the law. The alleged reason for the law was to protect the health and safety of California consumers and decrease the risk of foodborne illness and the negative fiscal impact on California.
In late 2019, several national farm organizations challenged Proposition 12 and sought a declaratory judgment that the law was unconstitutional under the dormant Commerce Clause. The plaintiffs also sought a permanent injunction preventing Proposition 12 from taking effect. The plaintiffs claimed that Proposition 12 impermissibly regulated out-of-state conduct by compelling non-California producers to change their operations to meet California’s standards. The plaintiffs also alleged that Proposition 12 imposed excessive burdens on interstate commerce without advancing any legitimate local interest by significantly increasing operation costs without any connection to human health or foodborne illness. The trial court dismissed the plaintiffs’ complaint. National Pork Producers Council, et al. v. Ross, 456 F. Supp. 3d 1201 (S.D. Cal. 2020).
On appeal, the plaintiffs focused their argument on the allegation that Proposition 12 has an impermissible extraterritorial effect of regulating prices in other states and, as such, is per se unconstitutional. This was a tactical mistake for the plaintiffs. The appellate court noted that existing Supreme Court precedent on the extraterritorial principle applied only to state laws that are “price control or price affirmation statutes.” National Pork Producers Council, et al. v. Ross, 6 F. 4th 1021 (9th Cir. Jul. 2021). Thus, the extraterritorial principle does not apply to a state law that does not dictate the price of a product and does not tie the price of its in-state products to out-of-state prices. Because Proposition 12 was neither a price control nor a price-affirmation statute (it didn’t dictate the price of pork products or tie the price of pork products sold in California to out-of-state prices) the law didn’t have the extraterritorial effect of regulating prices in other states.
The appellate court likewise rejected the plaintiffs’ claim that Proposition 12 has an impermissible indirect “practical effect” on how pork is produced and sold outside California. Id. Upstream effects (e.g., higher production costs in other states) the appellate court concluded, do not violate the dormant Commerce Clause. The appellate court pointed out that a state law is not impermissibly extraterritorial unless it regulates conduct that is wholly out of state. Id. Because Proposition 12 applied to California and non-California pork production the higher cost of production was not an impermissible effect on interstate commerce.
The appellate court also concluded that inconsistent regulation from state-to-state was permissible because the plaintiffs had failed to show a compelling need for national uniformity in regulation at the state level. Id. In addition, the appellate court noted that the plaintiffs had not alleged that Proposition 12 had a discriminatory effect on interstate commerce.
Simply put, the appellate court rejected the plaintiffs’ challenge to Proposition 12 because a law that increases compliance costs (projected at a 9.2 percent increase in production costs that would e passed on to consumers) is not a substantial burden on interstate commerce in violation of the dormant Commerce Clause.
U.S. Supreme Court
In 2021, the SCOTUS declined to review Proposition 12 in a different case brought by the North American Meat Institute. North American Meat Institute v. Bonta, No. 20-1215, 2021 U.S. LEXIS 3405 (S. Ct. Jun. 28, 2021). In that case, the plaintiff sought to preliminarily enjoin Proposition 12. The trial court declined to do so on the basis that Proposition 12 does not have a discriminatory purpose due to a lack of evidence of a protectionist intent that the law treats in-state pork producers more favorably that out-of-state pork producers (never mind that California has virtually no pork production). The trial court also determined that Proposition 12 does not regulate extraterritorial conduct because it is not a price control or price affirmation statute. Similarly, the trial court held that Proposition 12 did not substantially burden interstate commerce. The Ninth Circuit affirmed. North American Meat Institute v. Becerra, 825 Fed. Appx. 518 (9th Cir. 2020). As noted, the U.S. Supreme Court declined to hear the case.
In March of 2022, the U.S. Supreme Court agreed to review the other case discussed above challenging the constitutionality of Proposition 12. Oral arguments occurred in early October. On May 11, the Court issued a 5-4 plurality opinion dismissing the case for failure to state a claim and never getting to the merits of the case. However, the Court issued a total of five opinions including a dissent that can provide guidance for future cases alleging a dormant commerce clause violation.
The controlling plurality opinion (Justices Gorsuch, Thomas, Barrett, Sotomayor and Kagan) pointed out that the Congress has the power to regulate interstate commerce (Article I, Section 8), but hadn’t enacted any statute that would displace Proposition 12. So, the Court noted, the pork producers were claiming that the dormant Commerce Clause should be utilized to negate Proposition 12. The pork producers didn’t allege any purposeful discrimination by California, instead relying on the “extraterritoriality doctrine.” But, as noted above, that argument was a poor one in this case because price discrimination was not involved, and the Court was not willing to accept a “per se” rule under the dormant Commerce Clause that would strike down state legislation that has an impact beyond that state’s borders. Indeed, the Court said, “This argument falters out of the gate.”
The fallback argument of balancing under Pike was rejected by Justices Gorsuch, Thomas and Barrett on the basis that balancing state interests was a policy decision to be left up to the Congress. Indeed, Justice Barrett concluded that the benefits and burdens of Proposition 12 were impossible to measure, but that the complaint plausibly alleged a substantial burden on interstate commerce that would be felt almost exclusively outside California. Justices Sotomayor and Kagan would have engaged in balancing but because the pork producers failed to plausibly allege a substantial burden on interstate commerce – which is a requirement under Pike. The Court said it had no way to weigh the costs of Proposition 12 against California’s “moral and health interests.” Again, the Court said the matter was a policy choice to be left up to the Congress and that the Commerce Clause does not protect a particular structure or method of business operation – “That goes for pigs no less than gas stations.”
Chief Justice Roberts wrote a dissenting opinion that was joined by Justices Alito, Kavanaugh and Jackson. The dissent concluded that a substantial burden on interstate commerce was present because Proposition 12 impacted practically the entire U.S. hog industry due to the interconnected nature of the nationwide pork industry which would require the compliance of the vast majority of hog producers. It was more than a cost of compliance issue. The question was then, in the words of the dissent, whether the burden of Proposition 12 was clearly excessive in relation to the “putative local benefits.” This determination needed to be made by the lower courts.
Justice Kavanaugh wrote separately to point out that California was regulating hog production in other states and that other states had good reason for allowing hogs to be raised in a manner the California found offensive. He also noted that it would be virtually impossible for hog farmers and pork processors to segregate individual hogs based on their ultimate destination, and that each state has its own rules for health and safety as applied to hog production. Justice Kavanaugh stated, “California’s approach undermines federalism and the authority of individual States by forcing individuals and businesses in one State to conduct their farming, manufacturing and production practices in a manner required by the laws of a different State.” If Proposition 12 were to be upheld, a “blueprint” could be provided for other states. Justice Kavanaugh also stated that California’s approach could also be challenged under the Privileges and Immunities Clause, the Import-Export Clause and the Full Faith and Credit Clause. He concluded with a biting criticism of the lawyers for the pork producers by stating, “It appears, therefore, that properly pled dormant Commerce Clause challenges under Pike to laws like California’s Proposition 12 (or even to Proposition 12 itself) could succeed in the future – or at least survive past the motion-to-dismiss stage.”
Conclusion
The Court has been careless in applying the anti-discrimination test, and in many cases, neither of the two requirements--interstate competition or harm to the national economy--is ever mentioned. See, e.g., Hughes v. Oklahoma, 441 U.S. 322 (1979). The reason interstate competition goes unstated is obvious – in most cases the in-state and out-of-state actors compete in the same market. But, the reason that the second requirement, harm to the national economy, goes unstated is because the Court simply assumes the issue away.
The dormant Commerce Clause is something to watch for in court opinions involving agriculture. As states enact legislation designed to protect the economic interests of agricultural producers in their states, those opposed to such laws could challenge them on dormant Commerce Clause grounds. But, such cases must be plead carefully to show an impermissible regulation of extraterritorial conduct.
In the present case, practically doubling the cost of creating hog barns to comply with the California standards was not enough, nor was the interconnected nature of the pork industry. California gets to call the shots concerning the manner of U.S. pork production for pork marketed in the state. This, in spite of overarching federal food, health and safety regulations that address California’s purported rationale for Proposition 12.
Clearly a majority of the Justices said such matters as Proposition 12 is up to the Congress. On that point, since 2015 legislation has been introduced in the U.S. House on multiple occasions to address interstate commerce cannibalization by a state. On two occasions, the legislation passed the House but only to die in the U.S. Senate and not get included in a Farm Bill. The legislation, was entitled the “Protect Interstate Commerce Act” and would have barred a state from imposing a standard or condition on the production or manufacture of agricultural products sold or offered for sale in interstate commerce if (1) the production or manufacture occurs in another state, and (2) the standard or condition adds to standards or conditions applicable under Federal law and the laws of the state in which the production or manufacture occurs. Presently, Senator Marshall from Kansas has renamed the bill and introduced it into the U.S. Senate.
The dormant commerce clause is one of those legal theories “floating” around out there that can have a real impact in the lives of farmers, ranchers and consumers, and how economic activity is conducted. But, a case challenging a state law on dormant Commerce Clause grounds must be plead and argued properly for a court to hear it. That didn’t happen in the present situation.
May 15, 2023 in Regulatory Law | Permalink | Comments (0)
Saturday, April 29, 2023
Selling Collateralized Ag Products – The “Farm Products” Rule; Are Racehorses (and Breeding Rights) an Agricultural Commodity?
Overview
When a farmer sells farm products such as crops and livestock in the normal course of the farming business, those products often are also serving as collateral for a lender’s security interest. So what are the rights of the buyer in that instance? Does the buyer take the goods subject to a pre-existing security interest created by the farmer-seller? That’s an important question for both farmer-sellers and buyers of farm products to know. Another question is what the scope of definition of “farm products” includes. Is it broad enough to include racehorses and their breeding rights?
The “farm products rule,” and the 1985 Farm Bill modification and its application – it’s the topic of today’s post.
The Farm Products Rule
Original rule. There is a long history behind the farm products rule. Prior to a change in the law that was contained in the 1985 Farm Bill, the majority rule was that a buyer in the ordinary course of business (BIOC) from a seller engaged in farming operations did not take free of a perfected security interest unless evidence existed of a course of past dealing between the secured party and the debtor from which it could be concluded that the secured party gave authority to the debtor to sell the collateral. UCC § 9-307(1). Thus, a farmer's sale of secured farm products did not cut off the creditor's right to follow farm products into the hands of buyers, such as grain elevators. This meant that when a farmer failed to settle with secured parties, buyers of farm products sometimes had to pay twice unless the buyer could show that the secured party gave the debtor authority to sell the collateral.
Under the farm products rule, farm products were not considered “inventory” to a farmer. Instead, “farm products” were defined as crops, livestock (including, apparently, fowl) or supplies used or produced in farming operations and products of crops or livestock in their unmanufactured states if they were in the possession of a debtor engaged in the raising, fattening, or grazing of livestock or other farming operations. Under the rule, the holder of the perfected security interest could recover farm products subject to the interest from a bona fide purchaser purchasing watermelons from a roadside stand, steers in carload lots, or a load of corn, if the purchase was from a seller engaged in farming operations. However, crops, livestock, or the products of crops or livestock if in the possession of one not engaged in farming ceased to be farm products and were inventory. Similarly, if farm products passed to one engaged in marketing for sale or a manufacturer or processor, they became inventory.
Impact of the rule. The farm products rule was highly protective of secured parties. Purchasers of farm products had to be cautious in all transactions and were given strong incentive to always check the record for filed financing statements, and to have checks made payable jointly to the seller and the lender. However, creditors secured by farm products still needed to have a properly perfected security interest in the crops or livestock and include a specific provision in the security agreement specifying whether the debtor could sell the collateral. If sales were allowed, the lender needed to state clearly how payment was to be made, whether checks were to be sent directly to the lender, whether the debtor and lender were to be joint payees, or, whether a specified percentage of the proceeds was to be remitted directly to the lender. In any event, the provisions on sale and payment of proceeds had to be consistently enforced.
From the mid-1970s until the mid-1980s, several states amended the UCC farm products rule to allow, in various circumstances, purchasers of farm products from a person engaged in farming operations to take free of a perfected security interest. By the end of 1985, about 40 percent of the states had modified the general rule.
1986 – A New Rule
Effective December 23, 1986, the 1985 Farm Bill (Food Security Act (FSA) of 1985) “federalized” the states' farm product rules. The new provision specified that, "a buyer who in the ordinary course of business buys a farm product from a seller engaged in farming operations shall take free of a security interest created by the seller, even though the security interest is perfected; and the buyer knows of the existence of such interest." 7 U.S.C. §1631(d). The term "farm product" means an agricultural commodity such as wheat, corn, soybeans, or a species of livestock such as cattle, hogs, sheep, horses, or poultry used or produced in farming operations, or a product of such crop or livestock in its unmanufactured state (such as ginned cotton, wool-clip, maple syrup, milk, and eggs), that is in the possession of a person engaged in farming operations. 7 U.S.C. §1631(c)(5).
State options. The FSA provision gave the states two options - adopt a prescribed central filing system or follow an “actual notice” rule. Thus, under the federal rule, if a BIOC buys a farm product that has been “produced in a state” from a seller engaged in farming, the BIOC takes the farm product free of any security interest created by the seller unless:
- Within one year before the sale of the farm products, the buyer has received written notice of the security interest from the secured party (the direct notice exception);
- The buyer has failed to pay for the farm products; or
- In states which have established a central filing system (all states now have adopted central filing), the buyer has received notice from the Secretary of State of an effective filing of a financing statement (EFS) or notice of the security interest in the farm products and has not obtained a waiver or release of the security interest from the secured party (the central filing exception).
To comply with the direct notice exception, a secured creditor had to send the farm products purchaser a written notice listing (1) the secured creditor’s name and address; (2) the debtor’s name and address; (3) the debtor’s social security number or taxpayer identification number; (4) a description of the farm products covered by the security interest and a description of the property; and (5) any payment obligations conditioning the release of the security interest. The description of the farm products had to include the amount of the farm products subject to the security interest, the crop year, and the counties in which the farm products are located or produced.
Under central filing, the secured creditor must file a financing statement containing the same information as required in the written notice under the direct notice exception, except the secured creditor need not include crop year or payment obligation information. Also, notwithstanding errors contained in the financing statement, a financing statement in a central filing state remains effective so long as the errors “are not seriously misleading.” However, the general rule is that there is no “substantial compliance” rule with respect to the direct notice exception. A secured creditor must comply strictly with the requirements of the direct notice exception. See, e.g., State Bank of Cherry v. CGB Enterprises, Inc., 984 N.E.2d 449 (Ill. 2013), aff’g., 964 N.E.2d 604 (Ill. Ct. App. 2012). However, the Kansas Supreme Court has applied a substantial compliance rule to the direct notice exception. First National Bank & Trust v. Miami County Cooperative Assoc., 257 Kan. 989, 897 P.2d 144 (1995).
2002 Farm Bill amendments. The 2002 Farm Bill made several changes in the federal farm products rule. Under the legislation, a financing statement is effective if it is signed, authorized or otherwise authenticated by the debtor. A financing statement securing farm products needs to describe the farm products and specify each county or parish in which the farm products are produced or located. Also, the required information on the security agreement must include a description of the farm products subject to the security interest created by the debtor, including the amount of such products where applicable, crop year, and the name of each county or parish in which the farm products are produced or located.
Application of revised Article 9. Secured transactions under Article 9 of the Uniform Commercial Code (UCC) involve personal property and fixtures including loans on crops, livestock, inventories, consumer goods and accounts receivable. Effective in 2001, Article 9 was revised such that “farm products” means goods, other than standing timber, with respect to which the debtor is engaged in a farming operation and which are:
- Crops grown, growing or to be grown, including crops produced on trees, vines and bushes; and aquatic goods produced in aquacultural operations;
- Livestock, born or unborn, including aquatic goods produced in aquacultural operations;
- Supplies used or produced in a farming operation; or
- Products of crops or livestock in their unmanufactured states.
“Farming operation” means raising, cultivating, propagating, fattening, grazing or any other farming, livestock or aquacultural operation. As such, the revised definition of “farm products” eliminates the provision explicitly requiring the collateral to be in the possession of a person engaged in a farming operation.
Legal Issues Under the 1985 Rule
Buyer in direct notice state buying farm products in central filing state. Under the farm products rule, before all states became central filing jurisdictions, a question was whether a buyer in a direct notice state that bought farm products produced in a central filing state was subject to a filing in an EFS central notice state. 7 U.S.C. §1631 says the answer to that question is “yes” but does not define what “produced in” means. Is the phrase restricted in meaning only to production activities or does it also include marketing of the farm products? One court has held that “produced in” means “the location where farm products are furnished or made available for commerce.” The court believed that “such an interpretation allowed lenders to discern where they must file notice of their security interests and ensures a practical means for buyers to discover otherwise unknown security interests in farm products.” Great Plains National Bank v. Mount, 280 P.3d 670 (Colo. Ct. App. 2012).
Are thoroughbreds “agricultural commodities”? As noted above, the 1985 rule change also defined a “farm product” as an “agricultural commodity.” In a recent Kentucky case, the court was faced with the question of whether thoroughbred racehorses (and their breeding rights) were farm products that fell within the scope of federal preemption under the farm 7 U.S.C. §1631(d) that was codified in Ky. Rev. Stat. §355.9-320(1) such that a purchaser took free of a prior perfected security interest.
Under the facts of the case, the plaintiff entered into a financing agreement with Zayat Stables, LLC (Zayat Stables) which owns, raises, maintains, buys, races, breeds, and sells horses – including American Pharoah, the winner of the 2015 Triple Crown. In 2016 the plaintiff loaned Zayat Stables $30 million secured by “all the property and assets and all interests therein and proceeds thereof now owned or hereafter acquired by any person upon which a lien is granted or purported to be granted by such person as security for all or any part of the obligations, including, without limitation, all equine collateral.” Zayat Stables sold a series of horses and breeding rights without notifying the plaintiff, so the plaintiff sued for breach of contract and fraud, seeking to recover $23 million. The plaintiff also sued other purchasers, including the defendant. The trial court and the appellate court both held the purchasers were protected by the 1985 repeal of the farm products rule. The plaintiff claimed that thoroughbreds were exempt from the provision under K.R.S. §355.9-102(1)(ah) because they were not used for farming purposes.
The Supreme Court affirmed the lower courts, noting that there was no carve-out for thoroughbreds in the statute (the provision applied to all horses) and that the USDA had stated that the repeal of the farm products rule applies to “specific commodities, species of livestock, and specific products of crops or livestock” including “cattle & calves, goats, horses, mules, sheep & lambs, other livestock.” The Supreme Court stated the list did not put a limitation on types of horses and that the Kentucky legislature had expressed its acceptance of the provision’s application to thoroughbred horses through a series of statutory enactments.
The plaintiff further claimed that thoroughbred horses were not “farm products” because they were not an “agricultural commodity” as defined by 7 U.S.C. §1631(c)(5). The plaintiff’s position was the thoroughbreds were simply “too exceptional” to constitute a “commodity.” However, the Supreme Court determined that the plain language of the FSA demonstrated that thoroughbred horses were farm products and that such a construction was consistent with how the Kentucky legislature viewed the FSA as applied to all types of horses.
The Supreme Court also held that breeding rights to the thoroughbreds (including those of American Pharaoh) were included under the FSA provision as horses “produced” in a farming operation as well as a “product of such… livestock in its unmanufactured state.” Thus, the buyers of the thoroughbreds and their breeding rights took free of the plaintiff’s security interest. MGG Investments Group. LP v. Bemak N.V., Ltd., No. 2021-SC-0561-DG, 2023 Ky. LEXIS 50 (Ky. Sup. Ct. Mar. 23, 2023).
Conclusion
In difficult financial times, understanding the rights of creditors of agricultural products is important. The specific rules surrounding the sale of farm products are important to understand.
April 29, 2023 in Secured Transactions | Permalink | Comments (1)
Saturday, April 22, 2023
Deductibility of Personal Interest and the Home Mortgage Exception
Overview
The rules for the deductibility of interest can be a bit tricky. Also, to properly account for interest, the definition of interest is critical. In addition, there apparently is some confusion that has arisen concerning the proper classification of lender fees for tax purposes.
Today’s article takes a look at the deductibility of one of the classifications of interest – personal interest. A subsequent article will take a look at the tax deductibility of investment interest and business interest.
The tax treatment of personal interest and the exception for mortgage interest - it’s the topic of today’s post.
Background
Presently, there exist different rules for the three types of interest: personal interest, investment interest and business interest. For farmers and ranchers, the bulk of farm interest should be deductible as business interest. That makes the classification of interest the end of the inquiry critical to determining the proper tax treatment.
Personal Interest and the Exception for Mortgage Interest.
Personal interest is not deductible unless the debt is secured by a mortgage on the principal residence, which is referred to a qualified residence interest. I.R.C. §§163(h)(2)(D); (h)(3). Generally, qualified residence interest is any interest paid on a loan secured by the taxpayer’s main home and one other residence. See, e.g., Boehme v. Comr., T.C. Memo. 2003-81 (where loan was acquisition debt, but repayment was secured by taxpayer’s right to receive future lottery payments rather than the residence, loan interest was not qualified residence interest). If the other residence is rented out, the taxpayer or a member of the taxpayer’s family must use the second home for more than the greater of two weeks or 10 percent of the number of days when the residence is rented for a fair rent to persons other than family members. The loan may be a mortgage to buy the home, or a second mortgage. The exception to the rule of nondeducibility of personal interest applies to “qualified residence interest.” That is defined as interest associated with the taxpayer's principal residence on the first $750,000 ($375,000 if married filing separately) of indebtedness. These limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer’s main home and second home. The deduction is on a per taxpayer basis to unmarried co-owners of a qualified residence. See, e.g., Voss v. Comr., 796 F.3d 1051 (9th Cir. 2015).
Note: A higher limitation applies ($1 million ($500,000 if married filing separately)) if the mortgage interest is attributable to indebtedness incurred before December 16, 2017. Through 2022 this threshold also included mortgages taken out before October 13, 1987.
If the residence contains a business office for which a home office deduction is claimed, an allocation must be made between the part of the home that is the qualified home and the part that is not. The business portion of the home mortgage interest allowed as a deduction is included in the business use of the home deduction that is reported on Schedule C (Form 1040), line 30, or Schedule F (Form 1040), line 32. For taxpayers that itemize deductions on Schedule A, the personal part of the deductible mortgage interest is reported on Schedule A, line 8a or 8b and the business portion is reported on Schedule C (or F).
Mortgage interest is not deductible unless the taxpayer files either Form 1040 or 1040-SR and itemizes deductions on Schedule A. Also, the mortgage must be secured debt on a qualified home in which the taxpayer’s has an ownership interest. The mortgage must provide that the home satisfies the debt in the event of default. The mortgage must be recorded, and both the taxpayer and the lender must intend that the loan be repaid. A “wraparound mortgage” is secondary financing and is not secured debt unless it is recorded or otherwise perfected under state law.
Note. For tax years 2018 through 2025, an interest deduction is no longer available for home equity indebtedness unless the indebtedness is used to buy, build or substantially improve the taxpayer’s personal residence that secures the loan. The total loan balance (first mortgage and home equity loan is subject to the $750,000 (mfj) limitation. IR 2018-32, Feb. 21, 2018.
An election can be made to treat secured mortgage debt as not secured by the home. The election may only be revoked with IRS consent. The election might make sense in situations where the debt would be fully deductible as business debt regardless of whether it qualifies as home mortgage interest and would allow a greater interest deduction on another debt that would give rise to a deduction for home mortgage interest.
Unique Situations
Divorce. Questions concerning the deductibility of qualified residence interest can arise in unique situations. For example, if a divorce decree or separation agreement requires the taxpayer to make all of the mortgage payments on a jointly owned home with an ex-spouse, the taxpayer and the ex-spouse may each treat one-half of the interest payments as qualified residence interest if the home is a qualified residence. IRS Pub. No. 504 (2022), p. 14.
Retirement plan. If a loan from a qualified retirement plan is characterized as a distribution and is a bona fide loan, the interest may satisfy the definition of qualified residence interest. F.S.A. 200047022 (Aug. 22, 2000).
Trust or estate. Simply transferring title of a qualified residence to a trust does not disqualify the grantor’s continued payment of interest on the indebtedness as deductible qualified residence interest. See, e.g., Investment Research Associates Limited & Subsidiaries v. Comr., T.C. Memo. 1999-407. After the grantor dies, if the estate or a trust pays interest on a mortgage attributable to a residence that the estate or trust holds, the interest is treated as qualified residence interest if the residence is a qualified residence of a beneficiary having a present or residuary interest in the estate or trust. I.R.C. §163(h)(4)(D).
Mortgage interest refunds. The IRS ruled in Rev. Rul. 92-91, 1992-2 CB 49, that an interest overcharge due to the lender’s miscalculation of an adjustable-rate mortgage that the cash basis borrower paid was deductible in the year paid as qualified residence interest even though it was reimbursed in a later tax year.
Conclusion
A subsequent article will take a look at investment interest and business interest. Included in the discussion will be the issue of whether loan extension fees meet the definition of deductible business interest. That’s an issue that arisen recently with respect to some farm loans.
April 22, 2023 in Income Tax | Permalink | Comments (0)
Thursday, April 20, 2023
Bibliography – First Quarter of 2023
The following is a listing by category of my blog articles for the first quarter of 2023.
Bankruptcy
Failure to Execute a Written Lease Leads to a Lawsuit; and Improper Use of SBA Loan Funds
Chapter 12 Bankruptcy – Proposing a Reorganization Plan in Good Faith
Business Planning
Summer Seminars
https://lawprofessors.typepad.com/agriculturallaw/2023/03/summer-seminars.html
Registration Now Open for Summer Conference No. 1 – Petoskey, Michigan (June 15-16)
Civil Liabilities
Top Ag Law and Tax Developments of 2022 – Part 1
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 8 and 7
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1
Contracts
Top Ag Law and Developments of 2022 – Part 2
Failure to Execute a Written Lease Leads to a Lawsuit; and Improper Use of SBA Loan Funds
Double Fractions in Oil and Gas Conveyances and Leases – Resulting Interpretive Issues
Environmental Law
Here Come the Feds: EPA Final Rule Defining Waters of the United States – Again
Top Ag Law and Developments of 2022 – Part 2
Top Ag Law and Developments of 2022 – Part 3
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 10 and 9
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 6 and 5
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 4 and 3
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1
Estate Planning
Tax Court Opinion – Charitable Deduction Case Involving Estate Planning Fraudster
Happenings in Agricultural Law and Tax
Summer Seminars
https://lawprofessors.typepad.com/agriculturallaw/2023/03/summer-seminars.html
RMD Rules Have Changed – Do You Have to Start Receiving Payments from Your Retirement Plan?
Common Law Marriage – It May Be More Involved Than What You Think
The Marital Deduction, QTIP Trusts and Coordinated Estate Planning
Registration Now Open for Summer Conference No. 1 – Petoskey, Michigan (June 15-16)
Income Tax
Top Ag Law and Developments of 2022 – Part 3
Top Ag Law and Developments of 2022 – Part 4
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 8 and 7
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1
Tax Court Opinion – Charitable Deduction Case Involving Estate Planning Fraudster
Deducting Residual (Excess) Soil Fertility
Deducting Residual (Excess) Soil Fertility – Does the Concept Apply to Pasture/Rangeland? (An Addendum)
Happenings in Agricultural Law and Tax
Summer Seminars
https://lawprofessors.typepad.com/agriculturallaw/2023/03/summer-seminars.html
RMD Rules Have Changed – Do You Have to Start Receiving Payments from Your Retirement Plan?
Registration Now Open for Summer Conference No. 1 – Petoskey, Michigan (June 15-16)
Real Property
Equity “Theft” – Can I Lose the Equity in My Farm for Failure to Pay Property Taxes?
Happenings in Agricultural Law and Tax
Adverse Possession and a “Fence of Convenience”
Double Fractions in Oil and Gas Conveyances and Leases – Resulting Interpretive Issues
Abandoned Rail Lines – Issues for Abutting Landowners
Regulatory Law
Top Ag Law and Developments of 2022 – Part 2
Top Ag Law and Developments of 2022 – Part 4
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 10 and 9
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 8 and 7
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 6 and 5
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 4 and 3
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1
Foreign Ownership of Agricultural Land
Abandoned Rail Lines – Issues for Abutting Landowners
Secured Transactions
Priority Among Competing Security Interests
Water Law
Top Ten Agricultural Law and Tax Developments of 2022 – Numbers 2 and 1
Happenings in Agricultural Law and Tax
April 20, 2023 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Tuesday, April 11, 2023
Registration Now Open for Summer Conference No. 1 – Petoskey, Michigan (June 15-16)
Overview
Again this summer, Washburn Law School will be conducting two summer seminars focused on farm and ranch income taxation and farm and ranch estate, business and succession planning. The first of the two events will be in Petoskey, Michigan on June 15-16 at North Central Michigan College. Registration is now open and can be accessed here: https://www.washburnlaw.edu/employers/cle/farmandranchtaxjune.html
August Conferences in Idaho
The finishing touches are just about complete on the second two-day event this summer which will be at North Idaho College in Coeur d’Alene, Idaho on August 7-8. Both events will also be simulcast live over the web. The Idaho event will feature a “conference within a conference.” The standard two days will be devoted to farm/ranch income tax and farm/ranch estate and business planning topics. But starting a bit later each day and ending slightly earlier, a second conference will be occurring simultaneously in a nearby meeting hall in the same building on the North Idaho College campus devoted to topics in agricultural law. The them of this two-day conference will be on representing the ag client. Many thanks to the Idaho Bar Association, the ag law section of the Idaho Bar, Prof. Rich Seamon and the University of Idaho College of law and others in helping put this conference together. Details on this these two conferences in Coeur d’Alene will be posted here soon with registration information.
June Michigan Conference
The itinerary for the Michigan event is below. The Idaho tax/e.p./b.p. conference follows the same Day 1 itinerary as the Michigan event, but Day 2 in Idaho will have a few different topics and speakers.
Here’s the itinerary for the Michigan conference.
Day 1 Itinerary
7:30-8:00 a.m. – Registration
8:00–8:05 a.m. - Welcome and Announcements
8:05–9:05 a.m. – Tax Update (Cases and Rulings) (McEowen) [60 minutes tax update CPE]
This opening session takes a look at the most significant tax cases and rulings from the courts and the IRS during the past year that have implications for farm and ranch clients, rural landowners, and agribusiness professionals.
9:05–9:45 a.m. – The Definition of “Farm Income” for Farm Program Purposes (Neiffer) [40 minutes tax update CPE]
Many Farm Service Agency programs grant extra payments if AGI from farming is more than 75% of total AGI. This session will review how FSA determine AGI and why it can be substantially different from IRS calculations.
9:45–10:05 a.m. – Morning Break
10:05–10:30 a.m. – Machinery Trades (McEowen) [25 minutes of tax law CPE]
This session examines the trade of farm machinery with no or low basis for new machinery and the resulting gain computation, combined with substantial depreciation claimed on the new machine.
10:30–10:55 a.m. – Selected Topics - Inventory Method Options for Farmers; How Bonus Depreciation and Expense Method Depreciation Can Work Together for Farm Clients (Neiffer) [25 minutes of tax update CPE]
Tax Reform simplified many accounting methods for taxpayers including farmers. We will review those change and why Section 179 can be more beneficial than bonus depreciation.
10:55–11:45 a.m. – Solar Panel Tax Issues; Other Rental Tax Issues (McEowen) [50 minutes of tax law CPE]
This discussion explores the tax issues associated with the placement of solar panels on farmland and also looks at other tax issues associated with rentals that farming operations often encounter.
11:45–12:45 p.m. – Luncheon
12:45 p.m.– 1:45 p.m. – Protecting a Tax Practice From Scammers (IRS CID) [60 minutes of tax law]
What steps can a tax practice take to protect itself from scams, including those from the dark web? What is good office protocol? What are the essential things that can be done and what are the signs to look for to detect scammers?
1:45 p.m.–2:25 p.m. – Selected Topics - Amending Partnership Returns; Corporate Provided Meals and Lodging; Charitable Remainder Trusts for Retiring Farmers (Neiffer) [40 minutes of tax law CPE]
This session will update the required method of amending partnership returns depending on whether the centralized partnership audit regime applies; a review of the change in corporate provided meals and why charitable remainder trusts can save taxes for a retiring farmer especially with increasing interest rates.
2:25-2:45 p.m. – Afternoon Break
2:45–3:10 p.m. – Easement Tax Issues (McEowen) [25 minutes of tax update CPE]
Rural landowners are finding easement tax issues to be more commonplace. This brief session provides a review of the basic tax issues associated with easements, particularly income tax basis offset issues and the character of the easement payments.
3:10–4:00 p.m. – IC-DISC for Farmers; Disallowance of Cash Method for Farming Activities; Accounting for Hedging Transactions; When to Deduct a Purchased Growing Crop (Neiffer) [50 minutes of tax law CPE]
An IC-DISC can cut a farmer’s income taxes in half – we review when it might apply. More farming activities include non-material participating taxpayers. This can cause the entity to be on the accrual method. The reporting of hedging activities is not always intuitive. We review the requirement and the options and when can a farmer deduct purchased growing crop.
4:00–4:25 p.m. – Soil Fertility Deductions (McEowen) [25 minutes of tax law CPE]
When a farm is purchased an allocation of value can be made to depreciable items. One of those items might be excess fertilizer supply. The IRS has a specific procedure that must be followed for valuing the excess amount. This session examines the IRS approach, the amount to be amortized, the timeframe for amortization and the possibility of recapture.
4:25 p.m. - Adjournment
Day 2
Here’s the itinerary for Day 2 of the Michigan event (farm estate and business planning track):
7:30-8:00 a.m. — Registration
8:05-8:55a.m. — Current Developments in Estate and Gift Taxation (McEowen) [50 minutes tax update CPE]
This session provides an update of legislative, regulatory and court developments involving federal estate and gift tax including developments involving a decedent’s gross estate, asset valuation, gifts made during life, retirement plans and miscellaneous issues.
8:55-9:45 a.m. – “Top Ten” Strategies For a Successful Farm Business (Rhea and Dikeman) [50 minutes tax update CPE]
As we look toward the next 12 months, several items deserve increased attention for farm businesses. This presentation delivers a Top 10 list of forward-looking strategies to consider for success. Changes in cost, income, inflation, tax laws, and estate planning are some key topics discussed. These will be on the mind of farms and ranches as they navigate the uncertain economic conditions and the impact of higher asset values, growing debt, and rising interest rates. We will also demonstrate the performance distinctions of top 1/3 producers.
9:45-10:05 a.m. — Morning Break
10:05-10:55 a.m. – Taxes in Probate: Form 1041 and Distribution Deductions (McEowen) [50 minutes tax law CPE]
This session walks the practitioner through the completion of Form 1041, the assets included in the probate estate, possible income generating items for an estate, the handling of capital gain or loss, and estate accounting. A discussion of e-filing and electronic signatures will also be included. In addition, common issues associated with the death of a farmer will be addressed.
10:55 a.m.-11:45 a.m. – SLATs – Why It Might be the Best Option for Your Farmers (Neiffer) [50 minutes of tax law CPE]
This session reviews the various trust options available to farm families to transfer assets to the next generation in a tax efficient manner. The session will then review why a Spousal Lifetime Access Trust (SLAT) might be the best option.
11:45-12:45 p.m. — Lunch
12:45 p.m.-1:35 p.m. – Why Social Security is an Investment, not a Tax (Neiffer) [50 minutes of tax law CPE]
Most farmers view social security as an unnecessary tax. However, with optimal planning, social security maybe one of the best investments they ever make. We review how benefits are calculated, why spousal benefits provide even more bang for their buck and some common claiming options.
1:35 p.m.-2:50 p.m. — Tax Strategies for the Farm and Ranch Client (Rhea and Dikeman) [75 minutes of tax law CPE]
This session highlights several changes were made by the Tax Cuts & Jobs Act of 2017; many sunset after 2025 and demand attention for optimal tax planning strategies the next 3 years. We will also explain how rising inflation rates are at times helping reduce tax liability and when it does not. Rising interest rates and inflated asset values are dramatically shifting costs of farm transitions to the detriment of young and beginning farmers. Stepped-up basis is a big thing; we detail how this can be helpful to farm successors. Unintended consequences of high income and options for tax management after year end are analyzed.
2:50 p.m. – 3:10 p.m. – Afternoon Break
3:10 p.m. – 3:25 p.m. – New Estate Planning Clients – Screening Clients and Gathering Information [15 minutes of tax law CPE]
This session takes a brief look at a suggested approach to handling potential new estate/business planning clients. How to screen clients, identify potential problem clients, engagement letters and information gathering as preparatory to determining the appropriate path forward for the client.
3:25-4:25 p.m. – Ethics for Estate Planners (McEowen) [1 hour of tax ethics CPE]
What are the ethical issues facing practitioners working with clients on estate/business and tax planning matters? How might the Circular 230 rules impact tax professionals in the estate and business planning context when income tax advice is involved? This session looks at some of the common issues that can arise, applicable caselaw, and some of the more unusual situations that might arise that present difficult situations for the planner.
4:25 p.m. — Conference Adjourns
Conclusion
The registration link for the Michigan event can be found here:
As noted above, both days of the conference will be broadcast live online. Also, if you business is interested in being a sponsor, please contact me.
April 11, 2023 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)
Sunday, April 9, 2023
The Marital Deduction, QTIP Trusts and Coordinated Estate Planning
Overview
A married person can leave an unlimited amount of property outright to the surviving spouse at death with no resulting federal estate tax. I.R.C. §2056. The is also an unlimited gift tax marital deduction. I.R.C. §2523. This means that interspousal transfer, either during lifetime or at death, may be made tax-free regardless of amount. In addition, for lifetime spousal transfer, no gift tax return need be filed.
But, to qualify for the marital deduction, the transfer to the spouse must be outright. It cannot be a life estate, or a terminable interest as defined in I.R.C. §2056(b). That is, unless the terminable interest is a qualified terminable interest property (QTIP) interest. I.R.C. §2056(b)(7).
A QTIP trust was at the heart of a multi-year family dispute that the U.S. Tax Court recently decided. The case points out that QTIP trusts must be utilized carefully to avoid negative tax consequences and family disputes.
QTIP Trusts – The Basics
A QTIP trust is similar to a marital A/B trust set-up. They are both irrevocable “credit shelter” trusts that take effect when the first spouse of a married couple dies. With an A/B trust arrangement, an allocation of the first spouse’s assets at the time of death is done. In general, for an estate potentially subject to federal estate tax, an amount equal to the estate tax unified credit should be taxed in the first spouse’s estate which would then be offset by the credit. The balance should pass to the surviving spouse outright and qualify for the marital deduction. This is the A/B trust arrangement – a credit shelter trust and a marital deduction trust. The amount in the credit shelter trust is taxed in the first spouse’s estate but offset by the unified credit, and the amount in the marital deduction trust is offset by the marital deduction. The result is often little to no tax in the first estate and estate tax optimization in the second spouse’s estate. The difference between a QTIP trust and a marital trust is that with a QTIP trust has the right to income from the trust (and, perhaps, principal) but control does not pass to the surviving spouse. With a marital trust the surviving spouse controls the asset distribution.
In situations, such as a second marriage, where the first spouse to die wants to ensure the passage of property to someone other than the surviving spouse, the marital deduction would be lost to the first spouse’s estate without the QTIP provision. But, with a QTIP the first spouse can control disposition of the property upon the surviving spouse’s death while still qualifying the property for the marital deduction in the decedent’s estate.
QTIP requirements. An election must be made to achieve QTIP treatment and certain requirements must be satisfied – 1) the property must pass to a spouse from the decedent; 2) the decedent’s spouse must be entitled to all of the income from the property for life, payable at least as frequently as annually; and 3) no one, including the spouse, may have a power to appoint any part of the principal to anyone other than the spouse during the spouse’s life. If these conditions are satisfied, the estate of the first spouse to die, can claim a marital deduction for the value of the property in the QTIP trust.
Note: A QTIP trust does not necessarily restrict the surviving spouse’s ability to withdraw principal, but it is common that a QTIP trust does not grant such a withdrawal power
Estate of Kalikow v. Comr., T.C. Memo. 2023-21
Basic facts. A prominent New York City real estate developer died in 1990 with a will that created a QTIP trust for the benefit of his surviving wife. The QTIP trust contained ten income-producing apartment buildings in New York City. The trustees were instructed to pay the trust’s net income at least quarterly to the surviving spouse for life along with discretionary principal distributions, and then the assets were to be divided and paid to trusts for the benefit of the couple’s two adult children.
In 1997, the couple’s son and the family’s CPA (as trustees of the trust) created a Family Limited Partnership (FLP) and the QTIP trust was transferred to the FLP in exchange for a 98.5 percent partnership interest. At the time of the surviving spouse’s death in early 2006, the QTIP trust held the FLP interest, $835,000 of cash and marketable securities. After payment of expenses, the balance of the surviving spouse’s estate passed to charity. The couple’s daughter was also added as a trustee. Under the surviving spouse’s will, the trust was responsible for its share of estate tax arising from the inclusion of the trust property in the decedent’s estate.
A grandchild of the couple’s petitioned a local court to compel the trustees to render an account of income distributions from the QTIP trust to the surviving spouse. The trustees filed competing reports and the CPA-trustee claimed that the FLP had failed to distribute to the trust its full share of FLP distributable amounts which diminished the decedent’s receipt of trust income by almost $17 million. The CPA-trustee requested the court to order he and the other trustee to pay this amount, plus interest, to the estate from the trust’s income. However, the decedent’s children (appointed as limited administrators of their mother’s estate) filed a petition claiming that there had been an overdistribution of $3.27 million from the trust to the surviving spouse. The matter was litigated for a decade and the parties reached a settlement agreement that the trust would pay the estate $9.2 million which represented unpaid income of $6.5 million and $2.7 million in fees from January 1, 2002, through 2005.
The executor of the surviving spouse’s estate (the CPA who was also a co-trustee of the QTIP trust) filed Form 706 (federal estate tax return) in early 2007 reporting “other miscellaneous property” of $31,869,441 including $4,632,489 of undistributed income from the pre-deceased spouse’s estate and a yet to be determined claim of the estate against the trustees of the pre-deceased husband’s trust for loss of profits, excess taxes paid, interest and other damages. The children filed a Form 706 on the same day that mirrored the executors’ Form 706, but also included the assets of their father’s trust – another $43.3 million (which included the 98.5 percent FLP interest and the cash and marketable securities).
The IRS position and the Tax Court. The IRS issued a notice of deficiency asserting that the trust’s value of the 98.5 percent FLP interest was $105,664,857 instead of $42.465 million as reported on the limited administrators’ Form 706. The IRS also reduced the estate’s assets by the value of the pending claim against the trust. The executors and the limited administrators both filed a Tax Court action claiming that the IRS’ reduction of the gross estate by the $4.632,489 of the estate’s claim against the trust. The executors claimed that the pending claim should be included in the gross estate at $16,946,827, and the limited administrators asserted that the value of the trust should be reduced by the amount of any claim allowed for undistributed income due the estate from the trust and the resulting net value be included in the gross estate under I.R.C. §2044. Thus, the issues before the Tax Court were (1) whether the value of the QTIP trust assets included in the surviving spouse’s gross estate should be reduced by the agreed-upon undistributed income amount; and (2) whether the surviving spouse’s estate could deduct any part of that undistributed income as an administration expense under I.R.C. §2053. The estate asserted that the gross estate should be reduced, and an administration expense could be claimed. The IRS disagreed.
Note: The executors and limited administrators stipulated that the value of the trust’s FLP interest at the date of the decedent’s death was $54,492,712.
The Tax Court noted that under I.R.C. §2044(a), the QTIP trust property was to be included in the surviving spouse’s gross estate at fair market value as of the date of her death. Thus, the stipulated value of the trust’s FLP interest plus the cash and marketable securities of $55,327,712 was included in her gross estate. The Tax Court disagreed with the assertion that the gross estate should be decreased by the amount of the agreed-upon settlement amount. The Tax Court pointed out that by the terms of the trust, the FLP was not liable for the settlement payment and, as such, the liability had no impact on the date of death fair market value of the trust’s FLP interest. The Tax Court agreed with the assertion of the IRS that the trust would have an offsetting claim against third parties for the undistributed income payment liability. In addition, the enhanced value of the surviving spouse’s gross estate increased the estate’s charitable contribution by a like amount. The Tax Court also concluded that the estate was not entitled to deduct any part of the agreed-upon settlement payment other $838,044 attributable to paying out commissions.
Estate Planning and Family Structure
The Kalikow case presents an interesting illustration of the family dynamics that estate planners often must deal with. This apparently was not a second marriage situation for either spouse – at least there is no indication of that by the Tax Court. This raises a question as to why a QTIP trust was created under the terms of the husband’s will? Did he suspect that if his wife survived him that she would disinherit their children? Were there creditor issues? The husband died at age 70 after battling Parkinson’s disease for 36 years. Indeed, her will left the residue of her estate to charity rather than the children. Also, the co-trustees of the QTIP trust were a son, a non-family member CPA and the surviving spouse. After the death of the surviving spouse, their daughter was added as a co-trustee. But neither child was an executor of their mother’s estate. Were they estranged? The Tax Court opinion doesn’t shed any light on that question either.
Clearly, planners must think about the potential for conflict between the surviving spouse and the remainder beneficiaries that a QTIP trust can create. Those conflicts typically involve investment decisions, tax strategies and the administration of the trust. These conflicts are caused ty the surviving spouse not having any control over the trust and that the final disposition of the trust remains subject to the prior deceased spouse’s control. This means that the planner must carefully evaluate the relationship between the surviving spouse and the remainder beneficiaries and whether the surviving spouse has income and assets outside the QTIP trust.
It is a bit puzzling why a QTIP trust was utilized in Kalikow – a multimillion-dollar estate. With a QTIP trust, the trustees had no ability to allocate trust income and principal among the next generation of family members as a long-term tax minimization strategy. While a basis step-up of the QTIP assets is achieved in the surviving spouse’s estate, in such a large estate as Kalikow, the unified credit is woefully inadequate to eliminate estate tax in the survivor’s estate. That might explain the charitable gift of the remainder of the surviving spouse’s assets, but if that is a correct assumption why not simply utilize a standard credit shelter trust and give the surviving spouse the power to control the assets consistent with optimal tax planning? Also, the difference in the beneficiaries of the surviving spouse’s estate and the QTIP trust triggers a tax apportionment “tax trap” that pegs the estate tax liability on the assets of the QTIP trust.
The Kalikow estate also involve overlapping roles of fiduciaries and professionals – the family CPA was also a co-trustee and executor. Rarely is that structure recommended. With the inherent conflict given the differences between the disposition of the surviving spouse’s estate and what had been established via the QTIP, perhaps the FLP could have been structured in a manner to help minimize conflict.
Conclusion
In the end, the QTIP was valued at approximately $55 million (pre-tax) and the unpaid income amount was settled at around $6.5 million. The legal fees are not known, but they would have been substantial. The family litigation dragged on for over a decade. Was it worth it?
QTIP trusts can be beneficial, and they do have their place, but clearly they are not for everyone. Estate planning is difficult and often there is a need to coordinate the planning over subsequent deaths and even subsequent generations.
April 9, 2023 in Estate Planning | Permalink | Comments (0)
Friday, April 7, 2023
Common Law Marriage - It May Be More Involved Than What You Think
Overview
A minority of states along with the District of Columbia recognizes common-law marriages. But, even in these states, it’s not enough to just simply live together for a certain amount of time. That’s a common misconception.
Common law marriage – it’s the topic of today’s post.
Background
Whether a couple is in a common law marriage can be an important issue when it comes to inheritance rights, spousal rights in land, and liabilities for a spouse’s debts, among other issues. That makes it important to know the requirements for a common law marriage. One common requirement of a common law marriage in the states that recognize the concept is that the couple must hold themselves out to the public as married persons. There are various ways that can be done, including using the same last names and filing joint tax returns. Each state that recognizes common-law marriage sets forth certain tests that must be followed to establish the relationship.
Kansas Cases
The issue of whether a common law marriage existed has been litigated in two recent Kansas cases. These cases follow another Kansas case on the issue in 2010.
In re Marriage of Dyche, No. 97,639, 2008 Kan. Unpub. LEXIS 508 (Kan. Ct. App. Aug. 8, 2008); related proceeding at Beat v. United States, 742 F. Supp. 2d 1227 (D. Kan. Aug. 2010), recon. den., No. 08-1267-JTM, 2010 U.S. Dist. LEXIS 114139 (D. Kan. Oct. 26, 2010); further opinion at No. 08-1267-JTM, 2011 U.S. Dist. LEXIS 40501 (D. Kan. Apr. 12, 2011).
In Kansas, a couple must satisfy three requirements to be in a common law marriage – 1) they must have the capacity to marry; 2) they must agree to be married and represent to the public that they are married. The first two tests typically aren’t difficult to establish, but the third one – a public representation of the marital relationship – is more difficult.
In this case, a Kansas farmer died in 2001, leaving his entire multi-million-dollar estate to his partner (Theresa Beat) who claimed she was the decedent’s common-law wife. They had been in a “relationship” for over twenty years beginning at a time that they were both married to other persons. She was named the executor and claimed a 100 percent marital deduction on the decedent’s federal estate return and Kansas inheritance tax returns for the entire value of the estate. That wiped out tax at both the federal and state levels. But both the IRS and the Kansas Department of Revenue (KDOR) disagreed with her characterization as the decedent’s common-law wife. If she was not the decedent’s spouse at the time of his death, then the estate could not claim any marital deduction with the result that a substantial amount of tax would be due at both the federal and state levels – with interest and penalties.
In 2005, the “widow” filed a motion with the county trial court, seeking a determination that she was the common-law wife of the decedent. She claimed that they had been “married” for 20 years, had a monogamous relationship and held themselves out in the community as being married. She stated that she even wore his ring for most of the “marriage.” There was no question that they had the capacity to marry after they each were divorced from their respective spouses and the statutory waiting period for a subsequent marriage had expired. But the IRS and KDOR claimed that they had substantial evidence that there was no valid common-law marriage. Also, the KDOR pointed out that the “wife” failed to exhaust administrative remedies by prematurely filing suit with the trial court. The KDOR claimed it had primary jurisdiction to determine marital deduction issues. The IRS also intervened and got the case removed to federal court. The court granted the IRS’ motion to dismiss for a lack of subject matter jurisdiction because the court determined that it did not yet have the authority to rule on the “wife’s” pre-enforcement allegations for her failure to exhaust administrative remedies. The court remanded the case to the local trial court for a determination of all other issues.
In July 2006, the “widow” submitted 165 paragraphs of “uncontroverted facts” asserting her status as common-law wife. She also submitted a wealth of affidavits, deposition testimony and other exhibits to prove her status as a common-law wife. The court found several “facts” compelling, including the exchange of rings. Additionally, the decedent’s daughters referred to the “wife” as their stepmother, the community considered them a couple, the decedent referred to her as his “old-lady,” and he also identified her as “next of kin” on several important documents. The couple established a successful farming business in which they worked together every day. There was additional evidence presented indicating that the couple even went on a “honeymoon” in Hutchinson, Kansas, where the couple agreed to be common-law married at a restaurant and he “carried her over the threshold” of their motel room. But, she couldn’t the specific date of the “honeymoon.”
The IRS and KDOR moved for dismissal of the case alleging that the couple identified themselves as “single” on several land deeds, filed separate income tax returns, and filed for Social Security benefits as single individuals. The decedent’s ex-wife also testified that she rarely heard her ex-husband refer to his new friend as his “wife” and that the rings were never referred to as wedding bands. Additionally, the decedent intentionally prepared his will as a single person and indicated on his children’s application for college aid that he was unmarried.
In a procedural determination, the trial court struck her “affidavit of uncontroverted facts” as not having been properly submitted. On motions of the state and federal government for summary judgment, the court set forth 138 factual findings based upon their assessment of the pleadings and other evidence. The court granted the motions, stating that the parties put “different spins on the same set of facts.” The court stated that there were not enough “controverted” facts for the case to proceed to trial.
The trial court set forth the three essential elements to establish a common-law marriage in Kansas – (1) the parties must have the capacity to marry; (2) the parties must mutually agree to be presently married; and (3) the parties must mutually hold themselves out to the public as husband and wife. The trial court stated that her evidence was purely subjective and there was not enough verifiable evidence that the couple had established a common-law marriage. The court concluded that the parties did have the capacity to marry, but there was no mutual agreement to marry. The only direct evidence of an agreement to marry was her testimony regarding the Hutchinson “honeymoon.” However, there was no supporting evidence offered to establish that the couple really had a “present agreement” to marry. As to the third element, the trial court found that the parties never signed any documents representing that they were a married couple. Probably the most damaging evidence cited by the IRS and KDOR was that the decedent executed his will as a single person and refused to refer to her as his wife. Despite his attorney’s suggestions that they formalize the marriage, the decedent indicated that he left the plaintiff with enough assets to cover any estate tax or inheritance liability. The court went so far as to state the “widow” completely failed to prove a common-law marriage.
On appeal, the appellate court disagreed with the trial court’s granting of the motion for summary judgment in favor of IRS and KDOR. They found that there was a “considerable amount of evidence” that should have been weighed by the judge or a jury. In essence, the appellate court held that the determination of the existence of a common-law marriage was a fact question to be determined by a jury. One of these “problems” with the trial court’s determination was that there was (according to the appellate court) ample evidence to suggest that the couple held themselves out as a married couple. The appellate court went on to state that even though a couple never tells any member of his or her family or the public that they are actually married, that does not necessarily preclude a common-law marriage in Kansas. The appellate court believed that there were other factual indications that the couple held themselves out to the public as husband and wife.
Finally, the appellate court determined that the trial court improperly weighed the evidence in favor of the KDOR and IRS. The appellate court determined that the trial court utilized “objective” evidence and, as such, improperly “weighed” the evidence during the summary judgment motions. In the appellate court’s view, a weighing of the evidence should have taken place only during a trial. On remand, the sole issue before the trial court was whether the couple had established a common-law marriage. The matter of an estate tax refund was not ripe because the decedent’s estate had not yet filed a claim for refund.
On the later tax refund action back in federal court, the court was unimpressed by the “widow’s” arguments. Indeed, the court noted that a rational factfinder could conclude that no common-law marriage existed and that the evidence supporting a common-law marriage was so lacking that her estate tax refund claim could be considered fraudulent. The court noted that the decedent and the “widow” went to great lengths to conceal their relationship from family and neighbors. The court also determined that the doctrine of consistency should be applied – for over two decades they represented themselves to the IRS on their federal tax returns that they were not married. Accordingly, the court denied her motion for a refund of estate tax based on the marital deduction.
But, at a later trial in the federal court on the issue of whether a common-law marriage existed, the jury determined that a common law marriage had been established. The IRS had claimed that she owed $1.4 million in estate tax, another $1 million for fraud and $434,000 in interest associated with tax liabilities. On further review, the court allowed the deduction for interest expense and ordered a refund of interest on an assessed fraud penalty.
In re Common-Law Marriage of Heidkamp, No. 125,617, 2023 Kan. LEXIS 13 (Kan. Sup. Ct. Mar. 31, 2023)
In this case, the plaintiff sought a judicial confirmation that she had been in a common law marriage with her husband at the time of his death. She based this assertion on the belief that a common law marriage existed after they had lived together for seven years. The trial court confirmed that a common-law marriage existed based on the facts that the parties had the legal capacity to marry, mutually agreed that they were married, conducted themselves as if they were married, and held themselves out to the public as a married couple. They lived together; paid all of their utilities under the same name; made joint charitable contributions; had a joint savings account; owned multiple pieces of real estate together; were listed as each other’s beneficiaries on IRA accounts; called each other “husband” and “wife” at family events and in social settings; and attended medical appointments as a married couple. The plaintiff appealed due to the U.S. Supreme Court’s ruling in Commissioner v. Estate of Bosch, 387 U.S. 456 (U.S. 1967), where the Supreme Court held that the IRS and federal courts are not bound by lower state court decisions. The Kansas Supreme Court considered all the evidence presented at the trial court and affirmed the trial court’s findings.
In re Estate of Gray, No. 124,085, 2023 Kan. App. Unpub. LEXIS 153 (Kan. Ct. App. Mar. 31, 2023)
In this case, the decedent died unexpectedly and intestate. He had been living in Kansas for several months where he was taking care of his mother’s affairs following her death. Prior to that, he had lived in Texas for five years with a woman he was not married to. He had inherited a home in Kansas from his mother and his death certificate listed his Kansas home as his residence and his marital status as “never married.” The decedent did have a biological son. Eight months after his death, the woman in Texas executed a deed purporting to sell the home to another man in Texas and his company, claiming to have been the decedent’s surviving common-law wife and sole heir. Her name was not on the title to the house. The sale price was indicated as $10,000 while a private appraiser had valued the home at $30,000. Five months later, the court-appointed administrator sold the home for $30,000, subject to the probate court’s approval. The administrator also filed a motion with the probate court to set aside the prior deed as invalid because the woman had no legal interest in the home.
At an evidentiary hearing, no witnesses were aware that the decedent was married at the time of death. The decedent’s son did not believe that his father was married and testified that another woman who was purportedly his father’s girlfriend sent him money periodically. While the woman alleging to be the decedent’s common-law wife produced letters the decedent had written to her as his “wife” and received mail in her name at their Texas residence, they never had a formal wedding ceremony even though she claimed that they had planned to get married when he returned from Kansas. She also had a life insurance policy that named her daughter as the primary beneficiary and the decedent (designated as her fiancé) as the contingent beneficiary. In addition, shortly before his death, the decedent opened a bank account in his name only and designated the pay-on-death beneficiary as the administrator of his mother’s estate. He also listed his Kansas house as his home address for the account. The couple also never filed joint tax returns, and he was not on the title to her Texas house.
The trial court determined that there was no common-law marriage, and that the administrator had the authority to sell the decedent’s home. The trial court also found that the buyer was not a bona fide purchaser and that even if he were, the sale had to be first authorized by the probate court and a title company had so informed the buyer.
The appellate court affirmed on all points. The couple did not have any present agreement to marry – a required element of a common-law marriage in both Texas and Kansas. The appellate court noted that a present agreement meant an intent to be married, rather than an intent to get married. The appellate court also pointed out that Kansas law (K.S.A. §59-2305(b)) requires that a private sale of a decedent’s real estate must be 75 percent or more of the appraised value. As such, the sale for one-third of the appraised value was impermissible.
Conclusion
Common-law marriage is recognized by statute in some states (CO, IA, KS, MT, NH, SC, TX and UT), is recognized by caselaw in RI and OK, and is grandfathered in other states if it was established before a certain date (PA, OH, IN, GA, FL, AL). However, the requirements for legally establishing a common-law marriage differ among the states that recognize the concept. In any event, the cases discussed above point out that not formalizing the marital relationship can lead to substantial legal issues and disrupt what might otherwise have been a desired disposition of property at death.
April 7, 2023 in Estate Planning | Permalink | Comments (0)
Friday, March 31, 2023
RMD Rules Have Changed – Do You Have to Start Receiving Payments from Your Retirement Plan?
Overview
Taxpayers have numerous options for saving for retirement, whether working for an employer or self-employed. But, there are limitations that apply to how much can be deposited each year into a retirement account and other rules apply that specify when distributions from retirement accounts must begin. If distributions are not taken when they should, penalties can apply.
The rules can be tricky, and the Congress has modified the rules in recent years. One of those changes applies to some people and will require the beginning of distributions (a required minimum distribution (RMD)) from certain retirement accounts by April 1, 2023 – tomorrow.
Rules involving RMDs from retirement accounts – it’s the topic of today’s post.
RMDs
Funds cannot be kept in a retirement account indefinitely. In general, distributions must be made from an IRA, SIMPLE IRA, SEP IRA, or retirement plan account when the account owner reaches age 72 (73 if age 72 is attained after Dec. 31, 2022). Normally, an RMD must be made by the end of the year. But, for those turning 72 during 2022, the first RMD may be made as late as April 1, 2023. This rule applies to IRAs, 401(k)s and similar workplace retirement accounts.
Note: For persons with a Roth IRA, funds need not be withdrawn during life. But the beneficiaries of the account are subject to the RMD rules. Designated Roth accounts in a 401(k) or 403(b) plan are subject to the RMD rules for 2022 and 2023. 2023 RMDs must be taken by April 1, 2024. However, for 2024 and later years, RMDs are no longer required from designated Roth accounts.
This April 1 rule only applies for the first year that an RMD is required. For later years, the RMD must be made by the end of the year – December 31. As a result, any taxpayer that received their RMD for 2022 in 2023 (on or before April 1 of 2023) must also receive their RMD for 2023 by the end of 2023. This means that both distributions will be taxable in 2023.
Employees. Individuals that are still employed by the plan sponsor, and who are not a 5 percent owner, may delay taking RMDs from workplace retirement plan until they retire, if the plan so allows. But, even those that are still employed must begin taking an RMD starting at age 72 from traditional IRAs, SEP, SIMPLE and SARSEP IRA plans.
Plans requiring an RMD. As noted above, RMDs are not required with respect to Roth IRAs. Likewise, for 2024 and later years, RMDs aren’t required to be taken from designated Roth accounts. The RMD rules, however, apply to traditional IRAs, SEPs and Simple IRAs during the owner’s life. RMDs are also required to be taken by owners of 401(k) plans, 403(b) and 457(b) plans.
Age change. While the rule as to when an account owner must start taking an RMD has been the year in which the owner reaches age 72, starting in 2023, the required RMD must begin for the year in which the account owner turns 73. In other words, for account owners that turned 72 in 2022, the first RMD must be taken by April 1, 2023, with the RMD computed based on the account balance as of the end of 2021. For those reaching age 72 in 2023, there is no RMD requirement for this year. Instead, the first RMD will be for 2024 because that will be the year in which the individual will turn 73. The first RMD for these persons must be taken by April 1, 2025.
Meeting RMD Requirements. The RMD requirement can be satisfied by withdrawing from multiple accounts – traditional IRAs, SEPs, SIMPLEs and SARSEPs. Withdrawals need not be taken from each account the owner holds. What is required is that the total withdrawals must be at least what the total RMD requirement.
Calculating the RMD. The IRS provides Publication 590 to assist in computing the RMD. Publication 590 contains RMD tables that are used to calculate the RMD. Basically, from the table an account owner will locate their age on the IRS Uniform Lifetime Table, find the “life expectancy factor” corresponding to their age, and then divide the account balance as of December 31 of the prior year by the current life expectancy factor. The computation is different if the account owner’s spouse is the only primary beneficiary and is more than 10 years younger than the owner. In that instance, the IRS Joint Life and Last Survivor Expectancy Table (contained in Pub. 590) is used. The account owner’s life expectancy factor is based on the ages of both the account owner and spouse. The formula, however, does not change.
For persons with multiple retirement plans, the RMD is to be calculated separately for each plan. But the RMDs can be combined, and the total amount withdrawn from a single plan or any combination of plans.
Conclusion
RMDs from retirement plans can be confusing, and for those with multiple accounts it’s probably best to consult with a financial and/or tax advisor to help with determining the best withdrawal strategy.
March 31, 2023 in Estate Planning, Income Tax | Permalink | Comments (0)
Wednesday, March 29, 2023
Summer Seminars
Overview
This summer Washburn Law School will be conducting two summer seminars focused on farm and ranch income taxation and farm and ranch estate, business and succession planning. The first of the two events will be in Petoskey, Michigan on June 15-16 at North Central Michigan College. Registration will open soon. When the law school has that ready, the link will be available on my website: www.washburnlaw.edu/waltr and I will share it here. The second two-day event this summer will be at North Idaho College in Coeur d’Alene, Idaho on August 7-8. Both events will also be simulcast live over the web.
The itinerary for the Michigan event is below. The Idaho event follows the same Day 1 itinerary as the Michigan event, but Day 2 in Idaho will have a few different topics and speakers on Day 2. Also, at the Idaho conference there will also be a dual track running at the same time devoted solely to agricultural law topics. The ag law track will start a bit later in the morning and end earlier than the estate and business planning conference. It will be held at the same location in Coeur d’Alene and the luncheon each day will be for all attendees of each track. Approximately 10 hours of CLE will be available for the ag law topics. I will post more on that once the topics and speakers are completely filled-in for that day.
Day 1 Itinerary
Here's the itinerary for Day 1 at both the Michigan and Idaho locations (farm tax track):
7:30-8:00 a.m. – Registration
8:00–8:05 a.m. - Welcome and Announcements
8:05–9:05 a.m. – Tax Update (Cases and Rulings) (McEowen) [60 minutes tax update CPE]
This opening session takes a look at the most significant tax cases and rulings from the courts and the IRS during the past year that have implications for farm and ranch clients, rural landowners, and agribusiness professionals.
9:05–9:45 a.m. – The Definition of “Farm Income” for Farm Program Purposes (Neiffer) [40 minutes tax update CPE]
Many Farm Service Agency programs grant extra payments if AGI from farming is more than 75% of total AGI. This session will review how FSA determine AGI and why it can be substantially different from IRS calculations.
9:45–10:05 a.m. – Morning Break
10:05–10:30 a.m. – Machinery Trades (McEowen) [25 minutes of tax law CPE]
This session examines the trade of farm machinery with no or low basis for new machinery and the resulting gain computation, combined with substantial depreciation claimed on the new machine.
10:30–10:55 a.m. – Selected Topics - Inventory Method Options for Farmers; How Bonus Depreciation and Expense Method Depreciation Can Work Together for Farm Clients (Neiffer) [25 minutes of tax update CPE]
Tax Reform simplified many accounting methods for taxpayers including farmers. We will review those change and why Section 179 can be more beneficial than bonus depreciation.
10:55–11:45 a.m. – Solar Panel Tax Issues; Other Rental Tax Issues (McEowen) [50 minutes of tax law CPE]
This discussion explores the tax issues associated with the placement of solar panels on farmland and also looks at other tax issues associated with rentals that farming operations often encounter.
11:45–12:45 p.m. – Luncheon
12:45 p.m.– 1:45 p.m. – Protecting a Tax Practice From Scammers (IRS CID) [60 minutes of tax law]
What steps can a tax practice take to protect itself from scams, including those from the dark web? What is good office protocol? What are the essential things that can be done and what are the signs to look for to detect scammers?
1:45 p.m.–2:25 p.m. – Selected Topics - Amending Partnership Returns; Corporate Provided Meals and Lodging; Charitable Remainder Trusts for Retiring Farmers (Neiffer) [40 minutes of tax law CPE]
This session will update the required method of amending partnership returns depending on whether the centralized partnership audit regime applies; a review of the change in corporate provided meals and why charitable remainder trusts can save taxes for a retiring farmer especially with increasing interest rates.
2:25-2:45 p.m. – Afternoon Break
2:45–3:10 p.m. – Easement Tax Issues (McEowen) [25 minutes of tax update CPE]
Rural landowners are finding easement tax issues to be more commonplace. This brief session provides a review of the basic tax issues associated with easements, particularly income tax basis offset issues and the character of the easement payments.
3:10–4:00 p.m. – IC-DISC for Farmers; Disallowance of Cash Method for Farming Activities; Accounting for Hedging Transactions; When to Deduct a Purchased Growing Crop (Neiffer) [50 minutes of tax law CPE]
An IC-DISC can cut a farmer’s income taxes in half – we review when it might apply. More farming activities include non-material participating taxpayers. This can cause the entity to be on the accrual method. The reporting of hedging activities is not always intuitive. We review the requirement and the options and when can a farmer deduct purchased growing crop.
4:00–4:25 p.m. – Soil Fertility Deductions (McEowen) [25 minutes of tax law CPE]
When a farm is purchased an allocation of value can be made to depreciable items. One of those items might be excess fertilizer supply. The IRS has a specific procedure that must be followed for valuing the excess amount. This session examines the IRS approach, the amount to be amortized, the timeframe for amortization and the possibility of recapture.
4:25 p.m. - Adjournment
Day 2 (farm estate and business planning track)
Here’s the itinerary for Day 2 of the Michigan event (farm estate and business planning track):
7:30-8:00 a.m. — Registration
8:05-8:55a.m. — Current Developments in Estate and Gift Taxation (McEowen) [50 minutes tax update CPE]
This session provides an update of legislative, regulatory and court developments involving federal estate and gift tax including developments involving a decedent’s gross estate, asset valuation, gifts made during life, retirement plans and miscellaneous issues.
8:55-9:45 a.m. – “Top Ten” Strategies For a Successful Farm Business (Rhea and Dikeman) [50 minutes tax update CPE]
As we look toward the next 12 months, several items deserve increased attention for farm businesses. This presentation delivers a Top 10 list of forward-looking strategies to consider for success. Changes in cost, income, inflation, tax laws, and estate planning are some key topics discussed. These will be on the mind of farms and ranches as they navigate the uncertain economic conditions and the impact of higher asset values, growing debt, and rising interest rates. We will also demonstrate the performance distinctions of top 1/3 producers.
9:45-10:05 a.m. — Morning Break
10:05-10:55 a.m. – Taxes in Probate: Form 1041 and Distribution Deductions (McEowen) [50 minutes tax law CPE]
This session walks the practitioner through the completion of Form 1041, the assets included in the probate estate, possible income generating items for an estate, the handling of capital gain or loss, and estate accounting. A discussion of e-filing and electronic signatures will also be included. In addition, common issues associated with the death of a farmer will be addressed.
10:55 a.m.-11:45 a.m. – SLATs – Why It Might be the Best Option for Your Farmers (Neiffer) [50 minutes of tax law CPE]
This session reviews the various trust options available to farm families to transfer assets to the next generation in a tax efficient manner. The session will then review why a Spousal Lifetime Access Trust (SLAT) might be the best option.
11:45-12:45 p.m. — Lunch
12:45 p.m.-1:35 p.m. – Why Social Security is an Investment, not a Tax (Neiffer) [50 minutes of tax law CPE]
Most farmers view social security as an unnecessary tax. However, with optimal planning, social security maybe one of the best investments they ever make. We review how benefits are calculated, why spousal benefits provide even more bang for their buck and some common claiming options.
1:35 p.m.-2:50 p.m. — Tax Strategies for the Farm and Ranch Client (Rhea and Dikeman) [75 minutes of tax law CPE]
This session highlights several changes were made by the Tax Cuts & Jobs Act of 2017; many sunset after 2025 and demand attention for optimal tax planning strategies the next 3 years. We will also explain how rising inflation rates are at times helping reduce tax liability and when it does not. Rising interest rates and inflated asset values are dramatically shifting costs of farm transitions to the detriment of young and beginning farmers. Stepped-up basis is a big thing; we detail how this can be helpful to farm successors. Unintended consequences of high income and options for tax management after year end are analyzed.
2:50 p.m. – 3:10 p.m. – Afternoon Break
3:10 p.m. – 3:25 p.m. – New Estate Planning Clients – Screening Clients and Gathering Information [15 minutes of tax law CPE]
This session takes a brief look at a suggested approach to handling potential new estate/business planning clients. How to screen clients, identify potential problem clients, engagement letters and information gathering as preparatory to determining the appropriate path forward for the client.
3:25-4:25 p.m. – Ethics for Estate Planners (McEowen) [1 hour of tax ethics CPE]
What are the ethical issues facing practitioners working with clients on estate/business and tax planning matters? How might the Circular 230 rules impact tax professionals in the estate and business planning context when income tax advice is involved? This session looks at some of the common issues that can arise, applicable caselaw, and some of the more unusual situations that might arise that present difficult situations for the planner.
4:25 p.m. — Conference adjourns
Here’s the itinerary for Day 2 of the Idaho event (farm estate and business planning track):
7:30-8:00 a.m. — Registration
8:05-8:55a.m. — Current Developments in Estate and Gift Taxation (McEowen) [50 minutes tax update CPE]
This session provides an update of legislative, regulatory and court developments involving federal estate and gift tax including developments involving a decedent’s gross estate, asset valuation, gifts made during life, retirement plans and miscellaneous issues.
8:55-9:45 a.m. – Who Wants the Farm; and Should They Get It? (Bosch) [50 minutes of tax law CPE]
9:45-10:05 a.m. — Morning Break
10:05-10:55 a.m. – Taxes in Probate: Form 1041 and Distribution Deductions (McEowen) [50 minutes of tax law CPE]
This session walks the practitioner through the completion of Form 1041, the assets included in the probate estate, possible income generating items for an estate, the handling of capital gain or loss, and estate accounting. A discussion of e-filing and electronic signatures will also be included. In addition, common issues associated with the death of a farmer will be addressed.
10:55 a.m.-11:45 a.m. – SLATs – Why It Might be the Best Option for Your Farmers (Neiffer) [50 minutes of tax law CPE]
This session reviews the various trust options available to farm families to transfer assets to the next generation in a tax efficient manner. The session will then review why a Spousal Lifetime Access Trust (SLAT) might be the best option.
11:45-12:45 p.m. — Lunch
12:45 p.m.-1:35 p.m. – Why Social Security is an Investment, not a Tax (Neiffer) [50 minutes of tax law CPE]
Most farmers view social security as an unnecessary tax. However, with optimal planning, social security maybe one of the best investments they ever make. We review how benefits are calculated, why spousal benefits provide even more bang for their buck and some common claiming options.
1:35 p.m.-2:50 p.m. - Strategies and Considerations for Transferring Farm Ownership and Operations (Hemenway)
This session will explore various issues connected with the transfer of farm ownership to successive generations. Topics will include timing the transfer of labor and management; preparing the next generation for farm ownership; planning for multiple inheritors; and considerations for long-term care and asset protection planning.
2:50 p.m. – 3:10 p.m. – Afternoon Break
3:10 p.m. – 3:25 p.m. – New Estate Planning Clients – Screening Clients and Gathering Information (McEowen) [15 minutes of tax law CPE]
This session takes a brief look at a suggested approach to handling potential new estate/business planning clients. How to screen clients, identify potential problem clients, engagement letters and information gathering as preparatory to determining the appropriate path forward for the client.
3:25-4:25 p.m. – Ethics for Estate Planners (McEowen) [1 hour of tax ethics CPE]
What are the ethical issues facing practitioners working with clients on estate/business and tax planning matters? How might the Circular 230 rules impact tax professionals in the estate and business planning context when income tax advice is involved? This session looks at some of the common issues that can arise, applicable caselaw, and some of the more unusual situations that might arise that present difficult situations for the planner.
4:25 p.m. — Conference adjourns
Conclusion
I look forward to either seeing you in-person at one of these events this summer or online. At the end of Day 1 at the Idaho event, there will be a reception sponsored by the University of Idaho College of Law. Also, many thanks to Teresa Baker at the Idaho Bar Association for her assistance in locating speakers as well as to Prof. Richard Seamon (Univ. of ID College of Law) and Kelly Stevenson (leader of the ag law section off the Idaho Bar) for helping identify topics as well as speakers.
More details and registration links coming soon.
March 29, 2023 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)
Saturday, March 25, 2023
Abandoned Rail Lines – Issues for Abutting Landowners
Overview
Federal law has established a procedure that a railroad must go through when abandoning a rail line and its corridor. 49 U.S.C. §10903. In the 1970s, the Congress specified that before abandonment can be completed, other entities can intervene to preserve the corridor for future use. 16 U.S.C. §1247(d). This process creates numerous issues for farmers, ranchers and other rural landowners along the corridor.
A couple of recent cases highlighting the issues that can arise for adjacent property owners when a rail line is abandoned – it’s the topic of today’s post.
“Railbanking” – Background
The railbanking process allows a railroad to negotiate with another entity which would then assume the financial and managerial responsibility for the corridor by operating a recreational trail on it. See, e.g., Presault v. Intertstate Commerce Commission, 494 U.S. 1 (1990). But, before the trail operator can start negotiations with the railroad, it must file a railbanking petition. See 49 C.F.R. §1152.29(a). The trail operator must state that it is willing to assume full responsibility for managing the right-of-way and assume any legal liability for the transfer or use of the right-of-way. The trail operator also must pay any and all taxes on the right-of-way. In addition, the trail operator must acknowledge that the land will remain subject to possible reconstruction and reactivation of the right-of-way for rail service. Once these certifications are made, then the trail group can negotiate with the railroad. Any agreement that is struck is then submitted to the Surface Transportation Board (STB) which will then issue a Notice of Interim Trail Use (NITU). The NITU allows the railroad to discontinue service without abandonment and allows the trail operator to use the corridor for use as a recreational trail.
The issuance of a NITU can result in a taking of property owned by the original grantor of the corridor easement. See, e.g., Presault v. Interstate Commerce Commission, 494 U.S. 1 (1990). That’s because it’s often the case that the railroad merely owns an easement and not an outright fee simple. In that situation, state law commonly provides that the easement is to revert (go back) to the abutting property owner when the railroad ceases operation. But, because interim trail use under the railbanking program is a discontinuance rather than an abandonment, the easement doesn’t revert to the abutting landowners. A taking may also occur if the original easement grant to the railroad under state law is not broad enough to allow for a recreational trail. When a trail is operated in that situation, it’s a taking of a new easement requiring compensation under the Fifth Amendment. See, Caquelin v. United States, 959 F.3d 1360 (Fed. Cir. 2020).
Recent Cases
Central Kansas Conservancy, Inc., v. Sides, 56 Kan. App. 2d 1099, 44 P.3d 337 (2019), rev. den., No. 119,605, 2019 Kan. LEXIS 527 (Kan. Sup. Ct. Dec. 19, 2019), cert. den. sub. nom., Sides v. Central Kansas Conservancy, Inc., 140 S. Ct. 2741 (2020).
In this case, the Union Pacific Railroad acquired a right-of-way over a railroad corridor that it abandoned in the mid-1990s. At issue in the case was a 12.6-mile length of the abandoned line between McPherson and Lindsborg, Kansas. NITU was issued in the fall of 1995. The corridor was converted into a trail use easement under the National Trails System Act. In 1997, Union Pacific gave the plaintiff a "Donative Quitclaim Deed" to the railroad’s easement rights over the corridor, with one-quarter mile of it running through the defendant’s property at a width of 66 feet. Pursuant to a separate agreement, the plaintiff agreed to quit claim deed its rights back to the railroad if the railroad needed to operate the line in the future. By virtue of the easement, the plaintiff intended to develop the corridor into a public trail.
In 2013, the plaintiff contacted the defendant about developing the trail through the defendant’s land. The defendant had placed machinery and equipment and fencing in and across the corridor which they refused to remove. In 2015, the plaintiff sued to quiet title to the .75-mile corridor strip and sought an injunction concerning the trail use easement over the defendant’s property. The defendant admitted to blocking the railway with fencing and equipment, but claimed the right to do so via adverse possession or by means of a prescriptive easement. The defendant had farmed, grazed cattle on, and hunted the corridor at issue since the mid-1990s. The defendant also claimed that the plaintiff had lost its rights to the trail because it had failed to complete development of the trail within two years as the Kansas Recreational Trail Act (KRTA) required.
In late 2016, the trial court determined that the two-year development provision was inapplicable because the Interstate Commerce Commission had approved NITU negotiations before the KRTA became effective in 1996. The trial court also rejected the defendant’s adverse possession/prescriptive easement arguments because trail use easements are easements for public use against which adverse possession or easement by prescription does not apply.
During the summer of 2017 the plaintiff attempted work on the trail. When volunteers arrived, the defendant had placed equipment and a mobile home on the corridor preventing any work. The plaintiff sought a "permanent prohibitory injunction and permanent mandatory injunction." The defendant argued that he had not violated the prior court order because "[a]ll the Court ha[d] done [was] issue non-final rulings on partial motions for summary judgments, which [were], by their nature, subject to revision until they [were] made final decisions." Ultimately, the trial court granted the plaintiff’s request for an injunction, determined that the defendant had violated the prior summary judgment order, but also held that the plaintiff had not built or maintained fencing in accordance with state law.
On appeal, the appellate court partially affirmed, partially reversed, and remanded the case. The appellate court determined that the defendant did not obtain rights over the abandoned line via adverse possession or prescriptive easement because such claims cannot be made against land that is held for public use such as a recreational trail created in accordance with the federal rails-to-trails legislation. The appellate court also determined that the plaintiff didn’t lose rights to develop the trail for failing to comply with the two-year timeframe for development under the KRTA. The appellate court held that the KRTA two-year provision was inapplicable because a NITU was issued before the effective date of the KRTA. However, the appellate court determined that the plaintiff did not follow state law concerning its duty to maintain fences. The appellate court held that Kan. Stat. Ann. §58-3212(a) requires the plaintiff to maintain any existing fencing along the corridor and maintain any fence later installed on the corridor. In addition, any fence that is installed on the corridor must match the fencing maintained on the sides of adjacent property. If there is no fencing on adjacent sides of a landowner’s tract that abuts the corridor, the plaintiff and landowner will split the cost of the corridor fence equally.
The appellate court remanded the case for a determination of the type and extent of fencing on the defendant’s property, and that the plaintiff has the right to enter the defendant’s property to build a fence along the corridor. Any fence along the corridor is to be located where an existing fence is located. If no existing fence exists along the corridor, the corridor fence is to be located where the plaintiff’s trail easement is separated from the defendant’s property.
The Kansas Supreme Court declined to review the case, and the U.S. Supreme Court later decline to grant certiorari.
Behrens, et al. v. Heintz, et al., 59 F. 4th 1339 (Fed. Cir. 2023)
This case involved a 144.3-mile rail line in Missouri that had been in operation for over 100 years. The railroad had acquired the necessary easements for the corridor via condemnations and agreements with the abutting landowners. The easements were granted to the railroad in 1901 and 1902. 18 of the 19 deeds containing the easements did not limit the use of the easement for railroad purposes. Ultimately, a successor-railroad to the easements sought to discontinue service and abandon the railway. In late 2014, the Missouri Department of Natural Resources filed a request to intervene in the abandonment proceeding seeking to utilize the easement for interim trail use on the corridor. Five years later, the STB was notified that a trail use agreement had been executed in accordance with the NITU and the STB regulations.
The plaintiffs, owners of the abutting land along the corridor, filed a Takings claim in 2015 in the U.S. Court of Federal Claims on the basis that the railroad originally acquired easements under Missouri law rather than a fee interest and that the easements were for railroad purposes only. Accordingly, the plaintiffs claimed that the conversion of the easements to recreational trail use was beyond the scope of the easements and constituted a Taking. The Court of Federal Claims agreed that the property interest acquired involved easements, but that interim trail use was permissible. Upon reconsideration, the Court of Federal Claims again held that no Taking had occurred because the scope of the easements was broad enough to allow for trail use. The plaintiffs appealed.
On appeal, the appellate court determined that the railroad had, under Missouri law, undisputedly acquired easements and not fee simple interests. See Mo. Rev. Stat. §388.210(2). As to the scope of the easements, the appellate court determined that Mo. Rev. Stat. §388.210(2) explicitly limited the scope of the 18 easements to “railroad purposes” only. That statute, the appellate court noted, defines the purposes of such voluntary grants to railroads as the ones involved in the case “to aid in the construction, maintenance and accommodation of the railroads.” The appellate court noted that the Missouri Supreme Court had construed this language to mean that such grants are for “all railroad purposes.” Brown v. Weare, 152 S.W.2d 649 (Mo. Sup. Ct. 1941).
On the takings issue, the appellate court determined that the issue was whether the trail use and railbanking were “railroad purposes” and, as a result, within the scope of the easements. On that issue, the appellate court cited a Missouri case finding that trail use is not included in the meaning of “railroad purposes.” Boyles v. Missouri Friends of Wabash Trace Nature Trail, Inc., 981 S.W.2d 644 (Mo. Ct. App. 1998). The appellate court also cited one of its own prior opinions holding that trail use is not a railroad purpose under other states’ laws. See, e.g., Presault v. Interstate Commerce Commission, 100 F.3d 1525 (Fed. Cir. 1996)(construing Vermont law); Toews v. United States, 376 F.3d 1371 (Fed. Cir. 2004)(construing California law). The appellate court also noted that the speculative possibility that the trail would return to rail use did not fall within the scope of the easements that were granted for railroad purposes. There simply was no realistic possibility the future rail use would occur. Likewise, the appellate court noted that the easements were granted for the benefits of the railroads to operate a rail line, not the benefit of “some future unidentified entity that might receive the easement in the future.” The preservation of a tract of land (corridor) for future rail use under the National Trail System Act does not transform an interim trail use into a “railroad purpose.”
Accordingly, the appellate court held that a Fifth Amendment Taking had occurred, reversed the Court of Federal Claims, and remanded the case to that court for a determination of damages on the Takings issue.
Conclusion
Recreational trails operating on abandoned rail lines present numerous legal issues for abutting landowners. The constitutional takings issue is a major, but other issues can arise involving fencing, trash and liability for personal injury. Expect this issue to remain an important one for landowners along abandoned railroad corridors.
March 25, 2023 in Real Property, Regulatory Law | Permalink | Comments (0)
Sunday, March 19, 2023
Double Fractions in Oil and Gas Conveyances and Leases – Resulting Interpretive Issues
Overview
A common interpretive problem in oil and gas conveyances and leases arises when the owner of a fractional mineral interest either conveys or reserves a fraction using unclear language. One way that can happen is when a “double fraction” clause is used. That’s a clause that creates uncertainty as to whether the grant or reservation is a fraction of what the grantor owns or a fraction of the whole interest. For instance, if Bubba owns an undivided ½ interest in minerals and conveys “an undivided ½ interest in the minerals,” does that mean that Bubba conveyed a ½ interest in all of the minerals or simply ½ of Bubba’s ½? This interpretive issue can also arise when mineral interests are devised from a decedent’s estate. It also occurs when a conveyancing instrument refers to both “minerals” and a “royalty” or blends the two concepts in the same instrument.
The interpretive issues associated with a double fraction clause recently came up again in a Texas case. That case involved the construction of a 1924 deed containing a mineral reservation clause, and it could have wide-ranging impact on oil and gas titles in Texas and, perhaps, elsewhere.
The meaning of a “double-fraction” clause and the impact on future oil and gas conveyances – it’s the topic of today’s post.
Royalty Deed Interpretation
A royalty interest is an interest in a share of production, or the value or proceeds of production, free of the costs of production, when and if there is production. It is usually expressed as a fraction. But, the way those fractional interests are expressed can create confusion, whether the fraction is expressed as a “fraction of royalty” or as a “fractional royalty.”
Fractional royalty interests. With a fractional royalty interest, the owner is entitled to a share of gross production, free of cost in an amount determined by the fractional size of the owner’s interest. The share of production the owner is entitled to does not “float” with royalties of differing amounts reserved in an oil and gas lease. An expression of a fractional royalty clause is, for example, “an undivided 1/16th royalty interest of any oil, gas, or minerals that may hereafter be produced.”
Fraction of royalty interest. With a fraction or royalty interest, the amount of production that is associated with the interest will “float” depending on the royalty reserved in an oil and gas lease. The owner gets a share in production equal to a fraction multiplied by the royalty reserved in an oil and gas lease. Examples of such a clause would be, “1/16th of all oil and gas royalty” or “an undivided ½ interest in and to all of the royalty” or “1/2 of 1/8th of the oil, gas and other mineral royalty that may be produced.”
Double fractions. Complexity increases when a double fraction is used to describe the royalty interest. For instance, “1/4th of 1/8th of all royalty…” is an example of a double fraction clause. Many courts utilize the multiplication approach and would conclude that such a clause would convey a 1/32nd interest. Indeed, for conveyance or reservation clauses drafted before the 1970s, the general assumption was that the royalty provided for in an oil and gas lease would always be 1/8th. Thus, a right to “1/4th of royalty” would be the same thing as the right to 1/4th of the 1/8th royalty reserved in an oil and gas lease – a 1/32nd royalty. But, since the 1970s, mineral owners have often been able to negotiate a wider range of royalties in mineral leases with many of them larger than 1/8th (often ranging from 10 percent to over 30 percent). This resulted in the double fraction clause creating confusion as to the drafter’s intent. This confusion can arise not only in oil and gas conveyancing instruments, but also in bequests from a decedent’s estate.
Bequests. In Hysaw v. Dawkins, 483 S.W.3d 1 (Tex. 2015), the decedent executed a will in 1947 that divided three tracts of real estate among her three children. The will also distributed her mineral estates on the tracts using double fraction language – “each of my children shall have and hold an undivided one-third (1/3) of an undivided one-eighth (1/8) of all oil, gas or other minerals in or under that may be produced from any of said lands… and should there be any royalty sold during my lifetime then [the three children], shall each receive one-third of the remainder of the unsold royalty.” The question was whether the double fraction language fixed the heirs devised royalty at 1/24th with any negotiated royalty above 1/8th passing to the current fee owner, or if the decedent intended her heirs to receive 1/3 of all future royalties, regardless of what the royalty fraction was. The heirs of two of the decedent’s children sought 1/3rd of the 1/5th royalty in a new oil and gas lease, and the successors of the other child claimed that the successors of the siblings were only entitled to 1/3rd of 1/8th and that any additional royalty belonged to the fee simple owner.
Note: The Hysaw case involved the “estate-misconception theory.” That theory reflects the historic prevalent belief that, in entering into an oil-and-gas lease, a lessor retained only a 1/8 interest in the minerals rather than the entire mineral estate in "fee simple determinable.” In turn, for decades afterwards, many lessors referred to their entire interest in the mineral estate with the simple use of “1/8.” One court has described the “estate misconception” theory as follows: “In earlier times, many landowners labored under the misconception that when they leased their mineral estate to an operator, they only retained 1/8th of the minerals in place, rather than a fee simple determinable with the possibility of reverter in the entirety of the mineral estate... Therefore, when the landowner conveyed a mineral interest to a third party in land that was already subject to a lease, he would often use a fraction of 1/8 to express what interest he intended to convey in his possibility of reverter. Since a landowner in reality retains a full 8/8 interest in the reverter, the application of the estate misconception doctrine has tremendous consequences.” Greer v. Shook, 503 S.W.3d 571 (Tex. Ct. App. 2016).
The Texas Supreme Court determined that the outcome should turn on the decedent’s intent. Based on the evidence, the Court found that intent to be to equally divide the royalties among the decedent’s children. Accordingly, the Court held that the decedent had devised a 1/3rd fraction of a royalty interest (regardless of the amount of that royalty) to each of her children. In other words, the decedent has used the phrase "one-eighth royalty" as a shorthand phrase for the entire royalty interest that a lessor could retain under a mineral lease. She had left a floating 1/3rd royalty to each child.
Recent Texas Case
Van Dyke v. The Navigator Group, No. 21-0146,
2023 Tex. LEXIS 144 (Tex. Sup. Ct. Feb. 17, 2023)
Facts. This case culminated a decade-long battle over a mineral interest reservation involving a double fraction and accumulated royalties of approximately $44 million. In 1924, the Mulkeys deeded their ranch to White and Tom reserving “one-half of one-eighth” of all minerals and mineral rights. After the conveyance, both parties conducted themselves as if they believed that they each owned one-half of the mineral interest, as did all successors-in-interest.
In 2012, an energy company drilled a well and paid both the successors-in-interest to the Mulkeys (the “Mulkey parties”) and the successors-in-interest to White and Tom (the “White parties”) equal one-half shares. The White parties filed a trespass-to-try-title action, claiming that the 1924 deed reserved only a 1/16th (1/2 of 1/8th) of the minerals to the Mulkey parties, and that the White parties owned fifteen-sixteenths of the minerals. The Mulkey parties claimed that the interest reserved was one-half of the total mineral estate, and that the reference to one-eighth of the minerals was a term of art under the “estate misconception” theory. Under that theory (which had been forgotten over time), one-eighth was commonly believed to mean the entire mineral estate.
Alternatively, the Mulkey parties claimed entitlement to one-half of the minerals because of the long history of the original parties and the successors-in-interest acting as if each party owned one-half of the mineral interest.
Trial and appellate courts. The trial court held that the 1924 deed unambiguously reserved a one-sixteenth interest in the Mulkey parties. The appellate court affirmed, also concluding that the “estate misconception theory” did not apply because “the deed did not contain any conflicting provisions requiring harmonization and the subject property was not burdened by an oil and gas lease at the time of conveyance.”
Texas Supreme Court. On further review, the Texas Supreme Court reversed and remanded. The Court noted that in the early 20th century that landowners commonly retained a one-eighth royalty interest under an oil and gas lease and that, over time, “1/8th” became synonymous with the mineral interest itself or as a proxy for the customary royalty of 1/8th. In essence, it became a term of art. The Court looked to Hysaw where, as noted, the Court held that each child received a “floating one-third interest in the royalty” based on what the evidence showed was the decedent’s intent. While, as the Court noted, using “1/8” to mean the entire mineral estate is rebuttable, such a rebuttal can only be accomplished with evidence from the document itself suggesting basic multiplication be applied. The Court found that while “1/8” was a term of art in use at the time the deed was drafted to mean the entire mineral estate, there was nothing else in the deed to rebut this meaning. As a result, the Court held that the Mulkey grantors did in fact reserve a full 1/2 interest in the mineral estate.
Note: The Court also noted that the court of appeals misapprehended how the estate-misconception theory is applied to instruments, such as the 1924 deed. Instead of looking to whether the lack of inconsistencies in an instrument require harmonization, courts should first assume that the specific use of a double fraction was intentional (a rebuttable presumption) and if the document lacks anything that could rebut that presumption (inconsistencies) then the intended (historical) use of the double fraction stands. For instance, the instrument in this case included the use of a double fraction (“1/2 of 1/8”) and there was no evidence to rebut the presumption that the parties intended “1/2 of 1/8” to mean “1/2 of the mineral estate.” As for the land not being encumbered by a lease at the time of the deed, the Court stated that the theory’s “relevance has never depended on the considerations that the court of appeals identified.”
The Court went on to examine the presumed-grant doctrine – a common law form of adverse possession. The Court noted three elements which must be satisfied for the presumed grant doctrine to prevail: “(1) a long-asserted and open claim, adverse to that of the apparent owner; (2) nonclaim by the apparent owner; and (3) acquiescence by the apparent owner in the adverse claim.” The Court noted that a ninety-year history existed between the parties in which “conveyances, leases, ratifications, division orders, contract, probate inventories, and a myriad of other instruments” were recorded, thus providing notice of the interests owned by both parties. Likewise, for nearly a century, both parties had stipulated multiple times to the one-half ownership of the mineral estate. Indeed, in a 1950 conveyance, White had recited that he only held an undivided one-half interest in the oil, gas, and other minerals on the ranch. Based on all of this evidence and the conduct of the parties over time, the Court held that the Mulkey parties conclusively established their ownership under the presumed grant doctrine.
What Would Happen In Kansas?
In Kansas, a royalty deed is normally interpreted in accordance with the evidence concerning usage over time by the parties involved along with other relevant evidence. But, in Bellport v. Harrison, 255 P. 52 (Kan. 1927), the Court held that “royalty” must be construed in accordance with its “well-known meaning” and that it was not appropriate to look to custom to define the term “royalty.” The Court also concluded that the term “royalty” cannot have a meaning different from its “well-known” meaning as a result of usage. The case involved a sale by Harrison of “one-half of [a] royalty.” The receipt stated, “Received of A.J. Bellport, $2,400.00 payment for 1/16 royalty…”. The mineral interest was leased at the time and provided for payment of a 1/8th royalty. Harrison asserted that Bellport acquired one-half of Harrison’s 1/8th royalty, but Bellport claimed he purchased one-half of the mineral interest and that the reference to “1/16th royalty” conveyed to him a one-half mineral interest entitling him to one-half of the 1/8th royalty.
The trial court, based on custom, agreed with Bellport but the Kansas Supreme Court reversed. Arguably, the Court believed that the usage was unreasonable and not probative. The Court made a clear distinction between a royalty interest and a mineral interest. A “royalty” refers to a right to share in the production of oil and gas at severance. A royalty is personal property and does not include a perpetual interest in and to oil and gas in and other minerals in and under the land. Conversely, a “mineral interest” means an interest in and to oil and gas in and under the land and constitutes the present ownership of an interest in real property. See, e.g., Shepard v. John Hancock Mutual Life Insurance Co., 368 P.2d 19 (Kan. 1962).
As a result, a Kansas court facing a double-fraction set of facts in a conveyancing instrument would likely focus on facts that enlighten the true nature of the instrument based on the language utilized rather than what the parties call it. This appears to be somewhat like the approach of the Texas Supreme Court taken in Van Dyke. The “estate misconception” theory is merely instructive, perhaps, but is not dispositive. It might also be safe to say that is the approach in Texas. See, e.g., Concord Oil Co. v. Pennzoil Exploration & Production Co., 966 S.W.2d 451 (Tex. 1998).
Conclusion
The Van Dyke ruling, at least in Texas, will probably have longstanding effect on oil and gas titles. The term “one-eighth” in a double fraction clause refers to the entire estate absent evidence to the contrary that proves otherwise and satisfies the presumed-grant doctrine. In any event, practitioners would do well to refrain from using double-fraction clauses.
March 19, 2023 in Contracts, Real Property | Permalink | Comments (0)
Tuesday, March 14, 2023
Adverse Possession and a "Fence of Convenience"
Overview
When land is possessed by someone that knows the possession violates the ownership rights of someone else, the concept of adverse possession can come into play. It’s a legal principle that says a person without legal title to a tract of land may acquire legal ownership based on continuous possession absent the true owner’s permission. If the true owner does not exercise their right to eject the violator after a certain period of time, the true owner will be prevented form excluding the violator and a new title to the tract at issue could be issued to the violator who then would be the actual owner of the tract. But there are elements that must be established to successfully assert an adverse possession claim. In addition, certain facts can defeat an adverse possession claim - one of those is that a fence that is not on the actual legal boundary is not a "fence of convenience."
Adverse possession and a "fence of convenience" – it’s the topic of today’s post.
Background
Each state has its own adverse possession statute and associated timeframe after which adverse possession can be claimed. The elements of an adverse possession claim also vary from state to state. One common requirement is that the party claiming adverse possession must assert a claim that is “hostile” to the true owner’s rights. That certainly means that the permission for the usage must not have been granted. It also means that the adverse possessor knows that their asserted possession is against the true owner’s rights.
Here's a sampling of cases involving adverse possession and a brief description of the court’s holding:
- Gibbons v. Lettow, 42 P.3d 925 (Or. Ct. App. 2002) (no acquisition by adverse possession because continuous use of land not made for statutory period).
- Ebenhoh v. Hodgman, 642 N.W.2d 104 (Minn. Ct. App. 2002) (acquisition of adverse possession occurred because planting of crops on disputed strip for over 40 years demonstrated sufficient continuous use exclusive of any other party).
- Davis v. Chadwick, 55 P.3d 1267 (Wyo. 2002) (fence used continuously for over 50 years for grazing of cattle and horses; survey revealed that fence not on boundary, but fence held to be boundary under theory of adverse possession; fence not fence of convenience);
- Kosok v. Fitzpatrick, No. 2008AP2351, 2009 Wisc. App. LEXIS 883 (Wisc. Ct. App. Nov. 17, 2009)(plaintiff established statutory elements of adverse possession of disputed strip of land for 20 years; fence remnants were sufficient to “raise a flag of hostility” and were, in fact, treated as the boundary between the properties).
- Wallace v. Pack, et al., No. 12-0277, 2013 W. Va. LEXIS 1012 (W. Va. Sup. Ct. Oct. 3, 2013)(trial court properly determined that defendants acquired 28 acres via adverse possession; uses of disputed tract included enclosing portions with fencing, keeping livestock, picking berries, picnicking, etc.).
Fence of “Convenience”
Sometimes a fence is not located on the actual border (partition) between adjacent parcels simply because it is not convenient to construct it there because of the terrain or natural obstructions that make it practically impossible to locate the fence on the actual property boundary. A fence that the adjoining landowners know is not on the actual surveyed line can give rise to a comparable concept – the “doctrine of practical location.” The usage of a particular line by the adjoining owners for the statutory timeframe (the same length of time that applies to adverse possession), can lead to that line becoming the actual legal boundary. The question in this situation is whether the fence is a “fence of convenience.” The fence is simply placed where it is convenient for the adjoining landowners. In that situation, adverse possession cannot apply in states that have a "hostility" requirement as part of an adverse possession statute or the common law. This precise issue came up in a recent court opinion from Wyoming.
Lyman v. Childs, 2023 WY 16 (2023)
The defendants asserted that the plaintiffs were trespassing and took action to eject them. In response, the plaintiffs filed an adverse possession claim against the defendant for approximately 100 acres of property deeded to the defendant, but on the plaintiffs’ side of a fence. The trial court found the fence was not built in accordance with the surveys because it was a fence of convenience - it was the best place to build the fence given the terrain. It was not meant to delineate the property line.
Note: When a fence is one of convenience then it is presumptively permissive, so an adverse possession claim will fail.
The trial court ruled in favor of the defendants and the plaintiffs appealed. The Supreme Court of Wyoming began by noting that the plaintiffs had presented a prima facie case for adverse possession – they had actual possession of the property on their side of the fence; the use was notorious (open and obvious to the defendant) given their use of the property and the no trespass signs they posted; the no trespass signs were enough to show an exclusive use; and the combination of the fencing, signs, and use showed hostility towards the true owner; and the use had been continuous and uninterrupted for the required 10 years needed to establish adverse possession. Once the plaintiffs showed a prima facie case of adverse possession, the burden of disproving adverse possession falls on the defendants.
The showing that a fence is one of convenience establishes permissive use, which defeats the hostility requirement for adverse possession. The Supreme Court explained that several factors are considered when determining if a fence is one of convenience including: the fence’s physical appearance; whether the fence meanders; whether the fence avoids natural barriers and obstacles; whether trees or bushes are used as fencing material; changes in elevation on the deeded boundary compared to the fence line; and the type of land the fence is dividing, among other things. The trial court found the fence did not run-in straight lines, avoided natural barriers, and changed direction for no reason other than terrain. The fence often used trees or bushes as posts and the irregularity showed it was not meant to depict the property line. The trial court gave more credit to the defendants’ expert who stated that the fence was likely built in this manner to reduce costs of building along the actual boundary line, because the easier the fence was to build the cheaper it would be. It would have been cheaper to just follow the easiest path than to require the builders to try to build the fence on along the rough terrain.
The Supreme Court noted that the trial court is to be given considerable deference when weighing testimony and found no reason to interfere with the trial court’s decision to provide more weight to the defendants’ expert. The plaintiffs asserted that if the fence was one of convenience, then the defendant needed to prove that each disputed parcel was enclosed by a fence of convenience rather than a boundary fence. The Supreme Court rejected this argument because the plaintiffs had relied on a case which contained differing facts than this one where the fence was all used for the same purpose of blocking ground and not used to be a boundary for a homeplace. The plaintiffs could not prove any parcel was used differently than the next. The plaintiffs also claimed that the trial court allowed a layman’s testimony to be utilized as expert testimony when it should not have been because the layman had not been to the site in over 30 years. However, the Supreme Court noted that the fence had not moved over that 30-year timeframe and, as a result, the layman’s testimony was valid. Finally, the plaintiffs claimed that they used the property in such a manner that the use had to been seen as hostile. The Supreme Court held the plaintiffs failed to record any deeds that showed they owned the property, so there was no notice to the defendants on the record. Further, using the ground for grazing or recreational purposes is not a hostile use in Wyoming.
The Supreme Court affirmed the trial court’s decision that the defendants had lawfully ejected the plaintiffs off the property because the plaintiffs did not own the property and held the plaintiffs did trespass. The plaintiffs began to trespass once they were aware of the defendants’ notice to not come onto the disputed property any longer, but they continued to do.
Conclusion
A fence that is not actually on the surveyed property boundary may can give rise to a quiet title action either under an adverse possession theory or the theory of boundary by acquiescence. However, those theories will not apply if the fence is merely a fence of convenience. That determination will be based on the particular facts of each situation.
March 14, 2023 in Real Property | Permalink | Comments (0)
Saturday, March 11, 2023
Happenings in Agricultural Law and Tax
Overview
The legal issues in agricultural law and tax are seemingly innumerable. The leading issues at any given point in time are often tied to the area of the country involved. In the West and the Great Plains, water and grazing issues often predominate. Boundary disputes and lease issues seem to occur everywhere. Bankruptcy and bankruptcy taxation issues are tied to the farm economy and may be increasing in frequency in 2023 – the USDA projects net farm income to be about 16 percent lower in 2023 compared to 2022. Of course, estate planning, succession planning and income tax issues are always present.
With today’s post, I take a look at some recent cases involving ag issues. A potpourri of recent cases – it’s the topic of today’s post.
Dominant Estate’s Water Drainage Permissible.
Thill v. Mangers, No. 22-0197, 2022 Iowa App. LEXIS 961 (Iowa Ct. App. Dec. 21, 2022)
The plaintiffs sued their neighbor, the defendant, for nuisance. Rainwater from the defendant’s property would run off onto the plaintiffs’ property. In the 1950s and 1960s the city installed a few culverts to help with the water drainage. The water drained into an undeveloped ground area where the plaintiffs later built their home. The plaintiffs tried numerous ways to block the flow, ultimately causing drainage problems for the defendant who then tried to direct the excess water back onto the plaintiffs’ property. The plaintiffs claimed that defendant’s activity caused even more damage to their property than had previously occurred, causing a neighbor to also complain. All of the parties ended up suing each other on various trespass and nuisance claims. The trial court dismissed all of the claims because the court believed that all of the parties’ actions caused the water drainage problems. The appellate court explained that the defendant, as the owner of the dominant estate, had a right to drain water from his land to the servient estate (the plaintiffs’ property) and if damage resulted from the drainage, the servient estate is normally without remedy under Iowa Code §657.2(4). The only time a servient estate could recover damages is if there is a substantial increase in the volume of the water draining or if the method of drainage is substantially changed and actual damage results. Under Iowa law, the owner of the servient estate may not interrupt or prevent the drainage of water to the detriment of the dominant owner. The plaintiffs argued that the defendant violated his obligation by installing a berm and barricade, and presented expert testimony showing that the water flow changed when the defendant added the features, but the defendant had his own expert who provided contrary testimony. The appellate court held that the defendant’s expert was more reliable because the defendant’s expert used more historical information and photographs to analyze how the water historically flowed rather than focusing on the current condition of the neighborhood as did the plaintiffs’ expert. When the plaintiffs’ expert looked at these historical photographs, he even agreed with the defendant’s expert that the natural flow of water was through the culverts onto the plaintiffs’ property. The appellate court affirmed the trial court’s finding that the plaintiffs did not prove that the defendant substantially changed the method or manner of the natural flow of water, because the water would have flowed the same way with or without the defendant’s berm and barricade.
Mortgage Interest Deduction Disallowed
Shilgevorkyan v. Comr., T.C. Memo. 2023-12
The petitioner claimed a mortgage interest deduction for 2012 associated with a home that his brother purchased for $1,525,000 in 2005. The purchase was financed with a bank loan. The brother and his wife were listed as the borrowers on the loan. The brother (and wife) and another brother also took out a $1,200,000 construction loan. Both loans were secured by the home. The construction loan was used to build a separate guesthouse on the property. In 2010, one brother executed a quit claim deed in favor of the petitioner with respect to the property. During 2012, the petitioner didn’t make any loan payments and was not issued a Form 1098 for the year. While the petitioner lived in the guesthouse for part of 2012, he did not list the property as being his place of residence or address. On his 2012 return, the petitioner claimed a $66,354 deduction for one-half of the total mortgage interest paid for the year as reported on Form 1098 that was issued to his brother and his brother’s wife. The IRS disallowed the deduction and the Tax Court agreed. The petitioner failed to prove that the debt on the property was his obligation, did not show ownership (legal or equitable) in the property, and the quitclaim deed did not convey title to him under state law. The Tax Court also determined that the petitioner failed to establish that the residence was his “qualified residence.”
Charitable Deduction Case Will Go to Trial on Numerous Issues
Lim v. Comr., T.C. Memo. 2023-11
During 2016 and 2017, the petitioners (a married couple) were the sole shareholders of an S corporation. In late 2016, after making a presentation to the petitioners concerning “The Ultimate Tax, Estate and Charitable Plan,” an attorney formed a “Charitable Limited Liability Company” for the petitioners to use as a vehicle for making charitable donations. The attorney agreed to transfer assets to the LLC, to transfer LLC units to a charity and to provide the supporting valuation documentation for the donation. He also agreed to represent them before the IRS and the Tax Court if the return(s) were later examined. His fee would be the greater of $25,000 or 6 percent of the “deductible amount” of assets capped at $1 million, plus 4 percent of the “deductible amount” of assets exceeding $1 million. The assets transferred to the LLC were five promissory notes with a face amount of $2,008,500. This generated a fee for the attorney of $84,000 based on a presupposed “deductible amount” of $1,600,000 even though the assets were not appraised until late January of 2017, which valued them at $1,600,000. The fee was to be paid in installments over six months beginning in January of 2017.
The attorney also created a second LLC in late December of 2016 with the petitioners as the managers, the attorney as the registered agent, and the petitioners’ S corporation as the single member. Petitioners promised to pay the second LLC $2,008,500 (the promissory notes) in seven years.
The charitable recipient was a Foundation (an I.R.C. §501(c)(3) organization) for which the attorney was the registered agent. The petitioners claimed that their S corporation donated “units” of the second LLC to the Foundation and claimed a charitable deduction. The IRS denied the deduction, partly on the basis of a lack of evidence that any property was actually transferred to the Foundation. The petitioners did not offer any explanation as to when or how the “units” were created or what physical form they took. The petitioners also claimed that they received an acknowledgement letter of the donation from the Foundation dated January 1, 2017. The letter referred to 1,000 units of an LLC that did not exist during 2016 or as of January 1, 2017. It was not addressed to the S corporation, but to the petitioner (wife) at their residence in a different city than the S corporation. The letter also was not signed by any person and appeared to be a form letter with taxpayer-specific information in bold font. It also did not refer to any property that the S corporation allegedly donated on December 31, 2016.
On January 4, 2017, the attorney submitted an appraisal, but it lacked substance. The appraisal asserted that LLC interests were donated to the Foundation in 2016, but did not denote how many interests had been contributed. The claimed charitable deduction was $1,608,808. The attorney also attached his curriculum vitae stating that he was a CPA, a certified valuation analyst and a licensed attorney in Kentucky. Also attached to the appraisal was a one-page “certification” on which the attorney stated that his fee was not contingent on the report in any manner and that he didn’t have any interest or bias with respect to the parties involved. This was despite his having arranged the entire transaction and being the registered agent for the second LLC.
The S corporation filed Form 1120S for 2016 and attached a copy of the appraisal and Form 8283 which described the donated property as “LLC units” with a basis of $2,008,500 that had been acquired by purchase, and an “appraised market value” of $1,608,808. The petitioners reported a non-cash charitable deduction of $1,608,808 on Schedule A that flowed through to them from the S corporation. Because the amount of the deduction exceeded the maximum allowable deduction for 2016, they claimed a $1,195,073 deduction for 2016 and carried the balance of $415,711 to their 2017 return.
The IRS audited the petitioners’ 2016 and 2017 returns and disallowed the charitable deductions for lack of substantiation. The petitioners challenged the disallowance in the Tax Court and the IRS moved for partial Summary Judgment. The Tax Court determined that the appraisal was not a “qualified appraisal” within the meaning of I.R.C. §170(f)(11)(C). Treas. Reg. §1.170A-13(c)(6)(i) requires, among other things, that “no part of the fee arrangement for a qualified appraisal can be based, in effect, on a percentage (or set of percentages) of the appraised value of the property.” Accordingly, the attorney’s fee was a prohibited appraisal fee within the meaning of the regulation. However, the Tax Court held that the petitioners had shown reasonable cause for failure to comply with the substantiation requirements of I.R.C. §170. They had presented sufficient proof that they relied upon professionals in claiming the charitable contribution deduction. Accordingly, the Tax Court denied the IRS summary judgment on this issue. The Tax Court also denied summary judgment to the IRS on the issue of whether the written acknowledgement was a “contemporaneous written acknowledgement” of the contribution in accordance with I.R.C. §170(f)(8)(A). Accordingly, the Tax Court granted the Summary Judgment motion of the IRS in part, while the remaining issues will be set for trial.
Note: In 2018 the Department of Justice filed a complaint against the attorney, alleging that he promoted the “Ultimate Tax Plan” as a tax evasion scheme. He was accused of running a $35 million federal tax advice scam offering fake deductions using three bogus charities for 19 years. The complaint alleged that he was at the helm of "a national charitable-giving tax scheme" that targeted "wealthy individuals in high tax brackets facing large tax liabilities.” He settled with the Government and agreed to a permanent injunction. On April 26, 2019, the U.S. District Court for the Southern District of Florida entered a final judgment of permanent injunction against him, holding that he had engaged in conduct penalizable under I.R.C. §6700 by promoting the “Ultimate Tax Plan.” The court permanently enjoined him from, among other things, promoting “the Ultimate Tax Plan or any plan or arrangement that is substantially similar.” The court ordered the attorney to perform other actions as well in relation to the plan.
Document Filed with FSA Not a Valid Lease
Coniglio v. Woods, No. 06-22-00021-CV, 2022 Tex. App. LEXIS 8926 (Tex. Ct. App. Dec. 7, 2022)
Involved in this case was land in Texas that the landowner’s son managed for his father who lived in Florida. The landowner needed the hay cut and agreed orally that the plaintiff could cut the hay when necessary. The hay was cut on an annual basis. So that he could receive government farm program payments on the land, the plaintiff filed a “memorialization of a lease agreement” with the local USDA Farm Service Agency (FSA). The landowner’s son also signed the agreement at the plaintiff’s request, but later testified that he didn’t believe the document to constitute a written lease. After three years of cutting the hay, the landowner wanted to lease the ground for solar development, and the plaintiff was told that the hay no longer needed to be cut and there would be no hay profits to share. The plaintiff sued for breach of a farm lease agreement. The trial court ruled in favor of the plaintiff on the basis that the form submitted to the USDA was sufficient to show the existence of a lease agreement. On appeal, the defendant claimed that the document filed with the FSA did not satisfy the writing requirement of the statute of frauds. The appellate court agreed, noting that the document didn’t contain the essential terms of the lease. It didn’t denote the names of the parties, didn’t describe the property, didn’t note the rental rate, and didn’t list any conditions or any consideration. Accordingly, the appellate court determined that no valid lease existed and reversed the trial court’s judgment.
Conclusion
I’ll provide another summary of recent cases in a subsequent post.
March 11, 2023 in Estate Planning, Income Tax, Real Property, Water Law | Permalink | Comments (0)
Sunday, March 5, 2023
Equity “Theft” - Can I Lose the Equity in My Farm for Failure to Pay Property Taxes?
Overview
In January, the U.S. Supreme Court agreed to hear a case from the U.S. Court of Appeals for the Eighth Circuit involving a Minnesota homeowner that failed to keep current on the payment of her property taxes. Ultimately, title to her home was forfeited to the State under the Minnesota statutory forfeiture procedure. The county cancelled her tax debt of $15,000 and then sold the home (a condominium) to a private party for $40,000, but did not remit the $25,000 surplus back to her.
The case highlights the issue of “home equity theft” that is possible in some states and raises concerns among farmers and ranchers as to whether it is possible that the same principle could apply
Home equity “theft” and the potential application to farms and ranches – it’s the topic of today’s post
Background
Equity in a home or a farm is the difference between the value of the home or farm and the remaining mortgage balance. Equity is a primary source of wealth for many owners. Indeed, the largest asset value for a farm or ranch family is in the equity wrapped up in the land. In the non-farm sector, primary residences account for 26 percent of the average household’s assets. Equity is a valuable asset. It can be borrowed against or converted into cash and invested in other assets or used to pay debts. Home equity, however, is also subject to seizure to settle tax debt – within the confines of the constitution. Certainly, the government has the constitutional power to tax property and seize property to pay delinquent taxes on that property. But, is it constitutional for the government to retain the proceeds of the sale of seized (forfeited) property after the tax debt has been paid? That’s the question presently before the U.S. Supreme Court.
The Minnesota Case
Presently, 12 states allow the government to keep the surplus equity proceeds of a sale. Minnesota is one of those, along with Alabama, Arizona, Colorado, Illinois, Maine, Massachusetts, Nebraska, New Jersey, New York, South Dakota, and Oregon. The Minnesota case, Tyler v. Hennepin County, 26 F. 4th 789 (8th Cir. 2022), cert. granted, 143 S. Ct. 644 (2023), involved the Minnesota statutory forfeiture procedure that applies when property taxes remain unpaid. Property taxes are a perpetual lien against the property. Minn. Stat. §272.31 Property taxes that the not paid during the year they are due become delinquent on January 1 of the following year. Minn. Stat. §279.03, subdiv. 1. Each year the county must file a delinquent tax list. Once a property is listed, a lawsuit is brought against the properties on which the delinquent taxes are owed. Id. §279.05. Property owners with outstanding taxes receive multiple notices of both the delinquent tax list and the legal action. Id. §279.06, 279.09, 279.091. If the owner fails to respond, a judgment is entered against the property. Id. §279.16. The county then buys the property for the amount of the unpaid taxes (plus penalties, costs and interest). At that point, title to the property vests in the State subject to statutory redemption rights. Id. §280.41. During the statutory redemption period (typically three years) the former owner may redeem the property for the amount of the delinquent taxes, penalties, costs and interest. During the redemption period, the county must notify the taxpayer of the right to redeem. If Id. §§281.01, 281.02 and 281.17. the redemption right is not exercised, a final forfeiture occurs which vests “absolute title” in the State and cancels all taxes, penalties, costs, interest, and special assessments against the property. Id. §§281.18, 282.07. Even after the “final forfeiture” the owner has six months to apply to buy the forfeited property. Id. §282.41. But, Minnesota law specifies that if the county ultimately sells the property the former owner cannot recover any proceeds of the sale that exceed the tax debt. In other words, the State takes the former owner’s equity in the property.
This is precisely what happened in Tyler. Hennepin County followed the statutory forfeiture procedure, the homeowner didn’t redeem her condominium within the allotted timeframe and the state ultimately sold the property and bagged the proceeds – including the homeowner’s equity in the property.
The homeowner sued, claiming that Hennepin County violated the Constitution’s Takings Clause (federal and state) by failing to remit the equity she had in her home. She also claimed that the county’s actions amounted to an unconstitutional excessive fine, violated her due process and constituted an unjust enrichment under state law. The trial court dismissed the case and the Eighth Circuit affirmed finding that she lacked any recognizable property interest in the surplus equity in her home. In so holding, the appellate court noted the detailed statutory forfeiture procedure under Minnesota law. The appellate court also affirmed the trial court’s conclusion that the retention of the surplus equity by the state did not constitute an excessive fine under either the federal or state Constitutions.
Other States
Wisconsin. The result in Tyler could have also happened in Wisconsin but in 2022 state law changed to bar the state from retaining equity obtained in forfeiture proceedings. Wis. Act. 216 (2022). In 2020, the Michigan Supreme Court determined that the state’s retention of equity in a forfeiture action was an unconstitutional taking of private property. Rafaeli, LLC v. Oakland Cty., 505 Mich. 429, 952 N.W.2d 434 (2020). The case involved an 83-year-old man who failed to pay $8.41 in property taxes and the county sold his home for $24,500 to pay the debt and kept the balance.
Massachusetts. A small alpaca farmer in Massachusetts filed a claim on January 10, 2023, to argue that the local town unconstitutionally took a $310,000 profit from the sale of his farm to pay a $60,000 property tax debt. A study by Ralph D. Clifford at the University of Massachusetts School of Law at Dartmouth found that Massachusetts “steals” almost $60,000,000 in equity from taxpayers annually. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3086247).
Note: In some instances, a private company will buy a property that has a delinquent tax debt and attach interest to it at the statutory rate – 16 percent in Massachusetts. The company then lets the interest accrue for three years (the statutory redemption timeframe) and then notifies the real homeowner one last time what they can pay to get their home back – including the interest charge.
Nebraska. In 2018, the Nebraska Supreme Court determined that 480-acre farm near North Platte worth $1..1 million had been properly acquired for $50,000 in delinquent taxes. Wisner v. Vandelay Invs., L.L.C., 300 Neb. 825, 916 N.W.2d 698 (2018). The owner was a 94-year-old woman in a nursing woman with arguable reduced mental capacity. One of her sons was named as an agent under a power of attorney who then assigned his duties to a trust officer at a local bank. The son assumed that the bank was paying the property taxes on the farm, but the bank never received any property tax notices and, thus, didn’t pay any property taxes. The taxes became delinquent, and a private company ultimately acquired the tax certificate for the farm and, after the required three-year redemption period, sent notice of intent to foreclose to the address where the owner had previously received her property tax statements. The notice was unclaimed which led the company to publish notice in a local newspaper for three consecutive weeks. Ultimately, the firm acquired the tax deed to the property.
The son sought to void the tax deed, claiming that the company didn’t comply with the statutory notice requirements (the paper wasn’t circulated in the entire county) and that the three-year redemption period should have been extended to five years on account of the owner’s mental condition. However, the Nebraska Supreme Court disagreed, holding that the son failed to overcome the presumption that the publication of notice was sufficient or that his mother had a mental condition sufficient to extend the statutory redemption period. A dissenting judge classified the majority’s opinion as a “windfall that borders on the obscene.”
Note: In the wake of the Wisner decision, the Nebraska Unicameral changed the requirements for service of notice when applying for a tax deed. Neb. Rev. Stat. §77-1832 was amended to provide that service of the notice is to be by personal or residential service on a person in actual possession of the property and on the person whose name the title to the real property appears of record who can be found in Nebraska. If personal or residential service is not possible, certified mail or designated delivery service can be used. In addition, the amendment specifies that certified mail or designated delivery service must be provided to every encumbrancer of record found by the title search. Only if a “diligent inquiry” fails to find the person(s) entitled to notice can notice then be by publication in the newspaper of general circulation designated by the county board.
Application can be made with the county treasurer for a tax deed if redemption has not been made. The county treasurer will issue the tax deed if, among other things, an affidavit proving service of notice is provided. If service of notice was by publication an affidavit of the publisher, manager, or newspaper employees is required. Also required to be provided is a copy of the notice and an affidavit of the purchaser (or the purchaser’s assignee) of the tax certificate.
Conclusion
Home (and farm) equity theft tends to bear more heavily on those that can least afford to hire legal assistance or qualify for legal aid (because they own a home or a farm). So, the lack of cases on the matter may underrepresent the extent of the problem. Also, each state bars a lender from keeping the proceeds of a forfeiture sale but, as noted above, not every state bars the government or a private company (that is not a lender), from keeping the surplus equity from a forfeiture sale.
Will the Supreme Court block the state and local governments (and private companies) from keeping surplus equity. We will soon find out.
March 5, 2023 in Real Property | Permalink | Comments (0)
Sunday, February 26, 2023
Deducting Residual (Excess) Soil Fertility – Does the Concept Apply to Pasture/Rangeland? (An Addendum)
Overview
Note: Last week I posted the following article. In response to numerous questions I have received over the past few months, I have now updated the article to address whether the deduction under I.R.C. §180 applies to pasture/rangeland. The new section on this issue can be found near the end of this article immediately preceding the concluding paragraph.
When farmland is purchased, depreciation can be claimed on depreciable assets associated with the farmland starting with the first tax year in which possession of the land is taken. The amount claimed is tied to the portion of the total cost of the farmland that can be allocated to any depreciable asset, such as fencing, field drainage tile, grain storage facilities, farm buildings, and irrigation equipment, just to name a few of the more common depreciable items.
In certain parts of the Midwest, above average soil fertility is also eligible for expense deductions. The concept is known as “residual soil fertility” and it can be available to farmland buyers that didn’t farm the acquired property within the immediately prior crop year.
Deductions associated with residual soil fertility, that’s the topic of today’s post.
The Deduction
I.R.C. §180 allows a taxpayer engaged in the trade or business of farming to annually elect (by deducting the expense on the return) the cost of fertilizer, lime, potash, or other materials which enrich, neutralize or condition land used in farming. If these fertilization costs are not expensed, they are required to be capitalized with expense deductions being amortized over a presumed useful life (similar to field drainage tile and/or fencing). This means that residual soil fertility is a capital asset in the hands of an operating farmer, crop-share landlord or cash rent landlord when farmland is acquired, with the cost amortized over the useful life of the asset. That useful life is typically three to four years. The general 15-year amortization rules don’t apply. Instead, the IRS position is that fertilizer costs should be amortized based on the percentage of use or benefit each year. That likely means that straight-line amortization probably does not apply. An agronomist or other soil scientist may be able to provide sufficient information so that the property annual expense allocation can be determined. See, e.g., IRS Pub. 225, Chapter 4.
Note: Usually about 60 percent is deducted in the first year, 30 percent in the second year and the last 10 percent in the third year.
For farmland inherited from a decedent, the date of the decedent’s death is the measurement date for determining whether residual soil fertility exists. If it does, the cost can be amortized by the decedent’s estate and/or the beneficiaries of the estate that receive the farmland.
In 1995, the IRS published a Market Segment Specialization Program (MSSP) addressing residual soil fertility. IRS MSSP, Guideline on Grain Farmers (Training 3149-133, Jul. 1995). In the MSSP, the IRS notes that a deduction for residual fertilizer supply will be denied unless the taxpayer can establish (1) beneficial ownership of the residual fertilizer supply; (2) the presence and extent of the residual fertilizer; and (3) that the residual fertilizer supply is actually being exhausted. In addition, the MSSP instructs IRS examining agents to make sure that the values assigned to depreciable farm assets is reasonable. See also, Tech. Adv. Memo. 9211007 (Dec. 3, 1991).
Allocation. The actual deduction might be less than the agronomist’s value of the excess amount. If the land’s value combined with the value of the excess fertility exceed the purchase price of the land, an allocation must be done for each one based on their respective fair market values. For example, assume that farmland is purchased for 8,000/acre. An agronomist pegs the excess fertility at $4,000/acre. Comparable land in the area without excess fertility sells for $7,000/acre. When the $4,000/acre for excess fertility is added to the land value without excess fertility, the total is $11,000. Thus, the land is 63.6 percent of the total value, and the excess fertility is 36.4 percent. The purchase price was $8,000/acre. 36.4 percent of that amount is $2,912/acre. That will be the amount that IRS will accept as the deduction for excess fertilizer supply – not the $4,000/acre that the agronomist determined.
Procedure
So, how can a taxpayer establish the presence and extent of residual fertilizer supply and that it is actually being exhausted? For starters, if farmland has an actual excess soil fertility base it will normally bring a price premium upon sale. That’s the same rationale that applies when farmland with good fences, field drainage tile and grain storage facilities is purchased – a price premium applies to factor in the existence of those assets. As for residual fertilizer supply, the excess amount can be measured by grid sampling. A buyer can anticipate that grid sampling will cost of approximately $4-$8 per acre. Agronomists and agricultural soil testing labs follow certain guidelines and procedures that they use to determine average (base) soil fertility for various soil types. Once grid soil samples are obtained, the fertility levels of those samples are compared to the base fertility guideline levels for particular soil types to establish the amount of “excess” fertility on a tract of acquired farm real estate.
The key is to obtain data for the established base soil fertility for the type of soil on the purchased farmland from comparable tracts and comparable soil types. By establishing the base soil fertility, the actual sampling on the purchased property will reveal whether excess residual fertilizer is present. That soil sampling should occur on or before the buyer takes possession of the farmland. For farmland that is inherited, the sampling should occur before the buyer applies any new fertilization.
Documentation
While the IRS does not require it, perhaps the best way to document the deduction for excess soil fertility is to provide for the allocation of value to the amount of above average soil fertility in the purchase contract for the farmland. In addition, a written summary of how the computation was made and the time period over which it would deplete due to crop production should be obtained from the agronomist or other expert involved. This will be beneficial for establishing the proper amortization period for the excess soil fertility and will provide substantiation of the deduction upon any subsequent IRS (or state) audit. Depending on the soil type involved, the deduction could range from $50 per acre to over $700 per acre – perhaps exceeding 10 percent of the land’s value.
Recapture
If a deduction for excess fertilizer supply is claimed and the land is later sold, the amount of the selling price attributable to the excess fertility will be recaptured as ordinary income. It does not qualify for capital gain treatment. Any remaining gain will be taxed at capital gain rates. Of course, if the taxpayer continues to own the land until death recapture is avoided.
Application to Pasture/Rangeland?
In recent months, I have been asked by numerous tax professionals about the assertion in certain marketing materials of private agronomic firms asserting that the I.R.C. §180 deduction can provide a substantial tax deduction for residual fertilizer supply on pasture and/or rangeland. In the meantime, I have conducted further research and discussed the matter with soil scientists and rangeland management specialists. The following is what I have gleaned from those conversations.
In general. The starting point on this particular question is to note that the IRS has not specifically addressed the application of I.R.C. §180 to pasture or rangeland. Indeed, the only IRS guidance on the excess soil fertility issue is the 1991 TAM and the MSSP referred to above. But, I.R.C. §180 does indicate that “land used in farming” for purposes of the provision includes “land used…for the sustenance of livestock.” So, in theory, the same concepts that apply to cropland apply to land used for grazing. However, the makeup and value of the minerals differs. With pasture and rangeland the value of potassium and phosphorous contained in the soil is much less than the value of the same minerals in soil used to raise row crops. The value per unit is simply not the same such that the owner of the grazing land would simply not apply fertilizer (especially at the current high prices) to enhance the land’s value – the economics disincentivize such activity.
Native pasture. The nutrient balance on a native pasture is very tight and there is no “excess” nutrient in a native pasture system. These systems are rarely if ever fertilized with commercial fertilizer or external manure applications, with the exception being (perhaps) for a native field that is hayed. Nitrogen can increase production and allow increased stocking rates, but is simply not profitable to do so. Native hay meadows are sometimes fertilized with 30-40# nitrogen and 10# phosphorous. Fertilizing native grass usually increases any cool-season grasses in the stand (e.g., Kentucky bluegrass and annual bromes) and increases broadleafs. Prescribed burning in the late spring is then recommended to set those unwanted species back the next year.
Native rangeland is very efficient as using N and gets nitrogen from lightning/rainfall and non-symbiotic fixation (e.g Clostridium and Azotobacter). There may be some symbiotic N fixation by native legumes. The year after a drought, biomass on rangeland may increase because of unused N in the soil, if rainfall is normal or above. This increase in production not only relies on moisture, but on how the pasture was managed during the year of drought.
Marketing material. The marketing material of the agronomic firms that I have seen that are in the business of measuring soil fertility makes a broad statement that I.R.C. §180 applies to grazing land. While true on its face, pasture grass is not the same as cropland when it comes to nutrients. While the concept applies equally, the application does not. Given that rangeland has a lower per acre fair market value than does cropland and the excess soil fertility (even if it is present and can be measured) would be less than what is present on cropland, any associated I.R.C. §180 deduction would likely be insufficient to justify the work to claim the deduction – and it is a deduction and not as valuable to the taxpayer as a credit.
The marketing material also states in numerous places that the firm asserting the deduction can apply to grazing land is not making any “recommendations, representations, or guarantees regarding the income tax implications” and that it is “…NOT intending to provide the Client with legal, tax or accounting advice.” The marketing material also states that the company makes “no express or implied warranties of any kind…regarding…[the] business deduction that can be claimed by Client…”. Clearly these firms are not standing behind their analysis when it comes to claiming a deduction based on their reports. Thus, a buyer of land that does so thinking that a substantial tax deduction may be forthcoming may have no recourse against these firms if the IRS disagrees. But, the buyer would know the nutrient content of the soil. That is worth something to the buyer, but not likely much (if any) of a tax deduction.
Conclusion
When farmland is acquired, an allocation of value can be made to depreciable items. In certain parts of the country, a depreciable item might be residual fertilizer supply. If it can be established with appropriate data, a tax benefit is available. It’s important, however, to follow the IRS guidelines. As applied to grazing land, however, the deduction is quite likely to be so small as to not justify the cost of the soil sampling and the associated tax work to claim the deduction.
Also, in some states, following the IRS guidance on deducting excess soil fertility may not be good enough.
February 26, 2023 in Income Tax | Permalink | Comments (0)
Tuesday, February 21, 2023
Deducting Residual (Excess) Soil Fertility
Overview
When farmland is purchased, depreciation can be claimed on depreciable assets associated with the farmland starting with the first tax year in which possession of the land is taken. The amount claimed is tied to the portion of the total cost of the farmland that can be allocated to any depreciable asset, such as fencing, field drainage tile, grain storage facilities, farm buildings, and irrigation equipment, just to name a few of the more common depreciable items.
In certain parts of the Midwest, above average soil fertility is also eligible for expense deductions. The concept is known as “residual soil fertility” and it can be available to farmland buyers that didn’t farm the acquired property within the immediately prior crop year.
Deductions associated with residual soil fertility, that’s the topic of today’s post.
The Deduction
I.R.C. §180 allows a taxpayer engaged in the trade or business of farming to annually elect (by deducting the expense on the return) the cost of fertilizer, lime, potash, or other materials which enrich, neutralize or condition land used in farming. If these fertilization costs are not expensed, they are required to be capitalized with expense deductions being amortized over a presumed useful life (similar to field drainage tile and/or fencing). This means that residual soil fertility is a capital asset in the hands of an operating farmer, crop-share landlord or cash rent landlord when farmland is acquired, with the cost amortized over the useful life of the asset. That useful life is typically three to four years. The general 15-year amortization rules don’t apply. Instead, the IRS position is that fertilizer costs should be amortized based on the percentage of use or benefit each year. That likely means that straight-line amortization probably does not apply. An agronomist or other soil scientist may be able to provide sufficient information so that the property annual expense allocation can be determined. See, e.g., IRS Pub. 225, Chapter 4.
Note: Usually about 60 percent is deducted in the first year, 30 percent in the second year and the last 10 percent in the third year.
For farmland inherited from a decedent, the date of the decedent’s death is the measurement date for determining whether residual soil fertility exists. If it does, the cost can be amortized by the decedent’s estate and/or the beneficiaries of the estate that receive the farmland.
In 1995, the IRS published a Market Segment Specialization Program (MSSP) addressing residual soil fertility. IRS MSSP, Guideline on Grain Farmers (Training 3149-133, Jul. 1995). In the MSSP, the IRS notes that a deduction for residual fertilizer supply will be denied unless the taxpayer can establish (1) beneficial ownership of the residual fertilizer supply; (2) the presence and extent of the residual fertilizer; and (3) that the residual fertilizer supply is actually being exhausted. In addition, the MSSP instructs IRS examining agents to make sure that the values assigned to depreciable farm assets is reasonable. See also, Tech. Adv. Memo. 9211007 (Dec. 3, 1991).
Allocation. The actual deduction might be less than the agronomist’s value of the excess amount. If the land’s value combined with the value of the excess fertility exceed the purchase price of the land, an allocation must be done for each one based on their respective fair market values. For example, assume that farmland is purchased for 8,000/acre. An agronomist pegs the excess fertility at $4,000/acre. Comparable land in the area without excess fertility sells for $7,000/acre. When the $4,000/acre for excess fertility is added to the land value without excess fertility, the total is $11,000. Thus, the land is 63.6 percent of the total value, and the excess fertility is 36.4 percent. The purchase price was $8,000/acre. 36.4 percent of that amount is $2,912/acre. That will be the amount that IRS will accept as the deduction for excess fertilizer supply – not the $4,000/acre that the agronomist determined.
Procedure
So, how can a taxpayer establish the presence and extent of residual fertilizer supply and that it is actually being exhausted? For starters, if farmland has an actual excess soil fertility base it will normally bring a price premium upon sale. That’s the same rationale that applies when farmland with good fences, field drainage tile and grain storage facilities is purchased – a price premium applies to factor in the existence of those assets. As for residual fertilizer supply, the excess amount can be measured by grid sampling. A buyer can anticipate that grid sampling will cost of approximately $4-$8 per acre. Agronomists and agricultural soil testing labs follow certain guidelines and procedures that they use to determine average (base) soil fertility for various soil types. Once grid soil samples are obtained, the fertility levels of those samples are compared to the base fertility guideline levels for particular soil types to establish the amount of “excess” fertility on a tract of acquired farm real estate.
The key is to obtain data for the established base soil fertility for the type of soil on the purchased farmland from comparable tracts and comparable soil types. By establishing the base soil fertility, the actual sampling on the purchased property will reveal whether excess residual fertilizer is present. That soil sampling should occur on or before the buyer takes possession of the farmland. For farmland that is inherited, the sampling should occur before the buyer applies any new fertilization.
Documentation
While the IRS does not require it, perhaps the best way to document the deduction for excess soil fertility is to provide for the allocation of value to the amount of above average soil fertility in the purchase contract for the farmland. In addition, a written summary of how the computation was made and the time period over which it would deplete due to crop production should be obtained from the agronomist or other expert involved. This will be beneficial for establishing the proper amortization period for the excess soil fertility and will provide substantiation of the deduction upon any subsequent IRS (or state) audit. Depending on the soil type involved, the deduction could range from $50 per acre to over $700 per acre – perhaps exceeding 10 percent of the land’s value.
Recapture
If a deduction for excess fertilizer supply is claimed and the land is later sold, the amount of the selling price attributable to the excess fertility will be recaptured as ordinary income. It does not qualify for capital gain treatment. Any remaining gain will be taxed at capital gain rates. Of course, if the taxpayer continues to own the land until death recapture is avoided.
Conclusion
When farmland is acquired, an allocation of value can be made to depreciable items. In certain parts of the country, a depreciable item might be residual fertilizer supply. If it can be established with appropriate data, a tax benefit is available. It’s important, however, to follow the IRS guidelines. Also, in some states, following the IRS guidance on deducting excess soil fertility may not be good enough.
February 21, 2023 in Income Tax | Permalink | Comments (0)
Thursday, February 16, 2023
Foreign Ownership of Agricultural Land
Overview
An issue that has been around a very long time and dates back to the foundation of the United States is that of agricultural land being owned by non-U.S. citizens and/or entities. It’s a national security and food security issue. Some states have had restrictions for many years and are considering strengthening existing provisions. Others are looking at the issue for the first time. The Kansas legislature currently has bills under consideration in both houses.
Foreign ownership of agricultural land – it’s the topic of today’s post.
Background of Foreign Ownership Restrictions
Under the English common law, aliens could not acquire title to land except with the King's approval. The King understood that control and ownership of the land was critical to national security and did not want disloyal subjects owning or acquiring an interest in land. The common law rule existed in England until it was abolished by statute in 1870. However, by that time, the notion of limiting alien ownership of agricultural land was well imbedded in United States jurisprudence. In the 1970s, the issue of foreign investment in and ownership of agricultural land received additional attention because of several large purchases by foreigners and the suspicion that the build-up in liquidity in the oil exporting countries would likely lead to more land purchases by nonresident aliens. The lack of data concerning the number of acres actually owned by foreigners contributed to fears that foreign ownership was an important and rapidly spreading phenomenon.
Agricultural Foreign Investment Disclosure Act
In 1978, the Congress enacted the Agricultural Foreign Investment Disclosure Act (AFIDA). 7 U.S.C. 3501 et seq. Under AFIDA, the USDA obtains information on U.S. agricultural holdings of foreign individuals and businesses. In essence, AFIDA is a reporting statute rather than a regulatory statute. The information provided in reports by the AFIDA helps serve as the basis for any future action Congress may take in establishing direct controls or limits on foreign investment in agricultural land and provides useful information to states considering limitations on foreign investment. The Act requires that foreign persons report to the Secretary of Agriculture their agricultural land holdings or acquisitions. The Secretary assembles and analyzes the information contained in the report, passes it on the respective states for their action and reports periodically to the Congress and the President.
AFIDA requires reports in four situations: (1) when a foreign person “acquires or transfers any interest, other than a security” in agricultural land; (2) when any interest in agricultural land, except a security interest, is held by any foreign person on the day before the effective date of the Act; (3) when a nonforeign owner of agricultural land subsequently becomes a foreign person; and (4) when nonagricultural land owned by a foreign person subsequently becomes agricultural land.
AFIDA defines “agricultural land” as “any land located in one or more states and used for agricultural, forestry, or timber production purposes...”. 7 U.S.C. § 3508(1). The regulations define agricultural land as “land in the United States which is currently used for, or if idle and its last use within the past five years was for, agricultural, forestry, or timber production, except land not exceeding one acre from which the agricultural, forestry, or timber products are less than $1,000 in annual gross sales value and such products are produced for the personal or household use of the person or persons holding an interest in such land.” 44 Fed. Reg. 7117 (1979); 7 C.F.R. § 781.2(b). In 1980, the Secretary proposed a change in this definition to increase the acreage amount to ten acres, while preserving the gross sales test. However, the proposed change has not yet become effective.
The reporting provisions of the AFIDA require the disclosure of considerable information regarding both the land and the reporting party. The information must be reported on Form FSA-153 and includes: (1) the legal name and address of the foreign person; (2) the citizenship of the foreign person, if an individual; (3) if the foreign person is not an individual or government, the nature of the legal entity holding the interest, the country in which the foreign person is created or organized, and the principal place of business; (4) the type of interest in agricultural land that the person acquired or transferred; (5) the legal description and acreage of the agricultural land; (6) the purchase price paid, or other consideration given, for such interest; (7) if a foreign person transfers an interest, the legal name and address of the person to whom the interest is transferred; (8) the agricultural purposes for which the agricultural land is being used and for which the foreign person intends to use the agricultural property; and (9) such other information as the Secretary of Agriculture may require by regulation. 7 U.S.C. § 3501(a)(9).
State Restrictions
State statutes designed to restrict alien ownership of real property are generally of three types: (1) outright restrictions on the acquisition of certain types of property; (2) limitations on the total amount of land that can be acquired; and (3) limitations on the length of time property can be held. Acquisition restrictions are common in the agricultural context, with the restriction generally applying only to the acquisition of farmland, as defined by the law. Exceptions are common for the acquisition of land for conversion to nonagricultural purposes, land acquired by devise or descent, and land acquired through collection of debts or enforcement of liens or mortgages. Acreage restrictions allow foreign investment but place a premium on having an effective method of discovering and preventing multiple acquisition by the same individuals through the use of various investment vehicles. Time restrictions generally do not apply to voluntary acquisition of the land by foreign investors but are associated with involuntary acquisitions. Some states require the disclosure of information concerning the land acquired and the investors.
Currently, about one-half of the states restrict agricultural land acquisition by aliens. The number is approximate because legislative efforts to legislate in this area have been swift in recent years and continue during the 2023 session in several states. The states with the most restrictive laws are IL, IN, IA, KY, MN, MO, NE, ND, OK, SD and WI. Approximately 13 other states have minor restrictions on foreign ownership of agricultural land.
Recently, the issue of restricting foreign investment in and/or ownership of agricultural land has been raised in Alabama, Arkansas, California, Florida, Indiana, Mississippi, Missouri, Montana, North Dakota, Oklahoma, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, Washington, and Wyoming. Each of these states have proposed, or plan to propose, legislation restricting foreign ownership and/or investment in agricultural land to varying degrees. Several high-profile events have spurred this renewed interest including a Chinese-owned company acquiring over 130,000 acres near an Air Force base in Texas and a 300-acre purchase by another Chinese company near a different Air Force base in North Dakota. Also, the very recent and slow “fly-over” of a Chinese spy balloon from Alaska to South Carolina, mysterious damages to many food processing facilities, pipelines and rail transportation have contributed to the growing interest in national security and restrictions on ownership of U.S. farm and ranchland by known adversaries.
The following is a brief summary of what some of the other states have proposed recently:
Colorado HB 23-1152
- Prohibits, starting on January 1, 2024, a nonresident foreign citizen, entity, or government of the People’s Republic of China, the Russian Federation or any country determined by the US secretary of state to be a state sponsor of terrorism from acquiring a controlling ownership share in ag land, mineral rights, or water rights in the state.
- A covered foreign person who acquires a controlling ownership share in a property interest in the state prior to January 1, 2024, may continue to own the property interest but not acquire controlling ownership in any additional property interests.
- A covered foreign person must register with the secretary of state within 60 days of acquiring ownership in property interests.
- If the state attorney general has reason to believe a covered foreign person has not complied with the law, the attorney general must bring a civil action against the covered person. If the court finds the covered foreign person has violated the prohibition the judgment will revert the property interest to the state.
Illinois HB 1267
- Would bar the purchase of public or private real estate by noncitizens for five years after the effective date.
- A “noncitizen” includes an foreign government, entity, corporation, partnership, or other association created under the laws of a foreign country and beneficially owned by a national of that foreign country
New Jersey A5120
- A foreign government or person owning or holding interest in ag land shall sell or convey the ownership within 5 years of the effective date of the Act.
- Ag land acquired by a foreign government or person shall be sold or conveyed within two years after title to the land is transferred thereto. Upon such conveyance, a deed of easement shall be attached to the land requiring it to remain devoted to ag use.
- The land conveyed should not be conveyed to a foreign person or government.
North Dakota SB 2371
- The bill gives counties and municipalities the power to prohibit local development by a foreign adversary.
- County commissions, city commissions, or city council may decide not to authorize a development agreement with a foreign adversary whether individual or government.
Oklahoma SB 212
- No person who is not a US citizen shall acquire title to land either directly through a business entity or trust.
- Exempt is any business entity that has legally operated in the U.S. for at least 20 years.
- Any deed recorded with a county clerk shall include proof that the person or entity obtaining the land is in compliance with the provision.
- No application to lands now owned by aliens so long as they are held by the present owners nor to any alien who shall take up bona fide resident of the state or any lawfully recognized business entity.
- It is the duty of the attorney general or district attorney to institute a suit on behalf of the state if they have reason to believe any lands are being held contrary to the Act.
- Creates a citizen land ownership unit to enforce the provisions of the act within the office of the attorney general.
Texas SB 711
- Prohibited foreign actors may not acquire title to real property without written notification to the seller.
- A “prohibited foreign actor” is an alien, business, government, or an agent from a country identified as a country that poses a risk to the national security of the U.S. in the most recent Annual Threat Assessment issued by the Director of National Intelligence.
- A buyer required to provide written notification shall do so as soon as possible but not later than 10 days before the closing of the property.
- Upon receipt of notification, seller may choose to proceed or revoke sale.
- Court shall dismiss any action brought against seller for revoking a sale.
Current Kansas Law
The Kansas restriction on foreign ownership, to the extent there is one, is contained in the Kansas Constitution and in the anti-corporate farming law. Section 17 of the Kansas Bill of Rights states as follows:
“No distinction shall ever be made between citizens of the state of Kansas and the citizens of other states and territories of the United States in reference to the purchase, enjoyment or descent of property. The rights of aliens in reference to the purchase, enjoyment or descent of property may be regulated by law.”
The Kansas Bill of Rights, as noted, gives the legislature the power to regulate foreign ownership of “property” – in terms of its, purchase, enjoyments or descent. One manner that the legislature has chosen to do that is by means of the anti-corporate farming law. Kan. Stat. Ann. §17-5904. This provision states that, “no corporation, trust, LLC, limited partnership or corporate partnership other than a family farm corporation … shall either directly or indirectly, own, acquire or otherwise obtain or lease any agricultural land in this state. However, there are many situations to which the restriction does not apply (in addition to not applying to a family farm corporation).
The law was later amended to provide that production contracts “shall not be construed to mean the ownership, acquisition, obtainment, or lease either directly or indirectly on any ag land.”
A violation of the anti-corporate farming law subjects the violator to a civil penalty of not more than $50,000 and the violator must divest itself of all land acquired in violation of the anti-corporate farming law. Violations may be pursued by either the state attorney general or by a county attorney.
Kan. Stat. Ann. §17-7505 contains a reporting requirement. It provides as follows:
- Every foreign corporation doing business in this state shall make a written business entity information report to the secretary of state.
- The report shall be made on a form prescribed by the secretary of state.
- The report shall contain:
- The name and the state or country of incorporation.
- The location of its principal office
- The names and addresses of the officers and board of directors.
- The number of shares of capital stock issued.
- The nature of the business
- If the corporation holds more than 50% equity in ownership in any other business registered with the secretary of state, the name and ID number of that other business.
- Corporations subject to the provisions of this section that holds ag land within this state shall show the following additional information.
- The acreage and location of ag land this state owned or leased by or to the corporation.
- The purposes of the ownership or lease
- The value of the ag and non-ag assets owned and controlled by the corporate within and without the state of Kansas and where situated.
- The number of stockholders of the corporation
- The number of acres owned and leased by the corporation and to the corporation.
- The number of acres of ag land held and reported in each category under paragraph 5
- Whether any of the ag land was acquired after July 1, 1981
- The official title of the person signing the report must be designated.
Note: Presently, 2.3 percent of all privately held agricultural land in Kansas is held by a foreign individual or entity. “Held” means anything from outright title ownership to any interest in the land other than a security interest. But, “held” does not include leaseholds of less than 10 years’ duration, contingent future interests, non-contingent future interests that don’t become possessory upon termination of the present estate, non-agricultural easements and rights-of-way, and interests solely in mineral rights. The percentage of foreign “holdings” includes land under long-term wind energy leases where the lessee is a foreign-owned entity.
Current Kansas Proposals
House Bill 2397
This bill, which would be effective, July 1, 2023, specifies that no person who is owned by or controlled by or subject to the jurisdiction of a “foreign adversary” shall purchase, acquire by grant, devise or descent or otherwise obtain ownership of any interest in real property. This is defined as an individual or entity acting as an agent, representative or employee, or anyone acting at the order, request or under the direction or control of a foreign adversary or whose activities are directly or indirectly under the supervision, control, direction or are being financed or otherwise subsidized primarily by a foreign adversary. An exception exists for a person that has acquired dual citizenship with the U.S. and a foreign adversary.
Note: While the bill does not limit the restriction on foreign ownership to agricultural land, it doesn’t prevent residential home ownership, for example, by a person who has dual residency in the U.S. and a foreign adversary or a “nation state” that is controlled by a foreign adversary. This is a reasonable approach to ensuring that home ownership is by a person that is not disloyal to the U.S. given the time necessary to become a dual citizen and the associated vetting that is done during the process to achieve dual citizenship. Of course, as noted below, there are very few countries that are on the foreign adversary list. In essence, home ownership by a non-U.S. citizen (even one that has dual citizenship with a foreign adversary) is permissible so long as the person is not a foreign agent.
“Foreign adversary” is defined by tying it to a federal regulation that provides a list set forth in 15 C.F. R Sec. 7.4 as that list exists on July 1, 2023. Currently on that list are: (1) the People's Republic of China, including the Hong Kong Special Administrative Region (China); (2) the Republic of Cuba (Cuba); (3) the Islamic Republic of Iran (Iran); (4) the Democratic People's Republic of Korea (North Korea); (5) the Russian Federation (Russia); and (6) Venezuelan politician Nicolás Maduro (Maduro Regime). The bill vests power in the Secretary of Agriculture to modify the list, but only if the federal government amends the list after July 1, 2023.
The provision does not apply to land acquired by the collection of debts, foreclosure pursuant to a forfeiture of a contract for deed, and any procedure for the enforcement of a lien or claim on the land.
Land subject to the provision, is to be sold or otherwise disposed of within two years after title is transferred, and a covered “person” who inherits real property on or after July 1, 2023, has 12 months to divest of property once the violation is known. Other subject land transaction may be forfeited.
The Kansas Attorney General has the power to enforce the provisions of the bill.
Senate Bill 100
Senate Bill 100 has also been proposed this session in the Kansas Senate. This bill seeks to restrict a “foreign national, foreign business entity, and foreign government” from acquiring, purchasing, or holding any interest in land within the state. A “foreign business entity” is defined by ownership. Ownership of land in Kansas is barred under the provision if the majority ownership of an entity is held by a foreign national (non-U.S. citizen) or foreign government (any non-U.S. nation); or foreign business entity. The provision is prospective only and does not apply to any real property purchased or otherwise acquired before July 1, 2023. Also, the provisions of the bill do not apply to real estate located wholly in Johnson, Sedgwick, Shawnee or Wyandotte counties.
Enforcement rests with the Kansas Attorney General and a violation of the provisions of the bill is deemed to be a level 10 nonperson felony. The Attorney General may investigate any transaction believed to violate the bill. Further. The bill specifies that land held in violation of the restriction is subject to forfeiture, with the state then taking possession of the land.
General Comments on the Kansas Proposals
The bills take different approaches to address the issue. The House Bill is more specifically tailored to restricting ownership by a “foreign adversary” as the federal government defines that term. The Senate Bill focuses on percentage ownership by a “foreign business entity” defined as ownership by persons that are not U.S. citizens as well as entities that are majority owned by non-U.S. citizens.
Over the past 30 years, the Kansas legislature has encouraged the use of “renewable” forms of energy. Often, the companies heavily involved in such energy production are foreign-owned. While the House Bill would not impact current or future development of projects on agricultural land (because the companies involved are not presently on the “foreign adversary” list), the Senate Bill appears to present some issues by its percentage ownership requirements and defining “foreign” as non-U.S. citizen.
Conclusion
Whichever approach the Kansas legislature takes on this issue, what should remain in focus is that the whole matter involves national security and control of the food supply. Neither of those are political issues. That’s true in Kansas and nationwide. Foreign ownership of agricultural land has been an issue from the time of the founding of the U.S. It’s an even greater concern today.
February 16, 2023 in Regulatory Law | Permalink | Comments (0)
Sunday, February 12, 2023
Priority Among Competing Security Interests
Overview
Most agricultural operations are dependent on borrowed money or financing for continuing in business. Presently, United States agriculture bears about $450 billion in total real estate and personal property debt. With this financing comes the need to understand the legal relations created by such debt, and the rights and obligations of the parties involved.
Recently, a bank in Texas got confused on the financing rules governing agricultural crops and lost its security interest as a result.
Ag financing and priority rules among competing security interests – it’s the topic of today’s post.
Background
Changing form of collateral and “proceeds.” The security interest created by a security agreement is a relatively durable lien. The collateral may change form as the production process unfolds. Fertilizer and seed become growing crops, animals are fattened and sold, and equipment is replaced. The lien follows the changing collateral and, in the end, may attach to the proceeds from the sales of products, at least up to ten days after the debtor receives the proceeds. In other words, a security interest in proceeds is automatically perfected if the interest in the original collateral was perfected. However, a security interest in proceeds ceases to be automatically perfected ten days after the debtor receives the proceeds. To avoid the ten-day rule from eliminating its security interest, a creditor often puts a provision in the security agreement stating that the security interest continues in the “proceeds” of the collateral.
Priority. If a debtor gives a security interest in the same collateral to two or more creditors, and the interests are perfected, it is necessary to determine which one has priority upon the debtor’s default. If the interests are perfected by filing, priority is determined by the time of filing. The creditor who filed first, wins. Therefore, because a financing statement may be filed before a security agreement is signed or the security interest attaches, a cautious creditor may wish to file early. If one or both are perfected in some manner other than filing, priority is determined by the time of perfection.
PMSI. A special type of security interest, known as a purchase money security interest (PMSI), is taken or retained by the seller of property to secure payment of the purchase price. A PMSI can also be obtained by a lender when it provides funds for the buyer to acquire specific property. But, when funds are loaned to a farmer to buy inputs to plant a crop, does the lender get a PMSI in the resulting crops that has priority to a different lender that had already loaned money to the farmer and had a perfected security interest in the farmer’s “crops and proceeds thereof?”
Recent Case
In Agrifund, LLC v. First State Bank of Shallowater, No. 07-22099925-CV, 2022 Tex. App. LEXIS 9010 (Tex. Ct. App. Dec. 9, 2022), a farm couple borrowed money from the plaintiff to finance their farming operation. They received multiple extension of the credit line with the final promissory note executed in December of 2017. The plaintiff perfected a security interest in the couple’s crops, among other items. The couple defaulted on the loan on March 15, 2018. Shortly thereafter, the couple borrowed money from the defendant. The couple used the funds to buy cotton seed and chemicals to enable them to put the 2018 cotton crop in the ground. They granted the defendant a security interest in all crops grown or to be grown for the 2018 crop year. The defendant perfected its security interest on June 4, 2018. Upon harvest, the couple sold the resulting cotton crop, and the defendant claimed its security interest beat out the plaintiff’s prior perfected interest on the basis that the defendant’s interest was a PMSI. The trial court agreed.
Under Texas law, “purchase money collateral” means “goods that secure a purchase-money obligation incurred with respect to that collateral.” Tex. Bus. & Com. Code Ann. §9.103(a)(1). A “purchase-money obligation” is “an obligation of an obligor incurred as part or all of the price of the collateral or for value to enable the debtor to acquire rights in or the use of the collateral if the value is in fact so used. Id. §9.103(a)(2). “Goods” are defined as “all things that are movable when a security interest attaches” and includes “crops grown, growing or to be grown….” Id. §9.102(a)(44). The defendant’s security interest stated that the property subject to the security interest included “supplies used or produced in a farming operation” and “crops grown or to be grown for the 2018 crop year.”
The defendant claimed it had a PMSI because it had a perfected security interest in “crops to be grown” which met the definition of “goods.” The appellate court disagreed noting that, by definition, a “purchase money security interest” means that the security interest must be taken in the items actually purchased. The couple borrowed money to produce a crop, not buy one. The appellate court also pointed out that purchased seed is not the same as a “crop to be grown.” A crop is distinguishable from the seed and chemicals, the purchase of which the defendant funded with its loan. The appellate court also rejected the defendant's claim that the cotton crop was the “proceeds” of the seed. Texas law defines “proceeds” as “whatever is acquired upon the sale, lease, license, exchange, or other disposition of the collateral….” Id. §9.102(a)(65)(A). As the appellate court pointed out, the resulting cotton crop was not the result of the sale, lease, license, exchange, or disposition of the seed. Crops are not the proceeds of seeds. See, e.g., Searcy Farm Supply, LLC v. Merchants & Planters Bank, 256 S.W.3d 496 (Ark. 2007). As a result, the appellate court held that the defendant did not have a PMSI in the farm couple’s crop and the plaintiff had priority to the sale proceeds of the crop.
Note: A dissenting judge would have held that the defendant had a PMSI superior to the plaintiff’s interest on the basis that the definition of “goods” included “crops to be grown.” But, the statute at issue defines “goods” as “all things that are movable when a security interest attaches.” At the time of attachment (when the defendant made the loan pursuant to the security agreement executed on account of the debtor's power to create a security interest), the “crops to be grown” were not in existence because the seeds hadn’t yet been planted. Thus, “goods”, by definition, could not include “crops to be grown.” The dissenting judge simply failed to apply the statute as written and misapplied the concepts of secured transactions law.
PMSI in Crop Rule
A prior version of Article 9 of the Uniform Commercial Code (UCC) provided for a unique limited PMSI that a creditor could obtain in crops to be grown. A perfected security interest in crops for new value, that is given to enable the debtor to produce the crops during the growing season and given not more than three months before the crops become growing crops by planting or otherwise, takes priority over an earlier perfected security interest to the extent that such earlier interest secures obligations due more than six months before the crops become growing crops by planting or otherwise, even though the person giving new value had knowledge of the earlier security interest.
The purpose of this PMSI in crop rule was to permit farmers to obtain financing to allow planting of a current crop in circumstances where current lenders will not advance funds to enable the farmer to put in a crop. This was precisely the situation involved in Agrifund, LLC, but the provision was eliminated in 1999. The Texas legislature, unlike Iowa, did not enact an optional provision that would have given priority status to a lender that extends credit to enable a farm debtor to produce crops.
Conclusion
The Texas case illustrates that ag financing rules are important to understand by farmers and lenders alike. While I don’t know the backstory of the case, I suspect that the defendant either failed to check the public records to determine if another lender had a prior perfected security interest in the cotton crop before making the loan or got bad legal advice as to the applicability of a PMSI. Of course, an input supply dealer could have financed the purchase of the seed and fertilizer and claimed a lien under Tex. Agric. Code Ann. §§128.001-128.048. That would have given the supplier equal priority to the plaintiff in the proceeds of the crop.
February 12, 2023 in Secured Transactions | Permalink | Comments (0)
Thursday, February 9, 2023
Chapter 12 Bankruptcy – Proposing a Reorganization Plan in Good Faith
Overview
The USDA’s Economic Research Service expects 2023 net farm incomes to decline nearly 16 percent in 2023 compared to 2022. That expectation is anticipated to be the result of lower cash receipts (projected to drop 4.3 percent), smaller government payments (down 34.4 percent) and higher production costs (particularly fertilizer, lime and soil conditioners). Interest expense is anticipated to increase 22 percent from 2022 and labor costs are projected to rise 7 percent. Net cash income is expected to drop 21 percent from last year. With high costs associated with planting the 2023 crop, if markets turn downward, the result could spell financial trouble for farmers even if yields are excellent.
That’s just the farm-related economic projections. As I mentioned in a prior blog article, the expanding war against Russia being fought in Ukraine will continue to dominate ag markets throughout 2023. In addition, the general economic outlook is not good and that will have implications in 2023 for farmers and ranchers. On January 26, the U.S Bureau of Economic Analysis issued a report (https://www.bea.gov/) showing that the U.S. economy grew by 2.9 percent in the fourth quarter of 2022 and 2.1 percent for all of 2022. But the report also showed that economic growth in the economy is slowing. Business investment grew by a mere 1.4 percent in the fourth quarter of 2022, consisting almost entirely of inventory growth. That will mean that businesses will be forced to sell off inventories at discounts, which will lower business profits and be a drag on economic growth in 2023. Nonresidential investment was down 26.7 percent due to the increase in home prices, increased interest rates and a drop in real income. On that last point, real disposable income dropped $1 trillion in 2022, the largest drop since 1932 - the low point of the Great Depression. Personal savings also dropped by $1.6 trillion in 2022. This is a "ticking timebomb" that is not sustainable because it means that consumers are depleting cash reserves and living off of credit cards. Indeed, the Federal Reserve reported that credit card debt increased 18.5 percent during calendar year 2022. This indicates that spending will continue to slow in 2023 and further stymie economic growth - about two-thirds of GDP is based on consumer spending. Relatedly, the Dow was down 8.8 percent for 2022, the worst year since 2008. 2022 also saw a reduction in the pace of international trade. Imports dropped more than exports which increases GDP, giving the illusion that the economy is better off.
With all of these “rough waters” ahead for farmers and ranchers, Chapter 12 bankruptcy might be one avenue that can provide debt relief for farmers and ranchers. A recent case points out that one aspect of Chapter 12 is critical.
The requirement of filing a Chapter 12 reorganization plan in “good faith” – it’s the topic of today’s post.
Good Faith Filing
A Chapter 12 plans is to be confirmed if, among other things, it is proposed in good faith. 11 U.S.C. § 1225(a)(3). There have been many court decisions since the enactment of Chapter 12 in 1986 that have dealt with the issue of good faith filing. A recent Chapter 12 case from Wisconsin has again illustrated the requirement that a Chapter 12 plan be filed in good faith.
Recent Case
In re Sternitzky, No. 21-11358-12, 2021 Bankr. LEXIS 3500 (Bankr. W.D. Wisc. Dec. 23, 2021); No. 21-11358-12, 2022 Bankr. LEXIS 205 (W.D. Wisc. Jan. 27, 2022); Sternitzky v. State Bank Financial, No. 21-cv-822-wmc, 2022 U.S. Dist. LEXIS 205895 (W.D. Wis. Nov. 14, 2022).
In Sternitzky, the debtors operated a dairy and filed Chapter 12 bankruptcy. Other family members were listed as co-debtors along with their farming business on various debts owed to a bank, including a mortgage on the farm real estate and a perfected security agreement where the other family members pledged equipment, fixtures, crops and inventory as collateral. This case is the third bankruptcy case for the debtors’ dairy operation. The first case was filed by the farming operation, and the next two filings were in the names of the debtors. The first case was dismissed, and the bank filed a foreclosure and replevin action against the debtors, family members and the farming operation. Before the notice concerning the lawsuit against the real estate was recorded, the family members transferred ownership of the mortgaged land by quitclaim deed to the debtors without the bank’s consent. The debtors filed the second case just before a summary judgment hearing was scheduled in state court. The bank then filed motions for relief from the automatic stay to bar the use of cash collateral, and to dismiss the case. The parties settled, agreeing to a payment plan. The debtors then defaulted on the payment plan and notified the bank of their intent to exit the dairy business and convert to a grain farming operation. The bankruptcy court approved the debtors’ sale of 160 acres of wooded land and farm personalty that was collateral of a different creditor. The case was then dismissed for the debtors’ failure to timely file a plan.
The debtors filed the third bankruptcy case immediately before a state court hearing on a summary judgment motion against them based on the stipulated settlement. The proceeds from the sale of collateral were insufficient to pay the bank debt in full. There were also delinquent real estate taxes. The bank sought relief from the automatic stay, and the court determined that the bank had established the existence of practically all of the factors a court considers for relief from the stay – obligations in default for a long time; motions by the bank in the prior cases for relief from the stay; debtors’ default on stipulations in the prior cases; strategic filings; repeated failure to pay taxes on collateral; the debt involved is not consumer debt; the filings and transfers of property were timed to precede events in state court foreclosure action; there were reasons for dismissal of the prior cases; strategic dismissal of prior Chapter 12 and refiled the current case; current case sought to avoid consequences of two prior agreements with the bank.
The court granted relief from the stay and waived the temporary stay of Bankruptcy Rule 4001(a)(3) to allow the bank to take action to pursue entry of judgment in state court. The bank also sought dismissal of the Chapter 12 case and the court found cause to dismiss or convert the case. The court noted that the debtors had almost four years to put together a feasible reorganization plan but did not do so, and their motive in filing the current case was to delay any foreclosure or replevin. The court ordered that the automatic stay be lifted pursuant to 11 U.S.C.§362(d)(1), waived the temporary stay, concluded that the case was filed in bad faith, dismissed the case for cause under 11 U.S.C. §1208(c) and imposed a 180-day bar against re-filing under 11 U.S.C. §109(g). In a later action, the debtors sought a stay against any actions of creditors pending appeal. The court, based on an analysis of all of the factors, granted a conditional stay and required the debtors to pay 2021 real estate taxes on a bank’s real estate collateral, pay all unpaid real estate taxes on that tract along with monthly interest payments to the bank.
The debtors appealed claiming that the bankruptcy court did not consider the totality of the circumstances; that the bankruptcy court incorrectly considered their defaults on prior stipulation agreements; and that the bankruptcy court should have held an evidentiary hearing. The district court reviewed the record for error and concluded that the bankruptcy court correctly looked at the totality of the circumstances and recognized that the plaintiffs had abused the bankruptcy process to avoid paying their debt or suffering repercussions with strategic filings. The district court also held that the bankruptcy court could consider the failed stipulation agreements, because the bankruptcy court still considered all the facts and did not consider any single fact dispositive. The plaintiffs tried to argue that the bankruptcy court did not consider the plaintiffs actions that were in good faith. The district court explained that the bankruptcy court did consider these but did not give them much weight because of all of the evidence of bad faith. The district court held that the bankruptcy court could give more weight to the bad faith evidence and the decision to find lack of good faith “is plausible in light of the record viewed in its entirety.” Plausible, but not error.
The debtors argued that 11 U.S.C. §349 prevented the bankruptcy court from considering an earlier stipulation agreement. The district court explained that 11 U.S.C. §349 is meant to make the earlier stipulation agreement unenforceable but does not restrict a court from considering it in a good faith filing. Finally, the debtors argued that the bankruptcy court was required to hold an evidentiary hearing, but the district court noted that nothing in the Federal Rules of Bankruptcy Procedure, nor 11 U.S.C. § 102(1), requires an evidentiary hearing. The bankruptcy court must have an informal hearing in particular circumstances, but here the record was clear enough for the bankruptcy court to make a proper decision. The district court affirmed the bankruptcy court’s decision to dismiss the plaintiffs’ Chapter 12 case and granted the defendant’s motion for relief from the automatic stay.
Conclusion
With 2023 projected to be a difficult year for agricultural producers, Chapter 12 filings may increase. One of the requirements to get a Chapter 12 reorganization plan approved is that be filed in “good faith.”
February 9, 2023 in Bankruptcy | Permalink | Comments (0)
Sunday, February 5, 2023
Tax Court Opinion - Charitable Deduction Case Involving Estate Planning Fraudster
Overview
The rules surrounding charitable giving can be rather complicated when the gift is not of cash and is of a significant amount. Those detailed rules were at issue in a recent U.S. Tax Court case. What made the case even more interesting was that it also involved taxpayers that got themselves connected with an estate planning and charitable giving fraudster that the U.S. Department of Justice eventually shut down. This is the second significant Tax Court decision in the past six months involving charitable giving. The Furrer farm family of Indiana was involved with a charitable remainder trust scenario that was structured completely wrong (see my blog article here: https://lawprofessors.typepad.com/agriculturallaw/2022/12/how-not-to-use-a-charitable-remainder-trust.html) and now another case.
The rules on charitable giving and a recent case involving a chartable giving scam. It’s the topic of today’s blog article.
Background
The Tax Code allows a deduction for any charitable contribution made during the tax year. I.R.C. §170(a)(1). The amount must be “actually paid during the tax year” and the taxpayer bears the burden to prove the surrender of dominion and control over the property that was contributed to a qualified charity. See, e.g., Pollard v. Comr., 786 F.2d 1063 (11th Cir. 1986); Goldstein v. Comr., 89 T.C. 535 (1987); Fakiris v. Comr., T.C. Memo. 2020-157.
For charitable contributions consisting of anything other than money, the amount of the contribution is generally the fair market value of the property at the time of the contribution. Treas. Reg. §1.170A-1(c)(1). For non-cash contributions exceeding $5,000 (at one time), the taxpayer must obtain a “qualified appraisal” of the property. I.R.C. §170(f)(11)(C). This includes attaching to the return a fully completed appraisal summary on Form 8283. Id.; Treas. Reg. §1.170A-13(c)(2). When a non-cash contribution exceeds $500,000, a copy of the appraisal must be attached to the return. I.R.C. §170(f)(11)(D). If the donor is an S corporation or a partnership, the qualified appraisal requirement is the obligation of the entity and not the members or shareholders. Id.
A “qualified appraisal” is one that is conducted by a “qualified appraiser” using generally accepted appraisal standards and otherwise satisfies the applicable regulations. A qualified appraisal is “qualified” only if it is “prepared, signed, and dated by a qualified appraiser.” Treas. Reg. §1.170A-13(c)(3)(i)(B). There are 11 categories of information that the appraisal must include. Id. subdiv. (ii). One of those is that “[N]o part of the fee arrangement for a qualified appraisal can be based, in effect, on a percentage (or set of percentages) of the appraised value of the property.” Treas. Reg. §1.170A-13(c)(6)(i). See also Alli v. Comr., T.C. Memo. 2014-15.
There is a reasonable cause exception for failing to satisfy the substantiation requirements. I.R.C. §170(f)(11)(A)(ii)(II). To use the reasonable cause exception, the taxpayer must show that willful neglect is not present based on the facts and circumstances. If the exception applies, the charitable deduction may be allowed. See, e.g., Belair Woods, LLC v. Comr., T.C. Memo. 2018-159.
Recent Case
In Lim v. Comr., T.C. Memo. 2023-11, during 2016 and 2017, the petitioners (a married couple) were the sole shareholders of an S corporation. In late 2016, after making a presentation to the petitioners concerning “The Ultimate Tax, Estate and Charitable Plan,” an attorney formed a “Charitable Limited Liability Company” for the petitioners to use as a vehicle for making charitable donations. The attorney agreed to transfer assets to the LLC, to transfer LLC unites to a charity and to provide the supporting valuation documentation for the donation. He also agreed to represent them before the IRS and the Tax Court if the return(s) were later examined. His fee would be the greater of $25,000 or 6 percent of the “deductible amount” of assets capped at $1 million, plus 4 percent of the “deductible amount” of assets exceeding $1 million. The assets transferred to the LLC were five promissory notes with a face amount of $2,008,500. This generated a fee for the attorney of $84,000 based on a presupposed “deductible amount” of $1,600,000 even though the assets were not appraised until late January of 2017 which valued them at $1,600,000. The fee was to be paid in installments over six months beginning in January of 2017.
The attorney also created a second LLC in late December of 2016 with the petitioners as the managers, the attorney as the registered agent, and the petitioners’ S corporation as the single member. Petitioners promised to pay the second LLC $2,008,500 (the promissory notes) in seven years.
The charitable recipient was a Foundation (an I.R.C. §501(c)(3) organization) for which the attorney was the registered agent. The petitioners claimed that their S corporation donated “units” of the second LLC to the Foundation and claimed a charitable deduction. The IRS denied the deduction, partly on the basis of a lack of evidence that any property was actually transferred to the Foundation. The petitioners did not offer any explanation as to when or how the “units” were created or what physical form they took. The petitioners also claimed that they received an acknowledgement letter of the donation from the Foundation dated January 1, 2017. The letter referred to 1,000 units of an LLC which did not exist during 2016 or as of January 1, 2017. It was not addressed to the S corporation, but to the petitioner (wife) at their residence in a different city than the S corporation. The letter also was not signed by any person and appeared to be a form letter with taxpayer-specific information in bold font. It also did not refer to any property that the S corporation allegedly donated on December 31, 2016.
On January 4, 2017, the attorney submitted an appraisal, but it lacked substance. The appraisal asserted that LLC interests were donated to the Foundation in 2016, but did not denote how many interests had been contributed. The claimed charitable deduction was $1,608,808. The attorney also attached his curriculum vitae stating that he was a CPA, a certified valuation analyst and a licensed attorney in Kentucky. Also attached to the appraisal was a one-page “certification” on which the attorney stated that his fee was not contingent on the report in any manner and that he didn’t have any interest or bias with respect to the parties involved. This was despite him having arranged the entire transaction and being the registered agent for the second LLC.
The S corporation filed Form 1120S for 2016 and attached a copy of the appraisal and Form 8283 which described the donated property as “LLC units” with a basis of $2,008,500 that had been acquired by purchase, and an “appraised market value” of $1,608,808. The petitioners reported a non-cash charitable deduction of $1,608,808 on Schedule A that flowed through to them from the S corporation. Because the amount of the deduction exceeded the maximum allowable deduction for 2016, they claimed a $1,195,073 deduction for 2016 and carried the balance of $415,711 to their 2017 return.
The IRS audited the petitioners’ 2016 and 2017 returns and disallowed the charitable deductions for lack of substantiation. The petitioners challenged the disallowance in the Tax Court and the IRS moved for partial Summary Judgment. The Tax Court determined that the appraisal was not a “qualified appraisal” within the meaning of I.R.C. §170(f)(11)(C). Treas. Reg. §1.170A-13(c)(6)(i) requires, among other things, that “no part of the fee arrangement for a qualified appraisal can be based, in effect, on a percentage (or set of percentages) of the appraised value of the property.” Accordingly, the attorney’s fee was a prohibited appraisal fee within the meaning of the regulation. However, the Tax Court held that the petitioners had shown reasonable cause for failure to comply with the substantiation requirements of I.R.C. §170. They had presented sufficient proof that they relied upon professionals in claiming the charitable contribution deduction. Accordingly, the Tax Court denied the IRS summary judgment on this issue. The Tax Court also denied summary judgment to the IRS on the issue of whether the written acknowledgement was a “contemporaneous written acknowledgement” of the contribution in accordance with I.R.C. §170(f)(8)(A). Accordingly, the Tax Court granted the Summary Judgment motion of the IRS in part, while the remaining issues will be set for trial.
Note: In 2018 the Department of Justice filed a complaint against the attorney, alleging that he promoted the “Ultimate Tax Plan” as a tax evasion scheme. He was accused of running a $35 million federal tax advice scam offering fake deductions using three bogus charities for 19 years. The complaint alleged that he was at the helm of "a national charitable-giving tax scheme" that targeted "wealthy individuals in high tax brackets facing large tax liabilities.” He settled with the Government and agreed to a permanent injunction. On April 26, 2019, the U.S. District Court for the Southern District of Florida entered a final judgment of permanent injunction against him, holding that he had engaged in conduct penalizable under I.R.C. §6700 by promoting the “Ultimate Tax Plan.” The court permanently enjoined him from, among other things, promoting “the Ultimate Tax Plan or any plan or arrangement that is substantially similar.” The court ordered the attorney to perform other actions as well in relation to the plan.
Conclusion
When non-cash gifts are made to charity particular rules must be followed for a charitable deduction to be claimed. Unfortunately, there are those engaged in unscrupulous techniques that prospective donors must be on the alert for.
February 5, 2023 in Estate Planning, Income Tax | Permalink | Comments (0)
