Agricultural Law and Taxation Blog

Probate Fees - How Much are They?

Overview

One of the reasons that people give for transferring property to a revocable trust during life is to avoid probate at death.  That can be accomplished if all of the decedent’s property has been transferred to the trust before death.  To make sure that occurs, the trust is often accompanied with a pour-over will.  The property that hasn’t been retitled into the name of the trustee of the trust is “poured over” into the trust at death. 

But just how much are probate fees?  How are they determined?  That’s the topic of today’s post.

Establishing Probate Fees

The avoidance of probate is often tied to the desire to avoid probate fees and maintain privacy.  As for fees, how much can be anticipated?  The answer depends.  The more complex the estate, and/or the more issues that come up post-death, the estate can anticipate incurring more probate fees.  The converse is also true.  In some states, a flat percentage of the gross estate value can be charged as an attorney fee for the estate.  That can range anywhere from about 1.5 percent to 6 percent or even higher. 

Kansas probate fees.  In Kansas, state law specifies that, “every fiduciary shall be allowed his or her necessary expenses incurred in the execution of his or her trust and shall have such compensation for services and those of his or her attorneys as shall be just and reasonable.” Kan. Stat. Ann. §59-1717.  There is no statute in Kansas that allows for a percentage fee for handling a decedent’s estate.  It’s not specifically disallowed if the percentage amount is backed up with itemized time sheets and is ultimately deemed reasonable by the probate court.  In essence, then, probate fees are based on an hourly rate for the amount of hours reasonably spent working on the estate.  In addition, an attorney’s fee for handling a decedent’s estate is also based on the eight factors of the Kansas Rules of Professional Conduct (KRPC).  The probate court considers these eight factors when determining whether a fee is appropriate. 

The eight factors are:

• The time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly;
• The likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer;
• The fee customarily charged in the locality for similar legal services;
• The amount involved and the results obtained;
• The time limitations imposed by the client or by the circumstances;
• The nature and length of the professional relationship with the client;
• The experience, reputation, and ability of the lawyer or lawyers performing the services; and
• Whether the fee is fixed or contingent. KRPC 1.5(a)

Kansas case.  A recent Kansas county district court decision involved the application of the factors.  In In re Estate of Appleby, No. CQ-2023-CV-000008 (Chautauqua Co. Dist. Ct., Nov. 9, 2023), from 2014 until death in 2021, the decedent had been the subject of a conservatorship.  The person that would become the executor of the decedent’s estate was the conservator.   The attorney that represented the executor for the decedent’s eventual estate, represented the conservator during the conservatorship.  The annual billing statements submitted to the conservator for the legal work in the conservatorship were itemized and detailed. The itemized billing statements listed each date services were performed; a description of the services performed on each date; the amount of time worked on each date; the amount charged for the services performed on each date; the total amount of time worked during the billing period; and the total amount charged for work performed during the billing period.  The conservator reviewed the statements, the court approved them and the conservator paid. 

However, for estate administration work, the attorney did not provide the executor with a written representation agreement and did not communicate the basis or rate of the fee he intended to charge the estate.  The executor believed the attorney would bill his time hourly, just as he had done for the previous seven years in the conservatorship matter.

The decedent died on July 6, 2021, with a gross estate value of $4,570,521.11.  However, the attorney only first informed the executor on May 2, 2022, that a fee of three percent of the estate’s gross value would be charged.  The executor informed the attorney that the fee should be based on an hourly rate.  The attorney replied as follows:

“I feel comfortable asking for a fee based upon 3%. If you want to oppose it, that's fine. Please remember that our… service to her predates your appointment as her conservator.  [We]…did quite a bit of "off the books" work for [the decedent] during her lifetime, … and… it would all even out when we handled the estate. Honestly, that's a common approach taken by attorneys ·when they know they'll be handling an estate at a later date. So, I don't know what I can say. I respect your views and your being upfront with me, but I know what the common practice has been and what we've always done.”

Ultimately, on May 30, 2023, the attorney generated a billing statement. The billing statement included descriptions of the work performed between the date of the decedent’s death and May 2023, but the descriptions were not tied to specific dates and did not include the amount of time spent performing any task on any date.  The May 30 billing statement concludes with the application of a 3% fee to the $4,570,521.11 value of the estate assets for a total fee of $137,115.63.  The local magistrate judge awarded the fee on June 5, 2023, and the executor appealed.

On appeal, the attorney estimated that he spent between 420 and 560 hours on the estate at a rate of $240 per hour.  Only specific tasks, based on the review of the emails, amounted to 174-242 hours.  The court then applied the eight factors of Rule 1.5(a) of the KRPC to the facts of the case.  The court noted that the attorney didn’t keep time records, even though being on notice that the executor wanted to know the amount of time that was being billed.  No time records kept.  There was also no engagement letter that had been entered into with the client.  The work on the estate, the court noted, did not involve difficult issues and a paralegal performed much of the work.  The fact that the attorney had billed on a percentage basis for 40 years was severely mitigated by subsequent caselaw specifying that, “"fees which are not supported by meticulous, contemporaneous time records that show the specific tasks being billed should not be allowed."  See, e.g., In re Estate of Trembley, 220 P.3d 1114 (Kan. Ct. App. 2009).  The court also noted that the attorney had a previous 7-year relationship with executor as conservator and billed hourly for the work on the conservatorship. 

Ultimately, the court approved what it deemed to be a reasonable fee of fee of $58,080 (down from the $137,115.63 requested).  In percentage terms, the approved fee worked out to be slightly less than 1.3 percent of the estate value.  

In reaching its decision, the court noted that approving attorney fees for work on an estate is a fact-based determination.  The fees must be supported by contemporaneous time records.  If they aren’t, an “award of…fees based on a percentage of an estate is not reasonable, regardless of the local custom.” 

Note:  The court also pointed out that the attorney involved “serves on the Kansas Board of Discipline for Attorneys.”

Conclusion

The fear of large and outrageous attorney fees for handling estates in Kansas is largely not justified.  The courts operate as an effective “brake” on attorneys trying to charge unjustified fees – at least that’s been the case in Kansas since 2009.  But, that may not be true in other states.  So, for those wanting to avoid probate fees, a revocable trust (or some other type of trust) might be an appropriate estate planning tool.  But, it’s important to understand just how attorney fees in probate are established.  One wonders how many estates in Kansas have been unjustly overbilled since 2009 by the attorney involved in the case.  All it took was one well-informed executor to get the right result.

The Importance of Proper Asset Titling

Overview

For many farmers and ranchers, the land is the most significant asset that is owned, at least in terms of value.  Land value often predominates in a farmer or rancher’s estate.  How the land is titled is important.  Holding title in the proper form facilitates estate planning in accordance with expressed goals and can ease the tax burden upon death or upon subsequent transfer of the property by the heir or heirs.  Conversely, failing to title property appropriately can undermine estate planning expectations, create family disharmony and result in a higher tax burden.

The distinction between co-tenancy and joint tenancy and why it matters – it’s the topic of today’s post.

Tenancy-In-Common

A tenant in common holds an undivided interest in property that does not terminate upon the tenant predeceasing surviving co-tenants.  Upon the death of a tenant in common, that person’s interest passes under that person’s will (or in accordance with state law if there is no will (or trust)) to heirs of the deceased cotenant.  For federal estate and state inheritance/estate tax purposes, only the portion of the property owned by the deceased tenant in common is included in the decedent’s gross estate at death and receives a fair-market basis at death.

Joint Tenancy

The distinguishing characteristic of joint tenancy is the right of survivorship, with the surviving joint tenant or tenants taking all upon the death of a fellow joint tenant regardless of the terms of the deceased joint tenant’s will.  In other words, when a joint tenant dies, the deceased joint tenant’s share in the property passes to the surviving joint tenant (or surviving joint tenants).  It does not pass to the heir of the deceased joint tenant (tenants).  Upon the death of the last of the joint tenants to die, the joint tenancy is extinguished.    

In addition, upon a conveyance of real property, transfer to two or more persons generally creates a tenancy in common unless it is clear in the deed or other conveyancing document that a joint tenancy is intended.  A joint tenancy is created by specific language in the conveyancing instrument.  That specific language, often referred to as “magic words of conveyance,” clearly denotes the survivorship feature of a joint tenancy.  In addition, unless the conveyancing instrument is clear in its intent to create a joint tenancy, the legal presumption is against joint tenancy and that a tenancy-in-common was created.  For example, assume that O conveys Blackacre to “A and B, husband and wife.”  The result of that language is that A and B own Blackacre as tenants in common.  To own Blackacre as joint tenants O needed to convey Blackacre as required by state law to create a joint tenancy.  The language for creating a joint tenancy is typically to “A and B as joint tenants with rights of survivorship” or to “A and B as joint tenants with right of survivorship and not as tenants in common.”

Except for husband-wife joint tenancies, the survivorship feature may generate an unacceptable property disposition pattern upon death.  However, on the death of the first of the joint tenants to die, probate may be simplified or eliminated with title obtained by the surviving joint tenant perfected by showing non-liability for taxes and by proving the death of the decedent by affidavit or death certificate.  This is possible in most (but not all) states.

When it cannot be determined that two (or more) joint tenants have died other than at the same time an interesting problem may arise.  Most states have enacted a simultaneous death statute to handle just such a situation.  Such statutes typically provide that the jointly held property is to be divided into as many equal shares as there were joint tenants and that the share allocable to each joint tenant is to be distributed as if such joint tenant had survived all of the other joint tenants.

A major estate planning limitation of the joint tenancy form of property ownership is that the survivorship right of joint tenancy precludes the use of the life estate-remainder arrangement for the nonmarital portion of the estate to reduce the death tax burden upon the survivor’s death.  The entire property, therefore, will pass to the survivor and may be taxed again in the survivor’s estate.  In addition, another problem with joint tenancy is that each joint tenant has a right to sever the joint tenancy relationship unilaterally (except for tenancies by the entirety).  As a result, a joint tenant furnishing consideration for acquisition of the property in effect grants to the other tenant a revocable interest that could be partitioned and severed at any time.  Consequently, each co-owner has the power to amend or destroy the other’s estate plan.

For marital joint tenancies, upon the death of the first spouse, one-half of the date-of-death value of the jointly held property is included in the first-spouse’s estate.  However, the full value of the jointly held property is included in the first spouse’s estate (and receives a date-of-death income tax basis in the hands of the surviving spouse) if the marital joint tenancy was established before 1977 and the spouse that bought the property died after 1981 (Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992)). 

Joint tenancy is not a cure-all for tax planning but, depending upon the circumstances, it may be a convenient means of owning and passing property.  For total estates of each of the husband and wife under $22.8 million (for 2019), there is no federal estate tax liability.  Therefore, joint ownership may serve a useful purpose as a will substitute in the first estate for estates that are not potentially subject to federal estate tax.  However, since it is not known which joint tenant will die first, the estate of the surviving joint tenant will be subject to probate as an intestate estate (where death occurs without a will), unless the survivor prepares a will or otherwise disposes of the property.  For combined spousal estates exceeding $22.8 million (for 2019) in value, joint tenancy ownership may expose a portion of the total estate of the surviving joint tenant to additional taxes, causing an otherwise unnecessary reduction of the estate assets passing to the heirs or other beneficiaries.

Recent Case

A recent case from Texas illustrates the difference between tenancy-in-common and joint tenancy.  It also illustrates how misunderstandings about how property is titled can create family problems.  In Wagenschein v. Ehlinger, 581 S.W.3d 851 (Tex. Ct. App. 2019), a married couple had seven children.  The parents also owned a tract of land.  Upon the last of the parents to die, each child held an undivided one-seventh interest as tenants in common in the tract.  In 1989, the heirs sold the land but executed a deed reserving a royalty interest.  The deed reservation read as follows:  “THERE IS HEREBY RESERVED AND EXCEPTED from this conveyance for Grantors and the survivor of Grantors, a reservation until the survivor's death, of an undivided one-half (1/2) of the royalty interest in all the oil, gas and other minerals that are in and under the property and that may be produced from it. Grantors and Grantors' successors will not participate in the making of any oil, gas and mineral lease covering the property, but will be entitled to one-half (1/2) of any bonus paid for any such lease and one-half (1/2) of any royalty, rental or shut-in gas well royalty paid under any such lease. The reservation contained in this paragraph will continue until the death of the last survivor of the seven (7) individuals referred to as Grantors in this deed.” 

An oil and gas company drilled a producing well in 2010 and began paying royalties to the heirs. As each heir died, the credited their royalty interest to the surviving heirs of each deceased heir.  That had the effect of increasing the respective royalty payments of the surviving heirs.  There were no problems until 2015.  In 2015, a child of a deceased heir sued claiming that the deed crediting the royalty reservation to “Grantors and Grantors’ successors” created a “tenancy in common” and not a “joint tenancy”.  If the deed created a tenancy in common, the children of the deceased heirs, rather than the surviving heirs, would inherit their parents’ royalty interests.  The trial court disagreed, noting that while the deed used “successor”, it only did so once and clearly and unambiguously reserved the royalty interest to the heirs and the “survivor[s]” of the heirs, rather than their “successors”, “heirs” or “beneficiaries.”  As such, the trial court concluded that the deed unambiguously created a joint tenancy with the right of survivorship, rather than a tenancy in common that the children of the deceased heirs could inherit.   Thus, as each heir died, their interest in the tract passed to the surviving siblings, not their children.  On appeal, the appellate court affirmed.  Further review was denied.

Conclusion

Properly titling property is important for various reasons – not the least of which is to fulfill expectations on property passage.  In the Texas case, confusion over how property was titled resulted in a family lawsuit.  Regardless of how the case would have been decided, some in the family would not be pleased.   

Funding a Buy-Sell Agreement with Corporate Owned Life Insurance – Will Corporate Value Be Enhanced?

Overview

In part one of this series (published back on July 3), I discussed buy-sell agreements in general and noted how beneficial they can be in the intergenerational transfer of a farm or ranch where keeping the business in the family is the key goal.  There I covered buy-sell agreements in general, the various types of agreements and common triggering events. 

With today’s article I dive deeper into other issues associated with buy-sell agreements -valuation rules and funding approaches.  A recent court opinion points out the importance of following the valuation procedures set forth in the buy-sell agreement.

Part two of a two-part series on buy-sell agreements – it’s the topic of today’s post.

Valuation 

While very few farming and ranching operations (and small businesses in general) are subject to the federal estate tax because of the current level of the exemption, some are.  For those that are, in addition to providing a market for closely held shares at a determinable price, the buy-sell agreement can serve as a mechanism for establishing the value of the interest for estate tax purposes – or otherwise establish value of the decedent’s interest at death.

General rule.  In general, the value of a closely held business (or other property) is determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the FMV of the property, or any restriction on the right to sell or use the property.  I.R.C. §2703(a).

Exception – statutory requirements.  A buy-sell agreement can establish the value of a deceased owner’s interest if six basic requirements are satisfied.  Three of the requirements are statutory and three have been judicially created.  The statutory requirements are found at I.R.C. §2703(b). 

The statutory requirements specify that the buy-sell agreement must:

• Be a bona fide business arrangement; I.R.C. §2703(b)(1)
• Not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; I.R.C. §2703(b)(2) and
• Contain terms that are comparable to other arrangements entered into by persons in arms’ length transactions.  I.R.C. §2703(b)(3)

A buy-sell agreement must satisfy each of the three statutory requirements if family members own 50 percent or more of the property subject to the restriction.  An agreement is deemed to satisfy all three of the statutory requirements if more than 50 percent of the value of the property subject to the restriction is owned directly or indirectly by individuals who are not members of the transferor’s family.  The interests owned by the nonfamily members must be subject to the same restrictions as the property owned by the transferor.  Treas. Reg. §25.2703-1(b)(3). 

Exception – caselaw requirements.  Judicial opinions have created three additional requirements that a buy-sell agreement must satisfy to be effective to establish the value of a decedent’s interest.  See, e.g., Estate of True v. Comr., 390 F.3d 1210 (10th Cir. 2004); St. Louis County Bank v. United States, 674 F.2d 1207 (8th Cir. 1982).  Based on these cases, the agreement must also: contain a purchase price that is fixed and determinable under the agreement; be legally binding during life and after death; and have been entered into for a bona fide business reason and not be a substitute for a testamentary disposition for full and adequate consideration. To establish the purchase price with certainty an appropriate valuation method must be established. An independent party valuation will not only satisfy the requirements of I.R.C. §2703 but also provide an estimate of the potential funding obligation and the liquidity expectations of the seller/estate. See Rev Rul. 59-60 as amplified by Rev. Rul. 83-120,1983-2 CB 170.

The courts have indicated that preserving a business with family control for purposes of continuity and management can serve as a bona fide business arrangement.  See St. Louis County Bank v. United States, 674 F.2d 1207 (8th Cir. 1982); Estate of Lauder v. Comr., T.C. Memo. 1992-736; Estate of Gloeckner v. Comr., 152 F.3d 208 (2nd Cir. 1998).  This includes planning for the future liquidity needs of the decedent’s estate.  Estate of Amlie v. Comr., T.C. Memo. 2006-76.  But an entity that consists only of marketable securities is not a bona fide business arrangement.  Holman v. Comr., 601 F.3d 763 (8th Cir. 2010).  The long-established position of the IRS is that, “It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts to determine whether the agreement represents a bona fide business arrangement or a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth.”  Rev.Rul 59-60, 1959-1 CB 137. See also Estate of True v. Comr., T.C. Memo 2001-167, aff’d., 390 F.3d 1210 (2004); Estate of Blount v. Comr., T.C. Memo. 2004-116.  

Note:  The business reasons for executing the buy-sell agreement should be documented.   

The buy-sell agreement must not simply be a device to reduce estate tax value.  This requires more than expressing a desire to maintain family control of the business.  See, e.g., Estate of True v. Comr., 390 F.3d 1210 (10th Cir. 2004); Estate of Lauder v. Comr., T.C. Memo. 1992-736.  In addition, a buy-sell agreement must have terms that are comparable to other buy-sell agreements that are entered into at arms-length. This requirement is satisfied if the agreement is one that unrelated parties in the same line of business could have reached in an arms’ length transaction.  Treas. Reg. §25.2703-1(b)(4).  This fair bargain standard is typically based on expert opinion testimony. 

Funding Approaches

To be operational, the parties to the agreement must have funds available to buy the stock at the time the agreement is triggered.  It is possible to use accumulated earnings of the business to fund a redemption. But such a strategy may not be treated as a “reasonable need of the business” with the result that the business (if it is a C corporation) could be subject to the accumulated earnings tax. I.R.C. §531. However, corporate accumulations used to pay off a note given a stockholder for a redemption is a reasonable need of the business, as a debt retirement cost. But see Smoot Sand & Gravel Corp. v. Comr., 274 F.2d 495 (4th Cir. 1960), cert. denied, 362 U.S. 976 (1960).

The use of life insurance.  Typically, life insurance is purchased for each business owner to cover the total purchase price (or at least the down payment). However, the premiums on such policies are not deductible (see I.R.C. §264) and can create a substantial ongoing expense.

Corporate-owned.  One approach is for the corporation to buy a life insurance policy on the life of each stockholder, with the corporation as the policy owner, premium payor, and beneficiary of these policies. The corporation would then use the life insurance to finance the purchase if, at the end of the first option period, the corporation buys the deceased stockholder’s interest. Or the corporation could lend the insurance proceeds to the stockholders if, at the end of the corporate option period, it is decided that the surviving stockholders should be the buyers (or to the extent stock remained to be purchased after the corporation’s option expires). Investment payments would be deductible to the stockholders and income to the corporation.

Shareholder-owned.  An alternative approach is for each shareholder to buy, pay for, own, and be the beneficiary of a life insurance policy for each of the other shareholders. The surviving shareholders would then receive the proceeds when one shareholder dies, and, if a cross-purchase is indicated and appropriate, use the proceeds as the necessary funds to carry out the buy-sell agreement. The surviving shareholders could also lend the proceeds to the corporation if a redemption agreement is utilized, to enable the corporation to buy additional shares, or the surviving shareholders could make capital contributions which would have the effect of increasing each shareholder’s stock basis.

Note:  The cash value of a permanent life insurance policy may be withdrawn by loan or surrender of the policy, but the value may be a very small percentage of the death benefit, inadequate to finance the buy-out. Disability insurance may be used to finance a purchase occasioned by an owner’s disability, but it can be quite expensive, and cannot be applied toward the purchase of an interest of an owner who is retiring or used to prevent the sale of an interest in the business to a buyer outside the family unit.

Other Approaches

A combination of the above approaches could also be used for funding the wait-and-see buy-sell agreement. For example, the corporation could own cash value life insurance and the owners could own term insurance. Also, the parties could have a split-dollar arrangement whereby the corporation pays for the cash value portion of the premiums and the shareholders own the policy and pay for the term portion of the premiums, with the proceeds split between them.

Potential Problem of Life-Insurance Funding

One potential problem of a corporation being the beneficiary of a life insurance policy designed to fund the buy-out of a deceased shareholder is that the IRS could argue that the policy proceeds are included in the corporate value.  In Estate of Blount v. Comr., T.C. Memo. 2004-116, the issue was whether the insurance proceeds contractually deduction to the redemption of corporate shares being valued be treated as corporate property for valuation purposes.  The decedent owned 83 percent of the stock in a corporation at death.  There was a life insurance policy owned by the company that provided some $3.1 million to pay off the mandated buyout of the shares under a buy-sell agreement providing for a fixed value of the decedent shares. The buy-sell agreement value was held not to be controlling for estate tax purposes, mainly because the deceased owned 83 percent of the stock and could have changed the agreement at any time. Furthermore, the court determined that the buy-sell agreement was not similar to those involved in arm’s length transactions.

The 11^th circuit reversed on the basis that the redemption obligation of the buy-sell agreement was a liability that offset the value of the death benefits used to fund the redemption. Estate of Blount v. Comr., 428 F.3d 1338 (11th Cir. 2005).  Thus, even if the death benefits were included in the corporate value, there was a corresponding offsetting liability that would be accounted for by a “reasonably competent business person interested in acquiring the company.”  Id. 

Note:  In a decision preceding the Tax Court’s decision in Blount, the Ninth Circuit court deducted the insurance proceeds from the value of the organization when they were offset by an obligation to pay those proceeds to the estate in a stock buyout.  Cartwright v. Comr., 183 F.3d 1034 (9th Cir. 1999).   

The issue in Blount and Cartwright resurfaced in Connelly v. United States, No. 4:19-cv-01410-SRC, 2021 U.S. Dist. LEXIS 179745 (E.D. Mo. Sept. 21, 2021). In Connelly, two brothers were the only shareholders of a closely-held family roofing and siding materials business.  They entered into a stock purchase agreement that required the company to buy back shares of the first brother to die.  The company then purchased about $3.5 million in life insurance coverage to ensure it had enough cash to redeem the stock.  The brother holding the majority of the company’s shares (77.18 percent) died on October 1, 2013.  The company received $3.5 million in insurance proceeds.  The surviving brother chose not to buy his shares, so the company used a portion of the proceeds to buy the deceased brother’s shares from his estate for $3 million pursuant to a Sale and Purchase Agreement.  Under the agreement the estate received $3 million, and the decedent’s son received a three-year option to buy company stock from the surviving brother.  If the surviving brother sold the company within 10 years, the brother and decedent’s son would split evenly any gains from the sale. 

The estate valued the decedent’s stock at $3 million and included that amount in the taxable estate.  Upon audit the IRS asserted that the fair market value of the decedent’s corporate stock should have factored-in the $3 million in life-insurance proceeds used to redeem the shares which, in turn, resulted in a higher value of the decedent’s stock than was reported.  The IRS assessed over $1 million in additional estate tax.  The estate paid the deficiency and filed a refund claim in federal district court. 

The district court noted that a stock-purchase agreement is respected when determining the fair market value of stock for estate tax purposes upon satisfying the requirements of I.R.C. §2703(b) (as noted above), and the additional judicially created requirements (also noted above).    The IRS expert claimed that the insurance proceeds should be included in the company’s value as a non-operating asset, and that allowing the redemption obligation to offset the insurance proceeds undervalued the company’s equity and the decedent’s equity interest in the company, and would create a windfall for a potential buyer that a willing seller would not accept.  The IRS expert concluded that the fair market value of the company was $6.86 million rather than $3.86 million.  The IRS also claimed that the stock purchase agreement failed to control the value of the company.  The estate claimed that the company sold the decedent’s shares at fair market value and that the shares had been properly valued.  Thus, according to the estate, the $3 million in life insurance proceeds were properly excluded from the decedent’s estate based on the appellate opinion in Blount.  The estate claimed that the stock purchase agreement provided a sufficient basis for the court to accept the estate’s valuation as the proper estate-tax value of the decedent’s shares.  On that point, the IRS claimed that the stock purchase agreement was not a bona fide business arrangement and, as such, didn’t control the value of the decedent’s stock.  The IRS position was that the stated estate planning objectives of the stock purchase of continued family ownership of the company were insufficient to make it a bona fide business arrangement, particularly because the brothers did not follow it by disregarding the agreement’s pricing mechanisms. 

The district court did not rule on the bona fide business arrangement issue because it determined that the estate had failed to show that the stock purchase agreement was not a device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration.  The process that the surviving brother and the estate used in selecting the redemption price bolstered the court’s conclusion that the stock purchase agreement was a testamentary device.  They also did not obtain an outside appraisal or professional advice on setting the redemption price, thereby disregarding the appraisal requirement set forth in the agreement.  The district court also noted that the agreement didn’t provide for a minority interest discount for the surviving brother’s shares or a lack of control premium for the decedent’s shares with the result that the decedent’s shares were undervalued.  This also, according to the district court, demonstrated that the stock purchase agreement was a testamentary device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration and was not comparable to similar agreements negotiated at arms’ length. 

On the issue of whether the life insurance proceeds should be included in corporate value, the court rejected the appellate court’s approach in Blount, finding it to be analytically flawed.  The court concluded that the appellate court in Blount had misread Treas. Reg. §20.2031-2(f)(2), and that the regulation specifically requires consideration to be given to non-operating assets including life insurance proceeds, “to the extent such nonoperating assets have not been taken into account in the determination of net worth.”  The district court concluded that the text of the regulation does not indicate that the presence of an offsetting liability means that the life insurance proceeds have already been “taken into account in the determination of a company’s net worth.”  The district court concluded that, “by its plain terms, the regulation means that the proceeds should be considered in the same manner as any other nonoperating asset in the calculation of the fair market value of a company’s stock…. And…a redemption obligation is not the same as an ordinary corporate liability.”  There is a difference, the court noted, between a redemption obligation that simply buys shares of stock, and one that also compensates for a shareholder’s past work.  One that only buys stock is not an ordinary corporate liability – it doesn’t change the value of the corporation as a whole before the shares are redeemed.  It involves a change in the ownership structure with a shareholder essentially “cashing out.”  The court noted that the parties had stipulated that the decedent’s shares were worth $3.1 million, aside from the life insurance proceeds.  The insurance proceeds were not offset by the company’s redemption obligation and, accordingly, the company’s fair market value and the decedent’s shares included all of the insurance proceeds, and the IRS position was upheld. 

On appeal the U.S Court of Appeals for the Eighth Circuit affirmed.  Connelly v. United States, 70 F.4th 412 (8th Cir. 2023).  The appellate court held that the stock purchase agreement requiring the redemption of a deceased shareholder’s shares did not affect the value of the shares for estate tax purposes under I.R.C. §2703 because it did not provide for a fixed price or a formula for arriving at one. Instead, the agreement merely laid out two mechanisms by which the brothers might agree on a price - mutual agreement or appraisal. As for the appraisal approach, there was nothing in the agreement that fixed or prescribed a formula or measure for determining the price that the appraisers would reach. Thus, neither mechanism constituted a fixed or determinable price for valuation purposes. The appellate court determined that the $3 million that the corporation actually paid for the deceased brothers shares constituted an amount determined after death that was derived by an agreement between the brothers and not by any formula in the buy-sell agreement.

As for the value of the corporation (and, hence, the deceased brother’s interest in the corporation), the appellate court determined that the life insurance proceeds were an asset that increased the shareholders’ equity and that an obligation to redeem shares is not a liability in the ordinary business sense.  Thus, the proper valuation of the corporation in accordance with I.R.C.  §§2042 and 2031 must include the life insurance proceeds without treating the obligation to redeem shares as an offsetting liability.  The court reasoned that in order for a willing buyer at the time of the brother’s death to own the stock outright, a willing buyer would account for control the life insurance proceeds and therefore would pay up to $6.86 million for the corporation, quote taking into account end quote the life insurance proceeds and then either extinguishing the agreement or redeeming the shares. Conversely, the appellate court determined that a hypothetical willing seller of the corporation would not find acceptable a price of $3.86 million with the knowledge that the company would be receiving $3 million in life insurance proceeds.

To illustrate its rationale, the appellate court explained explain that if it valued the corporation without accounting for the life insurance proceeds intended for redemption, then upon the brother’s death each share was worth $7,720 before redemption.  After redemption, the deceased brother’s interest is extinguished, with the surviving brother having full control of the corporation’s $3.86 million value.  The appellate court noted that this would essentially quadruple the value of the surviving brother’s shares, but that treating the life insurance as an offsetting liability would leave the stock value undisturbed (which was the estate’s position). The economic reality of the situation, the appellate court concluded, was that the life insurance proceeds was an asset that increased shareholders’ equity.  The buy-sell agreement thus had nothing to do with being a corporate liability. 

Note:  A separate insurance LLC could be used to fund a buy-sell agreement in light of Connelly.  The insurance LLC would collect the life insurance proceeds on the deceased owner.  The LLC’s value would not be increased by the death benefit because it is allocated to the other owners in accordance with the buy-sell agreement due to special allocations in a LLC taxed as a partnership.  See I.R.C. §704.  A formal appraisal would likely only be required if there is real estate or some other difficult to value asset that the LLC owns.  This does add a layer of complexity, but if there are more than two owners the additional complexity may be worth it.

Arguably, there is now a split on this issue between the 8th Circuit on one hand, and the 9th and 11th Circuits on the other (keep in mind the brothers in Connelly didn’t follow the buy-sell agreement).  Indeed, a petition for certiorari was filed with the U.S. Supreme Court on August 15, 2023.  Will the Supreme Court agree to hear Connelly?  Not very likely at all. 

Conclusion

A buy-sell agreement can be a very important part of a succession plan for a family farming/ranching business (or any small, family-owned business for that matter).  However, it’s critical that the agreement be drafted properly and followed by the business owners.

LLCs/LPs and S.E. Tax – Will Steve Cohen Now Settle?

Overview

As I have previously written on this blog, a big question in self-employment tax planning is whether an LLC member is a limited partner.  In those prior articles, it was noted that the IRS/Treasury hadn’t yet finalized a regulation that was initially proposed in 1997 to address the issue.  For businesses other than those providing professional services, characterization of an LLC member’s interest is determinative of whether the member has self-employment tax liability on amounts distributed to the member (other than guaranteed payments).  That means that proper structuring of the entity matters as does the drafting of the LLC operating agreement and the conduct of the members. 

Now, the U.S. Tax Court has issued a fully reported opinion confirming that state law classifications of a partner’s interest is not conclusive on the self-employment tax issue.  That is a key point because Steve Cohen, owner of the New York Mets, has filed a case with the Tax Court challenging the assessment of self-employment tax on about $350 million in distributions (other than guaranteed payments to limited partners in his investment (hedge fund) firm.  Is the Tax Court’s recent opinion a warning to Mr. Cohen that he should look to settle his case?  Perhaps.

Self-employment tax implications of LLCs – when is a member really a limited partner?   That’s the topic of today’s post.

Background - LLCs and Self-Employment Tax

Net earnings from self-employment includes the distributive share of income or loss from a trade or business carried on by a partnership.  I.R.C. §1402(a).  Thus, the default rule is that all partnership income is included, unless it is specifically excluded.  Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization.  Are they general partners or limited partners?  Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC.  So, what is a limited partner?  The test of whether an interest in an entity treated as a partnership for tax purposes is treated as a limited interest or a general interest, for the purpose of applying the self-employment tax is stated at Prop. Reg. §1.1402(a)-2(h), issued in 1997. 

Note:  Immediately after the Proposed Regulation was issued, the Congress passed a statute prohibiting the IRS from finalizing the Regulation within one year.  Nothing further has been forthcoming.  Although still in Proposed Regulation form, this regulation remains the best available authority. 

The Proposed Regulation establishes a three-part general rule, with two exceptions, that may permit limited partner treatment under certain conditions.  A third exception to limited partner treatment applies in the context of professional service businesses (e.g., law, accounting, health, engineering, etc.).  Under the general rule, a member is not treated as a limited partner if:  (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year.  Prop. Treas. Reg. §1.1402(a)-2(h)(2). 

An exception applies only if the interest-holder owns a single class of interest (regardless of whether there are multiple classes outstanding) and failure of the 500-hour test is the sole reason for treatment of the interest as a general interest.  In addition, the interest held must meet certain threshold requirements:

• There must be at least one member holding the same class of interest who meets all three of the requirements under the general rule, without application of any exceptions;
• The share of that class of interest held by those members must be “substantial” (with respect to the class of interest at issue and not with respect to the entity as a whole), based on the facts and circumstances (a safe harbor of 20 percent, in aggregate, is provided at Treas. Reg. §1.1402(a)-2(h)(6)(v)); and
• The interests held by those members must be “continuing” (an undefined term).

Another exception to the general rule applies only if the member owns at least two classes of interests and the same threshold requirements are satisfied.  This exception may permit a member to treat the distributive share attributable to at least one class as a limited interest if the three requirements of the general rule are met with respect to any class that the member holds.  In that case the distributive share attributable to that interest is not subject to self-employment tax.  But, the distributive share attributable to any interest held by a member that does not meet the three requirements of the general rule is subject to self-employment tax.  This all means that a portion of a member’s total distributive share may be subject to self-employment tax, and some may not be.

Note:  Under the general rule, it is likely that the entire distributive share of all members of a member-managed LLC will be subject to self-employment tax because state law likely gives all members the authority to contract.  Likewise, LLP statutes likely give management rights which means that the second requirement of the general rule cannot be satisfied.  As a result, neither exception to the general rule can be met because both exceptions require at least one member to satisfy all three requirements of the general rule. 

The Castigliola case.  In Castigliola, et al. v. Comr, T.C. Memo. 2017-62, a group of lawyers structured their law practice as member-managed Professional LLC (PLLC).  On the advice of a CPA, they tied each of their guaranteed payments to what reasonable compensation would be for a comparable attorney in the locale with similar experience.  They paid self-employment tax on those amounts.  However, the Schedule K-1 showed allocable income exceeding the member’s guaranteed payment.  Self-employment tax was not paid on the excess amounts.  The IRS disagreed with that characterization, asserting self-employment tax on all amounts allocated. 

The Tax Court (Judge Paris) agreed with the IRS.  Based on the Uniform Limited Partnership Act of 1916, the Revised Limited Partnership Act of 1976 and Mississippi law (the state in which the PLLC operated), the court determined that a limited partner is defined by limited liability and the inability to control the business.  The members couldn’t satisfy the second test.  Because of the member-managed structure, each member had management power of the PLLC business.  In addition, because there was no written operating agreement, the court had no other evidence of a limitation on a member’s management authority.  In addition, the evidence showed that the members actually did participate in management by determining their respective distributive shares, borrowing money, making employment-related decisions, supervising non-partner attorneys of the firm and signing checks.  The court also noted that to be a limited partnership, there must be at least one general partner and a limited partner, but the facts revealed that all members conducted themselves as general partners with identical rights and responsibilities.  In addition, before becoming a PLLC, the law firm was a general partnership.  After the change to the PLLC status, their management structure didn’t change. 

The court did not mention the proposed regulations, but even if they had been taken into account the outcome of the case would have been the same.  Member-managed LLCs are subject to self-employment tax because all members have management authority.  It’s that simple.  In addition, as noted below, there is an exception in the proposed regulations that would have come into play. 

Note:  As a side-note, the IRS had claimed that the attorney trust funds were taxable to the PLLC.  The court, however, disagreed because the lawyers were not entitled to the funds.

Structuring to Minimize Self-Employment Tax – The Manager-Managed LLC

There is an entity structure that can minimize self-employment tax.  An LLC can be structured as a manager-managed LLC with two membership classes.  With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4).  They do, however, have self-employment tax on any guaranteed payments.

Service businesses.  The manager-managed structure does not achieve self-employment tax savings for personal service businesses, such as the one involved in Castigliola.  Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership.  Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter).  Thus, for a professional services partnership (such as the law firm at issue in the case), structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.     

Note:  If a member of a services partnership (e.g. LLC) is merely an investor that is not involved in the operations of the LLC as a business and is separately paid for services rendered, any distributive share is not subject to self-employment tax.  See, e.g., Hardy v. Comr., T.C. Memo. 2017-16.  But, if the distributive share is received from fees from the LLC’s business, the distributive share is subject to self-employment tax.  See, e.g., Renkemeyer, Campbell & Weaver, LLP, 136 T.C 137 (2011). 

Farming and ranching operations.  For LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated.  The result is that a member holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.

Example.  Here's what it might look like for a farming operation:

A married couple operates a farming business as an LLC.  The wife works full-time off the farm and does not participate in the farming operation.  But she holds a 49 percent non-manager ownership interest in the LLC.  The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest.  But, the husband, as the farmer, also holds a 2 percent manager interest.  The husband receives a guaranteed payment for his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC.  The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax.  The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives.  This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC. 

Additional benefit.  There is another potential benefit of utilizing the manager-managed LLC structure.  Until the net investment income tax of I.R.C. §1411 is repealed, it applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return).  While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager.  I.R.C. §469(h)(5).  Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of the other spouse from passive to active income that will not be subject to the 3.8 percent surtax.

Note:  Returning to the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.

Soroban Capital Partners LP

The Tax Court has now issued a fully reported opinion (meaning it is of national significance in all jurisdictions) taking Castigliola one step further and holding that creating a limited partner interest under state law is not necessarily enough to have a limited partner interest for self-employment tax purposes.  Soroban Capital Partners LP v. Comr., 161 T.C. No. 12 (2023).  The petitioner was a limited partnership that made guaranteed payments and distributed ordinary income to its limited partners. However, the petitioner excluded distributions of ordinary income to its limited partners from its computation of net earnings from self-employment.  Its basis for doing so was that the limited partners’ interest conformed to state law.  The IRS disagreed asserting that wasn’t enough and that the functions and roles of the limited partners also had to be analyzed for self-employment tax purposes. The Tax Court agreed with the IRS.

The Tax Court was faced with the definition of a “limited partner” for purpose of the exception from s.e. tax under I.R.C. §1402(a)(13).  The Tax Court noted that the proposed regulations provided a definition, that the Congress froze the finalization of the regulation for six months and has said very little about the issue since the freeze was lifted, and has not provided a definition.  The Tax Court noted that it had applied a “functional analysis” test in Renkemeyer, but that this was the first time the Tax Court was asked to determine the self-employment tax status of limited partner in a state law limited partnership (having passed on the issue in a 2020 case).  The Tax Court determined that the functional analysis test applied based largely on statutory construction of I.R.C. §1402(a)(13) which excludes from self-employment tax “the distributive share of any item of income or loss of a limited partner, as such.”  The Court concluded that the “as such” language meant that there wasn’t a blanket exclusion for a limited partner.  Instead, the statute only applies to a limited partner that is acting as a limited partner.  If a limited partner is anything more than merely an investor, self-employment tax applies to the partner’s distributive share. 

Note:  The court noted that the petitioner cited legislative history in an attempt to support its position, but that the legislative history actually supported the position of the IRS.  The Tax Court also noted that the petitioner put forth “myriad other arguments” none of which were persuasive.  The petitioner even cited language in the instructions for Form 1065 which it claimed defined a limited partner, but the Tax Court noted that the definition did not purport to define a limited partner. 

The Tax Court held that a functional inquiry into the roles and activities of the petitioner’s individual partners under I.R.C. §1402(a)(13) “involves factual determinations that are necessary to determine Soroban’s aggregate amount of net earnings from self-employment.”  Accordingly, the Tax Court denied the petitioner’s motion for summary judgment and set forth the rule going forward in evaluating the application of self-employment tax for limited partners in professional service businesses.

Conclusion

The manager-managed LLC provides a better result than the result produced by the member-managed LLC for LLCs that are not service partnerships.  For those that are, such as the PLLC in Castigliola, the S corporation is the business form to use to achieve a better tax result.  For an S corporation, “reasonable” compensation will need to be paid subject to S.E. tax, but the balance drawn from the entity can be received self-employment tax free.  But, for farming operations with land rental income, the manager-managed LLC can provide a better overall tax result than the use of an S corporation because of the ability to eliminate the net investment income tax.    

Of course, the self-employment tax and the net investment income tax are only two pieces of the puzzle to an overall business plan.  Other non-tax considerations may carry more weight in a particular situation.  But for some, this strategy can be quite beneficial.

The decision in Castigliola would appear to further bolster the manager-managed approach – an individual that is a “mere member” appears to now have an even stronger argument for limited partner treatment.  In addition, the court didn’t impose penalties on the PLLC because of reliance on an experienced professional for their filing position. 

Soroban Capital Partners LP lays down the rule that it’s not enough to simply hold a limited partnership interest under state law (in the context of a professional service business).  A limited partner must truly be acting as an investor and no more.   The case involves a limited partnership that performs professional services, so it's fairly easy for the IRS to assert s.e. tax.  The opinion really doesn't address whether you can be a passive investor with some services provided to the limited partnership and still have it exempt from s.e. tax.  It also doesn't address whether you can be both a general partner and a limited partner and avoid s.e. tax on the income distributive share attributable to the limited partner interest.  The answer to those last two questions, according to the analysis provided above, should be "yes" for farm and ranch clients.  

Will Steve Cohen now move to try to settle his case with the IRS?  Are the limited partners in his hedge fund business truly limited partner investors?  Doubtful.

Proper structuring of the LLC and careful drafting of the operating agreement is important. 

Current Issues in Ag Law and Taxation

Overview

Today’s article addresses several current and recurring issues in the fields of law and taxation that are of importance to farmers and ranchers. 

Right to Repair

Agribusinesses can exert power over farmers through limits on technology use and access, as well as by other agreements that producers sign to utilize services and products.  A big issue is whether the ownership of the technology associated with farm equipment and machinery limits a farmer’s right to repair. 

When a farmer buys new machinery, the manufacturer may view the transaction more as a technology lease than as a machine sale. At issue is the ownership of the software and technology in the farm machinery.  The dramatic increase in computerization of equipment means that all types of data are sent to the cloud by a transmitter.  As a result, the manufacturer will claim that only an authorized dealer can make repairs. 

This is the crux of the “right to repair” argument.  John Deere has said it will provide timely electronic access to farmers and independent repair shops of the manuals, software and tools necessary to operate, maintain, repair or upgrade equipment.  But access won’t be free, and the agreement is off if a party to the deal introduces right to repair legislation in a state legislature.   Other manufacturers have struck similar deals.

At least 11 states have introduced legislation on the issue recently. Colorado’s right to repair law, “The Consumer Right to Repair Agriculture Equipment Act,” (HB 23-1011) goes into effect at the start of 2024. 

Good Husbandry Provisions in Ag Leases

According to the USDA, about 40 percent of all farmland is leased.  A requirement of good husbandry is a part of all ag leases, either through language in the lease or implicitly where a court will require the tenant to farm in accordance with generally accepted farming practices.  See, e.g., Bostic v. Stanley, 608 S.W.3d 907 (Ark. Ct. App. 2020).  It’s tied to the common law duty of “waste” – the tenant can’t mismanage the land resulting in substantial injury.  Examples include removing topsoil, demolishing buildings or fences, cutting timber or destroying cover crops.  It can also include improper tillage practices and failing to control weeds or insects.  There’s no specific legal definition, so the interpretation of good husbandry’s meaning is left up to the courts unless the lease has a specific clause. 

In one case, a breach of the duty of good husbandry was found where the tenant started harvesting wheat too late.  A breach was also found in another case where the tenant removed manure at the end of the lease.  But a breach won’t likely be found if weather prevents completion of harvest and other farms in the area have been similarly affected. 

If you’re concerned about your tenant’s farming practices, consider putting a clause in a written lease detailing the farming practices that you deem appropriate and those that you don’t. 

WOTUS Update

The legal challenges and disputes continue related to the regulatory definition of “waters of the United States” or WOTUS.  The disputes concern the EPA and Corp of Engineers regulation published on September 8 purportedly conforming the regulatory definition of “waters of the United States” to the Supreme Court’s ruling in a case last May.  https://www.federalregister.gov/documents/2023/09/08/2023-18929/revised-definition-of-waters-of-the-united-states-conforming  The disputes have implications for many farmers and ranchers.  Twenty-six states have sued claiming that the EPA and the Corps of Engineers violated the law when it modified its existing rule to supposedly comply with the Court’s ruling.  The states claim that the agencies didn’t provide enough analysis or explanation of the scope of federal jurisdiction in response to the Court’s decision.  They also claim the federal agencies are undermining state control over land management and failed to define terms such as “relatively permanent” and “continuous connection.” 

In addition, Texas and Idaho claim that the modified rule oversteps state sovereignty and asserts federal authority over non-navigable waters. Some industry and ag groups have joined this lawsuit. 

As the Supreme Court ruled, only relatively permanent waters that are directly connected to larger navigable water bodies are “waters of the U.S.”  It’s up to the federal agencies to write a rule that provides the parameters of that definition.  Expect the legal battles to continue.

Considerations When Buying Farmland

Whether to buy farmland is perhaps the biggest decision you’ll have to make with respect to your farming operation as well as your legacy.  But there are lots of things to consider before signing on the dotted line.  Of course, price is a primary consideration in most transactions, but there are factors that can influence the land’s value that aren’t necessarily reflected in the sale price. 

The following is a list of some of those factors:

• Make sure to account for any improvements that will be needed to buildings, fences and drainage tile.
• Also check the watershed and potential drainage or irrigation issues.
• Is the land in a drainage district?
• Is there potential for an endangered species habitat designation?
• Is there an old dump site on the property?
• Are there any government contracts such as the CRP or easements on the property?
• Is the land leased to a tenant? If so, has the tenancy been terminated?  Simply buying the land will not terminate an existing lease. 
• Is there a subsurface tenant?

Checking available public records and asking questions of the current owner and neighbors is a good thing to do.  Also, physically inspect the property, and get the seller to sign a thorough disclosure document.

Perhaps most importantly, don’t let your emotions drive the decision.

Exclusion of Meals and Lodging from Income

The value of meals and lodging furnished on the business premises for the employer’s convenience and as a condition of employment is not taxable income to the employee and is deductible by the employer if the meals and lodging is provided in-kind.  It also isn’t wages for FICA and FUTA purposes.

This is a C corporation benefit.  A C corporation provides the broadest fringe benefits of any entity structure.  One of those is the ability to provide tax-free meals and lodging to employees.  The meals and lodging must be furnished on the business premises, be provided for the employer’s convenience and as a condition of employment.  Remoteness of the farm or ranch is a factor, but not a determining one.  See, e.g., Caratan v. Comr., 442 F.2d 606 (9th Cir. 1971).  Whether you have a good business reason to have employees on the premises at all times is.  A key to success on that issue is documenting the need and requirement in employment agreements or corporate resolutions.

If done right, it can be a nice tax-free fringe benefit for employees and a deduction for the corporation.

Hobby Losses

For a business expense to be deductible, it generally must be “ordinary and necessary” and incurred in a business that is conducted with a profit intent.  If not, the activity is deemed to be a hobby and associated losses are “hobby losses.” The impact of the tax law on hobby losses is currently harsh. 

Over the years, many cases involving ag activities have been the focus of the IRS.  If the activity is deemed to be a hobby, any losses are miscellaneous itemized deductions which are currently disallowed. See, e.g., Gregory v. Comr., 69 F.4th 762 (11th Cir. 2023), aff’g., T.C. Memo. 2021-115.  But all the income from the activity must be reported into gross income. 

The IRS and the courts analyze nine factors for determining whether there is a profit intent.  Those factors are the manner in which the activity is conducted; the taxpayer’s expertise or that of adviser(s); the time and effort put in; whether there’s an expectation that the assets will appreciate in value; the taxpayer’s success in carrying on similar activities; the taxpayer’s history of income or loss; whether there’s ever been a profit; and two socioeconomic factors.

None of the factors is conclusive by itself.  It’s how they stack up in a given situation.  What is for sure, though, is that the tax rule is harsh if your activity is deemed to be a hobby.

An S Corporation is a Separate Entity from Yourself

A key principle of tax law is that you can’t deduct expenses that you pay on behalf of someone else.  That rule extends to corporations and their shareholders.  The rule was applied in a recent Tax Court case, Vorreyer, et al. v. Comr., T.C. Memo. 2022-97, involving a farming business operating as an S corporation. 

You can’t deduct an expense of your corporation as your own - even if the corporation is a pass-through entity such as an S corporation.  While there’s a limited exception, it didn’t apply in the recent case where the taxpayers operated a farm individually and through several related entities including an S corporation.  They paid the corporation’s property taxes and utility expenses and deducted the amounts on their personal returns. 

But the Tax Court said that the business expenses of the S corporation could not be disregarded at the corporate level.  The S corporation’s income must be matched at the corporate level against the S corporation’s expenses that were incurred to produce that income before the net income or loss amount can flow through to the shareholders. 

The result was that the deductions on the shareholders’ personal returns were disallowed.  Although S corporate income or loss would eventually flow through to them, a corporation is a separate taxable entity.

The lesson is clear – make sure to respect an entity structure.  You can’t claim a personal deduction for a corporate expense.

FBAR Penalties

In recent years some American farmers have started farming operations in foreign countries, particularly in South America.  Doing so could trigger a provision in the Bank Secrecy Act and if the provision is violated, the penalties can be harsh.  Under the rule, persons with a bank account in a foreign country containing $10,000 or more must report the account to the IRS by the annual tax filing deadline. 

In a recent case involving a dual citizen of the U.S. and Romania, the IRS asserted penalties of almost $3 million.  He didn’t know about the requirement and didn’t report his foreign accounts for several years.  He disputed the penalty amount, claiming that it should be reduced to $50,000 based on his failure to file one form annually for five years that disclosed all of his foreign accounts.  The Government claimed the penalty was on a per account basis.  He won the argument at the trial court but lost on appeal.  At the Supreme Court he won – the penalty is on a per-form basis. Bittner v. United States, 598 U.S. 85 (2023).

For farmers with farming operations outside the U.S. it’s likely that a foreign bank account exists.  If so, it’s imperative that Form FinCen 114 is filed annually that reports those accounts to the IRS. 

Conclusion

I’ll ramble on more next time.  And…I’m starting to compile my list of the biggest ag law and tax developments of 2023.  What do you think were the most important ones?

More on Gift Giving

Overview

Earlier this month I wrote about one aspect of the tax rules surrounding making gifts.  In that discussion I pointed out one way in which the IRS determines that a gift has been made – out of a “detached and disinterested generosity.”  In other words, there is no quid pro quo.  There’s nothing expected in return.  But there are even more rules surrounding gifting.  Today, I take a look at some of those additional rules in the context of how they came up in some recent cases and IRS rulings.

More on gift giving – it’s the topic of today’s post.

Disclosure and Statute of Limitations

A federal gift tax return (Form 709) must be filed when gifts to one person in a year total more than $17,000 this year.  That amount goes to $18,000 for gifts made in 2024.  That threshold is known as the “present interest annual exclusion”  and it covers outright gifts up to that ceiling.  Any excess amount gifted to a person in a calendar year then use up the donor’s unified credit that is available to offset taxable gifts during life or federal estate tax at death.  So, while gifts over the threshold may not be taxable because of the credit, they still must be reported on Form 709.  That’s an important point because filing Form 709 will toll the statute of limitations.  Otherwise, the statute is never tolled, and the IRS can come back years later and assert that gift tax (and penalties) is due.   

In Schlapfer v. Comr., T.C. Memo. 2023-65, the petitioner owned a life insurance policy that was issued in 2006.  It was funded by his solely owned corporation.  He assigned ownership of the policy to his mother, aunt and uncle in 2007.  In 2012, he got involved with the IRS Offshore Voluntary Disclosure Program (OVDP) because IRS thought he had undisclosed offshore assets that he hadn’t disclosed that triggered a tax reporting obligation.  As part of the disclosure packet that he submitted to the IRS in 2013, he included a 2006 Form 709 with an attached protective election describing a gift of just over $6 million of corporate stock but asserting that it wasn’t taxable because it was a gift of intangible personal property from a non-domiciled foreign citizen.  In 2016, he signed Form 872 for his 2006 Form 709, agreeing to extend the time to assess tax until November 30, 2017. 

Note:  The present interest annual exclusion was only $1 million for years 2006 and 2007.

In August of 2016, the IRS issued the petitioner a report for his gift tax return.  The IRS concluded in the report that there was no taxable gift in 2006, but that he had made a taxable gift of the insurance policy in 2007 (the year in which he relinquished dominion and control) for which he didn’t file a gift tax return and now owed over $4.5 million of gift tax, plus penalties of approximately $4.3 million.  The IRS didn’t buy his claim that he was a non-domiciled foreign citizen, noting that he had lived in the U.S. since 1979, possessed a green card, and actually became a citizen in 2008.  The IRS claimed that the 2007 wasn’t adequately disclosed and that the statute of limitations on assessment never began to run.  

The petitioner withdrew from the OVDP, and the IRS prepared a substitute gift tax return for 2007, followed with the provision in late 2019 of a statutory notice of deficiency formally asserting the $4.4 million in gift tax deficiency and $4.3 million in penalties.  In turn, he filed a Tax Court petition claiming that the three-year statute of limitations (running from the time the gift tax return is filed) to assess gift tax had expired because he had filed a gift tax return with a protective election.

The Tax Court agreed with the petitioner, noting that it was immaterial when the gifts were completed.  This was because the Tax Court determined that he had made adequate disclosure of incomplete gifts upon the filing of his 2006 return.  That was enough, the Tax Court reasoned, to trigger the three-year period of limitations (see Treas. Reg. § 301.6501(c)-1(f)(5)) because he had adequately disclosed the gifts on his 2006 gift tax return by providing the IRS with enough information by virtue of the return and accompanying documents.  Taken in total it was enough to satisfy the adequate disclosure requirement, resulting in substantial compliance.  This was true even though the petitioner had not strictly satisfied the requirements of Treas. Reg. § 301.6501(c)-1(f)(2).  Thus, the period of limitations to assess the gift tax had expired before the deficiency notice was issued.

Charitable Giving - Substantiation

If you are claiming a deduction for a charitable gift, you must substantiate the gift.  In Albrecht v. Commissioner, T.C. Memo. 2022-53, the petitioner donated approximately 120 pieces of jewelry to a museum in 2014.  The museum was a qualified charity.  The museum executed a “Deed of Gift” which specified, in part, that “all rights, titles, and interests” in the jewelry were transferred from the donor to the donee upon donation unless otherwise stated in the Gift Agreement.  The petitioner claimed a charitable deduction for the donation on her 2014 return and supported the claimed deduction by submitting the “Deed of Gift” documentation. 

The IRS denied the deduction on the basis that the “Deed of Gift” documentation did not meet the substantiation requirements of I.R.C. §170(f)(8)(B) that require a description of the donated item(s); whether the donee provided any form of consideration in exchange for the donation; and a good faith estimate of the value of the donation. The IRS pointed out that the “Deed of Gift” documentation from the museum did not state whether the museum provided any goods or services in return for the donation. In addition, the terms of the “Deed of Gift” documentation with the museum referred to a superseding agreement, “the Gift Agreement,” which left open the question of whether the donor retained some title or rights to the donation, and also indicated that the petitioner’s documentation did not include the entire agreement with the done. 

The Tax Court agreed with the IRS and held that the petitioner did not comply with the substantiation requirements of I.R.C. §170(f)(8)(B) and denied the charitable deduction. 

Estate Transfers

The decedent in Estate of Spizzirri v. Comr., T.C. Memo. 2023-25, had four children from the first of his four marriages and had three stepchildren as the result of his fourth marriage. Before his fourth marriage, the decedent and his next wife-to-be entered into a prenuptial agreement, which was modified several times during their marriage. Among other provisions, the prenuptial agreement, as modified, provided that the decedent’s will would include payments to the surviving spouse and a bequest of $1 million to each of the stepchildren.

Although the decedent’s fourth marriage was never dissolved, he and his wife were estranged for several years before his death as a result of his various relationships with other women that resulted in two illegitimate children. The decedent made large payments to a number of these women as well as to various other family members, but he never reported them as gifts or issued a Form 1099-MISC to the recipients.  The decedent’s will had been executed before his fourth marriage and did not contain the provisions he agreed to in the prenuptial agreement regarding payments to his surviving spouse and her children. The will generally provided that the decedent’s estate would go to his children from his first marriage. There were three codicils to this will, all of which specified the rights of his two bastard sons and one that provided for the payment of the mortgage on, and transfer of his interest in, a condominium he had purchased with one of his courtesans.

During probate, the decedent’s surviving spouse filed claims seeking enforcement of the prenuptial agreement, which were ultimately settled. The surviving spouse’s children also filed claims seeking to enforce the prenuptial agreement regarding the $1 million bequest to each of them. The estate ultimately paid these bequests and sent the Forms 1099-MISC reporting these payments.  After the claims were settled, the estate filed an estate tax return. Among other reported items, the return reported no adjusted taxable gifts, even though the decedent had made payments to various persons in excess of the gift tax annual exclusion. The return also reported the payments to the surviving spouse’s children as claims against the estate that reduced the decedent’s taxable estate. Additionally, the estate claimed as administrative expenses the cost of repairs to property of the estate.

The IRS issued a notice of deficiency that increased adjusted taxable gifts from zero to nearly $200,000, disallowed the deductions for the payments to the surviving spouse’s children, and disallowed administrative expenses for repairs to one of the estate’s properties.  The Tax Court determined that the estate had failed to meet its burden of proof that the transfers were not gifts. The estate argued that the transfers were payments for care and companionship services during the last years of the decedent’s life. The court noted that the decedent made the transfers by checks that contained no indication that they were meant as compensation. In addition, the decedent failed to issue any Forms 1099 or W-2 related to these payments, nor did he report them on his personal income tax returns. The Tax Court also noted that witness testimony failed to establish that the transfers were anything other than gifts.  The Tax Court also noted that the payments to the surviving spouse’s children would only provide a deduction for the estate if they were bonafide and contracted for “adequate and full consideration in money or money’s worth” and not be predicated solely on the fact that the claim is enforceable under state law. Based on these requirements, the Tax Court determined that the claims were not bonafide but were of a donative character, finding that payments to the surviving spouse’s children did not stem from an agreement for the performance of services — they were essentially bequests not contracted for adequate and full consideration in money or money’s worth.

Regarding the administrative expenses for repairs to the house, the Tax Court noted that Treas. Reg. §20.2053-3(a) limits deductible administrative expenses to those that are actually and necessarily incurred in the administration of the decedent’s estate. The Tax Court noted that the appraisal report for the house, on which the house’s claimed FMV was based, stated that the decks on the house that were repaired “may need to be replaced” and that the estate did not provide any corroboration that their replacement was necessary for a sale or to maintain the FMV claimed on its return. Thus, the court determined that the costs paid for the repairs were not deductible expenditures necessary for the house’s preservation and care but rather were nondeductible expenditures for improvements to it.

Conclusion

The rules on gifting can be complex.  If you are thinking about making substantial gifts and/or doing so in a complicated fashion, make sure to get good professional advice beforehand.

Ethics and 2024 Summer Seminars!

Tax Ethics

On December 15, I'll be conducting a 2-hour tax ethics program.  It will be online-only attendance.  If you are in need of a couple of hours of ethics, this will be a good opportunity to meet the ethics requirement.  I'll be covering various ethical scenarios that tax professionals encounter.  The session will be a practical, hands-on application of the rules, including Circular 230.  If you have attended or are registered to attend a KSU Tax Institute, you get a break on the registration fee. 

For more information you can click here: https://www.washburnlaw.edu/employers/cle/taxethics.html 

Also, you may register here:  https://form.jotform.com/232963813182156

Summer Seminars

On June 12 and 13, Paul Neiffer and I will be holding a farm tax and farm estate/business planning conference at the Keeter Center on the campus of the College of the Ozarks, just a bit south of Branson, MO.  This conference is in-person only.  On August 5 and 6, we will be doing another conference in Jackson Hole, WY, at the Virginian Resort.  Hold the dates  and be watching for more information.  This conference will be both in-person and online.  Registration will open for the seminars in January.  There is a room block established at the Virginian.

Hope to see you online at the ethics seminar and at one of the summer conferences.

Odds and Ends in Ag Law and Tax

Overview

The world of ag law and tax never stops revolving.  That’s probably not always a good thing for farmers and ranchers.  I suspect many involved in agriculture would appreciate less involvement of law and tax in their lives and their business operations.  But it’s the reality which means that it’s important to stay on top of the developments and issues that impact the business bottom line.

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

Scope of Dealer Trust Act at Issue

The Packers and Stockyards Act of 1921 (PSA) (7 U.S.C. §§ 181 et seq.), applies to transactions in livestock or poultry in interstate commerce involving a covered a packer, dealer, market agency, swine contractor, or live poultry dealer.  The PSA creates statutory trusts and requires bonds of market participants which may provide funds to reduce losses incurred by unpaid cash sellers of livestock or poultry.  A similar provision applies for perishable commodities created by the Perishable Agricultural Commodity Act. 7 U.S.C. § 499e(c).

Historically, there have been numerous attempts to amend the PSA to create a “Dealer Trust” that would establish a statutory trust similar to the Packer Trust created by the PSA at 7 U.S.C. § 196. These efforts succeeded with legislation signed into law on December 27, 2020, that adds new Section 318 to the PSA.  Codified at 7 U.S.C. § 217b.

In 2021, a Dealer Trust became part of the Packers and Stockyards Act to protect unpaid cash sellers of livestock from the bankruptcy of feeders, brokers and small processors.  The new law puts unpaid cash sellers of livestock ahead of prior perfected security interest holders.  It’s a provision similar to the trust that exists for unpaid cash sellers of grain to a covered grain buyer.  The first case testing the scope of the Dealer Trust Act is winding its way through the courts.

A case involving the new Dealer Trust Act is in the courts.  Over 100 livestock producers have $122 million in unpaid claims against three defunct cattle operations, and a lender says one of the feedyards sold about 78,000 cattle and didn’t pay on the loans.  The problems stem from a $175 million Ponzi and check-kiting scheme that the debtors were engaged in.

One issue is what the trust contains for the unpaid livestock sellers.  Is it all assets of the debtors?  It could be – for feedyards and cattle operations, practically all the income is from cattle sales.  So far, USDA has approved for payment only $2.69 million of claims for cash sellers of livestock, claiming that the balance is owed to non-cash sellers not covered by the law. 

The law is new, so it’s not clear yet what is a trust asset for the benefit of the cash livestock sellers, and what assets, if any, are in the debtors’ bankruptcy estates.   

What if the Trump Tax Cuts Aren’t Extended? 

A recent report from economists from Harvard, Princeton, the University of Chicago and the U.S. Treasury have produced a recent report that the Trump tax cuts, particularly the corporate tax reform provisions, created a large surge in business investment, economic growth, higher wagers for workers and little impact on government revenue.  The report can be found here:  https://conference.nber.org/conf_papers/f191672.pdf

The Trump tax cuts (known as the Tax Cuts and Jobs Act (TCJA)) permanently reduced the corporate tax rate from 35 percent to 21 percent and allowed for immediate expensing for shorter-term capital investments (although the provision is currently 80 percent for 2023 and is phasing down).  The economists noted in their report that, “the dynamic labor and corporate tax revenue feedback in the first 10 years is less than 2 percent of baseline corporate revenue, as investment growth causes both higher labor tax revenues from wage growth and offsetting corporate revenue declines from more depreciation deductions.”  In other words, the economists are saying that when companies reinvest and grow and become more efficient, employee salaries increase, and more taxes get paid.  The result is no net loss to the Treasury over a 10-year period.  The report noted that in 2017, the year before the Trump tax cuts took effect, revenue to the federal government was $3.3 trillion.  In fiscal year 2021 the Treasury took in $4 trillion and $4.9 trillion in fiscal year 2022.  But it dropped to $4.44 trillion in fiscal year 2023 due to the slowing economy burdened by inflationary economic policies. 

Many individual provisions of the TCJA are set to expire at the end of 2025.  For many, this could have a significant impact starting in 2026. Do you have a plan in place if the tax law changes dramatically at that time?  If Congress allows the TCJA to expire, how might it impact you?  For starters, tax rates will increase, and those currently in the 12 percent federal bracket will see a 25 percent increase in their tax rate.  Currently, the 12 percent bracket for married persons filing jointly applies to taxable incomes from $22,000-$89,450.  So, for instance, a married couple with $75,000 of taxable income would see their tax bill raise from $8,560 to approximately $10,350. 

In addition, the standard deduction will be reduced (essentially cut in one-half), but personal exemptions will be restored.  Also, the child tax credit will be reduced from $2,000 per qualifying child to $1,000, refundability will be reduced and the credit will be eliminated entirely for some families.  For homeowners, the current limit on the mortgage interest deduction will be removed.

The 2017 law removed the penalty for not getting government health insurance, but that will be restored starting in 2026, as will the deduction for state and local taxes.  In addition, the lower limit on charitable deductions will be reinstated.  For businesses that aren’t corporations, the 20 percent deduction on business income will go away.   

The estate tax exemption will be essentially cut in half, (from about $14 million in 2025 to about $7 million in 2026).  For larger estates, making gifts now might make some sense. 

It might be time to start thinking about the changes that could occur starting in 2026 and putting a good plan in place to handle what could happen.  If you operate a farming or ranching business, think of higher taxes as an additional cost that needs to be managed.

You're Responsible for Filing Your Tax Return

Lee v. United States, No. 22-10793, 2023 U.S. App. LEXIS 28228 (11th Cir. Oct. 24, 2023)

The plaintiff’s CPA failed to file the plaintiff’s tax return for three consecutive years, 2014-2016. Ultimately, the plaintiff filed his returns in December of 2018.    In 2019, the IRS assessed the plaintiff with over $70,000 in penalties for violating I.R.C. §6651(a) of the Internal Revenue Code and barred the plaintiff from applying his 2014 overpayment to taxes owed for 2015 and 2016, because as being beyond the statute of limitations in I.R.C. §6511(b).  The CPA informed the IRS that his tax preparation software couldn’t prepare the plaintiff’s returns because of their complexity but didn’t tell the plaintiff of the problem. 

The plaintiff learned about the problem when an IRS agent showed up at his office.  The CPA had failed to update the plaintiff’s address with the IRS.  The plaintiff sued the tax software company and the CPA for negligence and the suit settled in 2020.  The plaintiff sued for a refund of taxes, claiming that his failure to file was due to reasonable cause.  He also sought a refund of penalties.  The trial court ruled for the government based on United States v Boyle, 469 U.S. 241 (1985), where the U.S. Supreme Court applied a bright-line rule that “reliance on an agent,” without more, does not amount to “reasonable cause” for failure to file a tax return on time.  The question in this case was whether the rule in Boyle applies to e-filed returns. 

The appellate court noted that the plaintiff signed Form 8879, authorization to e-file, on time but the CPA failed to electronically transmit the taxpayer's return. In a case of first impression on the issue, the appellate court affirmed.  Here the Circuit Court sided with the IRS and held that the rule applies to e-filed returns and denied the taxpayer's reasonable cause for failure to file argument.  The appellate court determined that for the e-filing was the same as paper filing for the purpose of responsibility for filing the return and that Form 8879 did not make e-filing fundamentally different from paper filing.  The appellate court noted that the plaintiff had not experienced a disability or illness that affected his ability to exercise ordinary care and prudence.  He also did not ask the CPA to provide a copy to him for any of the years in question of the acceptance notice from the software company that his returns had been successfully electronically filed. 

Interest Paid on Late Child Support Is Includible in Payee’s Gross Income 

Rodgers v. Comr., T.C. Memo. 2023-56

The petitioner and her ex-spouse were involved in litigation concerning the termination of the ex-spouse’s child support obligation.  He was found to be arrears in his child support obligation to the extent of $18,000.  That amount was later amended to $16,044.37, which included $10,682.48 of interest.  The arrearage was paid, and the petitioner was issued a 1099-INT showing $7,824 of interest income for 2015.  The plaintiff did not include the interest amount in her income for 2015 and the IRS issued her a deficiency notice.  She took the position that the amount was nontaxable child support. 

The Tax Court noted that under Alabama law the amount for arrearages was specifically designated as interest. As such, the Tax Court upheld the position of the IRS that the amount was taxable interest to the plaintiff.  The Court found the amount to be taxable interest. 

Appraisal Necessary for Non-Cash Donations

Bass v. Comr., T.C. Memo. 2023-41 

 In 2017, the petitioner donated clothing and non-clothing items to the Goodwill and Salvation Army.  He made 173 separate trips to Goodwill and Salvation Army to avoid (at least in his mind) having the items appraised.  For each trip a worker provided him with a donation acknowledgement receipt which he filled out, listing the items donated and their market values.  The Goodwill receipts indicated the donated items were worth $18,837 and the Salvation Army items would worth $11,779.  He attached two Forms 8283 to his tax return but did not obtain a written appraisal, claiming that he didn’t need one because he did not donate any single item worth over $5,000.  Indeed, no single item exceeded $250. 

The Tax Court disagreed, holding that all of the non-cash items had to be aggregated for purposes of whether an appraisal is required.  The Tax Court affirmed the position of the IRS that the petitioner’s charitable deduction should be denied. 

Mortgage Interest Deduction Disallowed

Shilgevorkyan v. Comr., T.C. Memo. 2023-12

In this case, the petitioner claimed a mortgage interest deduction for 2012 associated with a home that his brother purchased for $1,525,000 in 2005.  The purchased 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 guest house 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 guest house 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.” 

Feeling Detached and Disinterested? – Then Gift Giving Is for You!

Overview

Soon the Christmas season will be upon us.  With that comes the joy of gift giving.  But not according to the IRS.  If you gift assets, either as part of an estate plan or for purposes of setting up another person in business or for other reasons, you must be “detached and disinterested.”  That sounds as if it saps the joy right out of gift giving.  Thanks, IRS! 

But, what does “detached and disinterested” mean?  When is a transfer of funds really a gift?  Why does it matter?  It matters because the recipient of a gift doesn’t have to report the value of the gifted amount into income.  If the amount transferred is not really a gift, then it’s income to the recipient and the value of the gifted property is still in the estate of the person making the gift.  When large amounts are involved, the distinction is of utmost importance.

When is a transfer of funds a gift?  It’s the topic of today’s post.

Definition of a “Gift”

Under the Internal Revenue Code (“Code”), gross income is income from whatever source derived unless otherwise excluded.  I.R.C. §61(a).  However, gross income does not include the value of property that is acquired by gift.  I.R.C. §102(a).  In Comr. v. Duberstein, 363 U.S. 278 (1960), the U.S. Supreme Court defined a gift under I.R.C. §102 as a transfer that proceeds from a “detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses.”  As a result, the Supreme Court concluded that the most important consideration in determining whether a gift has been made is the donor’s intent.  That’s a broader inquiry than simply looking at how the donor characterizes a particular transaction.  A court will examine objectively whether a gift occurs based on the facts and if those facts support a donor that intended a transfer based on affection, etc.  Detached and disinterested generosity is the key.  If the transfer was made out of a moral duty or some sort of expectation on the recipient’s part, it is not a gift under I.R.C. §102 because it did not arise out of a detached and disinterred generosity.  Similarly, when the recipient has rendered services to a donor, a payment for services is not a gift even if the transferor had no legal obligation to pay the remuneration for the services.   

Apart from the Court’s analysis in Duberstein, a particular transaction may amount to a “common law” gift.  A common law gift requires only a voluntary transfer without consideration.  If the donor had no legal obligation to make the payment, the transfer is a gift under the common law standard.  That’s an easier standard to satisfy than the Code definition set forth in Duberstein. 

Example – Tax Court Decision

In Kroner v. Comr., T.C. Memo. 2020-73 illustrates how the courts examine whether a particular transfer constitutes a gift and the consequences of misreporting the transaction(s) for tax purposes.  The petitioner was the CEO of a business that bought and sold structured settlement payments and lottery winnings.  The company would buy structured payments from lottery winners and resell the payments to investors.  The petitioner had historically worked in the discounted cashflow industry and, as a result, met a Mr. Haring, a wealthy British citizen, sometime in the 1990s.  Their business relationship lasted until 2007.

In 2003 and 2004, the petitioner was interested in protecting his assets and an attorney recommended the use of an “offshore” trust to hold the petitioner’s assets.  An offshore trust is often associated with tax scams, but I reserve that discussion for another post in the future.  In any event, the petitioner established the “Kroner Family Trust” in a small island in the Caribbean.  The petitioner was the beneficiary of the trust along with his son.  In 2007, the petitioner established another trust in the Bahamas to hold business assets.  From 2005-2007, the petitioner received wire transfers from Mr. Haring totaling $24,775,000.  Some of the transferred funds went directly to the petitioner, but others went to the trust in the Caribbean Island and still others went to the petitioner’s business.  The lawyer that set up the offshore trusts “advised” the petitioner that the transfers were gifts that the petitioner didn’t have to report as taxable income.  The attorney’s legal “analysis” which led him to this conclusion was a conversation he had with the petitioner and a note that he drafted for Mr. Haring stating that the transfers were gifts.  The attorney also advised the petitioner of the requirements to file Form 3520 every year that he received a transfer from Mr. Haring to report the gifts from a foreign person.  A CPA prepared the Form 3520 for the necessary years.  The petitioner never reported any of the transfers from Mr. Haring as taxable income. 

The petitioner was audited for tax years 2005-2007.  The IRS took the position that the transfers were not gifts, should have been reported as taxable income, and assessed accuracy-related penalties on top of the tax deficiency. 

The Tax Court agreed that the transfers should have been included in the petitioner’s taxable income.  They were not gifts.  The Tax Court noted that Mr. Haring’s intention was the most critical factor in determining the status of the transfers.  The petitioner bore the burden to establish Mr. Haring’s intent by a preponderance of the evidence.  However, Mr. Haring never appeared at trial and didn’t provide testimony.  Instead, the petitioner tried to establish the gift nature of the transfers by his own testimony.  The petitioner and Mr. Haring had operated some business interests together in the 1990s, and the petitioner acted as a nominee for Mr. Haring for certain of Mr. Haring financial interests.  He even formed a trust in Liechtenstein for Mr. Haring in 2000.  Mr. Haring also provided a loan for the petitioner’s credit counseling business in 2000.  That loan was paid off in 2007.  Mr. Haring also held about a 70 percent equity interest in the petitioner’s cashflow industry business in exchange for providing funding and loan guarantees.  He later liquidated his interest for $255 million. 

The petitioner last saw Mr. Haring in 2002 and testified at trial that he didn’t know where he lived and that he didn’t know his telephone number.  He did, however, receive a telephone call from Mr. Haring in 2005 that lasted no more than three minutes.  The petitioner claimed that Mr. Haring told him during the call that Mr. Haring had a “surprise” for the petitioner.  The petitioner later met with Mr. Haring’s associate and they set up the ability to receive wire transfers from Mr. Haring into the petitioner’s bank account.  That’s when the attorney drafted a note to the petitioner from Mr. Haring stating that the transfers would be gifts. 

The Tax Court didn’t buy the petitioner’s story, finding that neither the petitioner nor the attorney were credible witnesses.  The Tax Court stated that the petitioner’s testimony was self-serving and that the attorney’s testimony was “simply not credible.”  There was no supporting documentary evidence.  In addition, the attorney represented both Mr. Haring and the petitioner.  The Tax Court also noted that the attorney was “evasive in his answers and in his selective invocation of the attorney-client privilege with regard to the legal advice provided to Mr. Haring about the transfers.”  The Tax Court also doubted the authenticity and credibility of the 2005 note allegedly from Mr. Haring but drafted by the attorney regarding his desire to gift funds to the petitioner.  Thus, the note carried little weight in determining whether the transfers were gifts.     

The Tax Court also determined that the petitioner failed to prove that the transfers were made with disinterested generosity.  The record was simply devoid of any credible evidence to prove that Mr. Haring transferred the funds to the petitioner with detached and disinterested generosity.  The Tax Court noted that timing of some of the transfers with liquidity events of the petitioner’s business of which Mr. Haring was an investor.  That raised a question as to whether Mr. Haring was acting as the petitioner’s nominee. 

The Tax Court determined that the petitioner need not pay the 20 percent accuracy-related penalty because the IRS failed to satisfy its burden of production under I.R.C. §6751(b). 

Conclusion

The Kroner case is a textbook lesson on what constitutes a gift – detached and disinterested generosity.  The burden of establishing that a transfer is a nontaxable gift is on the party asserting that the transfer amounted to a gift.  The case is also a lesson into the messes that sloppiness and questionable lawyering can get a client into.  When the amount of the gift (or gifts) is as large as that involved in the Kroner case, attention to detail is a must.  The income tax consequences from being wrong are enormous. 

For gifts you make this Christmas season, remember that the resulting tax consequences to you are likely to be better if you remain “detached and disinterested.”

Split-Interest Land Acquisitions – Is it For You? (Part 2)

Overview

Yesterday’s article looked at what a split-interest transaction is, how it works, and when it can be useful as part of an estate plan.  In particular, the focus of Part 1 was on removing after tax income from a family farming corporation and how it can work when farmland is purchased.

Today’s article looks at the relative advantages and disadvantages of the split-interest transaction, and what the rules are when property that is acquired in a split-interest transaction is sold.

Part 2 of split-interest transactions – it’s the topic of today’s post.

Advantages and Disadvantages

Advantages.  Because land is not depreciable, the most efficient form of acquisition is to use earnings exposed to a low tax rate.  A closely-held C corporation is a relatively efficient entity for creating after-tax dollars with the current tax rate at a flat 21 percent.  Even though C corporation after-tax dollars are used for the acquisition of most of the cost of land, the split-interest technique avoids the long-term negative aspect of having the farmland trapped inside the C corporation, and thus avoids the risk of double taxation of land appreciation. 

Even though corporate dollars are used to acquire the asset, the individual succeeds to full tax basis in the asset (reduced by any tax depreciation allowable to the corporation on the depreciable portion of the property).  The remainderman acquires basis in the real estate even though no economic outlay has occurred by that individual. 

Disadvantages.  The individual who buys the remainder interest must do so entirely from other sources of after-tax earnings.  The land produces no income to the remainderman during the period that the land is available for use by the corporation under the specified term certain.  Also, if the land is purchased on a contract or installment payment arrangement, each party must provide its contribution, either to the down payment or the contract. 

Note.  The party with the cash for the down payment may provide any portion or all of such down payment, with an adjustment for that party’s contribution to the contract.  The contract may provide for interest only payments by one party, until the other party’s contribution toward the purchase has been fully paid. 

Example.  Sow’s Ear, Inc. has been retaining equity of approximately $40,000 per year ($50,000 taxable income minus state and federal taxes) for a number of years.  Chuck, the corporate president would like to purchase additional land with the funds that the corporation has accumulated.   Chuck wants the corporation to buy the land with those available funds.  However, having the corporation purchase the land would trap up that land inside the corporation and potentially expose it to the double tax upon liquidation as well as eliminating capital gain rates if the corporation would have to sell the land. 

An alternative solution would be a split interest purchase.  Assume that the land could be purchased for $1 million, with $450,000 down and a contract at 5 percent for the balance, payable $52,988.26 annually for 15 years.  Chuck would like to farm for another 20 years via the corporation.  Assume that the monthly IRS purchased interest rate for a 20-year split-interest purchase requires the term interest holder to pay 58 percent of the total purchase price or $580,000.  Sow’s Ear, Inc. may pay $200,000 of the down payment.  It’s share of the remaining balance due is $380,000.  Chuck, as the remainder holder, is responsible for $420,000.  The balance due for the down payment may be made by either party.  If Sow’s Ear, Inc. borrows to satisfy the remaining down payment of $250,000, it will assume $130,000 of the note payable for the balance due ($580,000 less $200,000 cash less $250,000 remaining down payment).  Chuck will assume the remaining balance due of $420,000. 

Each party must pay interest that economically accrues on its share of the seller-financed debt, otherwise the below-market rate loan rules apply, which tie in with OID requirements.  The parties may determine the share of principal to be paid by each, as long as a total of $52,988.26 annually is paid to satisfy the requirements of the seller-financed note.  Because Chuck, as the remainderman, has no cash flow coming from the property for the next 20 years, he will have to obtain funds from sources other than rents from the property to fund his payments.  The deductibility of interest expense will be subject to the passive activity rules of I.R.C. §469.  The interest expense is a passive activity deduction, even though no rent is currently received by Chuck.  If Chuck has no passive income from other activities, the interest expense will create a passive loss carryover, to be available to offset net rental income after the term interest held by the corporation expires. 

Observation.  The split-interest technique is essentially limited to C corporations, because if two related individuals are involved the person acquiring the term interest is treated as having made a gift of the value of the term right to the purchaser of the reminder right.

 

Observation.  In times of low interest rates (i.e., low AFR factors that determine the percentage to be paid by each party), the corporate share will be smaller than occurs in periods when interest rates are higher.

Sale of Split-Interest Property

If a sale occurs during the split ownership of the property, the sale proceeds must be allocated between the corporate term holder and the individual remainderman based on the IRS interest rate and the remaining term certain periods as of the date of the sale.  After allocating the sale proceeds to each party, gain or loss is recognized by each party (the corporate term holder and the individual remainderman) by comparing the sale proceeds to the adjusted tax basis of the property.  The adjusted tax basis needs to reflect the nondeductible amortization adjustment occurring annually and the shift of this basis to the remainderman in accordance with I.R.C. §167(e)(3). 

Example.  Assume that RipTiller, Inc. and Dave Jr. (from the prior example) purchased another farm seven years ago for $200,000, with the corporation acquiring a 32-year term certain.  Assume that using interest rates in effect at that time, Dave Jr. was required to pay $25,000 and the corporation paid $175,000 toward the farm purchase price.  The corporate basis was further allocated as $20,000 attributable to depreciable tiling and $155,000 attributable to the land cost.  By the current year, the corporation would have depreciated about $9,000 of the $20,000 of tiling, leaving an adjusted basis of approximately $11,000.  The land basis of $155,000 would also have been reduced annually under straight-line amortization over the 32-year term certain.  Assume that about $4,800 per year of amortization occurred over the seven-year holding period of the corporation, resulting in a total reduction to the corporate basis of $33,600.  The amortization would be treated as land basis reductions to the corporation, and as land basis increases to Dave Jr.  Accordingly, at the time of the sale of the farm, the adjusted tax basis to each party is as follows:

Corporate Basis

                                                                                   Land               Tiling               Total

Basis at Purchase                                                     $155,000       $20,000             $175,000

            Deductible Depreciation                                                      ($9,000)           ($9,000)

            Statutory Amortization                               ($33,600)                                 ($33,600)

                 Adjusted Basis                                       $121,400         $11,000           $132,400

Dave Jr.’s Basis:

            At Purchase                                                     $25,000

            Statutory Increase for Amortization          $33,600

            Total Adjusted Tax Basis                               $58,600

If the farm is sold for $250,000, the term certain percentage and remainder percentage must be calculated for a term certain with 25 years remaining.  Assume that the current IRS mid-term annual AFR is 6.0 percent.  According to the IRS term certain table for 6.0 percent, the 25-year income right is to be allocated 76,7001 percent and the remainderman is to be allocated 23.2999 percent.  Accordingly, about $192,000 of the sale proceeds are allocable to the corporation and the remaining $58,000 is allocable to the individual.  The corporation would compare its $192,000 of approximate proceeds to its adjusted tax basis in the land and tiling of approximately $132,000.  In this example RipTiller, Inc. would report $60,000 of gain.  Dave Jr. would report a small capital loss ($58,000 allocated sale price vs. $58,600 adjusted tax basis). 

Observation.  Interest rates at the time of purchase compared to interest rates at the time of sale can have a major influence on the allocations under the split-interest rules.  In the example, if interest rates rise from the time of purchase to the time of sale, Dave Jr. would have a lower percentage of the sale price allocable to his remainder interest, and could incur a significant capital loss that was not immediately deductible.

Split-Interest Purchases with Unrelated Parties

The IRS has addressed the tax effects of split-interest purchases where the term holder and the remainder holder were unrelated.  In two Private Letter Rulings (200852013 (Sept. 24, 2008) and 200901008 (Oct. 1, 2008)) that appear to address the same set of facts, two unrelated buyers acquired several parcels of commercial real estate that included both depreciable buildings and land.    The first buyer acquired a 50-year term interest in the property, and the second buyer acquired a remainder interest in that same property.  The IRS determined that the buyer of the term interest was entitled to depreciate the commercial real estate (which the buyer of the term interest intended to use in its active conduct of renting commercial and residential property) ratably over the 50-year period of the term certain.  The portion of the taxpayer’s basis allocable to the buildings was held to be depreciable under the normal I.R.C. §168 MACRS recovery periods.  In addition, the IRS determined that the holding period for the buyer of the remainder interest began at the time of the purchase.

Observation.  A term certain remainder purchase arrangement of farmland (that is used in the taxpayer’s trade or business) where the two parties are unrelated could result in a term certain amortizable interest in the land. This is the case, according to the IRS, even though the farmland is not depreciable.  But see the Lomas case referenced in Part 1).  Examples of unrelated parties under I.R.C. §267 for these rules would include cousins and in-laws, such as a father-in-law, brother-in-law, or sister-in-law. 

Estate Tax Implications

For transactions that are between unrelated parties (as defined in I.R.C. §267), several federal estate tax advantages can be achieved.  If the “split” property is fairly valued (by a qualified appraiser), there is no gift upon creation of the split interest if IRS tables are used to value each party’s contribution.  Also, because the life estate interest ends upon the death of the life estate holder, there is no taxable transfer by that person that would trigger estate tax.  There is no inclusion in the life estate holder’s estate (and no interest subject to probate).  The property becomes fully vested in the remainder holder upon the life estate holder’s death.  As a result, there is no basis “step-up” to fair market value at the time of the life estate holder’s death in the hands of the remainder holder.  The basis of the property in the hands of the remainder holder is the cost of the remainder interest (the amount paid for the remainder interest).

Conclusion

Is a split-interest transaction for you? The answer, of course, is that it “depends.” For transactions involving individuals, the tax advantages (income tax as well as estate tax) are lost if the parties to the transaction are related.  Also, it’s important to make sure to the remainder holder provides consideration for the acquisition of the remainder interest (and not simply the life estate holder providing the financing to the holder of the remainder interest).  If that doesn’t happen, the IRS will likely claim that the life estate holder made a gift of a future interest that is subject to gift tax and can’t be offset by the present interest annual exclusion (currently $17,000 per year per donee).

Still uncertain is whether, for example, a split-interest purchase between unrelated parties (such as between a farm tenant that is looking to farm additional land and an investment firm). The IRS letter rulings seem to address this issue in a commercial context. Another issue in some states is that the strategy won’t work in some states if the investor is a corporation, limited liability company or trust that is disqualified from owning and/or operating agricultural land by statute.

For split-interest transactions involving a C corporation, if done correctly, the technique can be beneficial from a tax standpoint.

Split Interest Land Acquisitions – Is it For You? (Part 1)

In General

A split-interest transaction involves one party acquiring a temporary interest in the asset (such as a term certain or life estate), with the other party acquiring a remainder interest.  The temporary interest may either refer to a specific term of years (i.e., a term certain such as 20 years), or may be defined by reference to one or more lives (i.e., a life estate).  The remainder holder then succeeds to full ownership of the asset after expiration of the term certain or life estate. 

A split-interest transaction is often used as an estate planning mechanism to reduce estate, gift as well as generation-skipping transfer taxes.  But there are related party rules that can apply which can impact value for estate and gift tax purposes. 

Another way that a split-interest transaction may work is as a mechanism for removing after-tax income from a family corporation.  In addition, if the farmland is being purchased, the split-interest arrangement allows most of the cost to be covered by the corporation, but without trapping the asset inside the corporation (where it would incur a future double tax if the corporation were to be liquidated).   

Split-interest land transactions – it’s the topic of today’s post.

Split-Interest Transactions

The Hansen case.  In Richard Hansen Land, Inc. v. Comr., T.C. Memo. 1993-248, the Tax Court affirmed that related parties, such as a corporation and its controlling shareholder, may enter into a split-interest acquisition of assets.  The case involved a corporation that acquired a 30-year term interest in farmland with the controlling shareholder acquiring the remainder interest.  Based on interest rates in effect at the time, the corporation was responsible for about 94 percent of the land cost and the controlling shareholder individually paid for six percent of the land cost.  Under the law in effect at the time, the court determined that the term interest holder’s ownership was amortizable.  The corporation was considered to have acquired a wasting asset in the form of its 30-year term interest. 

Tax implications.  The buyer of the term interest (including a life estate) may usually amortize the basis of the interest ratably over its expected life.  That might lead some taxpayers to believe that they could therefore take depreciation on otherwise non-depreciable property. For instance, this general rule would seem to allow a parent to buy a life estate in farmland from a seller (with the children buying the remainder) to amortize the amount paid over the parent’s lifetime.  If that is true, then that produces a better tax result than the more common approach of the parent buying the farmland and leaving it to the children at death.  Under that approach no depreciation or amortization would be allowed.  However, the Tax Court, in Lomas Santa Fe, Inc. v. Comr., 74 T.C. 662 (1980), held that an amortization deduction is not available when the underlying property is non-depreciable and has been split by its owner into two interests without any new investment.  Under the facts of the case, a landowner conveyed the land to his wholly owned corporation, subject to a 40-year retained term of years.  He allocated his basis for the land between the retained term of years and the transferred remainder and amortized the former over the 40-year period.  As noted above, the court denied the amortization deduction.

In another case involving similar facts, Gordon v. Comr., 85 T.C. 309 (1985), the taxpayer bought life interests in tax-exempt bonds with the remainder interests purchased by trusts that the taxpayer had created.  The taxpayer claimed amortization deductions for the amounts paid for his life interests.  The Tax Court denied the deductions on the basis that the substance of the transactions was that the taxpayer had purchased the bonds outright and then transferred the remainder interests to the trusts.   

Related party restriction.  For term interests or life estates acquired after July 28, 1989, no amortization is allowed if the remainder portion is held, directly or indirectly, by a related party.  I.R.C. §167(e)(3). 

Note:  I.R.C. §167(e) does not apply to a life or other terminable interest acquired by gift because I.R.C. §273 bars depreciation of such an interest regardless of who holds the remainder.  I.R.C. §167(e)(2)(A).   This provision is the Congressional reaction to the problem raised in the Lomas Santa Fe and Gordon cases.  Under the provision, “term interest” is defined to include a life interest in property, an interest for a term of years, or an income interest held in trust. I.R.C. §§167(e)(5)(A); 1001(e)(2). The term “related person” includes the taxpayer’s family (spouse, ancestors, lineal descendants, brothers and sisters) and other persons related as described in I.R.C. §267(b) or I.R.C. §267(e).  I.R.C. §167(e)(5)(B).  It also encompasses a corporation where more than half of the stock is owned, directly or indirectly by persons related to the taxpayer.  Also, even if the transaction isn’t between related parties, amortization deductions could still be denied based on substance over form grounds.  See, e.g., Kornfeld v. Comr., 137 F.3d 1231 (10th Cir. 1998), cert. den. 525 U.S. 872 (1998).

If the acquisition is non-amortizable because it involves related parties, the term holder’s basis in the property (i.e., the corporate tax basis, in the context of a family farm corporation transaction) is annually reduced by the amortization which would have been allowable, and the remainder holder’s tax basis (i.e., the shareholder’s tax basis) is increased annually by this same disallowed amortization. I.R.C. §167(e)(3).    Thus, in a split-interest corporation-shareholder arrangement, the corporation would have full use of the land for the specified term of years, and the individual shareholder, as remainderman, would then succeed to full ownership after the expiration of the term of years, with the individual having the full tax basis in the real estate (but less any depreciation to which the corporation was entitled during its term of ownership, such as for tiling, irrigation systems, buildings, etc.).

On the related party issue, the IRS has indicated in Private Letter Ruling 200852013 (Sept. 24, 2008) that if the two purchasers are related parties, the term certain holder could not claim any depreciation with respect to the land or with respect to the buildings on the land during the period of the life estate/term interest. 

A couple of points can be made about this conclusion:

• The ruling is correct with respect to the land. That’s because I.R.C. §167(e)(1) contains a general rule denying any depreciation or amortization to a taxpayer for any term interest during the period in which the remainder interest is held, directly or indirectly, by a related person.

• However, the ruling is incorrect with respect to the conclusion that no depreciation would be available for the buildings on the land. R.C. §167(e)(4)(B) states that if depreciation or amortization would be allowable to the term interest holder other than because of the related party prohibition, the principles of I.R.C. §167(d) apply to the term interest.  Under I.R.C. §167(d), a term holder is treated as the absolute owner of the property for purposes of depreciation.  Thus, this exception would allow the term holder to claim depreciation with respect to the buildings but not the land, in the case of a related party term certain-remainder acquisition.

Observation.  The IRS guidance on this issue is confusing and, as noted, incorrect as to the buildings on the land.  It is true that the value paid for the term interest is not depreciable.  However, the amount paid for the building and other depreciable property remains depreciable by the holder of the property.  Thus, the term interest holder claims the depreciation on the depreciable property during the term.  The remainderman takes over depreciation after the expiration of the term.  Basis allocated to the intangible (the split-interest) is a separate basis, which is not amortizable.  Likewise, the basis allocated to the split-interest may not be attributed over to the depreciable property to make it amortizable. 

Allocation procedure.  To identify the proper percentage allocation to the term certain holder and the remainderman, the monthly IRS-published AFR interest rate is used, along with the actuarial tables of IRS Pub. 1457 (the most recent revision is June 2023).  The relevant interest rate is contained in Table 5 of the IRS monthly AFR ruling.

Example.  RipTiller, Inc. is a family-owned C corporation farming operation.  The corporation is owned by Dave Sr. and Dave Jr.  The corporation has a build-up of cash and investments from the use of the lower corporate tax brackets over a number of years.  The family would like to buy additional land, but their tax advisors have discouraged any land purchases within the corporation because of the tax costs of double tax upon liquidation.  On the other hand, both Dave Sr. and Dave Jr. recognize that it is expensive from an individual standpoint to use extra salaries and rents from the corporation to individually purchase the land. 

The proposed solution is to have the corporation acquire a 30-year term interest in the parcel of land, with Dave Jr. buying the remainder interest.  Assuming that the AFR at the time of purchase is 4.6 percent, and assuming a 30-year term, the corporation will pay for 74.0553 percent of the land cost and Dave Jr. will be obligated for 25.9447 percent.  RipTiller, Inc. may not amortize its investment, but it is entitled to claim any depreciation allocable to depreciable assets involved with this land parcel.  Also, each year, 1/30^th of the corporate tax basis in the term interest is decreased (i.e., the nondeductible amortization of the term interest reports as a Schedule M-1 addback, amortized for book and balance sheet purposes but not allowable as a deduction for tax purposes) and added to Dave Jr.’s deemed tax cost in the land.  As a result, at the end of the 30-year term, Dave Jr. will have full title to the real estate, and a tax cost equal to the full investment (although reduced by any depreciation claimed by the corporation attributable to depreciation allocations).      

Caution.  Related party split-interest purchases with individuals (e.g., father and son split-interest acquisition of farmland) should be avoided, due to the potentially harsh gift tax consequences of I.R.C. §2702 which treats the individual acquiring the term interest, typically the senior generation, as having made a gift of the value of the term ownership to the buyer of the remainder interest.  For this purpose, the related party definition is very broad and includes in-laws, nieces, nephews, uncles and aunts.  Similarly, any attempt to create an amortizable split-interest land acquisition, by structuring an arrangement between unrelated parties, must be carefully scrutinized in terms of analyzing the I.R.C. §267 related party rules and family attribution definitions.

Conclusion

In Part 2, I’ll take a deeper look at the relative advantages and disadvantages of of split-interest transactions with additional examples.

Reporting of Beneficial Ownership Information; Employee Retention Credit; Exclusion of Gain on Sale of Land with Residence; and a Farm Lease

Introduction

As I try to catch up on my writing after being on the road for a lengthy time, I have several items that seem to be recurring themes in what I deal with. 

Another potpourri of random ag law and tax issues – it’s the topic of today’s post.

New Corporate Reporting Requirements

The Corporate Transparency Act (CTA), P.L. 116-283, enacted in 2021 as part of the National Defense Authorization Act, was passed to enhance transparency in entity structures and ownership to combat money laundering, tax fraud and other illicit activities. In short, it’s an anti-money laundering initiative designed to catch those that are using shell corporations to avoid tax.  It is designed to capture more information about the ownership of specific entities operating in or accessing the U.S. market.  The effective date of the CTA is January 1, 2024.    

Who needs to report?  The CTA breaks down the reporting requirement of “beneficial ownership information” between “domestic reporting companies” and “foreign reporting companies.”  A domestic reporting company is a corporation, limited liability company (LLC), limited liability partnership (LLP) or any other entity that is created by filing of a document with a Secretary of State or any similar office under the law of a state or Indian Tribe.  A foreign reporting company is a corporation, LLC or other foreign entity that is formed under the law of a foreign country that is registered to do business in any state or tribal jurisdiction by the filing of a document with a Secretary of State or any similar office. 

Note:  Sole proprietorships that don’t use a single-member LLC are not considered to be a reporting company. 

Reporting companies typically include LLPs, LLLPs, business trusts, and most limited partnerships and other entities are generally created by a filing with a Secretary of State or similar office. 

Exemptions.  Exemptions from the reporting requirement apply for securities issuers, domestic governmental authorities, insurance companies, credit unions, certain large accounting firms, tax-exempt entities, public utility companies, banks, and other entities that don’t fall into specified categories.  In total there are 23 exemptions including an exemption for businesses with 20 or more full-time U.S. employees, report at least $5 million on the latest filed tax return and have a physical presence in the U.S.   But, for example, otherwise exempt businesses (including farms and ranches) that have other businesses such as an equipment or land LLC or any other related entity will have to file a report detailing the required beneficial ownership information.  Having one large entity won’t exempt the other entities. 

What is a “Beneficial Owner”?  A beneficial owner can fall into one of two categories defined as any individual who, directly or indirectly, either:

• Exercises substantial control over a reporting company, or
• Owns or controls at least 25 percent of the ownership interests of a reporting company

Note:  Beneficial ownership is categorized as those with ownership interests reflected through capital and profit interests in the company.

What must a beneficial owner do?  Beneficial owners must report to the Financial Crimes Enforcement Network (FinCEN).  FinCEN is a bureau of the U.S. Department of the Treasury that collects and analyzes information about financial transactions to combat domestic and international money laundering, terrorist financing and other international crimes.  Beneficial owners must report their name, date of birth, current residential or business street address, and unique identifier number from a recognized issuing jurisdiction and a photo of that document.  Company applicants can only be the individual who directly files the document that creates the entity, or the document that first registers the entity to do business in the U.S.  A company applicant may also be the individual who is primarily responsible for directing or controlling the filing of the relevant document by someone else. This last point makes it critical for professional advisors to carefully define the scope ot engagement for advisory services with clients.

Note:  If an individual files their information directly with FinCEN, they may be issued a “FinCEN Identifier” directly, which can be provided on a BOI report instead of the required information.

Filing deadlines.  Reporting companies created or registered in 2024 have 90 days from being registered with the state to file initial reports disclosing the persons that own or control the business. NPRM (RIN 1506-AB62) (Sept 28, 2023). If a business was created or registered to do business before 2024, the business has until January 1 of 2025 to file the initial report.  Businesses formed after 2024 must file within 30 days of formation.  Reports must be updated within 30 days of a change to the beneficial ownership of the business, or 30 days from when the beneficial owner becomes aware of or has reason to know of inaccurate information that was previously filed. 

Note:  FinCEN estimates about 32.6 million BOI reports will be filed in 2024, and about 14.5 million such reports will be filed annually in 2025 and beyond. The total five-year average of expected BOI update reports is almost 12.9 million.

Penalties.  The penalty for not filing is steep and can carry the possibility of imprisonment.  Specifically, noncompliance can result in escalating fines ranging from $500 per day up to $10,000 total and prison time of up to two years.     

State issues.  A state is required to notify filers upon initial formation/registration of the requirement to provide beneficial ownership information to the FinCEN.  In addition, states must provide filers with the appropriate reporting company Form.

Withdrawing an ERC Claim

Over the past year or so many fraudulent Employee Retention Credit claims have been filed. You may have heard or seen the ads from firms aggressively pushing the ability to claim the ERC.    It’s gotten so bad that the IRS stopped processing claims for the fourth quarter of 2023.  Many farming operations likely didn’t qualify for the ERC because they didn’t experience at least a 20 percent reduction in gross receipts on an aggregated basis (an eligibility requirement for the ERC) but may have submitted a claim.

Now IRS has provided a path for those that want to withdraw their claim so as not to be hit with a tax deficiency notice and penalties. IR 2023-169 (Sept. 14, 2023).

A withdrawal is possible for those that filed a claim but haven’t received notice that the claim is under audit.  Just file Form 943 and write “withdrawn” on the left-hand margin.  Make sure to sign and date the Form before sending it to the IRS. If your claim is under audit provide the Form directly to the auditor.  If you received a refund but haven’t cashed it, write “VOID and ERC WITHDRAWAL” and send it back to the IRS. 

How Much Gain on Land Can Be Excluded Under Home Sale Rule?

When you sell your principal residence, you can exclude up to $500,000 of gain on a joint return ($250,000 on a single return) if you have owned the home and used it as your principal residence for at least two out of the last five years immediately preceding the sale.  I.R.C. §121.  But how much land can be included with the sale of the home and have gain excluded within that $500,000 limitation?  The Treasury Regulations provide guidance. 

For starters, the land must be adjacent to the principal residence and be used as a part of the residence. Treas Reg. §1.121-1(b)(3).  In addition, the taxpayer must own the land in the taxpayer’s name rather than in an entity that the taxpayer has an ownership interest in (unless the entity is an “eligible entity” defined under Treas. Reg. §301.7701-3(1)).  Land that’s been used in farming within the two-year period before the sale isn’t eligible because its use in farming means it’s not been used as part of the residence. 

Note:  Sale of the principal residence and sale of the adjacent land is treated as a single sale for purposes of the gain limitation amount.  That’s true even if the sale occurs in different years but within the two-year time constraint.  Treas. Reg. §1.121-1(b)(3)(ii)(c).  Also, when computing the maximum limitation for the gain exclusion, the sale of the principal residence is excluded before any gain for the sale of the vacant land. Treas. Reg. §1.121-1(b)(3)(ii). 

For land that is eligible to be included with the residence, how much can be included?  It depends.  Land that contains a garden for home use and land that is landscaped as a yard can be included.  Also, local zoning rules might be instructive.  This all means that it’s a fact-based analysis.  There is no bright-line rule.  IRS rulings and caselaw illustrate that point. 

Written Farm Lease Expires by its Terms; No Holdover Tenancy

A recent case from Kansas illustrates how necessary it is to pay attention to the terms of a written farm lease.  Under the facts of the case, the plaintiff entered into a written farm lease with a landowner on January 10, 2018.  The purpose of the lease was the maintenance and harvesting a hay crop on the leased ground.  By its terms, the lease terminated on December 31, 2018, and contained a provision specifying that the parties could mutually agree in writing to extend the lease.  However, the parties did not extend the lease and it expired as of December 31, 2018.

In 2019, the landowner sold the farm to a third-party buyer.  After the sale, but before the buyer took possession, the plaintiff had the hay field fertilized.  During the summer of 2019, the new landowner hired the defendant to cut and bale the hay, which the defendant ultimately completed late one night. However, early the next morning the plaintiff entered the property and took some of the hay after it was harvested and baled.  The new owner called law enforcement and the plaintiff was informed not to return to the property.  But the plaintiff returned to the property and took more hay.  The plaintiff was criminally charged for multiple offenses.  Ultimately, the plaintiff received a diversion in lieu of prosecution for the charges (against the new owner’s wishes) and was required to provide restitution and perform community service.

The plaintiff claimed that he was entitled to the hay bales because he had a verbal lease and tried to tender a rent check after removing the bales.  The landowner refused to cash the check and moved cattle onto the hay ground.  The plaintiff sued for breach of contract, breach of duty of good and fair dealing, and tortious interference with a contract or business relationship.  The trial court rejected all of the claims and dismissed the case as a matter of law on the basis that the plaintiff did not have a valid lease after 2018.  The trial court denied a motion to reconsider.  On appeal, the appellate court affirmed noting that the lease had not been extended in writing and a holdover tenancy did not exist.  As for monetary damages, the new landowner recovered $27,000 from the plaintiff.  Thoele v. Lee, 2023 Kan. App. Unpub. LEXIS 381 (Kan. Ct. App. Sept. 15, 2023).

Ag Law and Tax Topics – Miscellaneous Topics

I haven’t been able to write for the blog recently given my heavy travel and speaking schedule, and other duties that I have.  But that doesn’t mean that all has been quiet on the ag law and tax front.  It hasn’t.  Today I write about several items that I have been addressing recently as I criss-cross the country talking ag law and tax.

What if TCJA Isn’t Extended?

Tax legislation that went into effect in 2018 is set to expire at the end of 2025.  For many, this could have a significant impact starting in 2026. Do you have a plan in place if the tax law changes dramatically at that time? 

If Congress allows the 2017 tax law to expire, how might it impact you?  For starters, tax rates will increase, and those currently in the 12 percent federal bracket will see a 25 percent increase in their tax rate.  Currently, the 12 percent bracket for married persons filing joints applies to taxable incomes from $22,000-$89,450.  So, for instance, a married couple with $75,000 of taxable income would see their tax bill raise from $8,560 to approximately $10,350. 

In addition, the standard deduction will be reduced (essentially cut in one-half), but personal exemptions will be restored.  Also, the child tax credit will be reduced from $2,000 per qualifying child to $1,000, refundability will be reduced and the credit will be eliminated entirely for some families.  For homeowners, the current limit on the mortgage interest deduction will be removed.

The 2017 law removed the penalty for not getting government health insurance, but that will be restored starting in 2026, as will the deduction for state and local taxes.  In addition, the lower limit on charitable deductions will be reinstated.  For businesses that aren’t corporations, the 20 percent deduction on business income will go away.   

The estate tax exemption will be essentially cut in half, (from about $14 million in 2025 to about $7 million in 2026).  For larger estates, making gifts now might make some sense. 

It might be time to start thinking about the changes that could occur starting in 2026 and putting a good plan in place to handle what could happen.  If you operate a business, think of higher taxes as an additional cost that needs to be managed.

Buying Farmland with a Growing Crop

Buying farmland with a growing crop presents unique tax issues.  It has to do with allocating the purchase price and the timing of deductions. 

When you buy farmland with a growing crop on it the tax Code requires that you allocate the purchase price between crops and land based on their relative fair market values.  You can’t deduct the cost of the portion of the land purchase allocated to the growing crop.  While the IRS has not been clear on the issue, the costs should be capitalized into the crop and deducted when the income from the crop is reported or fed to livestock, which may be in a year other than the year in which the crop is sold.

If you buy summer fallow ground, you can’t deduct or separately capitalize for later deduction the value of costs incurred before the purchase.  Additional costs incurred before harvest such as for hauling are deductible if you’re on the cash method.

One approach to consider that could lead to a better tax result might be to lease the land before the purchase.  That way you incur the planting costs and can deduct them rather than the landlord that will sell the farmland to you. 

If your considering buying farmland with a growing crop talk with your farm tax advisor so you get the best tax result possible for your particular situation.

What is Livestock?

The definition of “livestock” can come up in various settings.  For example, sometimes the tax Code says that bees are livestock for one purpose but are not for other purposes.  The issue of what is livestock can also arise in ag lending situations, ag contracts as well as zoning law and ordinances. 

What is “livestock”? The definition of “livestock” for purposes of determining whether an asset is used in a farming business includes “cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals.”  It does not include “poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, and reptiles.” While that definition normally does not include bees and other insects as livestock, the IRS has ruled that honeybees destroyed due to nearby pesticide use qualify for involuntary conversion treatment. 

When pledging livestock as collateral for an ag loan, it should be clear whether unborn young count as “livestock” subject to the security agreement.  From a contract standpoint, semen is not livestock unless defined as such. 

For zoning laws and ordinances, clarity is the key.  Is a potbellied pig “livestock” or a pet”?  Will an ordinance that bans livestock prohibit the keeping of bees in hives?  It probably won’t unless it specifically defines bees as “livestock.” 

Partition of Farmland

If your estate plan is to simply “let the children figure it out,” it’s likely instead that a judge will.  Indeed, one of those situations where a judge gets involved is when the parents have left farmland in co-equal ownership to multiple children after the last of the parents to die.  That often leads to a partition and sale with the proceeds being split among the children. 

Partition and sale of land is a legal remedy available if the co-owners cannot agree on whether to buy out one or more of them or sell the property and split the proceeds.  It’s often the result of a poorly planned estate where the surviving parent leaves the land equally to all of the children and not all of them want to farm or they simply can’t get along.  Because they each own an undivided interest in the entire property, they each have the right of partition to parcel out their interest.  But that rarely is the result because they aren’t able to establish that the tract can be split exactly equally between them in terms of soil type and slope, productivity, timber, road access, water and the like.  So, a court will order the entire property sold and the sale proceeds split equally.  That result can devastate an estate plan where the intent was to keep the farm in the family for future generations.

A little bit of estate planning can produce a much better result.

Crop Insurance Proposal

For many farmers, crop insurance is a key element of an effective risk management strategy. Private companies sell and service the policies, but taxpayers subsidize the premiums.  That means the public policy of crop insurance is a component of Farm Bill discussions.  There’s a current reform proposal on the table. 

A crop insurance reform proposal has been introduced in the U.S. House.  Its purpose is to help smaller farming operations get additional crop insurance coverage.  But its means for doing so is to eliminate premium subsidies for large farmers without providing additional coverage for smaller producers. 

The bill caps annual premium subsidies at $125,000 per farmer and eliminates them for farmers with more than $250,000 in adjusted gross income.  The bill also reduces the subsidies to crop insurance companies which is projected to reduce their profit from 14 percent to about 9 percent. 

In addition, the bill eliminates subsidies for Harvest Price Option and requires the USDA to disclose who gets subsidies and the amount.  It also restricts crop insurance to active farmers.

The bill represents a dramatic change to the crop insurance program.  There’s not really anything in the bill to help smaller farming operations, and if the bill passes all farmers would see an increase in crop insurance premiums. 

Veterinarian’s Lien

A lien gives the lienholder an enforceable right against certain property that can be used to pay a debt or obligations of the property's owner. Most states have laws that give particular persons a lien by statute in specific circumstances. These statutory liens generally have priority over prior perfected security interests.

The rationale behind statutory liens is that certain parties who have contributed inputs or services to another should have a first claim for payment.  But you have to be able to prove entitlement to the lien.

In a recent case, a veterinarian treated a rancher’s cattle.  The rancher didn’t pay the vet bill and while the bill remained outstanding, the vet came into possession of cattle that the rancher was grazing for another party.  The vet cared for the cattle for over two months and then filed a lien for his services.  Ultimately the cattle were sold at a Sheriff’s sale and the rancher’s lender claimed it had a prior lien on the proceeds.  Normally, the veterinarian’s lien would beat out the lender’s lien, but the court concluded that the veterinarian couldn’t establish who actually delivered the cattle to him or that the rancher requested his services. 

The court said the vet didn’t meet his burden of proof to establish that the lien was valid. While liens have position, their validity still must be established.

Digital Assets and Estate Planning

One often overlooked aspect of estate planning involves cataloguing where the decedent’s important documents are located and who has access to them.  The access issue is particularly important when it comes to the decedent’s digital assets such as accounts involving email, banks, credit cards and social media. 

Who has access to a decedent’s digital assets and information?  Certainly, the estate’s fiduciary should have access, but it’s the type of access that is the key.  The type of access, such as the ability to read the substance of electronic communications, should be clearly specified in the account owner’s will or trust.  If access to digital assets and information is to be granted to a third party before death, the type and extent of access should be set forth in a power of attorney. 

But, even with proper planning, it is likely that a service provider will require that the fiduciary obtain a court order before the release of any digital information or the granting of access. 

Digital assets are a very common piece of a decedent’s estate.  Make sure you have taken the needed steps to allow the proper people to have access post-death.  Doing so can save time and expense during the estate administration process.

There are also tax consequences of exchanging digital assets after death.

Conclusion

These are just a few items of things that have been on my mind recently.  I am sure more will surface soon.

KSU Tax Institutes – Kansas and Online

Overview

Dating back into the 1940’s, the Department of Agricultural Economics at Kansas State University has provided educational tax seminars for tax preparers.  I have been privileged to be a part of them since 1993.  These are outstanding seminars for all who prepare tax returns – CPAs; accountants; enrolled agents; attorneys; and all others that prepare tax returns professionally or for their own business, including farming operations.  With respect to farm returns, the last time survey data was compiled, it revealed that over 90 percent of all farm returns in Kansas were prepared by persons that attended a Kansas Tax Institute.  That’s impressive!

Dates and Locations

This year the institute will be held at six in-person locations across the state.  In addition, there will be two online institutes.  Each institute is a two-day conference.  Here are the dates and locations for each institute:

Online 1 – November 1 and 2

Garden City – November 6 and 7

Hays – November 8 and 9

Lawrence – November 20 and 21

Salina – November 27 and 28

Wichita – December 7 and 8

Pittsburg – December 13 and 14

Online 2 – December 18 and 19

Ethics

There will be a 2-hour ethics session for tax preparers on December 15.  This will be online only (as of this time). 

Speakers

Along with myself, this year’s speakers include Paul Neiffer (formerly of CliftonLarsonAllen); Prof. Ed Morse (Creighton Law School); and Cathy Murphy (formerly of IRS and now owner of Kingdom CPA Service, LLC in the St. Louis area).  Also, the Kansas Department of Revenue, represented by Carl York and Roger Basinger will make a presentation at each location.

Itinerary

The itinerary for each school as well as who is teaching each topic is as follows:

Online 1; Garden City; Hays; and Online 2

Day 1 [Roger McEowen; Paul Neiffer; and Carl York/Roger Basinger]

New Developments (Part 1)

• Employee Retention Credit
• Energy Credits; Corporate taxes; and healthcare and payroll tax provisions
• Form 1099-K issues

Ag Issues (Part 1)

• Deducting residual soil fertility
• Charitable remainder trusts
• Tax issues with easement payments
• Ag-related rulings and cases
  • Excise tax
  • Hobby losses
  • Lodging and meals
  • Conservation easements

Small Business Issues

• Planning and pitfalls of pass-through entity tax
• Corporate transparency act
• Form 7203
• Appendix – questions to consider in electing the PTE tax

 

Capitalization vs. Repair Review

• Fundamental concepts
• Capitalization vs. repair decisions
• Changing an accounting method
• Dispositions under the tangible property regulations

Select topics for Partnership Operations

• Partnership agreement
• Capital accounting
• Guaranteed payments
• Allocations
• Effect of I.R.C. §§734(b) and 743(b) adjustments
• Debt-financed acquisitions and distributions
• Partnerships and S.E. tax

Depreciation

• Applicability
• Computing basis
• Listed property limitations
• R.C. §179
• Bonus depreciation
• Depreciation system and method
• Recovery period for remaining basis
• Proper convention
• Change in business use
• Correcting errors

Retirement Plan Issues for Individuals

• Inherited retirement plans
• Secure Act 2.0
• Roth IRA update

Kansas Department of Revenue

• 2023 Legislative Changes
  • Discussion of various bills passed in the 2023 Legislative Session
• Updates to 2022 Legislation Session
  • Discussion could include updates to SALT Parity, Aerospace and Aviation Tax Credit,

and Homestead Senior and Disabled Veteran Claim (SVR)

• Changes impacting tax filings for 2023 and 2024
  • Personal Exemption for Disabled Veterans
  • Corporate Income Tax Reduction
  • Sales Tax Delivery Charges
  • Sales Tax Filing Frequency Changes
  • Research and Development Tax Credit

Rulings and Cases (Part 1)

Day 2 – [Roger McEowen and Cathy Murphy]

New Developments (Part 2)

• Changes to R&E and R&D Credit
• Retirement plan distributions
• Estate tax “clawback” and DSUEA ordering rules
• Digital asset taxation
• Expiring provisions

Ag Issues (Part 2)

• Buy-sell agreements
• Form 1041 for farm estates and trusts
• Tax treatment of R&E and R&D expenses
• Ag-related rulings and cases
  • Farming-related deductions
  • Entity tax issues
  • Real estate tax issues
  • Shareholder compensation

Individual Taxpayer Issues

• Estimated tax payments
• College cost planning
• Settling a taxpayer’s estate

Written Information Security Plans and Protecting Client Data

• Legislative mandates
• Creating a WISP
• WISP template
• Risk assessment
• Data attacks
• Involvement of outside IT services firms
• Discussion scenarios

IRS Update

• New Forms and instructions
• New 1099 filing procedures 
• Correspondence audits and secure messaging
• Timely mailed/ received dates for returns
• Statute of Limitations
• Offers in compromise

Independent Contractors

• Determining worker classification
• Tax home issues
• Gross income issues
• Treatment of equipment
• Travel expenses
• Meals and entertainment expenses
• Other expense issues
• SE tax
• State income tax issues

Ruling and Cases (Part 2)

Lawrence; Salina; Wichita; Pittsburg

Day 1 [Ed Morse and Carl York/Roger Basinger]

New Developments

• Employee Retention Credit
• Energy Credits; Corporate taxes; and healthcare and payroll tax provisions
• Form 1099-K issues
• Changes to R&E and R&D Credit
• Retirement plan distributions
• Estate tax “clawback” and DSUEA ordering rules
• Digital asset taxation
• Expiring provisions

Small Business Issues

• Planning and pitfalls of pass-through entity tax
• Corporate transparency act
• Form 7203
• Appendix – questions to consider in electing the PTE tax

 

Capitalization vs. Repair Review

• Fundamental concepts
• Capitalization vs. repair decisions
• Changing an accounting method
• Dispositions under the tangible property regulations

Select topics for Partnership Operations

• Partnership agreement
• Capital accounting
• Guaranteed payments
• Allocations
• Effect of I.R.C. §§734(b) and 743(b) adjustments
• Debt-financed acquisitions and distributions
• Partnerships and S.E. tax

Depreciation

• Applicability
• Computing basis
• Listed property limitations
• R.C. §179
• Bonus depreciation
• Depreciation system and method
• Recovery period for remaining basis
• Proper convention
• Change in business use
• Correcting errors

Retirement Plan Issues for Individuals

• Inherited retirement plans
• Secure Act 2.0
• Roth IRA update

Kansas Department of Revenue

• 2023 Legislative Changes
  • Discussion of various bills passed in the 2023 Legislative Session
• Updates to 2022 Legislation Session
  • Discussion could include updates to SALT Parity, Aerospace and Aviation Tax Credit,

and Homestead Senior and Disabled Veteran Claim (SVR)

• Changes impacting tax filings for 2023 and 2024
  • Personal Exemption for Disabled Veterans
  • Corporate Income Tax Reduction
  • Sales Tax Delivery Charges
  • Sales Tax Filing Frequency Changes
  • Research and Development Tax Credit

Rulings and Cases (Part 1)

 

Day 2 [Roger McEowen and Cathy Murphy]

IRS Topics [Supplemental Material]

Ag Issues

• Deducting residual soil fertility
• Charitable remainder trusts
• Tax issues with easement payments
• Ag-related rulings and cases
  • Excise tax
  • Hobby losses
  • Lodging and meals
  • Conservation easements
  • Farming-related deductions
  • Entity tax issues
  • Real estate tax issues
  • Shareholder compensation
• Buy-sell agreements
• Form 1041 for farm estates and trusts
• Tax treatment of R&E and R&D expenses
• Ag-related rulings and cases

Individual Taxpayer Issues

• Estimated tax payments
• College cost planning
• Settling a taxpayer’s estate

Written Information Security Plans and Protecting Client Data

• Legislative mandates
• Creating a WISP
• WISP template
• Risk assessment
• Data attacks
• Involvement of outside IT services firms
• Discussion scenarios

IRS Update

• New Forms and instructions
• New 1099 filing procedures 
• Correspondence audits and secure messaging
• Timely mailed/ received dates for returns
• Statute of Limitations
• Offers in compromise

Independent Contractors

• Determining worker classification
• Tax home issues
• Gross income issues
• Treatment of equipment
• Travel expenses
• Meals and entertainment expenses
• Other expense issues
• SE tax
• State income tax issues

 

Rulings and Cases (Part Two)

 

Registration Link

Here’s the link to find registration information about the Institutes:   https://agmanager.info/events/kansas-income-tax-institute

Conclusion

I hope to see you at one of the tax institutes.  If you can’t participate in-person, perhaps you can join online.  The institutes are top-notch instruction to get you fully prepared for the upcoming tax season.  You won’t find a better deal around for CPE/CLE on tax matters. 

Extended Livestock Replacement Period Applies in Areas of Extended Drought – IRS Updated Drought Areas

Overview

Each year, by the end of September, the IRS provides guidance on the extension of the replacement period under I.R.C. §1033(e)(2)(B) for livestock sold on account of drought, flood or other weather-related condition.  The extended replacement period allows taxpayers additional time to replace the involuntarily converted livestock with like-kind replacement animals without triggering gain on the sale.  Significant parts of the country in 2023 have experienced severe drought with many cattle being sold as a result.  That makes the tax rules surrounding distress sales of livestock critical to understand.

The IRS recently issued its 2023 guidance on the issue on the extended replacement period for drought (and other weather-related) sales of livestock.

Background

With Notice 2023-67, 2023-179, I.R.B., the IRS issued its annual Notice specifying those areas that are eligible for an extension of the replacement period for livestock that farmers and ranchers must sell because of severe weather conditions (drought, flood or other weather-related conditions).  For livestock owners in the listed areas that were anticipating that their replacement period would expire at the end of 2024 now have at least until the end of 2024 to replace the involuntarily converted livestock.

Involuntary Conversion Rules

In general.  I.R.C. §1033(e) provides that a taxpayer does not recognize gain when property is involuntarily converted and replaced with property that is similar or related in service or use.  Under I.R.C. §1033(e)(1), the sale or exchange of livestock that a taxpayer holds for draft, dairy or breeding purposes in an amount exceeding the number of livestock that the taxpayer would normally sell under the taxpayer’s usual business practice, is treated as a non-taxable involuntary conversion if the sale of the livestock is solely on account of drought, flood or other weather-related conditions. The weather-related conditions must result in the area being designated as eligible for assistance by the federal government. 

Note:   For purposes of this rule, poultry does not count as “livestock.”  Likewise, livestock raised for other purposes, such as slaughter or sport, are also not eligible for this relief.

The replacement period.  The livestock must be replaced with "like-kind" livestock. I.R.C. §1033(a)(1). Normally, the replacement period is four years from the close of the first tax year in which any part of the gain from the conversion is realized. I.R.C. §1033(e)(2)(A).  But the Treasury Secretary has discretion to extend the replacement period on a regional basis for “such additional time as the Secretary deems appropriate” (apparently without limit) if the weather-related conditions that resulted in the federal designation continue for more than three years.  I.R.C. §1033(e)(2)(B). If the IRS doesn’t extend the four-year replacement period, a taxpayer can request such an extension.  I.R.C. §1033(a)(2)(B)(ii). 

Note:  It is not clear when the three-year period begins.  It may begin on the date the area is designated as being eligible for assistance by the federal government or when the weather-related conditions begin.  IRS clarification is needed.

Note:  Any extension of the replacement period on a regional basis also extends the period in which a cash basis farmer may elect to defer gain for a year on the sale of excess livestock sold on account of weather-related conditions under I.R.C. §451(g). 

If the involuntary conversion of livestock is on account of drought and the taxpayer’s replacement period is determined under I.R.C. §1033(e)(2)(A), the extended replacement period under I.R.C. §1033(e)(2)(B) and Notice 2006-82, 2006-2 C.B. 529 is until the end of the taxpayer’s first taxable year after the first drought-free year for the applicable region.  That is defined as the first 12-month period that ends on August 31 in or after the last of the taxpayer’s four-year replacement period and does not include any weekly period for which exceptional, extreme or severe drought is reported for any location in the applicable region.  The “applicable region” is the county (and all contiguous counties) that experienced the drought conditions on account of which the livestock was sold or exchanged

Note:   If an area is designated as not having a drought-free year, the extended replacement period applies.

Thus, for a taxpayer who qualified for a four-year replacement period for livestock sold or exchanged on account of drought and whose replacement period is scheduled to expire at the end of 2022 (or, for a fiscal-year taxpayer, at the end of the first tax year that includes August 31, 2022), the replacement period extends until the end of the taxpayer’s first taxable year ending after a drought-free year for the applicable region.  In other words, eligible farmers and ranchers with a drought replacement period presently scheduled to expire on December 31, 2022, will now, in most instances, have until the end of their next tax year to replace the sold livestock (e.g., Dec. 31, 2023). 

Determining Eligible Locations

One way to determine if a taxpayer is in an area that has experienced exceptional, extreme or severe drought is to refer to the U.S. Drought Monitor maps that are produced on a weekly basis by the National Drought Mitigation Center  The U.S. Drought Monitor maps are archived at  https://droughtmonitor.unl.edu/Maps/MapArchive.aspx

Another way, of course, is to wait for the IRS to publish its list of counties, which it is required to issue by the end of September each year.

In accordance with the 2023 IRS Notice on the matter, the following is a list of the counties (and other areas) for which the 12-month period ending August 31, 2024, is not a drought-free year:

Alabama

Counties of Baldwin, Coffee, Colbert, Conecuh, Covington, Dale, Escambia, Geneva, Henry, Houston, Jackson, Lauderdale, Lawrence, Limestone, Madison, Marshall, Mobile, Monroe, Morgan, and Washington.

Arizona

Counties of Apache, Cochise, Coconino, Graham, Greenlee, La Paz, Mohave, Navajo, Pima, Santa Cruz, Yavapai, and Yuma.

Arkansas

Counties of Arkansas, Ashley, Baxter, Benton, Boone, Bradley, Calhoun, Carroll, Chicot, Clark, Clay, Cleburne, Cleveland, Columbia, Conway, Craighead, Crawford, Crittenden, Cross, Dallas, Desha, Drew, Faulkner, Franklin, Fulton, Garland, Grant, Greene, Hempstead, Hot Spring, Howard, Independence, Izard, Jackson, Jefferson, Johnson, Lafayette, Lawrence, Lee, Lincoln, Little River, Logan, Lonoke, Madison, Marion, Mississippi, Monroe, Montgomery, Nevada, Newton, Ouachita, Perry, Phillips, Pike, Poinsett, Polk, Pope, Prairie, Pulaski, Randolph, Saint Francis, Saline, Scott, Searcy, Sebastian, Sevier, Sharp, Stone, Union, Van Buren, Washington, White, Woodruff, and Yell.

California

Counties of Alameda, Alpine, Amador, Butte, Calaveras, Colusa, Contra Costa, Del Norte, El Dorado, Fresno, Glenn, Humboldt, Imperial, Inyo, Kern, Kings, Lake, Lassen, Los Angeles, Madera, Marin, Mariposa, Mendocino, Merced, Modoc, Mono, Monterey, Napa, Nevada, Orange, Placer, Plumas, Riverside, Sacramento, San Benito, San Bernardino, San Diego, San Francisco, San Joaquin, San Luis Obispo, San Mateo, Santa Barbara, Santa Clara, Santa Cruz, Shasta, Sierra, Siskiyou, Solano, Sonoma, Stanislaus, Sutter, Tehama, Trinity, Tulare, Tuolumne, Ventura, Yolo, and Yuba.

Colorado

Counties of Adams, Alamosa, Arapahoe, Baca, Bent, Cheyenne, Conejos, Costilla, Crowley, Custer, Delta, Denver, Dolores, Elbert, El Paso, Fremont, Garfield, Huerfano, Jackson, Kiowa, Kit Carson, La Plata, Larimer, Las Animas, Lincoln, Logan, Mesa, Moffat, Montezuma, Montrose, Morgan, Otero, Phillips, Prowers, Pueblo, Rio Blanco, Rio Grande, Routt, San Miguel, Sedgwick, Teller, Washington, Weld, and Yuma.

Connecticut

Counties of Fairfield, Hartford, Litchfield, Middlesex, New Haven, New London, Tolland, and Windham. Delaware County of Sussex. District of Columbia District of Columbia.

Florida

Counties of Alachua, Baker, Bay, Bradford, Brevard, Broward, Calhoun, Charlotte, Citrus, Collier, Columbia, DeSoto, Dixie, Escambia, Flagler, Franklin, Gadsden, Gilchrist, Glades, Gulf, Hamilton, Hardee, Hendry, Hernando, Highlands, Hillsborough, Holmes, Indian River, Jackson, Jefferson, Lafayette, Lake, Lee, Leon, Levy, Liberty, Madison, Manatee, Marion, Martin, Miami-Dade, Monroe, Okaloosa, Okeechobee, Orange, Osceola, Palm Beach, Pasco, Pinellas, Polk, Putnam, Saint Lucie, Santa Rosa, Sarasota, Seminole, Sumter, Suwannee, Taylor, Union, Volusia, Wakulla, Walton, and Washington.

Georgia

Counties of Baker, Baldwin, Banks, Barrow, Berrien, Bibb, Bleckley, Brooks, Butts, Cherokee, Clarke, Clayton, Clinch, Cobb, Colquitt, Cook, Crawford, Dawson, Decatur, DeKalb, Douglas, Early, Echols, Elbert, Fannin, Forsyth, Franklin, Fulton, Gilmer, Grady, Greene, Gwinnett, Habersham, Hall, Hancock, Hart, Henry, Houston, Jackson, Jasper, Jones, Lamar, Lanier, Laurens, Lincoln, Lowndes, Lumpkin, McDuffie, Madison, Miller, Mitchell, Monroe, Morgan, Murray, Newton, Oconee, Oglethorpe, Peach, Pickens, Pike, Pulaski, Putnam, Rabun, Rockdale, Seminole, Stephens, Taliaferro, Taylor, Thomas, Towns, Twiggs, Union, Upson, Walton, Warren, Washington, White, Wilkes, and Wilkinson.

Hawaii

Counties of Hawaii, Honolulu, Kalawao, Kauai, and Maui.

Idaho

Counties of Adams, Bannock, Bear Lake, Benewah, Blaine, Bonner, Bonneville, Boundary, Butte, Camas, Caribou, Cassia, Clearwater, Custer, Franklin, Fremont, Gooding, Idaho, Kootenai, Latah, Lemhi, Lewis, Lincoln, Minidoka, Nez Perce, Oneida, Owyhee, Power, Shoshone, Teton, Twin Falls, Valley, and Washington.

Illinois

Counties of Adams, Alexander, Bond, Boone, Brown, Bureau, Carroll, Cass, Champaign, Christian, Clark, Clay, Clinton, Coles, Cook, Crawford, Cumberland, DeKalb, De Witt, Douglas, DuPage, Edgar, Effingham, Fayette, Ford, Franklin, Fulton, Gallatin, Grundy, Hamilton, Hancock, Hardin, Henderson, Henry, Iroquois, Jackson, Jasper, Jefferson, Jo Daviess, Johnson, Kane, Kankakee, Kendall, Knox, Lake, La Salle, Lee, Livingston, Logan, McDonough, McHenry, McLean, Macon, Madison, Marion, Marshall, Mason, Massac, Menard, Mercer, Monroe, Morgan, Moultrie, Ogle, Peoria, Perry, Piatt, Pike, Pope, Pulaski, Putnam, Randolph, Rock Island, Saint Clair, Saline, Sangamon, Schuyler, Scott, Shelby, Stark, Stephenson, Tazewell, Union, Vermilion, Warren, Washington, Whiteside, Will, Williamson, Winnebago, and Woodford.

Indiana

Counties of Benton, Boone, Carroll, Cass, Clay, Clinton, DeKalb, Elkhart, Fayette, Fountain, Fulton, Hamilton, Hancock, Harrison, Hendricks, Henry, Howard, Jasper, Johnson, LaGrange, Lake, LaPorte, Madison, Marion, Miami, Montgomery, Morgan, Newton, Noble, Owen, Parke, Perry, Porter, Pulaski, Putnam, Randolph, Shelby, Starke, Steuben, Sullivan, Tippecanoe, Tipton, Union, Vermillion, Vigo, Warren, Wayne, and White.

Iowa

Counties of Adair, Adams, Allamakee, Appanoose, Audubon, Benton, Black Hawk, Bremer, Buchanan, Buena Vista, Butler, Calhoun, Carroll, Cass, Cedar, Cerro Gordo, Cherokee, Chickasaw, Clarke, Clay, Clayton, Clinton, Crawford, Dallas, Davis, Decatur, Delaware, Des Moines, Dickinson, Dubuque, Emmet, Fayette, Floyd, Franklin, Fremont, Greene, Grundy, Guthrie, Hamilton, Hancock, Hardin, Harrison, Henry, Howard, Humboldt, Ida, Iowa, Jackson, Jasper, Jefferson, Johnson, Jones, Keokuk, Kossuth, Lee, Linn, Louisa, Lucas, Lyon, Madison, Mahaska, Marion, Marshall, Mills, Mitchell, Monona, Monroe, Montgomery, Muscatine, O'Brien, Osceola, Page, Palo Alto, Plymouth, Pocahontas, Polk, Pottawattamie, Poweshiek, Ringgold, Sac, Scott, Shelby, Sioux, Story, Tama, Taylor, Union, Van Buren, Wapello, Warren, Washington, Wayne, Webster, Winnebago, Winneshiek, Woodbury, Worth, and Wright.

Kansas

Counties of Allen, Anderson, Atchison, Barber, Barton, Bourbon, Brown, Butler, Chase, Chautauqua, Cherokee, Cheyenne, Clark, Cloud, Coffey, Comanche, Cowley, Crawford, Decatur, Dickinson, Doniphan, Douglas, Edwards, Elk, Ellis, Ellsworth, Finney, Ford, Franklin, Geary, Gove, Graham, Grant, Gray, Greeley, Greenwood, Hamilton, Harper, Harvey, Haskell, Hodgeman, Jackson, Jefferson, Jewell, Johnson, Kearny, Kingman, Kiowa, Labette, Lane, Leavenworth, Lincoln, Linn, Logan, Lyon, McPherson, Marion, Marshall, Meade, Miami, Mitchell, Montgomery, Morris, Morton, Nemaha, Neosho, Ness, Norton, Osage, Osborne, Ottawa, Pawnee, Phillips, Pratt, Rawlins, Reno, Republic, Rice, Riley, Rooks, Rush, Russell, Saline, Scott, Sedgwick, Seward, Shawnee, Sheridan, Sherman, Smith, Stafford, Stanton, Stevens, Sumner, Thomas, Trego, Wabaunsee, Wallace, Washington, Wichita, Wilson, Woodson, and Wyandotte.

Kentucky

Counties of Adair, Allen, Anderson, Ballard, Barren, Bath, Boone, Bourbon, Boyd, Boyle, Bracken, Breckinridge, Bullitt, Butler, Caldwell, Calloway, Carlisle, Carroll, Carter, Casey, Christian, Clark, Crittenden, Daviess, Edmonson, Elliott, Estill, Fayette, Fleming, Franklin, Fulton, Gallatin, Garrard, Grant, Graves, Grayson, Green, Greenup, Hancock, Hardin, Harrison, Hart, Henry, Hickman, Hopkins, Jefferson, Jessamine, Kenton, Larue, Lawrence, Lee, Lewis, Lincoln, Livingston, Logan, Lyon, McCracken, McLean, Madison, Marion, Marshall, Mason, Meade, Menifee, Mercer, Metcalfe, Montgomery, Morgan, Muhlenberg, Nelson, Nicholas, Ohio, Oldham, Owen, Pendleton, Powell, Robertson, Rockcastle, Rowan, Scott, Shelby, Simpson, Spencer, Taylor, Todd, Trigg, Trimble, Union, Warren, Washington, Webster, Wolfe, and Woodford. Louisiana Parishes of Acadia, Allen, Ascension, Assumption, Avoyelles, Beauregard, Bienville, Bossier, Caddo, Calcasieu, Caldwell, Cameron, Catahoula, Concordia, De Soto, East Baton Rouge, East Carroll, East Feliciana, Evangeline, Franklin, Grant, Iberia, Iberville, Jackson, Jefferson, Jefferson Davis, Lafayette, Lafourche, La Salle, Livingston, Madison, Morehouse, Natchitoches, Orleans, Ouachita, Plaquemines, Pointe Coupee, Rapides, Red River, Richland, Sabine, Saint Bernard, Saint Charles, Saint Helena, Saint James, Saint John the Baptist, Saint Landry, Saint Martin, Saint Mary, Saint Tammany, Tangipahoa, Tensas, Terrebonne, Vermilion, Vernon, Washington, Webster, West Baton Rouge, West Carroll, West Feliciana, and Winn.

Maine

Counties of Androscoggin, Cumberland, Knox, Lincoln, Sagadahoc, Waldo, and York.

Maryland

City of Baltimore.

Counties of Anne Arundel, Baltimore, Carroll, Frederick, Harford, Howard, Montgomery, and Prince George's.

Massachusetts

Counties of Barnstable, Berkshire, Bristol, Dukes, Essex, Franklin, Hampden, Hampshire, Middlesex, Norfolk, Plymouth, Suffolk, and Worcester. Michigan County of Allegan, Barry, Branch, Cass, Clinton, Eaton, Genesee, Gogebic, Gratiot, Hillsdale, Ingham, Ionia, Jackson, Kent, Lake, Lapeer, Lenawee, Livingston, Macomb, Manistee, Mason, Missaukee, Monroe, Montcalm, Oakland, Ontonagon, Osceola, Saint Clair, Saint Joseph, Sanilac, Shiawassee, Washtenaw, Wayne, and Wexford.

Minnesota

Counties of Aitkin, Anoka, Becker, Beltrami, Benton, Big Stone, Blue Earth, Brown, Carlton, Carver, Cass, Chippewa, Chisago, Clay, Clearwater, Cottonwood, Crow Wing, Dakota, Dodge, Faribault, Fillmore, Freeborn, Goodhue, Grant, Hennepin, Houston, Hubbard, Isanti, Itasca, Jackson, Kanabec, Kandiyohi, Kittson, Koochiching, Lac qui Parle, Lake, Lake of the Woods, Le Sueur, Lincoln, Lyon, McLeod, Marshall, Martin, Meeker, Mille Lacs, Morrison, Mower, Murray, Nicollet, Nobles, Norman, Olmsted, Otter Tail, Pine, Pipestone, Pope, Ramsey, Redwood, Renville, Rice, Rock, Roseau, Saint Louis, Scott, Sherburne, Sibley, Stearns, Steele, Stevens, Swift, Todd, Traverse, Wabasha, Wadena, Waseca, Washington, Watonwan, Wilkin, Winona, Wright, and Yellow Medicine.

Mississippi

Counties of Adams, Amite, Bolivar, Claiborne, Coahoma, Copiah, Covington, DeSoto, Forrest, Franklin, George, Greene, Hancock, Harrison, Hinds, Holmes, Humphreys, Issaquena, Jackson, Jefferson, Jefferson Davis, Lafayette, Lamar, Lawrence, Leflore, Lincoln, Madison, Marion, Marshall, Panola, Pearl River, Perry, Pike, Pontotoc, Quitman, Rankin, Sharkey, Simpson, Smith, Stone, Sunflower, Tate, Tunica, Union, Walthall, Warren, Washington, Wilkinson, and Yazoo.

Missouri

Counties of Adair, Andrew, Atchison, Audrain, Barry, Barton, Bates, Benton, Bollinger, Boone, Buchanan, Butler, Caldwell, Callaway, Camden, Cape Girardeau, Carroll, Carter, Cass, Cedar, Chariton, Christian, Clark, Clay, Clinton, Cole, Cooper, Crawford, Dade, Dallas, Daviess, DeKalb, Dent, Douglas, Dunklin, Franklin, Gasconade, Greene, Grundy, Harrison, Henry, Hickory, Holt, Howard, Howell, Iron, Jackson, Jasper, Jefferson, Johnson, Knox, Laclede, Lafayette, Lawrence, Lewis, Lincoln, Linn, Livingston, McDonald, Macon, Madison, Maries, Marion, Mercer, Miller, Mississippi, Moniteau, Monroe, Montgomery, Morgan, New Madrid, Newton, Oregon, Osage, Ozark, Pemiscot, Perry, Pettis, Phelps, Pike, Platte, Polk, Pulaski, Putnam, Ralls, Randolph, Ray, Reynolds, Ripley, Saint Charles, Saint Clair, Sainte Genevieve, Saint Francois, Saint Louis, Saline, Schuyler, Scotland, Scott, Shannon, Shelby, Stoddard, Stone, Sullivan, Taney, Vernon, Warren, Washington, Wayne, Webster, and Wright.

Montana

Counties of Beaverhead, Blaine, Broadwater, Cascade, Chouteau, Custer, Daniels, Dawson, Deer Lodge, Fallon, Fergus, Flathead, Gallatin, Garfield, Glacier, Granite, Hill, Jefferson, Judith Basin, Lake, Lewis and Clark, Liberty, Lincoln, McCone, Madison, Meagher, Mineral, Missoula, Petroleum, Phillips, Pondera, Powell, Prairie, Ravalli, Richland, Roosevelt, Sanders, Sheridan, Silver Bow, Teton, Toole, Valley, Wheatland, and Wibaux.

Nebraska

Counties of Adams, Antelope, Arthur, Banner, Blaine, Boone, Box Butte, Boyd, Brown, Buffalo, Burt, Butler, Cass, Cedar, Chase, Cherry, Cheyenne, Clay, Colfax, Cuming, Custer, Dakota, Dawes, Dawson, Deuel, Dixon, Dodge, Douglas, Dundy, Fillmore, Franklin, Frontier, Furnas, Gage, Garden, Garfield, Gosper, Grant, Greeley, Hall, Hamilton, Harlan, Hayes, Hitchcock, Holt, Hooker, Howard, Jefferson, Johnson, Kearney, Keith, Keya Paha, Kimball, Knox, Lancaster, Lincoln, Logan, Loup, McPherson, Madison, Merrick, Morrill, Nance, Nemaha, Nuckolls, Otoe, Pawnee, Perkins, Phelps, Pierce, Platte, Polk, Red Willow, Richardson, Rock, Saline, Sarpy, Saunders, Scotts Bluff, Seward, Sheridan, Sherman, Sioux, Stanton, Thayer, Thomas, Thurston, Valley, Washington, Wayne, Webster, Wheeler, and York.

Nevada

City of Carson City.

Counties of Churchill, Clark, Douglas, Elko, Esmeralda, Eureka, Humboldt, Lander, Lincoln, Lyon, Mineral, Nye, Pershing, Storey, Washoe, and White Pine.

New Hampshire

Counties of Cheshire, Hillsborough, Merrimack, Rockingham, and Strafford.

New Jersey

Counties of Atlantic, Bergen, Cape May, Cumberland, Essex, Hudson, Hunterdon, Mercer, Middlesex, Monmouth, Morris, Passaic, Salem, Somerset, Sussex, and Union.

New Mexico

Counties of Bernalillo, Catron, Chaves, Cibola, Colfax, Curry, DeBaca, Dona Ana, Eddy, Grant, Guadalupe, Harding, Hidalgo, Lea, Lincoln, Los Alamos, Luna, McKinley, Mora, Otero, Quay, Rio Arriba, Roosevelt, Sandoval, San Juan, San Miguel, Santa Fe, Sierra, Socorro, Taos, Torrance, Union, and Valencia.

New York

Counties of Bronx, Columbia, Dutchess, Kings, Nassau, New York, Orange, Putnam, Queens, Richmond, Rockland, Suffolk, Ulster, and Westchester.

North Carolina

Counties of Cherokee, Clay, Graham, Jackson, Macon, Swain, and Transylvania.

North Dakota

Counties of Barnes, Benson, Billings, Bottineau, Bowman, Burke, Burleigh, Cass, Cavalier, Dickey, Divide, Dunn, Eddy, Emmons, Foster, Golden Valley, Griggs, Hettinger, Kidder, LaMoure, Logan, McHenry, McIntosh, McKenzie, McLean, Mountrail, Nelson, Pembina, Pierce, Ramsey, Ransom, Renville, Richland, Rolette, Sargent, Sheridan, Sioux, Slope, Stark, Steele, Stutsman, Towner, Traill, Walsh, Ward, Wells, and Williams.

Ohio

Counties of Adams, Brown, Clermont, Darke, Preble, Scioto, and Williams.

Oklahoma

Counties of Adair, Alfalfa, Atoka, Beaver, Beckham, Blaine, Bryan, Caddo, Canadian, Carter, Cherokee, Choctaw, Cimarron, Cleveland, Coal, Comanche, Cotton, Craig, Creek, Custer, Delaware, Dewey, Ellis, Garfield, Garvin, Grady, Grant, Greer, Harmon, Harper, Haskell, Hughes, Jackson, Jefferson, Johnston, Kay, Kingfisher, Kiowa, Latimer, Le Flore, Lincoln, Logan, Love, McClain, McCurtain, McIntosh, Major, Marshall, Mayes, Murray, Muskogee, Noble, Nowata, Okfuskee, Oklahoma, Okmulgee, Osage, Ottawa, Pawnee, Payne, Pittsburg, Pontotoc, Pottawatomie, Pushmataha, Roger Mills, Rogers, Seminole, Sequoyah, Stephens, Texas, Tillman, Tulsa, Wagoner, Washington, Washita, Woods, and Woodward.

Oregon

Counties of Baker, Benton, Clackamas, Clatsop, Crook, Deschutes, Douglas, Gilliam, Grant, Harney, Hood River, Jackson, Jefferson, Josephine, Klamath, Lake, Lane, Lincoln, Linn, Malheur, Marion, Morrow, Multnomah, Polk, Sherman, Tillamook, Umatilla, Union, Wallowa, Wasco, Wheeler, and Yamhill. Pennsylvania Counties of Lancaster and York.

Rhode Island

Counties of Bristol, Kent, Newport, Providence, and Washington.

South Carolina Counties of Abbeville, Anderson, Greenville, Laurens, McCormick, Oconee, Pickens, and Spartanburg.

South Dakota

Counties of Aurora, Beadle, Bennett, Bon Homme, Brookings, Brown, Brule, Buffalo, Campbell, Charles Mix, Clark, Clay, Codington, Corson, Custer, Davison, Day, Deuel, Dewey, Douglas, Edmunds, Fall River, Faulk, Grant, Gregory, Haakon, Hand, Hanson, Hutchinson, Jackson, Jerauld, Kingsbury, Lake, Lawrence, Lincoln, Lyman, McCook, McPherson, Marshall, Meade, Mellette, Miner, Minnehaha, Moody, Oglala Lakota, Pennington, Roberts, Sanborn, Spink, Stanley, Todd, Tripp, Turner, Union, Walworth, Yankton, and Ziebach.

Tennessee

Counties of Bedford, Benton, Bledsoe, Blount, Bradley, Cannon, Carroll, Chester, Coffee, Davidson, Decatur, DeKalb, Dyer, Franklin, Gibson, Giles, Grundy, Hamilton, Hardin, Henderson, Henry, Hickman, Houston, Humphreys, Lake, Lauderdale, Lawrence, Lewis, Lincoln, Loudon, McMinn, McNairy, Madison, Marion, Marshall, Meigs, Monroe, Montgomery, Moore, Obion, Perry, Polk, Rhea, Roane, Rutherford, Sequatchie, Shelby, Stewart, Sumner, Tipton, Van Buren, Warren, Wayne, Weakley, White, Williamson, and Wilson.

Texas

Counties of Anderson, Andrews, Angelina, Aransas, Archer, Armstrong, Atascosa, Austin, Bailey, Bandera, Bastrop, Baylor, Bee, Bell, Bexar, Blanco, Borden, Bosque, Bowie, Brazoria, Brazos, Brewster, Briscoe, Brooks, Brown, Burleson, Burnet, Caldwell, Calhoun, Callahan, Cameron, Carson, Castro, Chambers, Cherokee, Childress, Clay, Cochran, Coke, Coleman, Collin, Collingsworth, Colorado, Comal, Comanche, Concho, Cooke, Coryell, Cottle, Crane, Crockett, Crosby, Culberson, Dallam, Dallas, Dawson, Deaf Smith, Delta, Denton, DeWitt, Dickens, Dimmit, Donley, Duval, Eastland, Ector, Edwards, Ellis, El Paso, Erath, Falls, Fannin, Fayette, Fisher, Floyd, Foard, Fort Bend, Freestone, Frio, Gaines, Galveston, Garza, Gillespie, Glasscock, Goliad, Gonzales, Gray, Grayson, Gregg, Grimes, Guadalupe, Hale, Hall, Hamilton, Hansford, Hardeman, Hardin, Harris, Harrison, Hartley, Haskell, Hays, Hemphill, Henderson, Hidalgo, Hill, Hockley, Hood, Hopkins, Houston, Howard, Hudspeth, Hunt, Hutchinson, Irion, Jack, Jackson, Jasper, Jeff Davis, Jefferson, Jim Hogg, Jim Wells, Johnson, Jones, Karnes, Kaufman, Kendall, Kenedy, Kent, Kerr, Kimble, King, Kinney, Kleberg, Knox, Lamar, Lamb, Lampasas, La Salle, Lavaca, Lee, Leon, Liberty, Limestone, Lipscomb, Live Oak, Llano, Loving, Lubbock, Lynn, McCulloch, McLennan, McMullen, Madison, Marion, Martin, Mason, Matagorda, Maverick, Medina, Menard, Midland, Milam, Mills, Mitchell, Montague, Montgomery, Moore, Motley, Nacogdoches, Navarro, Newton, Nolan, Nueces, Ochiltree, Oldham, Orange, Palo Pinto, Panola, Parker, Parmer, Pecos, Polk, Potter, Presidio, Randall, Reagan, Real, Red River, Reeves, Refugio, Roberts, Robertson, Rockwall, Runnels, Rusk, Sabine, San Augustine, San Jacinto, San Patricio, San Saba, Schleicher, Scurry, Shackelford, Shelby, Sherman, Smith, Somervell, Starr, Stephens, Sterling, Stonewall, Sutton, Swisher, Tarrant, Taylor, Terrell, Terry, Throckmorton, Tom Green, Travis, Trinity, Tyler, Upton, Uvalde, Val Verde, Van Zandt, Victoria, Walker, Waller, Ward, Washington, Webb, Wharton, Wheeler, Wichita, Wilbarger, Willacy, Williamson, Wilson, Winkler, Wise, Yoakum, Young, Zapata, and Zavala.

Utah

Counties of Beaver, Box Elder, Cache, Carbon, Daggett, Davis, Duchesne, Emery, Garfield, Grand, Iron, Juab, Kane, Millard, Morgan, Piute, Rich, Salt Lake, San Juan, Sanpete, Sevier, Summit, Tooele, Uintah, Utah, Wasatch, Washington, Wayne, and Weber.

Vermont

County of Windham.

Virginia City of Falls Church.

Counties of Accomack, Clarke, Fairfax, Fauquier, Frederick, Loudoun, Northampton, Rappahannock, Shenandoah, and Warren.

Washington

Counties of Asotin, Benton, Chelan, Clallam, Columbia, Cowlitz, Franklin, Garfield, Grays Harbor, Jefferson, King, Kitsap, Kittitas, Lewis, Mason, Okanogan, Pacific, Pend Oreille, Pierce, San Juan, Skagit, Skamania, Snohomish, Stevens, Thurston, Wahkiakum, Walla Walla, Whatcom, Whitman, and Yakima. West Virginia County of Jefferson.

Wisconsin

Counties of Adams, Ashland, Barron, Bayfield, Brown, Buffalo, Burnett, Calumet, Chippewa, Clark, Columbia, Crawford, Dane, Dodge, Douglas, Dunn, Fond du Lac, Forest, Grant, Green, Green Lake, Iowa, Iron, Jackson, Jefferson, Juneau, Kenosha, La Crosse, Lafayette, Langlade, Lincoln, Manitowoc, Marathon, Marquette, Milwaukee, Monroe, Oneida, Outagamie, Ozaukee, Pepin, Pierce, Polk, Portage, Price, Racine, Richland, Rock, Rusk, Saint Croix, Sauk, Sawyer, Sheboygan, Taylor, Vernon, Vilas, Walworth, Washburn, Washington, Waukesha, Waupaca, Waushara, Winnebago, and Wood.

Wyoming

Counties of Albany, Campbell, Carbon, Converse, Fremont, Goshen, Laramie, Lincoln, Niobrara, Park, Platte, Sublette, Sweetwater, Teton, Uinta, and Weston.

Federated States of Micronesia

State of Kapingamarangi.

Republic of the Marshall Islands

Atoll of Wotje.

Commonwealth of Puerto Rico

Municipalities of Aibonito, Arecibo, Barranquitas, Camuy, Cayey, Cidra, Coamo, Guayama, Hatillo, Isabela, Lares, Orocovis, Quebradillas, Salinas, San Sebastian, Utuado, and Villalba.

United States Virgin Islands

Islands of Saint Croix, Saint John, and Saint Thomas.

Hunting Use Agreements and Recreational Entrants – Legal Issues

Overview

A farm or ranch is a business much like any other.  Every day people may come to a farm to buy, sell, visit, hunt, fish, or to do any number of activities.  With respect to people coming on a farm or ranch to hunt, some do it by oral permission, but other landowners may take the step executing a written agreement to avoid misunderstandings and minimize future legal issues.  So, what are the elements of a good hunting use agreement? 

Building a solid hunting use agreement – it’s the topic of today’s post.

The Property Interest Involved

All wildlife, whether animal, fish, or fowl not privately owned belongs to the state.  See, e.g., Kan. Stat. Ann. §32-107.  But this does not allow hunters or fishermen to enter land at will and take what belongs to the state.  Outdoorsmen have no right to enter another person’s land to hunt or fish without first getting permission.  Doing so could subject the person to either a civil action for trespass; prosecution under a criminal trespass statute; or prosecution under an unlawful hunting statute. 

Note:  In Kansas (and most other states), licensed hunters are allowed to pursue wounded game upon the land of others without permission in order to capture the game.  But such persons must leave the premises upon the landowner’s request.  In these situations, the best approach for the landowner is to call the Sheriff and never personally try to force the trespasser off the land with threats of physical violence or at gunpoint. 

Engaging in a hunting activity on someone else’s property involves the property law concept of that of a license.  A license is a term that covers a wide range of permissive land uses which, unless permitted, would be trespasses.  Thus, a hunter who is on the premises with permission is a licensee.  The license can be terminated at any time by the person who created the license (the landowner) by denying permission to hunt.  A license is only a privilege. It is not an interest in the land itself and can be granted orally. 

As for a farm tenancy, without a specification in a written lease, the tenant has the right to hunt the leased ground.  The hunting rights follow the possession of the ground.  Thus, the landlord does not have a right to hunt the leased premises during the term of the lease unless the lease is in writing and the landlord reserves the right in the written lease.

Elements of a Hunting Use Agreement

When permission to hunt is obtained in writing, what makes for a good agreement?

Legal description and map.  It is essential to include a description of the property that the “hunting operator” may hunt.  Provide the number of acres and give a general description of the property, and then provide a precise legal description attached as an “Exhibit” to the agreement.  Also, it is generally a good idea to provide a map showing any areas where hunting is not allowed and attach the map as an Exhibit to the agreement. 

Hunting rights.  The agreement should clearly specify the rights of the hunting operator.  Because the agreement is a hunting use agreement, the document should clearly state that the “hunting operator” has the right to use the property solely for the purpose of hunting wild game that is specifically described in the agreement.  That specific game should not only be listed, but bag limits, species, sex, size and antler/horn limitations should be noted as appropriate. 

The agreement should also clearly specify whether the hunting operator’s right to use the property for hunting game are exclusive or non-exclusive.  If the hunting operator is granted an exclusive hunting right, the landowner is not entitled to use the property for game hunting purposes during the term of the agreement.  If the hunting operator’s right is non-exclusive, the landowner (and/or any designees) is entitled to use the property for game hunting purposes.  With non-exclusive rights, it may be desirable to denote any limitations to the landowner’s retained hunting rights. 

On the hunting rights issue, it is usually desirable on the landowner’s part to include a clause in the agreement specifying that the landowner and the landowner’s family, agents, employees, guests and assigns retain the right to use and control the property for all purposes.  Those purposes should be listed, with the common “including but not limited to” language.  Such uses as livestock grazing; growing crops and orchards; mineral exploration; drilling and mining; irrigation, timber harvesting; granting of easements and similar rights to third parties; fishing; horseback riding; hiking; and other recreational activities, etc., may want to be listed.

Specification of the beginning and ending date of the hunting operator’s right to use the property should be included.  It is suggested to denote that the property may be used for game hunting purposes limited to legal hunting seasons and hours tied to the particular wild game at issue.  The agreement should not extend the hunting operator’s rights beyond the applicable hunting season(s). 

Consideration.  What is a “fair” rate to charge for the granting of hunting rights?  The answer to that question will depend upon rates charged for similar properties and game in the area. That could be difficult to determine, but data might be available for comparison.  Check your state’s land grant university Extension Service for any information that might be available.  County Extension agents may be a good place to start.  

The agreement should describe how payment is to me made and when it is due.  In addition, give thought to including clause language noting that the landowner might have lien rights under state law and state whether a security deposit is required and/or security agreement is or has been executed to secure payment. 

Think through whether and to what extent (if any) payment is required if the property (or a part thereof) becomes unavailable to hunting because of unanticipated events such as flood; fire; government taking or condemnation; drilling, mining or logging operations, etc.  Is payment to be adjusted?  If so, how? 

Improvements.  Is the hunting operator to be given the right to construct improvements on the property?  If so, the right needs to be detailed.  Is the landowner obligated to construct any improvements?  For larger hunting operations the landowner commonly constructs certain improvements such as new roads; fences; gates; hunting camps; wildlife crops and feeding facilities; water facilities; blinds; tree stands, and similar structures.  List a completion date for constructed improvements.  Also, give thought to including a provision in the agreement for the cleaning, repair and maintenance of improvements.  Which party does what, and which party pays? 

Prohibited uses.   Clearly state what uses on the property are not allowed.  Are campfires allowed?  What about the use of dogs?  What about camping overnight on the property?  Are pack animals to be used?  If so, specify that the animals must be in compliance with any applicable branding or other identification requirements.  If pack animals are allowed, that might mean that corrals will be needed and feeding requirements will have to be met.  Also, with respect to pack animals, make sure the document requires that the hunting operator complies with inspection, inoculation, vaccine and health requirements.  The landowner should be provided with reports and certificates, etc. 

The driving of vehicles should be restricted to particular areas and if gates are to be driven through, include a provision requiring the hunting operator to be responsible for leaving the gates in the condition found (locked, unlocked, etc.). 

Insurance coverage.  An important aspect of any fee-based activity on the premises is insurance.  The agreement should specify whether which party (or both) is to maintain liability insurance coverage and in what amount.  Make sure the insurance covers any improvements on the property.  Also, for landowners, don’t rely on coverage under an existing comprehensive liability policy for the farm or ranch.  That policy likely has an exclusion for non-farm (or ranch) business pursuits of the insured. Being compensated for hunting on the property would likely fall within the exclusion. 

Miscellaneous.  There may be numerous miscellaneous provisions that might apply. These can include provisions for the landowner’s warranty of ownership; whether the agreement is to be recorded; and the maintenance of trade association memberships and licenses and permits. 

Liability Issues

Numerous states have enacted agritourism legislation designed to limit landowner liability to those persons engaging in an “agritourism activity.”  Typically, such legislation protects the landowner (commonly defined as a “person who is engaged in the business of farming or ranching and provides one or more agritourism activities, whether or not for compensation”) from liability for injuries to participants or spectators associated with the inherent risks of a covered activity.  The statutes tend to be written very broadly and can apply to such things as corn mazes, hayrides and even hunting and fishing activities.

Recognizing the potential liability of owners and occupiers of real estate for injuries that occur to others using their land under the common law rules, the Council of State Governments in 1965 proposed the adoption of a Model Act to limit an owner or occupier's liability for injury occurring on the owner's property. The Council noted that if private owners were willing to make their land available to the general public without charge, every reasonable encouragement should be given to them. The stated purpose of the Model Act was to encourage owners to make land and water areas available to the public for recreational purposes by limiting their liability toward persons who enter the property for such purposes. Liability protection was extended to holders of a fee ownership interest, tenants, lessees, occupants, and persons in control of the premises.  Land which receives the benefit of the act include roads, waters, water courses, private ways and buildings, structures and machinery or equipment when attached to the realty. Recreational activities within the purview of the act include hunting, fishing, swimming, boating, camping, picnicking, hiking, pleasure driving, nature study, water skiing, water sports, and viewing or enjoying historical, archeological, scenic or scientific sites.  Most states have enacted some version of the 1965 Model legislation.

Note:  The point is to check state law with respect to both agritourism statutes and recreational use statues.  Generally, they will provide liability protections to the landowner for hunting activities on the premises if the landowner does not act willfully or wantonly (with reckless disregard to the safety of the hunting operator).  State laws vary on the protection of the statutes if a fee is charged.  Also, it is a good idea to check with an insurance agent to see if coverage is extended if you charge a fee for hunting.  The statutes don’t remove the possibility of a suit being brought and the landowner being required to defend.  Instead, a recreational use statute is typically used as an affirmative defense. 

Conclusion

Allowing hunting activities to be engaged in on farming or ranching property can provide an additional source of income.  But it’s important to enter into properly drafted written agreements with hunters (and others on the premises for recreational purposes) and ensure that appropriate insurance coverage applies. 

Of Accounting Methods, Farmland Leases and Farm Program Benefits

Overview

An accounting method is the manner in which a taxpayer reports income and deducts business-related expenses.  Under the cash method, income is reported in the year it is received, and expenses are deducted in the year they are paid.  I.R.C. §461(a).  Conversely, taxpayers on the accrual method keep a closing and opening inventory and take into account income when it is earned (when it accrues) rather than when sold, and expenses when incurred rather than when paid.  For accrual basis taxpayers, income is reported when it shows up in the closing inventory.  Accrual basis taxpayers may have a more even income stream, but there are some very significant tax negatives associated with accrual accounting such as its relative complexity as compared with cash accounting. 

Note:  Farm taxpayers that utilize cash accounting taxpayers practically always hold inventory that has not been reported as income.   At death, the potential gain is eliminated as property takes on a new basis at death equal to fair market value (except for items categorized as “income in respect of decedent”).  Consequently, it is usually advantageous for a farmer or rancher to use the cash method of accounting. 

Farming businesses, in general, can use the cash method of accounting, and most do.  A taxpayer generally may adopt any permissible method. Treas. Reg. Sec. 1.446-1(e)(1). 

But, certain rules apply when a taxpayer changes from one method of accounting to another.  Those rules came up in a case involving an Arkansas farming corporation involving the corporation’s tax treatment of income and deductions associated with its leasing of farmland.

Change in accounting method rules – it’s the topic of today’s post.

Computation of Taxable Income

A taxpayer computes taxable income “under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.”  I.R.C. §446(a).  By definition, an accounting method consists of both the overall plan of accounting for gross income or deductions and the treatment of any material item used in that overall plan.  Treas. Reg. Sec. 1.446-1(e)(2)(ii).  Once an accounting method has been adopted, the general rule is that it cannot be changed without IRS consent.  I.R.C. §446(e).  A change in the treatment of an asset from non-depreciable or nonamortizable to depreciable or amortizable, or vice versa, is a change in the taxpayer’s method of accounting.  Treas. Reg. §1.446-1(e)(2)(ii)(d)(2).  In addition, such a change in treatment results in an adjustment under I.R.C. §481to prevent the duplication or omission of income or deductions and to reflect the cumulative difference between the old and new methods.  Treas. Reg. §446-1(e)(2)(ii)(d)(5)(ii). 

Note:  A change in the method of accounting does not include a change in treatment resulting from a change in the underlying facts.  Treas. Reg. §1.446-1(e)(2)(ii)(b). 

Accounting Methods and Farming

Many farmers participate in the federal government’s farm programs and receive farm program payments.  The amount of payments a farm is eligible to receive is tied to the farm “base acres.” In other words, base acres is farmland that establishes a “base” for the right to receive farm subsidies for the production of certain commodities.  Base acres are a farm’s crop specific acreage of wheat, feed grains, rice, oilseeds, pulse crops, or peanuts that are eligible to be used for Farm Service Agency (FSA) program purposes.  Base acres do not necessarily align with current plantings.  For instance, upland cotton base acres on the farm are renamed “generic” base acres.   

Note:  A farmer’s base acreage is reduced by the portion of cropland placed in the Conservation Reserve Program (CRP) but is increased by CRP base acreage leaving the CRP.

Government allotments or quotas.  Historically, farmers have been required to participate in acreage allotments.  An acreage allotment is a particular farm’s share, based on its historic production, of the national acreage needed to produce sufficient supplies of a particular crop.  In essence, an allotment represents the federal government’s attempt to micro-manage production of certain types of crops.  These allotments have been held to not be depreciable due to a lack of a determinable useful life.  For example, in Wenzel v. Comr., T.C. Memo. 1991-166, the Tax Court addressed the peanut base acreage allotment as part of the federal farm programs was depreciable.  The Tax Court noted that while the program had been controversial for some time, it continued to be reauthorized by subsequent farm bills.  Thus, the Tax Court determined that the peanut program was a stable program that would continue unless the Congress took action to terminate it.  Because the actions of Congress were completely unpredictable, the Tax Court held that the peanut program base acreage allotment was indeterminant and the associated cost to the taxpayer was not depreciable. 

Later, in C.C.A. 200429001 (Jul. 16, 2004), the IRS noted that three additional Farm Bills had become law since the Tax Court’s ruling in Wenzel and the peanut program continued.  That lead the IRS to conclude that the duration of the peanut program could not be determined with reasonable certainty or accuracy.  Consequently, the IRS determined, the peanut base acreage allotment did not have a determinable useful life and could not be depreciated.   But a transferable right to receive a premium price for a fixed quantity of milk in accordance with a regional milk marketing order has been held to be amortizable (e.g., the cost could be spread over the useful life – 15 years) when it has a statutory expiration date and is not expected to be renewed.  For example, in Van de Steeg v. Comr., 60 T.C. 17 (1973), aff’d., 510 F2d 961 (9th Cir. 1975), the taxpayers were dairy farmers who marketed their milk production subject to a Federal Milk Marketing Order.  On several occasions they purchased an intangible asset (referred to as a "class I milk base") which they used in their dairy business. They claimed depreciation for the milk base and IRS disallowed the deduction on the basis that the asset had an indeterminable useful life – it depended on the will of the Congress whether to extend the program.  The Tax Court (affirmed by the Ninth Circuit) held that the program that created the class I milk base always contained an express termination date and the existence of two extensions did not change the fact that a termination date always existed, even though the date had changed. 

Note:  While the IRS disagrees with the Van de Steeg opinion, it did announce that it would follow it.  Rev. Rul. 75-466, 1975-2 C.B. 74.

Changing Tax Treatment of “Base” Acres

Conmac Investments, Inc. v. Comr., T.C. Memo. 2023-40

In this case, the petitioner was a corporation that owned and leased farmland to tenant farmers under oral leases.  The petitioner did not personally farm any of the land, but was a mere investor.  The petitioner's line of business involved  the retail sale of new and used automobiles.  The farmland contained “base acres” –such as wheat, corn, soybeans, cotton, rice, etc., from the USDA.  The farm program payments (paid pursuant to the 2008 and 2014 Farm Bills) were paid to the tenants.  Under the oral leases, the tenants received all of the payments attributable to the base acres and the annual rent payment was generally 25 percent of the gross income from the farmland, with “gross income from the farmland” including any farm subsidy payments received on account of the base acres. 

Before 2009, the petitioner did not claim any deductions for amortization or depreciation of the base acres.  But, starting in 2009, the petitioner began claiming an amortization or depreciation deduction for base acres acquired and placed in service in 2004 through 2013 (i.e., asserting an ownership interest in an intangible asset).  Changing the treatment of an asset from non-depreciable to depreciable or non-amortizable to amortizable (or vice-versa) is a change of accounting that results in an I.R.C. §481 adjustment.

Note:  Why the petitioner decided to claim deductions against, essentially, cash rent, is not known.  It was the tenants that were assuming the risk of production under the leases, not the petitioner.  In essence, the petitioners started claiming deductions against guaranteed rental income without assuming any of the risk of the expenses under the leases. 

However, the petitioner did not attach Form 3115 (application for change in accounting method) to its Form 1120 (corporate tax return) or otherwise seek IRS consent to change its accounting method.  The petitioner also did not file amended returns with an explanatory statement for all open years reclassifying the base acres as amortizable under I.R.C. §197.  The petitioner also did not adopt the same accounting treatment for all bases acres that it owned. 

The IRS determined that the petitioner had adopted an impermissible method of accounting and asserted deficiencies of approximately $116,000 for 2013 and $114,000 for 2014, and that an I.R.C. §481 adjustment of $141,614 for 2009-2012 was required.  The petitioner claimed that it had not changed its accounting method because of a change in underlying facts impacting its business.  In addition, the petitioner claimed that even if there weren’t a change in the underlying facts that supported an accounting method change, the lack of IRS consent didn’t matter because the relevant tax years had closed.  The petitioner also claimed that an I.R.C. §481 adjustment wasn’t necessary because it should have been made for the “year of change” (e.g., 2009) and that IRS could no longer require the adjustment because 2009 was a closed tax year.

The Tax Court (opinion by Judge Paris) agreed with the IRS noting that the petitioner had changed an accounting method in violation of I.R.C. §446(e) which requires IRS consent for such a change, and that an I.R.C. §481 adjustment was proper.  The facts did not involve the application of an existing accounting method to a change in business practices.  Indeed, there was no change in business practices - the petitioner continued to serve as landlord to the tenant farmers and didn’t change the terms of the leases.  Instead, the only economic consequence was the tax benefit that the petitioner received on account of the change – there was no change in existing legal or economic relationships. In addition, the petitioner continued to treat base acres acquired and placed in service in other years as nonamortizable or non-depreciable.  The Tax Court determined that the petitioner has simply made a business decision in 2009 to start claiming amortization deductions on farmland what it had acquired and placed in service beginning in 2004.  The corporation, the Tax Court pointed out, failed to identify the facts that had changed that caused it to change its tax treatment of the rented farmland.

Note:  Judge Paris brought up on her own the case of Comr. v. Brookshire Bros. Holding, Inc., 320 F.3d 507 (5th Cir. 2003), aff’g., T.C. Memo. 2001-150.  In that case, the appellate court, affirming the Tax Court, held that an IRS challenge to a method change for which consent was not given must be for the year of the improper change, and that failure to obtain prior consent did not serve as a basis to challenge the change for a closed year.  Judge Paris distinguished Brookshire on the basis that the corporation in the present case did not file amended returns with an explanatory statement for all open years reclassifying the base acres. In addition, based on the corporation’s inconsistent treatment of the base acres depending on the year the farmland was placed in service, the Tax Court determined that finding an unauthorized change in accounting would promote consistency and wouldn’t offend basic fairness.

The Tax Court also sustained the I.R.C. §481 adjustment.  The Tax Court rejected the petitioner’s argument that the I.R.C. §481 adjustment was barred by the statute of limitations after finding that the “year of the change” was the oldest open tax year.  The Tax Court explained that the only limitation on an I.R.C. §481(a) adjustment is that no pre-1954 adjustments may be made.  So long as a change in an accounting method has occurred, the IRS may adjust a taxpayer’s income in an open year to reflect amounts attributable to years for which the applicable statute of limitations has expired (i.e., time-barred years).  Huffman v. Comr., 518 F.3d 357 (6th Cir. 2008), aff’g., 126 T.C. 322 (2006). 

Conclusion

The bottom line in Conmac was that the petitioner’s failure to get IRS permission under I.R.C. §446(e) prevented the corporation from implementing an accounting method change with respect to the base acres rented to tenants for tax years 2009-2014.  As a result, the petitioner had tax deficiencies to pay and had to include in income for 2013 a positive I.R.C. §481 adjustment for I.R.C. §197 amortization deductions claimed for the base acres for 2009-2012. 

Not understanding the tax nuances of agricultural leases and the tax treatment of ag-related intangibles, as well as the procedures for changing accounting methods ending up costing the petitioner a large sum in tax deficiencies (about $100,000) an I.R.C. §481 adjustment of about $141,000 plus attorney fees. 

Developments in Ag Law and Ag Tax

Overview

In recent weeks, a number of important and interesting developments have occurred in the realm of agricultural law and taxation.  The subjects include various tax issues; oil and gas; state taxation issues; IRS information; and farm program payments.

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

Revised Form I-9

Form I-9 is an important document for ag employers hiring workers.  It verifies the identity and employment authorization of farm employees and protects the employer from penalties associated with improper hires.  A new version of the Form became available on August 1 and it’s this version that must be used starting November 1.   

All U.S. employers must ensure proper completion of Form I-9 for each individual hired, and whether the employment involves citizens or noncitizens. While agriculture is often treated differently under the law in many situations, that’s not the case when it comes to Form I-9.  There is no exception based on size of the farming operation or for family owned farming businesses.

The Form applies to employment situations.  It doesn’t apply when a farmer hires custom work or work to be done as an independent contractor.

A revised version of Form I-9 became available on August 1.  The Form has been condensed in some instances and it clarifies the difference between “noncitizen national” and “noncitizen authorized to work.”  Also, the revised Form can be filled out on tablets and mobile devices, and a checkbox has been added for employers to indicate when they have remotely examined Form I-9 documents.  Certain other revisions have been made and the Instructions for the Form have also been updated. 

Both employees and employers must complete the Form within three days of the hire.  Employers must retain the Form and make it available for inspection. 

You can access the new version here:  https://www.uscis.gov/sites/default/files/document/forms/i-9.pdf  The government’s summary of the revised Form is here:  https://www.uscis.gov/sites/default/files/document/fact-sheets/FormI9SummaryofChangesFactSheet.pdf

Florida Foreign Ownership Law in Effect – Injunction Denied

Ownership of U.S. land, specifically agricultural lands, by foreign persons or entities has been an issue that traces to the origins of the United States. Today, approximately fourteen states specifically forbid or limit nonresident aliens, foreign businesses and corporations, and foreign governments from acquiring or owning an interest in agricultural land within their state. Although these states have instituted restrictions, each state has taken its own approach. In other words, a uniform approach to restricting foreign ownership has not been established because state laws vary widely.

Currently, the following states restrict (in one fashion or another) foreign ownership of agricultural land.  about one-half of the states restrict agricultural land acquisition by aliens.  AL, AR, FL, HI, ID, IN, IA, KS, KY, LA, MN, MS, MO, MT, NE, ND, OH, OK, PA, SC, SD, TN, UT, VA, WI,   

The states with the most restrictive laws are IA, KY, MN, MO, NE, ND, OK, SD and WI.  The other 16 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, Arizona, Arkansas, California, Florida, Indiana, Iowa, Mississippi, Missouri, Montana, North Dakota, Oklahoma, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, Washington, and Wyoming. Each of these states have proposed, or planned 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 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 Florida provision limits landownership rights of certain noncitizens that are domiciled either in China or other countries that are a “foreign country of concern.”  Fla. Stat. §§692.201-.204.   The countries considered as a FCOC under the law include China; Russia; Iran; North Korea; Cuba; Venezuela’s Nicolás Maduro regime; and Syria. Four Chinese citizens living in Florida, along with a real estate brokerage firm, claimed that the law violated their equal protection rights because it restricts their ability to purchase real property due to their race. They also claimed that the law violated the Due Process Clause and the Supremacy Clause of the Constitution and the Fair Housing Act (FHA). Under the law, Chinese investors that are not U.S. citizens that hold or acquire and interest in real property in Florida on or after July 1, 2023, must report their interests to the state or be potentially fined $1,000 per day the report is late.  Chinese acquisitions after July 1, 2023, are subject to forfeiture to the state with such acquisitions constituting a third-degree felony.  The seller commits a first-degree misdemeanor for knowingly violating the law.

The plaintiffs sought an injunction against the implementation of the law before it went into effect on July 1, 2023.  However, the law went into effect on July 1, with the litigation pending.

On August 17, the court denied the plaintiffs’ motion for an injunction.   Shen v. Simpson, No. 4:23-cv-208-AW-HAF, 2023 U.S. Dist. LEXIS 152425 (N.D. Fla. Aug. 17, 2023).  The court determined that the Florida provision classified persons by alienage (status of an alien) rather than by race because it barred landownership by persons who are not lawful, permanent residents and who are domiciled in a “country of concern” while exempting noncitizens domiciled in countries that were not “countries of concern.”  Thus, the restriction was not race-based (it applied equally to anyone domiciled in China, for example, regardless of race) and was not subject to strict scrutiny analysis which would have required the State of Florida to prove that the law advanced a compelling state interest narrowly tailored to achieve that compelling interest.  Strict scrutiny, the court noted only applies to laws affecting lawful permanent aliens, and the Florida provision exempts nonresidents who are lawfully permitted to reside in the U.S.  Thus, the law was to be reviewed under the “rational basis” test.  See, e.g., Terrace v. Thompson, 263 U.S. 197 (1923).

The court held that the State of Florida did have a rational basis for enacting the ownership restrictions – public safety and to “insulate [the state’s] food supply and…make sure that foreign influences…will not pose a threat to it.”  This satisfied the rational basis test for purposes of the plaintiffs’ equal protection challenge and the FHA challenge (because the law didn’t discriminate based on race) and also meant that the court would not enjoin the law because the plaintiffs’ challenge on this basis was unlikely to succeed. 

The Florida law, the court concluded, also defined “critical military infrastructure” and “military installation” in detail which gave the plaintiffs sufficient notice that they couldn’t own ag land or acquire an interest in ag land within 10 miles of a military installation or “critical infrastructure facility,” or within five miles of a “military installation” by an individual Chinese investor.  Thus, the court determined that the plaintiffs’ due process claim would fail. 

The plaintiffs also made a Supremacy Clause challenge claiming that federal law trumped the Florida law because the Florida law conflicted with the manner in which land purchases were regulated at the federal level.  They claimed that federal law established a procedure to review certain foreign investments and acquisitions for purposes of determining a threat to national security.  The court disagreed, noting the “history of state regulation” of alien ownership” and that the Congress would have preempted state foreign ownership laws conflicted with the federal review procedure. 

USDA Payments Nontaxable?

Partisan legislation has been introduced into the U.S. House (no bill number yet) that would make numerous farm program benefits nontaxable.  Identical legislation was introduced into the Senate in late 2022.  The law, known as The Family Farmer and Rancher Tax Fairness Act of 2023, would make payments to “distressed” borrowers tax-free, as well as certain payments to “underserved” farmers in high poverty areas and payments to farmers that have allegedly been discriminated against by the USDA. Specifically, the payments covered by the bill are defined as any payment described in section 1066(e) of the American Rescue Plan Act of 2021 (as amended by section 22007 of Public Law 117–169) or section 22006 of Public Law 117–169.  It should be noted that none of the USDA program payments that the bill makes nontaxable are associated with the virus.  While the bill could end up being included in the Farm Bill (which will likely not be passed this year).  However, the bill makes little tax or economic sense (it would create perverse economic incentives) and will likely face stiff opposition. 

Conclusion

These are just a few recent developments in the world of ag law and tax.  More will be forthcoming in another post.

EPA Finalizes Amendments to WOTUS Rule

Overview

On August 29, the Environmental Protection Agency (EPA) issued a final amendment to its “Waters of the United States (WOTUS) rule that became final earlier this year.  The amendment was necessary because the EPA had issued its final rule before the U.S. Supreme Court released its opinion in a case where the definition of a wetland under the Clean Water Act was at issue.  With the amendment, the EPA purports to conform the regulatory definition to fit the Supreme Court’s opinion in the Sackett case. 

Note:  For further discussion of the Sackett opinion, click here:  https://lawprofessors.typepad.com/agriculturallaw/2023/05/victory-for-property-rights-scotus-narrows-federal-control-of-land-use.html

Background

On December 30, 2022, the EPA and the U.S. Army Corps of Engineers (COE) announced the final "Revised Definition of 'Waters of the United States'" rule which became effective on March 20, 2023. 88 Fed. Reg. 3004 (Jan. 18, 2023).  It represents a “change of mind” of the agencies from the positions that they held concerning a WOTUS and wetlands from just over three years ago.  The bottom line is that the new interpretation was extremely unfriendly to agriculture, particularly to farmland owners in the prairie pothole region of the upper Midwest.    

As promised, the Final Rule uses a definition that was in place before 2015 (for purposes of the Clean Water Act) for traditional navigable waters, territorial seas, interstate waters, and upstream water resources that “significantly” affect those waters.

Note:  Two joint memos were published with the final rule to set forth the delineation of the implementation of roles and responsibilities between the agencies.  One is a joint coordination memo to “ensure accuracy and consistency of jurisdictional determinations under the final rule.”  The other is a memo with the USDA to provide “clarity on the agencies’ programs under the Clean Water act and the Food Security Act (Swampbuster).”

Adjacency.  With the Final Rule, the EPA attempted to restore the “significant nexus” test via “adjacency.”  This is a big change in the definition of “adjacency.”  It doesn’t mean simply “abutting.”  Instead, “adjacent” includes a “significant nexus” and a “significant nexus” can be established by “shallow hydrologic subsurface connections” to the “waters of the United States.  A “shallow subsurface connection,” the Final Rule states, may be found below the ordinary root zone (below 12 inches), where other wetland delineation factors may not be present.  Frankly, that means farm field drain tile.      

Specifically, the Final Rule set forth two kinds of adjacency: 1) the traditional “relatively permanent” standard; and 2) the “significant nexus” standard.  The EPA and the COE say the agencies will not assume that all wetlands in a specific geographic area are similarly situated and can be assessed together on a watershed basis in a significant nexus analysis.  But it is clear from the Final Rule that the agencies intend to expand jurisdiction over isolated prairie pothole wetlands using the “significant nexus” standard. 

Note:  The “significant nexus” can be established via a connection to downstream waters by surface water, shallow subsurface water, and groundwater flows and through biological and chemical connections.  The Final Rule states that adjacency can be supported by a “pipe, non-jurisdictional ditch… or some other factors that connects the wetland directly to the jurisdictional water.”  This appears to be the basis for overturning the NWPR.  Consequently, the prairie pothole region is directly in the “bullseye” of the Final Rule.

Prior converted cropland.  The agencies say the final rule increases “clarity” on which waters are not jurisdictional – including prior converted cropland.  This doesn’t make much sense.  Supposedly, the agencies are “clarifying” that prior converted cropland, (which is not a water), is not a water, but it somehow could be a water if the agencies had not clarified it?  In addition, the burden is placed on the landowner to prove that prior converted cropland is actually prior converted cropland and therefore not a water.

Ditches and drainage devices.  The Final Rule is vague enough to give the government regulatory authority over non-navigable ponds, ditches, and potholes.

The Sackett Opinion - Implications for Agriculture 

The Sackett opinion has significant ramifications for agriculture.  It solidified the Trump Administration’s National Water Protection Rule (NWPR) of 2019 as the correct approach to defining a federally jurisdiction wetland under the Clean Water Act.  The NWPR limited federal jurisdiction to traditional navigable waters and their tributaries.  Under the NWPR and the Sackett opinion, streams and ditches and private waters that don’t have a continuous surface connection to navigable waters aren’t subject to the CWA.  This will make it more difficult for the EPA or COE to assert regulatory control over private land under the CWA – as the Congress intended.  It also eliminates federal control under the CWA over private ponds, as well as ditches and streams where there is no continuous flow into a WOTUS. 

Also, farmers that are in the farm programs are subject to the Swampbuster rules.  A “wetland” is defined differently under Swampbuster.  There are two separate definitions.  The one at issue in Sackett involves "waters of the United States" contained in 33 U.S.C. Sec. 1362(7) which a "navigable water" must be.  To have jurisdiction over those waters the Court is saying that the government must 1) establish that an adjacent water body is a relatively permanent body of water connected to interstate navigable water; and 2) such area has a continuous surface connection with that water making it difficult to determine where the water ends, and the wetland begins.  

Swampbuster involves the definition of a wetland contained in 16 U.S.C. 3801(27).  So, there are two different definitions of a "wetland" - one for CWA purposes - which ties into the "navigable waters of the United States" definition, and the other one for Swampbuster.  This all means that a farmers may not have a wetland that the EPA/COE can regulate under the CWA, but might have a wetland that can’t be farmed without losing farm program benefits. 

The Court’s decision will not likely have any discernable effect on water quality.  While the decision does set forth a narrower interpretation of “the waters of the United States” for purposes of the entire CWA, the matter of pollution control is a separate matter.  As noted above, navigation and pollution control are two separate issues which the Court’s opinion more clearly distinguishes.  This is due, in part, to the Supreme Court’s decision in a case from Hawaii in 2020.  In that case, the Court held that a “pollutant” that reaches navigable waters after traveling through groundwater requires a federal permit if the discharge into the navigable water is the “functional equivalent’ of a direct discharge from the actual point source into navigable waters.  Hawai’i Wildlife Fund, et al. v. County of Maui, 886 F.3d 737 (2018), vac’d and rem’d. by County of Maui v. Hawaii Wildlife Fund, et al., 140 S. Ct. 1462 (2020).  That is a broad interpretation of “discharge of pollutants” creating the distinct possibility that a contamination of federal jurisdictional waters could result from activities on land that is not subject to the CWA under the Sackett Court’s definition of a “wetland.” 

In addition, the Court’s decision in Sackett applies only to the federal CWA.  It has no application to existing state and local regulations.  Indeed, many of those rules were already in place before the CWA amendments of 1972, and many of them are significant. 

EPA Amendments

On August 29, the EPA and the COE issued a finalized amendment to the existing WOTUS rule that had been issued March of 2023 in light of the Supreme Court’s decision in Sackett v. United States EPA. The amendments modify the definition of “waters of the United States” contained at 33 C.F.R. §328.3. Key points of the amendment are as follows:

• The amendment is effective immediately upon issuance.
• The amendment was finalized without issuing a draft for public comment under the “good cause” exception to the notice-and-comment requirement of the Administrative Procedure Act because EPA believed that a rule update was “sufficiently urgent.” 5 U.S.C. 553(d)(3).
• Purports to remove the “significant nexus” test that allowed streams and wetlands adjacent to larger water bodies to be jurisdictional under the CWA. The U.S. Supreme Court, in Sackett v. EPA unanimously rejected the significant nexus test.
• Purports to limit federal jurisdiction over wetlands to those that are relatively permanent and have a continuous surface connection to navigable waterways.
  • Wetlands which would share a surface water connection with a WOTUS but no longer have that connection due to manmade barriers such as levies, dikes or sand dunes are not included in the definition of a WOTUS

Many questions are left unaddressed, particularly “nuts-and-bolt” issues about the particular definition of “ditches” and other farm features that are filled with water only sometimes (ephemeral streams, etc.)

Currently, 27 states have enjoined the final rule from taking effect.   See Texas v. United States Environmental Protection Agency, No. 3:23-cv-17, 2023 U.S. Dist. LEXIS 45797 (S.D. Tex. March 19, 2023); West Virginia v. United States Environmental Protection Agency, No. 3:23-cv-032, 2023 U.S. Dist. LEXIS 64372 (D.N.D. April 12, 2023).   Kentucky v. United States Environmental Protection Agency, Nos. 23-5343/5345, 2023 U.S. App. LEXIS 11517 (6th Cir. May 10, 2023). 

Note:  The states where the rule is enjoined are:  AK; AL; AR; FL; GA; IA; ID; IN; KS; KY; LA; MO; MS; MT; ND; NE; NH; OK; OH; SC; SD; TN; TX; VA; VT; WV and WY.

These outstanding cases regarding the 2023 rule are currently paused with their future uncertain.   

Conclusion

Will the litigation concerning the definition of a WOTUS end?  Unlikely.  But, to have the Supreme Court unanimously decide any part of a major environmental case, which is what happened in Sackett with respect to the rejection of the significant nexus test and that the Sackett’s tract was not a wetland, is rare.

Kansas Court of Appeals Decides Major Hog Nuisance Case

Overview

A recent opinion by the Kansas Court of Appeals provides a thorough explanation of property rights with respect to road ditch rights-of-way, as well as the common law of trespass and nuisance in addition to the Kansas Right-to-Farm law.  The case involved what is perhaps the most egregious ag nuisance case that has ever gone to an appellate-level court in Kansas.  The case is Ross et al. v. Nelson, et al., No. 125,274, 2023 Kan. App. LEXIS 32 (Kan. Ct. App. Aug. 25, 2023).

Of trespass, nuisance and right-to-farm laws – it’s the topic of today’s post.

Background Facts

The defendant (Nelson) owns multiple farming operations and installed about 2 miles of pipeline in the road ditch right-of-way next to a public road to transport liquified hog waste to spread on his crop fields.  He installed the three underground pipes (two to carry water to his hog operation and one to carry the effluent) without the consent of the adjacent landowners (the plaintiffs).  He also did not follow the applicable county permitting process.  The defendant’s daughter-in-law later filled-out a permit application and paid the fee for installing the pipes but neither the county clerk nor Road and Bridge Supervisor ever signed the permit application.  The defendant also created an impression with the County Commissioners that he had the permission of the landowners adjacent to the roadway where he was wanting to install pipes.  The County Attorney advised the Commissioners that the adjacent landowners had to consent before the application could be approved.  But the fact remained that the Commission never granted approval to install the pipes and the County Attorney called the Sheriff who temporarily stopped the installation process.  However, the defendant later completed the installation. The Sheriff also contacted the Kansas Department of Health and Environment (KDHE), but the KDHE explained that it does not oversee piping installation between hog operations and disposal sites.  The KDHE regulates the disposal of hog waste.

Note:  The defendant consistently maintained that he didn’t need permission to install the pipes in the road ditch right-of-way.  He also lobbied the county commissioners and the state legislature for express authority to lay the pipelines.  His lobbying efforts were not successful. 

Once installed, the pipes ran for a mile along each of the plaintiffs’ road frontages.  The liquified hog manure was sprayed from a pivot irrigation system (and end gun) near a home of one of the plaintiffs.  The plaintiffs, also farmers, sued for trespass and nuisance. 

The spray from the pivot came within 200 feet of one of the plaintiffs’ homes.  As noted, neither of the plaintiffs gave permission to the defendant to lay pipes in the road right-of-way, and the defendant choose not to dispose of the hog waste on other land that he owned where no one lived nearby. 

In the Spring of 2019, the waste was pumped through the pipelines and effluent was sprayed on the field.  The plaintiffs filed a report with the Sheriff concerning the odor.  The report noted that hog waste mist would drift onto the plaintiffs’ property and sprayed one of the plaintiffs personally as well as their home which then became covered in flies.  The wife of one of the plaintiff couples moved to their Nebraska home.   One of the plaintiffs had planned to sell their farmland to one of their tenants, but the sale fell through because of the odor.

Trial Court

The plaintiffs sued for trespass and nuisance.  The trial court ruled for the plaintiffs on both issues.  On the trespass issue, the trial court noted that the defendant did not have a public purpose for installing pipes in the road right-of-way and he didn’t have permission – either from the landowners, the county or the legislature.   

The trial court also ruled for the plaintiffs on the nuisance issue.  The Kansas Right-to-Farm law didn’t apply to authorize the defendant’s conduct because the nuisance was the result of the defendant’s trespass. 

The trial court also added a claim for punitive damages. 

The jury returned a verdict of $126,720 in property damages for the plaintiffs, plus $2,000 in nuisance damages plus $50,000 of punitive damages. 

The defendant appealed.

Appellate Court

The appellate court affirmed and in doing so made some important points relevant to all farming operations.

Use of road ditch right-of-way.  The appellate court pointed out that a road ditch right-of-way cannot be used for private purposes without first securing the adjacent landowners’ permission or otherwise receiving local or legislative authority.  The right-of-way is owned by the adjacent property owners.  The public has an easement to use the roadway for travel, that’s it.  Shawnee County Commissioners v. Beckwith, 10 Kan. 603 (1873).  The ownership of the land and “everything connected with the land over which the road is laid out” does not pass to the public but remains with the owner of the underlying (and adjacent) land.  Id.  While the defendant lobbied the legislature for a change in the law on this point, the bill died in committee.  Thus, the defendant’s laying of the pipes in the road ditch right-of-way was a trespass. 

The appellate court specifically noted that “fee owners of real property containing a public roadway have a possessory right to use, control, and exclude others from the land, as long as they do not interfere with the public’s use of the road.  In contrast, the public has an easement over the property to use the road for transportation purposes…but not other rights beyond those purposes.  Any further use by member of the public may be authorized through state action, provided the landowner is compensated for the diminished property rights, or through the landowner’s consent.”  The scope of the public’s easement in a road ditch right-of-way, the court noted, must be for a public purpose.  Any private use must be merely incidental to the public purpose.  Stauber v. City of Elwood, 3 Kan. App. 2d 341, 594 P.2d 1115, rev. den. 226 Kan. 793 (1979). 

Because the defendant was using the road ditch right-of-way solely for his private purposes, he had no right to lay the pipelines without permission or official government authority.  He had neither.  The appellate court pointed out that it was immaterial that the pipelines didn’t interfere with public travel.  The appellate court also rejected as absurd and with no support in Kansas law the defendant’s argument that supplying pork for ultimate public consumption constituted a public purpose.  Consequently, the appellate court upheld the trial court’s determination that the defendant had committed a trespass.

Nuisance and right-to-farm.  The appellate court also upheld the trial court’s consideration of the nuisance claim and the resulting jury award for the plaintiffs on the nuisance claim.  The general legal principle underlying the doctrine of nuisance is that property must be used in such a manner that it does not injure that of others.  See, e.g., Wilburn v. Boeing Airplane Co., 188 Kan. 722, 366 P.2d 246 (1961).  However, there is a limitation placed on nuisance laws.  Many states, including Kansas, have adopted what are know as a “right-to-farm” law.  Such a law limits the extent to which a farm operation may be considered to be a nuisance.  Under the Kansas right-to-farm law, if a farming operation is conducted according to good agricultural practices and was established before surrounding nonfarming activities, the courts must presume that there is no nuisance.  Kan. Stat. Ann. §2-3202(a).  An activity is a good agricultural practice if it “is undertaken in conformity with federal, state, and local laws and rules and regulations.”  Kan. Stat. Ann. §2-3202(b). 

The defendant claimed that the Kansas right-to-farm law protected his fertilization practices from nuisance claims and that there was no evidence submitted at trial to support the jury’s finding that spraying the effluent as fertilizer was a nuisance. 

The appellate court noted that neither party raised on appeal whether the defendant’s activity predated the plaintiffs’ residing nearby.  Thus, the appellate court presumed that the right-to-farm law could apply to protect the defendant’s activity.  The appellate court also did not address the fact that the plaintiffs were also farmers.  It has been held in a district court case in Kansas that the Kansas right-to-farm provisions do not apply to disputes between farmers, since the law is designed to protect farmers only from nuisance claims brought by nonfarmers. 

The defendant’s basic argument was that his manure spreading activity was protected by the right-to-farm law because he was in compliance with all federal and state and local laws rules and regulations.  This was in spite of him already found to have committed a trespass which allowed him to engage in the activity that gave rise to the nuisance claim.  The defendant (and amici) tried to finesse this hurdle by asserting that the common law of trespass was not part of state law.  The appellate court concluded that this was another of the defendant’s absurd arguments and rejected it.  The appellate court determined that the nuisance was the result of a trespass (a violation of state law) and was not protected. 

Punitive damages.  The appellate court also upheld the trial court’s assessment of punitive damages against the defendant.  While an award of punitive damages is a relatively rare occurrence, it will be assessed where the court determines that the evidence warrants it based on the defendant’s particularly bad conduct.  Here, the appellate court determined that witness testimony was persuasive – the wife of one of the plaintiff couples hadn’t stayed at the home for a year; the plaintiffs couldn’t host guests at their home because of the hog odor; a plaintiff’s house was covered with the effluent mist and coated with flies; there was a lingering stench both outside and inside a plaintiff’s home; spray drifted onto one of the plaintiffs; and after the lawsuit was filed, the defendant sprayed twice as much fertilizer as he had the prior year.  The defendant also piled truckloads of manure across from one of the plaintiffs’ homes for several days straight.  The appellate court concluded that this was clearly “willful” and “reprehensible” conduct that warranted imposing punitive damages. 

The defendant claimed that the punitive damage award should be set aside due to “instructional error.”  He claimed that the jury verdict form was unclear as to whether the punitive damages were for trespass or for nuisance.  But his attorney failed to object to the verdict form and the appellate court determined that the form was not clearly erroneous. 

Conclusion

The appellate court’s opinion is thorough and well thought-out.  It is a “win” for property rights in upholding an adjacent owner’s rights in road ditch rights-of-way and noting that the protections of the right-to-farm law is limited to situations where the farming operation accused of committing a nuisance is in compliance with state law – all of it, including state common law. 

The appellate court began its opinion by stating that the case arose “at the intersection of property rights, public roadways and the Kansas Right to Farm Act.”  Unfortunately, the path that led to that intersection was lined with arrogance, greed and a lust for power.