FARM AND RANCH INCOME TAX/ESTATE AND BUSINESS PLANNING WASHBURN UNIVERSITY SCHOOL OF LAW KSU AGRICULTURAL ECONOMICS PICPA JUNE 7, 2018
SHIPPENSBURG, PENNSYLVANIA Roger A. McEowen Kansas Farm Bureau Professor of Agricultural Law and Taxation Washburn University School of Law
[email protected] Paul G. Neiffer Principal, CliftonLarsonAllen, LLP
[email protected]
washburnlaw.edu/waltr
The Washburn Agricultural Law and Tax Report (WALTR) is authored by Roger A. McEowen, the Kansas Farm Bureau Professor of Agricultural Law and Taxation at Washburn University School of Law. WALTR focuses on legal and tax issues that agricultural producers, agricultural businesses, and rural landowners face. Some issues are encountered on a daily basis; others may arise on a more cyclical basis. Many issues illustrate how the legal and tax systems in the United States uniquely treat agriculture and the singular relationship between the farm family and the farm firm. In addition, there are basic legal principles that have wide application throughout the entire economy, and those principles are evident in the annotations, articles, and media resources.
WALTR is also designed to be a research tool for practitioners with agricultural-related clients. Many technical issues are addressed and practitioners can also find seminars to attend where the concepts discussed are more fully explored. In addition, media resources address agricultural law and taxation in action as it applies to current events impacting the sector.
Annotations
The Washburn Agricultural Law and Tax Report covers annotations of court cases, IRS developments, and other technical rulings involving agricultural law and taxation. The annotations are broken down by topic area and are the most significant recent developments from the courts, regulatory agencies, and the IRS so you can stay on the cutting edge of all things legal and tax in agriculture. Each annotation is a concise summary of the particular development with just enough technical information for practitioners to use for additional research purposes.
Articles
http://washburnlaw.edu/practicalexperience/agriculturallaw/ waltr/articles/index.html
Roger on the Air
Professor McEowen regularly appears on radio and television programs heard nationally and on the internet. He is regularly featured on: • RFD TV (and Sirius Satellite Radio) • WIBW Radio’s “Kansas Ag Issues Podcast” (Ag-Issues) • WHO-TV’s “Agribusiness Report” (AgBus-Report)
For students and those involved in agriculture either as producers of commodities, consumers, or in the agricultural industry, WALTR helps you gain an ability to identify agricultural legal problems and become acquainted with the basic legal framework surrounding agricultural issues and the tax concepts peculiar to agriculture. It will become evident that agricultural law and taxation is a very dynamic field that has wide application to everyday situations.
Continuing Education
Upcoming events include: • Agricultural Taxation Workshop 5/10/2018: Tony’s Pizza Events Center (Salina, Kansas) • Rules and Developments in Agriculture Taxation 5/14/2018: Live Webinar • Tax Law Update (In-person or Live Webinar) 5/18/2018: Iowa State Bar Association, (Des Moines, Iowa) • Summer 2018 - Farm Tax and Farm Business Education 6/7-6/8/2018 (Pennsylvania) • Agribusiness Symposium 2018 8/15/2018: Kansas Farm Bureau (Manhattan, Kansas)
Textbook/Casebook
Principles of Agricultural Law, by Roger A. McEowen, is an 850-page cutting-edge textbook on agricultural law and taxation. Now in its 40th release, the book blends the features of a casebook and a law treatise, with cases chosen that illustrate the concepts discussed in the text to provide a real-life relevance to the reader.
McEowen’s latest book, Agricultural Law in a Nutshell, was published by West Publishing Company in 2017.
@washburnwaltr
@washburnwaltr
You Tube
Ag Law & Tax Blog http://lawprofessors.typepad.com/agriculturallaw/ (signup for email alert)
TABLE OF CONTENTS Recent Developments in Agricultural Taxation............................................................................................1 Farm Income Averaging............................................................................................................................60 Financial Distress and Tax-Related Issues (Including the Handling of Farm Losses)...................................72 Income Tax Deferral Opportunities............................................................................................................94 Self-Employment Tax Primer - Structuring Leases and Entities.................................................................107 Repair/Capitalization Regulations - An Update and Review......................................................................126
Roger A. McEowen Kansas Farm Bureau Professor of Agricultural Law and Taxation Washburn University School of Law
[email protected] www.washburnlaw.edu/waltr @WashburnWaltr Paul G. Neiffer Principal, CliftonLarsonAllen, LLP
[email protected] farmcpatoday.com
FARM AND RANCH INCOME TAX PLANNING – SHIPPENSBURG, PA (DAY 1 – JUNE 7, 2018)
RECENT DEVELOPMENTS IN AGRICULTURAL TAXATION [Note: The materials for this first section have been prepared by staff at the University of Illinois Tax School, and are in draft form. The final version of this material will be included in the 2018 University of Illinois Tax Workbook that the speakers will teach from at tax schools this fall in various states.]
TAX CUTS AND JOBS ACT: INDIVIDUAL TAXPAYER PROVISIONS1 On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA). The TCJA changes individual income tax rates and lowers the top individual rate from 39.6% to 37%. It eliminates many individual deductions and credits while increasing others. The most significant changes include eliminating personal exemptions while increasing the standard deduction. The TCJA also doubles the exemption amount for the estate and gift tax. Most of the changes to the taxation of individuals are temporary and are effective for tax years beginning after December 31, 2017, and expire after December 31, 2025.2 The following material summarizes the most significant provisions in the TCJA that affect individual taxpayers.
TAXES AND RETURNS Income Tax Rates Old Law. Seven income tax rates apply to individual taxpayers. These rates are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. New Law. The 2018 tax rates are shown in the following tables. Single Taxpayers Income Range
Tax Rate
$0 to $9,525
10%
Over $9,525 but not over $38,700
12%
Over $38,700 but not over $82,500
22%
Over $82,500 but not over $157,500
24%
1
Joint Explanatory Statement of the Committee of Conference. [http://docs.house.gov/billsthisweek/20171218/Joint%20Explanatory%20Statement.pdf] Accessed on Jan. 4, 2018; The 2017 Tax Revision (P.L. 115-97): Comparison to 2017 Tax Law. Sherlock, Molly F. and Marples, Donald J. Feb. 6, 2018. Congressional Research Service. [https://fas.org/sgp/crs/misc/R45092.pdf] Accessed on Feb. 14, 2018. 2
Joint Committee on Taxation, Macroeconomic Analysis of the Conference Agreement for H.R. 1, the “Tax Cuts and Jobs Act” (JCX-69-17), Dec. 22, 2017.
1
Over $157,500 but not over $200,000
32%
Over $200,000 but not over $500,000
35%
Over $500,000
37%
Heads of Household Income Range
Tax Rate
$0 to $13,600
10%
Over $13,600 but not over $51,800
12%
Over $51,800 but not over $82,500
22%
Over $82,500 but not over $157,500
24%
Over $157,500 but not over $200,000
32%
Over $200,000 but not over $500,000
35%
Over $500,000
37%
Married Filing Joint Returns and Surviving Spouses Income Range
Tax Rate
$0 to $19,050
10%
Over $19,050 but not over $77,400
12%
Over $77,400 but not over $165,000
22%
Over $165,000 but not over $315,000
24%
Over $315,000 but not over $400,000
32%
Over $400,000 but not over $600,000
35%
Over $600,000
37%
2
Married Filing Separate Returns Income Range
Tax Rate
$0 to $9,525
10%
Over $9,525 but not over $38,700
12%
Over $38,700 but not over $82,500
22%
Over $82,500 but not over $157,500
24%
Over $157,500 but not over $200,000
32%
Over $200,000 but not over $300,000
35%
Over $300,000
37%
The rate structure shown in these tables does not apply to tax years beginning after December 31, 2025. In addition, the 3.8% tax on net investment income remains in effect.
Capital Gains Rates Old Law. Capital gains and qualified dividends are taxed at the following rates for individual taxpayers. Taxpayer’s Regular Income Tax Rate
Capital Gain Rate
10% or 15%
0%
25%, 28%, 33%, or 35%
15%
39.6%
20%
New Law. The tax rates on net capital gains and qualified dividends are generally unchanged. The breakpoints between the 0% and 15% capital gains rates are based on the same amounts as the breakpoints in effect before passage of the TCJA. These breakpoints have been indexed for inflation. The 0%, 15%, and 20% capital gains rates apply to taxpayers with taxable income in the ranges shown in the following table.3 Filing Status
3
0%
15%
20%
Married filing jointly (MFJ) or surviving spouse
$0 – $77,200
$77,201 – $479,000
Over $479,000
Head of household (HoH)
0 – 51,700
51,701 – 452,400
Over 452,400
IRC §1(j)(5)(B).
3
Married filing separately (MFS)
0 – 38,600
38,601 – 239,500
Over 239,500
All other individuals
0 – 38,600
38,601 – 425,800
Over 425,800
0 – 2,600
2,601 – 12,700
Over 12,700
Estates and trusts
Alternative Minimum Tax Old Law. An alternative minimum tax (AMT) is imposed on individual taxpayers in an amount by which the tentative minimum tax exceeds the regular income tax for the tax year. Individuals are allowed to exempt a certain amount of income from AMT. For tax years beginning in 2017, the AMT exemption amounts are:
$84,500 for MFJ taxpayers and surviving spouses,
$54,300 for single taxpayers and heads of household, and
$42,250 for MFS taxpayers.
For tax years beginning in 2017, the exemption amounts are phased out by 25% of the amount by which the individual’s alternative minimum taxable income (AMTI) exceeds:
$160,900 for MFJ taxpayers and surviving spouses,
$120,700 for single taxpayers and heads of household, and
$80,450 for MFS taxpayers.
A taxpayer’s AMTI is calculated by increasing the taxpayer’s taxable income by certain preference items and is further modified by AMT adjustments. These adjustments include, but are not limited to, the following.
Miscellaneous itemized deductions are not allowed.
Itemized deductions for state and local taxes are not allowed.
The standard deduction and the deduction for personal exemptions are not allowed.
New Law. For years beginning after December 31, 2017, and beginning before January 1, 2026, the TCJA increases the AMT exemption to:
$109,400 for MFJ taxpayers and surviving spouses,
$70,300 for single taxpayers and heads of household, and
$54,700 for MFS taxpayers.
The income phaseout thresholds for the AMT exemption are increased to:
$1 million for MFJ taxpayers and surviving spouses, and
$500,000 for all other taxpayers.
4
The AMT exemption and income phaseout amounts are indexed for inflation. As discussed later, miscellaneous itemized deductions subject to the 2% floor are not allowed for regular tax purposes for tax years 2018 through 2025. Therefore, no further adjustment for such expenses is needed for purposes of calculating AMT. Note. For 2018, the exemption amount for trusts and estates is $24,600, and the phaseout threshold is $500,000.4
Note. The corporate AMT is completely repealed for tax years beginning after December 31, 2017.
Kiddie Tax Old Law. A “kiddie tax” is imposed on the net unearned income of certain children. The kiddie tax applies if: 5
The child is either under age 18 by the end of the tax year, is under age 19 and does not provide more than half of their own support with their earned income, or is a full-time student under age 24 and does not provide more than half of their own support with their earned income;
Either of the child’s parents is alive at the end of the tax year;
The child’s unearned income exceeds $2,100 (for 2017); and
The child does not file a joint return.
Under the kiddie tax rules, the child’s net unearned income (unearned income over $2,100 for 2017) is taxed at the parents’ tax rates if the parents’ tax rates are higher than that of the child. The rest of a child’s taxable income is taxed at the child’s rates. New Law. The TCJA simplifies the kiddie tax by applying ordinary and capital gains rates applicable to trusts and estates to the net unearned income of a child. Taxable income attributable to net unearned income is taxed under the brackets that apply to trusts and estates, and earned income is taxed at rates and brackets that apply to unmarried taxpayers. Therefore, the child’s tax is unaffected by the tax of the child’s parent or the unearned income of the child’s siblings. This provision applies to tax years beginning after December 31, 2017, but does not apply to tax years beginning after December 31, 2025.
Inflation Adjustment Old Law. Many provisions in the Code are adjusted for inflation. Most of the adjustments are based on annual changes in the level of the consumer price index for all urban consumers (CPI-U). The CPI-U measures prices paid by typical urban consumers on a broad range of products. The individual income tax provisions that are adjusted for inflation include the following.
4 5
Regular income tax brackets
Rev. Proc. 2018-18, 2018-10 IRB 392. IRC §1(g).
5
Basic standard deduction
Additional standard deduction for the aged and the blind
Personal exemption amount
Thresholds for the limitation on itemized deductions and the personal exemption phaseout
The phase-in and phase-out thresholds of the earned income credit
Individual retirement arrangement (IRA) contribution limits and deductible amounts
Saver’s credit
New Law. The TCJA requires the use of the chained consumer price index for all urban consumers (C-CPI-U) to adjust tax provisions that were previously indexed by the CPI-U. The C-CPI-U differs from the CPI-U in that it accounts for the ability of individuals to alter their consumption patterns in response to relative price changes. The C-CPI-U does this by providing for consumer substitution between item categories in the market basket of consumer goods and services that make up the index. In contrast, the CPI-U only allows for modest substitution within categories. For example, pork and beef are two separate item categories. If the price of price of beef remains stable while the price of pork increases, consumers may buy more beef and less pork. In this situation, the C-CPIU would rise, but at a lower rate than an index based on fixed purchase patterns.6 The switch to the C-CPI-U takes effect for tax years beginning after December 31, 2017. This provision is permanent. Note. According to the Congressional Budget Office, the C-CPI-U results in lower estimates of inflation than the CPI-U does.7 One of the effects of this provision is that taxpayers will pay more taxes than they would without the change. The Joint Committee on Taxation estimates that tax revenues for the 2018–2027 fiscal years will increase by approximately $134 billion because of this change in indexing.8
Repeal of ACA Individual Mandate Old Law. The Affordable Care Act (ACA) mandates that individuals be covered by health insurance that provides minimum essential coverage (MEC). Individuals who do not have MEC are subject to a tax (also referred to as a penalty). This tax is imposed for any month that an individual does not have MEC unless they qualify for an exemption. New Law. Effective January 1, 2019, the tax imposed on individuals who do not maintain health insurance that provides at least MEC is reduced to zero.
6
Frequently Asked Questions about the Chained Consumer Price Index for All Urban Consumers. Jun. 29, 2016. Bureau of Labor Statistics. [www.bls.gov/cpi/additional-resources/chained-cpi-questions-and-answers.htm] Accessed on Mar. 5, 2018. 7 Differences Between the Traditional CPI and the Chained CPI. McClelland, Rob. Apr. 19, 2013. Congressional Budget Office. [www.cbo.gov/publication/44088] Accessed on Dec. 19, 2017. 8Joint Committee on Taxation, Estimated Revenue Effects of the “Tax Cuts and Jobs Act” As ordered Reported by the Committee on Finance on November 16, 2017. JCX-59-17 (Nov. 17, 2017); The Hutchins Center Explains: The Chained CPI. Ng, Michael and Wessel, David. Dec. 7, 2017. Brookings Institution. [www.brookings.edu/blog/up-front/2017/12/07/the-hutchins-center-explains-the-chainedcpi/] Accessed on Dec. 19, 2017.
6
No other ACA provisions were affected by the TCJA. Therefore, applicable large employers who fail to offer MEC to their employees may still be subject to shared responsibility payments under IRC §4980H. In addition, individual taxpayers who do not have MEC are not eligible for the premium tax credit.
Head of Household Preparer Due Diligence Requirement Old Law. Tax return preparers must comply with due diligence requirements when they prepare returns claiming any of the following credits to ensure that their clients who claim these credits are eligible.9
Earned income credit
Child tax credit
Additional child tax credit
American opportunity credit
Tax return preparers who are paid to prepare a claim for any of these credits must complete Form 8867, Paid Preparer’s Due Diligence Checklist. The tax preparer must submit this form with every electronic or paper return or claim for refund for any of these credits. Tax return preparers who fail to comply with due diligence requirements are subject to a penalty of $500 for each such failure. The penalty amount is adjusted annually for inflation. New Law. Effective for tax years beginning after December 31, 2017, tax return preparers are required to exercise due diligence in determining eligibility for head of household filing status. Preparers failing to comply with this requirement are subject to a penalty of $500 for each such failure. This amount is adjusted annually for inflation. 10
INCOME AND EXCLUSIONS Alimony Old Law. Alimony payments and separate maintenance payments are deductible by the payor spouse11 and must be included in the income of the recipient spouse.12 New Law. The TCJA permanently repeals the deduction for alimony and separate maintenance payments by the payor spouse and the inclusion in income by the recipient spouse for the following situations.
Divorce or separation instruments executed after December 31, 2018
Pre-January 1, 2019 agreements modified after December 31, 2018, if the modification expressly provides that the repeal applies
9
Refundable Credit Due Diligence Law. IRS. [www.eitc.irs.gov/tax-preparer-toolkit/preparer-due-diligence/due-diligence-law/eitc-duediligence-law-and-regulation] Accessed on Mar. 6, 2018. 10 IRC §6695(g). 11 IRC §§62(a)(10) and 215. 12 IRC §61(a)(8).
7
Recharacterization of IRA Contributions Old Law. Individuals can make contributions to two types of IRAs: traditional IRAs,13 to which both deductible and nondeductible contributions can be made;14 and Roth IRAs, to which only nondeductible contributions can be made.15 The principal difference between traditional IRAs and Roth IRAs concerns when the contribution is taxed. Under previous law, contributions could be recharacterized from one type of IRA to another before the due date for the individual’s income tax return for that year. This allowed a taxpayer to elect to treat a contribution made to one type of IRA as being made to the other type of IRA. Taxpayers could convert and reconvert between the two types of IRAs to reduce their tax liability. Example 1. In January 2017, Alicia established a traditional IRA. In March 2017, on the advice of her brother, she converted the traditional IRA to a Roth IRA. In April 2017, her tax accountant informed her that a traditional IRA would allow her to reduce her tax liability, so she reconverted the Roth to a traditional IRA. New Law. When an individual makes a contribution to a traditional IRA and later converts the traditional IRA to a Roth IRA, the TCJA precludes unwinding the conversion through a recharacterization. This provision is effective for tax years beginning after December 31, 2017. Example 2. Use the same facts as , except Alicia establishes the traditional IRA in January 2018 and converts it to a Roth IRA in March 2018. She cannot reconvert the Roth to a traditional IRA. Recharacterization is still permitted for other contributions. For example, an individual can make a contribution to a Roth IRA and recharacterize it as a contribution to a traditional IRA before the due date for the individual’s tax return for that year.
Rollover of Plan Loans Old Law. Qualified retirement plans, IRC §403(b) plans, and governmental §457(b) plans may provide loans to employees. A plan may provide that an employee’s obligation to repay a loan can be accelerated in certain circumstances, such as the termination of employment. If the loan is not repaid in accordance with the terms of the loan, the loan is canceled and the amount in the employee’s account balance is offset by the unpaid loan balance (referred to as the loan offset). A loan offset is treated as a distribution from the plan equal to the unpaid loan balance. The distribution is includable in the employee’s gross income and may be subject to the 10% additional tax on early distributions under IRC §72(t). To prevent a loan offset from resulting in a taxable distribution, the loan offset amount may be rolled over tax-free to another eligible retirement plan within 60 days of the loan offset. However, the plan is not required to offer a direct rollover of a plan loan offset amount. New Law. For plan loan offset amounts treated as distributed in years beginning after December 31, 2017, the TCJA increases the time period during which a qualified plan loan offset amount can be contributed to an eligible retirement plan. Under the new rules, the contribution can be made at any time up to the filing due date (including extensions) of the tax return for the tax year in which the loan offset occurs. However, this time extension only applies when the loan offset amount occurred as a result of:
Termination of the plan, or
Failure to meet loan repayment terms due to the employee’s severance from employment.
13
IRC §408. IRC §§219(a) and 408(o). 15 IRC §408A. 14
8
Discharge of Student Loans Old Law. A taxpayer’s gross income generally includes a discharge of the taxpayer’s indebtedness. However, a taxpayer’s gross income does not include any amount from the forgiveness of certain student loans in the following circumstances.16
The taxpayer works for a certain period in certain professions for a broad class of employers.
The loans are made by educational organizations (and certain tax-exempt organizations if the loan is refinanced) if the loan proceeds are used to pay costs of attendance at an educational institution or to refinance any outstanding student loans and the student is not employed by the lender organization.
The loan repayment amount is made under the National Health Service Corps loan repayment program or certain state loan repayment programs that are intended to provide for the increased availability of healthcare services in underserved or health professional shortage areas.
New Law. The TCJA modifies the exclusion of student loan discharges from gross income by allowing exclusions of certain discharges because of the death or the total and permanent disability of the student. The exclusions available under the old law still apply. Loans eligible for the exclusion under the TCJA are those made by:
The United States (or an instrumentality or agency thereof);
A state (or any political subdivision of a state);
Certain tax-exempt public benefit corporations that control a state, county, or municipal hospital and whose employees have been deemed to be public employees under state law;
An educational organization that originally received the funds from which the loan was made from the United States, a state, or a tax-exempt public benefit corporation; or
Private education loans as defined in section 140(7) of the Consumer Protection Act.
Example 3. In January 2018, Janelle had a federal student loan with an outstanding balance of $10,000. In February, Janelle was totally and permanently disabled as the result of a skiing accident. The government forgave the loan balance because of her disability. None of the forgiven indebtedness is includable in Janelle’s gross income. The provision applies to discharges of loans occurring after December 31, 2017. It does not apply to discharges of indebtedness occurring after December 31, 2025.
Bicycle Commuting Old Law. Qualified bicycle commuting reimbursements of up to $20 per month are excludable from an employee’s gross income.17 Amounts that are excluded from an employee’s gross income for income tax purposes are also excluded from wages for employment tax purposes.
16 17
IRC §108(f). IRC §132(f)(1)(D).
9
New Law. The TCJA suspends the exclusion from gross income and wages for qualified bicycle commuting reimbursements. The exclusion is not allowed for tax years beginning after December 31, 2017, and before January 1, 2026.
Moving Expense Deduction/Reimbursement Old Law. Employer reimbursements for qualified moving expenses are generally excludable from an employee’s gross income.18 Likewise, taxpayers can claim an above-the-line deduction for moving expenses incurred as a result of employment (or self-employment) at a new location if certain conditions are met.19 New Law. The deduction for moving expenses and the exclusion from gross income of qualified moving expense reimbursements are suspended for tax years 2018 through 2025 except for members of the Armed Services. The moving expense tax deduction is retained for members of the Armed Services on active duty (or their spouses or dependents). Moreover, the rules for exclusion of in-kind moving and storage expenses (and reimbursements or allowances for these expenses) are also retained. However, the move must be pursuant to a military order and incident to a permanent change of station. The suspension of the moving expense deduction does not apply to tax years beginning after December 31, 2025.
Modification of Rules for §529 Qualified Tuition Programs Old Law. Under a §529 qualified tuition program (QTP), a taxpayer can establish an account for the benefit of a designated beneficiary to provide for that beneficiary’s qualified higher education expenses. For purposes of receiving a tax-free distribution from a QTP, qualified higher education expenses include the following.
Tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution
Special-needs services incurred in connection with the enrollment or attendance of a special-needs beneficiary
Room and board for students who are enrolled at least half-time
Purchase of computer technology or equipment, or Internet access or related services, if the technology or services is used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible institution
No specific dollar limit is imposed on contributions to qualified tuition accounts. However, the QTP must have adequate safeguards to prevent contributions in excess of amounts necessary to provide for the beneficiary’s qualified higher education expenses. Contributions are not deductible for federal income tax purposes, but they may be deductible for state tax purposes. The earnings on the contributions are not taxable for federal tax purposes. New Law. The TCJA modifies §529 QTPs to allow such plans to distribute up to $10,000 in expenses for tuition incurred during the tax year for enrollment or attendance of the designated beneficiary at a public, private, or religious elementary or secondary school. This limit applies on a per-student basis, rather than a per-account basis. Accordingly, an individual may be the designated beneficiary of multiple accounts but may receive no more than $10,000 in tax-free distributions. This provision applies to distributions made after December 31, 2017.
18 19
IRC §132(a)(6). IRC §217.
10
DEDUCTIONS AND CREDITS Increase in Standard Deduction Old Law. The standard deduction amount varies depending on the taxpayer’s filing status and is adjusted for inflation annually. Before the TCJA was passed, the standard deduction for 2018 would have been $6,500 for single taxpayers, $9,550 for HoH taxpayers, and $13,000 for MFJ taxpayers. The additional standard deduction amount for the elderly or the blind is $1,300. This additional standard deduction is $1,600 if the individual is unmarried and not a surviving spouse.20 New Law. The standard deduction is temporarily increased for individuals in all filing statuses. The 2018 standard deduction amounts are shown in the following table. Filing Status
Standard Deduction
MFJ
$24,000
HoH
18,000
All other individual taxpayers
12,000
The amount of the standard deduction is indexed for inflation for tax years beginning after December 31, 2018. These increased deductions do not apply to tax years beginning after December 31, 2025. The additional standard deduction for the elderly and the blind remains unchanged from previous law.
Repeal of Personal Exemptions Old Law. A taxpayer calculates taxable income by subtracting from their adjusted gross income (AGI) the appropriate number of personal exemptions (i.e., for the taxpayer, spouse, and dependents) multiplied by the personal exemption amount and either the standard deduction or the total itemized deductions. Before the TCJA was enacted, the personal exemption amount would have been $4,150 for 2018.21 New Law. Effective with the 2018 tax year, no personal exemptions are allowed. The suspension of personal exemptions does not apply to tax years beginning after December 31, 2025.
Child Tax and Family Credit22 Old Law. A taxpayer can claim a nonrefundable child tax credit (CTC) of up to $1,000 per qualifying child. The CTC begins to phase out for taxpayers with modified adjusted gross income (MAGI) over $75,000 for single taxpayers, $110,000 for MFJ taxpayers, or $55,000 for MFS taxpayers. To the extent that the CTC exceeds the taxpayer’s tax liability, the taxpayer can qualify for a refundable additional child tax credit (ACTC) equal to 15% of earned income in excess of $3,000. The maximum ACTC is $1,000 per child.
20
Rev. Proc. 2017-58, 2017-45 IRB 489. Ibid. 22 IRC §24. 21
11
Taxpayers who claim the CTC and the ACTC must provide the taxpayer identification number of each qualifying child. This identification number is generally the child’s social security number (SSN) or individual taxpayer identification number (ITIN). The identification number must have been issued on or before the tax return due date. New Law. The CTC is increased to $2,000 per qualifying child. The maximum refundable ACTC amount is $1,400 per qualifying child. The ACTC earned income threshold is reduced to $2,500. The maximum ACTC amount will be adjusted for inflation beginning in 2019. All other inflation parameters related to the child credit are not indexed for inflation. In order to receive this credit, the taxpayer must include an SSN for each qualifying child on the tax return. The SSN must have been issued before the tax return due date. The previous-law age limit for a qualifying child is retained. Therefore, a qualifying child is an individual who has not attained age 17 during the tax year. The credit is further modified to provide a $500 nonrefundable credit for qualifying dependents other than qualifying children. The definition of “dependent” is unchanged from previous law. An SSN is not required for non-child dependents for whom the $500 credit is claimed. A qualifying child who is ineligible for the child tax credit because the child did not have an SSN may qualify for the nonrefundable $500 credit. The credit phases out for MFJ taxpayers with MAGI in excess of $400,000. For all other taxpayers, the phase-out range begins at $200,000. These thresholds are not indexed for inflation. The modified credit provisions apply to tax years beginning after December 31, 2017, and ending on or before December 31, 2025.
Deduction for Medical Expenses Old Law. An individual could claim an itemized deduction for unreimbursed medical expenses to the extent that such expenses exceed 10% of the taxpayer’s AGI.23 For tax years beginning after December 31, 2012, and ending before January 1, 2017, the 10% threshold was reduced to 7.5% for taxpayers who attained the age of 65 before the end of the tax year. For MFJ taxpayers, the 7.5% threshold applied if either spouse attained the age of 65 before the end of the tax year.24 New Law. For tax years beginning after December 31, 2016, and ending before January 1, 2019, taxpayers can claim an itemized deduction for unreimbursed medical expenses that exceed 7.5% of AGI. All taxpayers regardless of age are eligible for the 7.5% threshold, which applies for both AMT and regular tax purposes. The threshold reverts to 10% of AGI for tax years beginning after December 31, 2018.
State and Local Taxes Old Law. Individuals are allowed to claim a deduction for certain taxes, regardless of whether they are incurred in a taxpayer’s trade or business. These taxes are:
23 24
State and local real and foreign property taxes;
State and local personal property taxes;
IRC §213(a). IRC §213(f)(1).
12
State, local, and foreign income, war profits, and excess profits taxes.
A taxpayer can elect to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes. A taxpayer may be allowed a deduction in calculating their AGI if the taxes are incurred in connection with property used in a trade or business. Otherwise, such taxes are an itemized deduction. New Law. Under the TCJA, an individual may generally deduct state, local, and foreign property taxes, and sales taxes that are presently deductible in calculating the individual’s income on Schedule C, Profit or Loss From Business; Schedule E, Supplemental Income and Loss; or Schedule F, Profit or Loss from Farming. Therefore, an individual may generally deduct such items only if the taxes were imposed on business assets. The TCJA contains an exception to the preceding rule. Under this exception, a taxpayer may claim an itemized deduction of up to $10,000 ($5,000 for MFS taxpayers) of the total amount paid for:
State and local property taxes not paid in carrying on a trade or business; and
State and local income taxes (or sales taxes in lieu of income taxes), war profits, and excess profit taxes.
A taxpayer cannot deduct foreign real property taxes. This provision applies to tax years beginning after December 31, 2017, and beginning before January 1, 2026. Furthermore, an individual cannot claim an itemized deduction for 2017 on a prepayment of income tax for a future tax year in order to avoid the dollar limitation applicable to tax years beginning after 2017. Note. On December 27, 2017, the IRS issued an advisory in response to questions from tax professionals concerning the deductibility of prepaid real property taxes. The advisory states that “whether a taxpayer is allowed a deduction for the prepayment of state or local real property taxes in 2017 depends on whether the taxpayer makes the payment in 2017 and the real property taxes are assessed prior to 2018. A prepayment of anticipated real property taxes that have not been assessed prior to 2018 are not deductible in 2017. State or local law determines whether and when a property tax is assessed, which is generally when the taxpayer becomes liable for the property tax imposed.”25 Rep. Peter Roskam (R-IL) sent a letter to the Secretary of the Treasury inquiring as to whether real property taxes prepaid by Illinois taxpayers in 2017 are deductible on their 2017 returns. Roskam pointed out that Illinois property taxes are billed in arrears. A Treasury official responded that “As a general matter, taxpayers are permitted to deduct 2017 property taxes that were both paid and imposed in 2017.” The letter did not define “imposed,” but Roskam claimed victory, stating that “Hardworking taxpayers in our state are entitled to the same benefits as those from every other state. This announcement is a win for the thousands of 6th District residents who stood in line to prepay their property taxes last year."26 For information on which states assess property taxes in arrears, see http://www.fidelitycre.com/taxinfo-assessment.html?version=2.
Home Mortgage Interest Deduction Old Law. Qualified residence interest is allowed as an itemized deduction, subject to limitations. Qualified residence interest is defined as interest paid or accrued during the tax year on either acquisition indebtedness or
25
IRS News Rel. IR-2017-210 (Dec. 27, 2017). Chicago-area property tax prepayers are safe from the IRS, Roskam says. Hinz, Greg. Mar. 28, 2018. Crain’s Chicago Business. [www.chicagobusiness.com/article/20180328/BLOGS02/180329864?template=printart] Accessed on Apr. 25, 2018. 26
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home equity indebtedness. A qualified residence is defined as the taxpayer’s principal residence and one other residence of the taxpayer selected to be a qualified residence.27 Acquisition indebtedness is defined as indebtedness incurred in acquiring, constructing, or substantially improving a qualified residence of the taxpayer and is secured by the residence.28 The maximum amount that can be treated as acquisition indebtedness is $1 million ($500,000 for MFS taxpayers). Home equity indebtedness is defined as indebtedness other than acquisition indebtedness secured by a qualified residence. The maximum amount of home equity indebtedness is $100,000 ($50,000 for MFS taxpayers) and cannot exceed the fair market value (FMV) of the residence reduced by the amount of the acquisition indebtedness. Interest on qualifying home equity indebtedness is deductible, regardless of how the loan proceeds are used. New Law. For tax years beginning after December 31, 2017, and beginning before January 1, 2026, a taxpayer may treat no more than $750,000 as acquisition indebtedness ($375,000 for MFS taxpayers). For acquisition indebtedness incurred before December 15, 2017, the limit is $1 million ($500,000 for MFS taxpayers). If a taxpayer entered into a written binding contract before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and purchased the residence before April 1, 2018, the $1 million limit ($500,000 for MFS taxpayers) applies.29 In addition, refinanced indebtedness is treated as incurred on the date that the original indebtedness was incurred to the extent that the amount of the debt resulting from the refinancing does not exceed the amount of the refinanced indebtedness.30 Therefore, acquisition debt incurred prior to December 15, 2017, retains its status, even if the debt is refinanced. The maximum dollar amount that can be treated as principal residence acquisition indebtedness does not decrease because of refinancing. Example 4. Homer bought a house that he used for his principal residence in 2010. The original amount of his mortgage was $1 million. Over the years, he paid down the loan to $925,000, which was the outstanding mortgage balance on March 5, 2018. Homer refinanced the loan on March 5 for $975,000. He can only deduct interest on $925,000, because that was the mortgage balance on the date of refinancing. The rule that applies the $1 million (or $500,000 for MFS taxpayers) limit to refinanced debt does not apply to: 31
Indebtedness after the original loan term expires; or
If the principal of the original debt is not amortized over its term, the earlier of the date that the first refinancing of the debt expires or 30 years after the date of the first refinancing.
For tax years beginning after December 31, 2025, a taxpayer may treat up to $1 million ($500,000 for MFS taxpayers) as acquisition indebtedness. In addition, the TCJA suspends the deduction for interest on certain types of home equity indebtedness. Interest paid on home equity loans and home equity lines of credit is not deductible unless the loans are used to buy, build, or substantially improve the taxpayer’s home that secures the loan.32 This applies to tax years beginning after December 31, 2017, and ending on or before December 31, 2025. During these years, for example, interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same
27
IRC §163(h)(4)(A)(i). IRC §163(h)(3)(B)(i). 29 IRC §163(h)(3)(F)(i)(IV). 30 IRC §163(h)(3)(F)(iii). 31 IRC §163(h)(3)(F)(iii)(II). 32 IRS News Rel. IR-2018-32 (Feb. 21, 2018). 28
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loan used to pay personal expenses is not.33 The $750,000 limit ($375,000 for MFS taxpayers) applies to the combined amount of loans used to buy, build, or substantially improve the taxpayer’s principal residence and second home (if applicable).34 Example 5. In March 2018, Joy took out a $500,000 mortgage to purchase a home that had an FMV of $800,000. She uses the home as her principal residence. In April 2018, Joy took out a $250,000 home equity loan to build an addition on the home. All of the interest Joy pays on the loans is deductible because the total amount of both loans does not exceed $750,000 and the loans were used to buy, build, or substantially improve her principal residence.35 Example 6. Use the same facts as , except Joy uses the proceeds from the home equity loan to pay off student loans and to finance a dream vacation to Europe. None of the interest on the home equity loan is deductible. Example 7. Jake took out a $500,000 mortgage to purchase his principal residence in January 2018. The loan is secured by his principal residence. In July 2018, Jake took out a $250,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both loans does not exceed $750,000, Jake can deduct all the interest paid on both loans.36 The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal, or investment activities.37 Therefore, the interest on a home equity loan used for rental activities is deductible on Schedule E. Likewise, interest on a home equity loan used for trade or business activities is deductible on the sole proprietor’s Schedule C.
Charitable Contributions of Cash Old Law. Individual taxpayers who itemize their deductions can deduct charitable donations of cash or property to qualifying organizations. Limits apply to the total dollar amount that a taxpayer can deduct. Before the TCJA was enacted, most cash contributions were generally limited to 50% of the taxpayer’s contribution base. The contribution base is the taxpayer’s AGI, computed without any net operating loss carryback to the tax year under IRC §172.38 The limit applies to donations to charitable organizations described in IRC §170(b)(1)(A), which include public charities, private foundations other than nonoperating private foundations, and certain governmental units. Other limits may apply, depending on the type of organization to which the contribution was made and the type of property contributed. These limits are summarized in the following table.39 Contribution Base Percentage Limits for Individual Taxpayers Donee Organization
Public charities, private operating foundations,
Ordinary Income Capital Gain Property to Capital Gain Property Property and Cash the Recipient for the use of the Recipient 50%
30%
33
Ibid. Ibid. 35 Adapted from an example in IRS News Rel. IR-2018-32 (Feb. 21, 2018). 36 Ibid. 37 See IRS Pub. 535, Business Expenses. 38 IRC §170(b)(1)(H). 39 Joint Explanatory Statement of the Committee of Conference. [http://docs.house.gov/billsthisweek/20171218/Joint%20Explanatory%20Statement.pdf] Accessed on Feb. 26, 2018. 34
15
20%
and private distributing foundations Nonoperating foundations
private
30%
20%
20%
A taxpayer who claims a deduction for a charitable contribution must maintain written records regarding the contribution. This rule applies regardless of the amount of the contribution. To claim a charitable deduction of $250 or more, a taxpayer must generally obtain contemporaneous written acknowledgement from the donee organization. However, under IRC §170(f)(8)(D), contemporaneous written acknowledgement is not required if the donee organization files a return with the IRS that reports the information to be included in an acknowledgement. New Law. Individuals may deduct cash contributions up to 60% (previously 50%) of their contribution base for charitable contributions to organizations described in IRC §170(b)(1)(A). The increased deduction limit applies to tax years beginning after December 31, 2017, and before January 1, 2026.40 The amount disallowed because of the 60% limitation can be carried forward for five years. The 30% and 50% limits for a tax year are applied by reducing the allowable contribution limit (but not below zero) for that year by the total cash contributions allowed under the 60% limit for the year.41 Example 8. In 2018, Elizabeth has a contribution base of $100,000. She makes cash contributions totaling $20,000 to various public charities. Elizabeth’s cash contribution limit for 2018 is $60,000 ($100,000 × 60%). She also contributes a car worth $15,000 to a public charity in 2018. Elizabeth’s limit on contributions of capital gain property to public charities (and other qualified organizations) is $30,000 ($100,000 × 30%) reduced by Elizabeth’s $20,000 cash contributions. Therefore, Elizabeth’s contribution limit for 30% property is $10,000. Elizabeth can deduct $10,000 of the car’s value in 2018 and carry forward the remaining contribution of $5,000 ($15,000 value of car − $10,000 allowed in 2018) to subsequent years. The TCJA repeals the exception under IRC §170(f)(8)(D) that contemporaneous written acknowledgement is not required if the donee organization files a return that includes the same information. Consequently, contemporaneous written acknowledgement is now required for all contributions of $250 or more made in tax years beginning after December 31, 2016.
Charitable Contributions for Athletic Seating Rights Old Law. When a taxpayer receives or expects to receive a substantial return for a payment to charity, the payment is not deductible as a charitable contribution. However, a special rule applies to certain payments to institutions of higher education in exchange for the right to purchase tickets or seating at an athletic event. Taxpayers can deduct 80% of charitable contributions made to a college or university in exchange for the right to purchase tickets to athletic events. The cost of the tickets is not deductible. New Law. Taxpayers can no longer take a charitable contribution deduction for any amount paid to an institution of higher education in exchange for the right to purchase tickets or seats at an athletic event. The denial of this contribution is effective for years beginning after December 31, 2017.
40 41
IRC §170(b)(1)(G)(i). IRC §170(b)(1)(G)(iii)(II).
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Casualty and Theft Losses Old Law. A taxpayer can claim a deduction for a loss incurred during the tax year for which they were not compensated by insurance or otherwise. For individual taxpayers, deductible losses are those incurred in a trade or business or that consist of property losses arising from casualty or theft. Personal casualty or theft losses are deductible only if they exceed $100 per casualty or theft and only to the extent that aggregate net casualty and theft losses exceed 10% of the taxpayer’s AGI. New Law. The TCJA temporarily modifies the deduction for personal casualty and theft losses . Under this provision, a taxpayer can claim a personal casualty loss only if the loss is attributable to a federally declared disaster. However, a taxpayer can still offset personal casualty losses not attributable to a federally declared disaster against personal casualty gains to the extent that such losses do not exceed such gains. 42 When applying the 10% threshold to personal casualty losses attributable to a federally declared disaster, the amount of casualty gains taken into account is reduced by the portion of gains offset against casualty losses not attributable to federally declared disasters. 43 Example 9. Ronald’s AGI for 2018 is $125,000. In 2018, after applying the $100 floor for each casualty, he has $30,000 of federally declared disaster losses as well as $20,000 of other personal casualty losses. He also has $35,000 of personal casualty gains. Ronald’s $2,500 deductible loss is calculated as follows. Personal casualty gains
$35,000
Casualty losses other than federally declared disasters
(20,000)
Net casualty gains
$15,000
Total casualty losses from federally declared disasters
$30,000
Casualty losses from federally declared disasters used to offset casualty gains
(15,000)
10% of Ronald’s AGI ($125,000 × 10%)
(12,500)
Ronald’s deductible federally declared disaster loss
42 43
$15,000
$2,500
IRC §165(h)(5)(B)(i). IRC §165(h)(5)(B)(ii).
17
This provision is effective for losses incurred in tax years beginning after December 31, 2017. It does not apply to losses incurred after December 31, 2025.
Miscellaneous Itemized Deductions Old Law. Individual taxpayers who itemize their deductions can deduct miscellaneous expenses to the extent that the total of such expenses exceeds 2% of the taxpayer’s AGI. Expenses subject to the 2% threshold include the following.
Unreimbursed expenses attributable to the trade or business of being an employee, including the following Business bad debt of an employee Business liability insurance premiums Damages paid to a former employer for breach of an employment contract Depreciation on a computer that a taxpayer’s employer requires them to use in their work Dues to a chamber of commerce if membership helps the taxpayer perform their job Dues to professional societies Educator expenses Home office or part of a taxpayer’s home used regularly and exclusively in the taxpayer’s work Job search expenses in the taxpayer’s present occupation Laboratory breakage fees Legal fees related to the taxpayer’s job Licenses and regulatory fees Malpractice insurance premiums Medical examinations required by an employer Occupational taxes Passport fees for a business trip Repayment of an income aid payment received under an employer’s plan Research expenses of a college professor Rural mail carriers’ vehicle expenses Subscriptions to professional journals and trade magazines related to the taxpayer’s work Tools and supplies used in the taxpayer’s work Purchase of travel, transportation, meals, entertainment, gifts, and local lodging related to the taxpayer’s work Union dues and expenses Work clothes and uniforms if required and not suitable for everyday use Work-related education
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Tax preparation fees
Expenses for the production or collection of income, including the following44 Appraisal fees for casualty loss or charitable contribution Casualty and theft losses from property used in performing services as an employee Clerical help and office rent in caring for investments Depreciation on home computers used for investments Excess deductions allowed a beneficiary on termination of an estate or trust Fees to collect interest and dividends Hobby expenses, but generally not more than hobby income Indirect miscellaneous deductions from pass-through entities Investment fees and expenses Legal fees related to producing or collecting taxable income or getting tax advice Loss on deposits in an insolvent or bankrupt financial institution Loss on traditional IRAs or Roth IRAs, when all amounts have been distributed to taxpayer Some repayments of income Safe deposit box rental Service charges on dividend reinvestment plans Tax advice fees
Other expenses Trustee’s fees on IRA if separately billed and paid Repayments of income received under a claim of right (only subject to 2% floor if less than $3,000) Repayments of social security benefits Share of deductible investment expenses from pass-through entities
New Law. No miscellaneous itemized deductions subject to the 2% of AGI floor are allowed for tax years beginning after December 31, 2017, through December 31, 2025. Above-the-line deductions (i.e., expenses that are deductible in determining AGI) are unaf fected by this provision. In addition, other miscellaneous deductions (reported on line 28 of the 2017 Schedule A, Itemized Deductions) are also unaffected by this provision and are therefore still deductible. Such expenses include the following.45
44 45
Gambling losses (to the extent of gambling winnings reported on Form 1040, line 21)
See IRS Pub. 529, Miscellaneous Deductions. Instructions for Schedule A.
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Federal estate tax on income in respect of a decedent
Deduction for amortizable bond premium
Ordinary loss attributable to a contingent payment debt instrument or an inflation-indexed debt instrument
Repayment of amounts under a claim of right if over $3,000
Certain unrecovered investment in a pension
Impairment-related work expenses of a disabled person
Wagering Losses Old Law. A taxpayer can deduct losses incurred during the tax year on wagering transactions only to the extent of the gains realized during the tax year from such transactions.46 Gambling losses for most individuals are claimed as miscellaneous itemized deductions not subject to the 2% of AGI limitation.47 Professional gamblers, however, report gambling activities on Schedule C. Professional gamblers are also subject to the restriction that limits wagering losses to the amount of wagering gains. The court in Mayo v. Comm’r48 held that gambling expenses other than wagering losses are not subject to this restriction and are deductible if the taxpayer is a professional gambler. The IRS acquiesced in this result.49 New Law. The TCJA clarifies that the loss limitation applies not only to the actual costs of wagers incurred by an individual but also to other expenses incurred in connection with the conduct of that individual’s gambling activity. For example, an individual’s otherwise deductible expenses in traveling to and from a casino are subject to this limitation. This provision effectively reverses the court’s decision in Mayo. This provision is effective for tax years beginning after December 31, 2017. It does not apply to tax years beginning after December 31, 2025.
Limit on Itemized Deductions Old Law. The total amount of most otherwise allowable itemized deductions is limited for certain higher-income taxpayers. This limit is triggered when the taxpayer’s AGI exceeds a threshold level. For 2017, the threshold amounts were:
$261,500 for single taxpayers,
$287,650 for heads of household,
$313,800 for MFJ taxpayers, and
$156,900 for MFS taxpayers.
The limitation reduces itemized deductions by the lesser of: 1. 3% of the amount of AGI exceeding the threshold, or
46
IRC §165(d). IRC §67(b)(3). 48 Mayo v. Comm’r, 136 TC 81 (2011). 49 AOD 2011-06, IRB 2012-3. 47
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2. 80% of the itemized deductions that would otherwise be allowable.50 All other limits on itemized deductions are applied before the overall limit on itemized deductions.51 In addition, the following itemized deductions are not subject to this limit.
Medical and dental expenses
Gambling losses
Casualty and theft losses
Investment interest
New Law. The TCJA suspends the limitation on itemized deductions for higher-income taxpayers. This provision is effective for tax years beginning after December 31, 2017, and ending on or before December 31, 2025.
RELIEF FOR DISASTER LOSSES Distributions from Retirement Plans Old Law. A distribution from a qualified retirement plan, a §403(b) plan, a governmental §457(b) plan, or an IRA is generally included in income. Unless an exception applies, a distribution from a qualified retirement plan, a §403(b) plan, or an IRA that the taxpayer receives before turning age 59½ is subject to a 10% early withdrawal tax on the amount includable in income.52 Note. The 10% early withdrawal tax does not apply to distributions from a governmental §457(b) plan. New Law. An exception to the 10% early withdrawal tax applies to qualified disaster distributions from a qualified retirement plan, a §403(b) plan, or an IRA. In addition, income attributable to a qualified disaster distribution is included in income ratably over three years unless the individual elects not to have the ratable inclusion rule apply. Moreover, the amount of the distribution can be recontributed to an eligible retirement plan within three years. A qualified disaster distribution is a distribution from an eligible retirement plan made on or after January 1, 2016, and before January 1, 2018, to an individual:
Whose principal place of residence at any time during calendar year 2016 was located in a 2016 disaster area, and
Who sustained an economic loss because of a federally declared disaster during 2016.
An eligible retirement plan is a qualified retirement plan, a §403(b) plan, a governmental §457(b) plan, or an IRA. The maximum amount of distributions to an individual from all eligible retirement plans that may be treated as qualified disaster distributions is $100,000. A 2016 disaster area is defined as any area for which a major disaster was declared by the president under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act during calendar year 2016.53
50
IRC §68(a). IRC §68(d). 52 IRC §72(t). 53 TCJA §11028(a). 51
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Any portion of a qualified disaster distribution may be recontributed to an eligible retirement plan at any time during the 3-year period beginning on the day after the date on which the taxpayer received the distribution. Any amount recontributed within the 3-year period is treated as a rollover. Therefore, such amounts are not includable in income. If any portion of the distribution has not yet been included in the taxpayer’s income at the time of the contribution, the remaining amount is not includable in income. Example 10. In November 2016, Katrina, age 47, received a qualified disaster distribution of $60,000 from her 401(k). No portion of the $60,000 distribution is subject to the 10% early withdrawal tax. Katrina included $20,000 in income in each year from 2016 to 2018. Katrina files her 2018 tax return in April 2019. In October 2019, Katrina recontributes $60,000 to her 401(k), and this amount is treated as a rollover. Katrina can file amended returns to claim a refund of the tax attributable to the amount previously included in income for the 2016, 2017, and 2018 tax years. Example 11. Use the same facts as , except Katrina recontributes $60,000 to her 401(k) plan in March 2019. When she prepares her 2018 return in April 2019, she does not include the ratable $20,000 portion in her 2018 income. Katrina files amended returns to claim a refund for the tax attributable to the $40,000 she included in income for the 2016 and 2017 tax years.
Itemized Deduction for Casualty Losses Old Law. In 2016 and 2017, a taxpayer could generally claim a deduction for a loss sustained during the tax year and not compensated by insurance or otherwise. For individual taxpayers, deductible losses include property losses from fire, storm, shipwreck, or other casualty, or from theft. A taxpayer could take a deduction for personal casualty and theft losses only if the losses exceeded $100 per casualty or theft. In addition, a taxpayer could deduct aggregate net casualty and theft losses only to the extent they exceeded 10% of the taxpayer’s AGI. Example 12. In 2016, Andrew’s AGI was $125,000. He incurred a $4,000 personal casualty loss in 2016 that was not attributable to a federally declared disaster. He itemized his deductions on his 2016 return, and he had no other casualty or theft losses for the year. Andrew’s $4,000 loss is first reduced by the $100 floor, so his net casualty loss is $3,900. This is less than 10% of his AGI, or $12,500, so he cannot claim an itemized deduction for the loss. New Law. If an individual had a net disaster loss for the 2016 or 2017 tax year, such losses are deductible regardless of whether the aggregate net losses exceed 10% of the taxpayer’s AGI. To be deductible, the losses must exceed $500 per casualty. A net disaster loss is defined as the excess of qualified disaster-related personal casualty losses over personal casualty gains. The disaster-related personal casualty loss is one that occurred in a disaster area and that was attributable to the events that gave rise to a federal disaster declaration.54 Example 13. Use the same facts as , except Andrew’s 2016 loss was attributable to a federally declared disaster. He must reduce his $4,000 loss by the $500 floor attributable to disaster-related personal casualty losses. However, he does not have to further reduce the loss by 10% of his AGI. Therefore, he can claim an itemized deduction of $3,500 for the loss. An individual who incurred a net disaster loss in 2016 or 2017 and does not itemize deductions can increase their standard deduction by the amount of the net disaster loss. The increase in the standard deduction amount is also allowed as a deduction for purposes of calculating alternative minimum taxable income (AMTI).55
54 55
TCJA §11028(c). TCJA §11028(c)(1)(D).
22
Example 14. Use the same facts as , except Andrew does not itemize deductions. He can increase the $6,300 standard deduction for the 2016 tax year by the $3,500 disaster-related loss. Therefore, his standard deduction for 2016 is $9,800. In addition, if Andrew is subject to AMT, he cannot deduct the $6,300 standard deduction from his AMTI but he can deduct the additional $3,500 disaster loss. Note. As explained earlier, the TCJA modifies the rules for personal casualty and theft losses for tax years beginning after December 31, 2017, and before January 1, 2026.
ABLE ACCOUNTS Increased Contributions Old Law. IRC §529A provides for a tax-favored savings program intended to benefit individuals with disabilities, known as the Achieving a Better Life Experience (ABLE) program. Contributions can be made for the benefit of an individual with disabilities to assist them in paying qualified disability expenses. Contributions, which are not tax deductible, are subject to an annual overall limit equivalent to the per-donee annual gift tax exclusion ($15,000 for 201856). Distributions from an ABLE account are excludable from income to the extent that the total distribution does not exceed the qualified disability expenses of the designated beneficiary during the year. Qualified disability expenses are expenses related to the designated beneficiary’s blindness or disability that are paid for the benefit of the designated beneficiary. New Law. The TCJA provides that beginning December 22, 2017, until December 31, 2025, a designated beneficiary of an ABLE account can make additional contributions after the per-donee annual overall limit ($15,000 for 2018) is reached. The maximum additional annual contribution amount that the designated beneficiary can make is the lesser of:
The designated beneficiary’s compensation for the year, or
The federal poverty line for a 1-person household for the previous calendar year.57 Note. The federal poverty line (also called the federal poverty level) for 2017 for a 1-person household is $12,060 for the 48 contiguous states and the District of Columbia.58
Example 15. Jasper lives in Illinois and is the designated beneficiary of an ABLE account. In 2018, Jasper’s grandmother made the maximum per-donee contribution of $15,000 to his ABLE account. Jasper earns $15,000 of wages in 2018. He can make an additional contribution of $12,060 (the applicable federal poverty line amount) to his ABLE account for 2018 because that amount is less than his compensation for the year. A designated beneficiary who is allowed to make additional contributions to their ABLE account is one who is employed (or self-employed) and did not make a contribution during the tax year to a defined contribution plan, 403(b) plan, or 457(b) plan.59
56
Rev. Proc. 2017-58, 2017-45 IRB 489. IRC §529A(b)(2)(B)(ii)(II). 58 2017 Poverty Guidelines. U.S. Department of Health & Human Services. [https://aspe.hhs.gov/2017-poverty-guidelines] Accessed on Mar. 2, 2018. 59 IRC §529(b)(7)(A). 57
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Saver’s Credit Old Law. Eligible taxpayers can claim a nonrefundable tax credit for qualified retirement savings contributions (saver’s credit). The saver’s credit is a percentage of an individual’s contributions to qualified retirement savings accounts.60 The maximum annual contribution eligible for the credit is $2,000 per individual. The credit rate depends on the taxpayer’s AGI. Qualified retirement savings contributions consist of the following.
Elective deferrals to a 401(k) plan, a 403(b) plan, a governmental 457 plan, a savings incentive match plan for employees (SIMPLE) plan, or a salary reduction simplified employee pension (SARSEP) plan
Contributions to a traditional or Roth IRA
Voluntary after-tax employee contributions to a qualified retirement plan or 403(b) plan
New Law. A designated beneficiary of an ABLE account is temporarily allowed to claim the saver’s credit for contributions made to their ABLE account. No other changes were made to the saver’s credit. This provision applies to tax years beginning after December 22, 2017, and before January 1, 2026.
Rollovers to ABLE Accounts Old Law. Amounts in an ABLE account can be rolled over without incurring tax liability to another ABLE account for the same beneficiary. In addition, amounts in an ABLE account can be rolled over to another ABLE account for the designated beneficiary’s family member. Family member for this purpose includes a person with any of the following relationships to the designated beneficiary.61 1. Spouse 2. Child or descendant of a child 3. Brother, sister, stepbrother, or stepsister 4. Parent (or parent’s ancestor) 5. Stepfather or stepmother 6. Niece or nephew 7. Aunt or uncle 8. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law 9. Spouse of any individual in 2–8 10. First cousin New Law. The TCJA allows amounts to be rolled over from §529 qualified tuition programs to an ABLE account without penalty if the ABLE account is owned by the designated beneficiary of the §529 plan or a designated beneficiary’s family member (as described above). Any such rolled-over amounts count towards the overall annual limitation on contributions to an ABLE account. Any amount rolled over in excess of the limitation is includable in the distributee’s gross income.
60 61
IRC §25B. IRC §§529(c)(3)(C)(i)(III) and (e)(2).
24
This provision applies to distributions made after December 22, 2017, and before January 1, 2026.
AG-RELATED PROVISIONS IN THE TAX CUTS AND JOBS ACT COMMODITY GIFTS For tax years beginning before 2018, a parent could gift grain to a child and eliminate self-employment tax on the gifted grain. In addition, under the “kiddie-tax” rules, the tax rate of the child was generally the parent’s rate. However, under the TCJA, in most situations, the tax rate of the child will be the tax rates applicable to estates and trusts. Indeed, once the child has $12,500 of unearned income, the tax rate applicable to the child will be 37 percent on all excess amounts. This provision is applicable for tax years beginning after 2017 and before 2016. DEDUCTION FOR STATE AND LOCAL PROPERTY TAXES For tax years beginning after 2017, for individuals, State, local, and foreign property taxes and State and local sales taxes are allowed as a deduction without limitation only when paid or accrued in carrying on a trade or business, or an activity that produces income. Thus, only those deductions for State, local, and foreign property taxes, and sales taxes, that are presently deductible in computing income on an individual’s Schedule C, Schedule E, or Schedule F are allowed without limitation. However, a $10,000 cap is imposed for state and local property taxes that are not paid or accrued in carrying on a trade or business or an income-producing activity. Example. Bob and Sally own a home in Oblong, Illinois. Their real estate tax on their home is $2,100. They also pay $8,750 of Illinois state income tax. Thus, their total personal and real estate tax and state income tax is $10,850. The maximum deduction that they can claim on Schedule A for these taxes is limited to $10,000, however. The $10,000 limit does not apply, however, to real estate taxes paid on farm real estate. It is immaterial how the farmland is owned, whether individually or via an entity. Example. Jerry and Lisa own a farm near Goofy Ridge, Illinois. Part of the farmland is owned by an S corporation that Jerry and Lisa are the shareholders of. Part of the farmland is owned by an LLC that Jerry and Lisa own. Jerry and Lisa also own part of the farmland individually. The S corporation pays $15,000 of real estate taxes. The LLC pays $8,000 of real estate taxes. Jerry and Lisa pay another $9,000 of real estate taxes. All of the taxes are deductible. The $10,000 limit does not apply. Observation. Only real estate taxes on the taxpayer’s personal residence (or vacation home) are limited. Real estate taxes that are paid on farmland used in a farming business remain fully deductible. LOSS LIMITATION FOR NON-CORPORATE TAXPAYERS Excess business loss rule. For taxable years beginning after December 31, 2017 and before January 1, 2026, “excess business losses” of a taxpayer other than a corporation are not allowed for the taxable year. An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. 25
The threshold amount for a taxable year is $500,000 (indexed for inflation) on a joint return. The threshold amount is indexed for inflation. Note. The TCJA eliminated a provision limiting the deductibility of farm losses in excess of $300,000 (generally) and replaced it with the provision limiting all business losses (farm and nonfarm) to $250,000 ($500,000 for married couples filing a joint return). In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder. Net operating losses. The TCJA made changes to how farmers can treat NOLs. For tax years beginning after 2017 and before 2026), a farm taxpayer is limited to carrying back up to $500,000 (MFJ) of NOLs. NOLs exceeding the threshold must be carried forward as part of the NOL carryover to the following year.62 For tax years beginning after December 31, 2017, NOLs can be carried forward indefinitely (as opposed to being limited to a 20-year carryforward under prior law) but they will only offset 80 percent of taxable income (the former rule allowed a 100 percent offset). In addition, effective for tax years ending after December 31, 2017, NOLs can no longer be carried back five years (for farmers) or two years (for non-farmers). This effective date provision has an immediate impact on any farm corporation that has a fiscal year ending in 2018 insomuch as the corporation will not be allowed to carry back an NOL for five years. Instead, the NOL can only be carried back two years. All other corporate taxpayers can only carry an NOL forward. Observation. Fiscal year C corporations that are anticipating a large NOL for a fiscal year ending in 2018 may want to consider switching to a calendar year. Such a switch may allow the corporation to carry the NOL back five years (farm) or two years (non-farm). To change to a calendar year requires IRS permission and a valid business reason.
Note. Pre-2018 NOL carryovers are grandfathered such that they can offset 100 percent of taxable income. Presently uncertain is whether the definition of “taxable income” for purposes of the NOL computation is determined before or after any pre-2018 NOL carryovers. Example: Bill is single and operates a farm in South Dakota. In 2018, Bill’s farming operation experienced a $700,000 loss from the faming activity and from the sale of farm equipment. Bill can carryback $250,000 of the loss to 2016 under the two-year carryback provision. The remaining $500,000
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For tax years beginning before 2018, farm losses and NOLs were unlimited unless the farmer received a loan from the CCC. In that case, as noted above, farm losses were limited to the greater of $300,000 or net profits over the immediately previous five years with any excess losses carried forward to the next year on Schedule F (or related Form).
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loss carries forward to 2019. If, in 2019, Bill has $450,000 of income from his farming activity, he can offset the $450,000 of income with $400,000 (80 percent of $500,000) of loss carryover. Thus, Bill will have $50,000 of income subject to tax in 2019. The remaining $100,000 of unused loss carries over to 2020. CASH ACCOUNTING Cash accounting is available for taxpayers with annual average gross receipts that do not exceed $25 million for the three prior taxable year periods (the “$25 million gross receipts test”). The $25 million amount is indexed for inflation for taxable years beginning after 2018. The provision expands the ability of farming C corporations (and farming partnerships with a C corporation partner) that may use the cash method to include any farming C corporation (or farming partnership with a C corporation partner) that meets the $25 million gross receipts test. The provision retains the exceptions from the required use of the accrual method for qualified personal service corporations and taxpayers other than C corporations. Thus, qualified personal service corporations, partnerships without C corporation partners, S corporations, and other pass-through entities are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of the cash method clearly reflects income. In addition, the provision also exempts certain taxpayers from the requirement to keep inventories. In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership. In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership. BUSINESS INTEREST For tax years beginning after 2017, deductible business interest is limited to business interest for the tax year plus 30 percent of the taxpayer’s adjusted taxable income for the tax year that is not less than zero.63 Business interest income is defined as the amount of interest that is included in the taxpayer’s gross income for the tax year that is properly allocable to a trade or business. It does not include investment income within the meaning of I.R.C. §163(d). Adjusted taxable income is defined as the taxpayer’s taxable income computed without regard to any item of income, gain, deduction or loss that is not properly allocable to a trade or business; any business interest expense or business interest income; any NOL deduction and any I.R.C. §199A deduction, and (for tax years beginning before 2022) any deduction allowable for depreciation, amortization or depletion. Any disallowed amount is treated as paid or accrued in the succeeding tax year. However, businesses entitled to use cash accounting (i.e., average gross receipts don’t exceed $25 million for the three prior taxable years) are not subject to the limitation. Thus, if average gross revenues are $25 million or less, there is no change in the rules concerning the deductibility of interest. An electing farm business (as defined by I.R.C. §263A(e)(4)) that is barred from using cash accounting can elect to not be subject to the limitation on the deductibility of interest. In return, such farm business
63
For a partnership, the business interest limitation applies at the partnership level. Any business interest deductions are considered in determined the partnership’s non-separately stated taxable income or loss. Each partner’s adjusted taxable income is determined without regard to the partner’s distributive share of any of the partnership’s items of income, gain, deduction, or loss.
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(not cash rent landlords) must use alternative depreciation on farm property with a recovery period of 10 years or more. However, the election out will result in the inability to qualify otherwise eligible assets for bonus depreciation (in accordance with I.R.C. §263A). BUSINESS-PROVIDED MEALS Beginning in 2018, the current 100 percent deduction for amounts incurred and paid for the provision of food and beverage associated with operating a business drops to 50 percent. The provision applies to amounts incurred and paid after December 31, 2017 and until December 31, 2025, that are associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and are for the convenience of the employer. After 2025, the amount goes to zero. Thus, the provision allowing a deduction for meals provided to employees for the convenience of the employer is repealed for amounts paid or incurred after 2025. PARTNERSHIP LOSSES When determining a partner’s distributive share of any partnership loss, the partner takes into account the distributive share of the partnership’s charitable contributions and taxes, except that if the fair market value of a charitable contribution exceeds the contributed property’s adjusted basis, the partner is not to take into account the partner’s distributive share of the charitable contribution as to the excess. The result of this provision is that basis is not decreased by the excess fair market value over basis. The provision applies to partnership taxable years beginning after 2017. COST-RECOVERY PROVISIONS64 Farm Property New assets. The bill shortens the depreciable recovery period from seven to five years for any machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business, the original use of which commences with the taxpayer and is placed in service after December 31, 2017. Repeal of 150 percent method. The provision also repeals the required use of the 150-percent declining balance method for property used in a farming business (i.e., for 3-, 5-, 7-, and 10-year property). The 150 percent declining balance method will continue to apply to any 15-year or 20-year property used in the farming business to which the straight-line method does not apply, or to property for which the taxpayer elects the use of the 150-percent declining balance method. Note. For these depreciation purposes, the term “farming business” means a farming business as defined in I.R.C. § 263A(e)(4).
This section discusses the impact of the TCJA cost recovery provisions on farm taxpayers. Many states may not “couple” on some or all of the provisions mentioned. 64
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Plants. For tax years beginning before January 1, 2016, taxpayers with vineyards, orchards and plants with a pre-productive period of more than two years were required to capitalize all of the costs related to the plants until the crop reached “commercial production” (typically 3-5 years). Capitalized costs included direct costs of production and all of the indirect costs associated with the planting of the crop (including capitalizing depreciation on the equipment used during the pre-productive period). Once the plant reached commercial production, the taxpayer could depreciate costs related to the plant over 10 years or claim I.R.C. §179 or first-year bonus depreciation against the costs. Alternatively, the taxpayer could elect to expense all of the costs. If all of the costs were expensed, the taxpayer was required to use ADS depreciation and could not use bonus depreciation on any farm assets. Legislation enacted in 2015 provided for an election allowing first-year “bonus” depreciation for certain plants equal to 50 percent of their cost (for 2016) that are planted or grafted after 2015.65 That provision provided for an election that allows first-year “bonus” depreciation for certain plants equal to 50 percent of their cost (for 2016) that are planted or grafted after 2015. Under the provision a “specified plant” is any tree or vine which bears fruit or nuts, and any other plant which will have more than a single yield of fruits or nuts and which generally has a pre-productive period of more than two years from the time of planting or grafting to the time at which the plant begins bearing fruits or nuts. The definition of “specified plant” is uncertain and raises a question as to whether it includes the plant plus all I.R.C. §263A pre-productive costs incurred for the year of planting. If it does, then the amount that is available for bonus depreciation in the year of planting will include those costs. On the other hand, if that definition only includes the cost of the plant, then pre-productive costs that are associated with developing the plant might not be included. Under the TCJA, effective for tax years beginning after 2017, bonus depreciation is set at 100 percent through 2022. In addition, if a farmer has gross receipts of $25 million or less, they can expense all of the direct and indirect costs associated with plantings including the cost of the plants. However, for a taxpayer that previously chose to capitalize the direct and indirect costs but not have bonus depreciation available on any farm assets, it is uncertain whether the taxpayer can “now” elect back into the system. If the taxpayer can elect back into the system (and their revenues are $25 million or less), the taxpayer will be able to deduct all of the costs immediately. If an election back in is not possible, capitalization of the direct and indirect costs is required without the ability to claim bonus depreciation. This is the result even if no orchards or vineyards have been planted in recent years. Example. Michael is a farmer in Missouri. He planted an orchard in 2011. His average gross receipts do not exceed $25 million. He elected to expense the direct and indirect costs of the orchard which barred him from claiming bonus depreciation on any farm assets. In 2018, Michael purchased $1.75 million of new farm equipment. If Michael cannot elect back into the prior system, he will not be able to claim any bonus depreciation on the new farm equipment but will be able to claim expense method depreciation and regular MACRS depreciation. But, if Michael can elect back into the prior system, then the entire $1.75 million of new asset purchases will qualify for 100 percent bonus depreciation. Expense Method Depreciation
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I.R.C. §168(k)(5).
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The maximum amount a taxpayer may expense under I.R.C. §179 is increased to $1,000,000, and the phase-out threshold amount is increased to $2,500,000 for tax years beginning after 2017. The $1,000,000 and $2,500,000 amounts are indexed for inflation for tax years after 2018. In addition, some additional types of property are specified to qualify for I.R.C. §179. Bonus Depreciation The TCJA allows for full expensing of assets presently eligible for first-year “bonus” depreciation under I.R.C. §168(k) for property placed in service after September 27, 2017 through December 31, 2022. After 2022, the provision is phased-out by 20 percentage points every year thereafter with a complete phase-out for property placed in service beginning in 2027. The same rules apply to specified plants bearing fruits and nuts that are planted or grafted after the applicable timeframe. It is not required that the original use of the qualified property commence with the taxpayer. Thus, bonus applies to new and used property. A transition rule provides that, for a taxpayer’s first taxable year ending after September 27, 2017, the taxpayer may elect to apply a 50 percent allowance instead of the 100 percent allowance. Observation. As noted above, the TCJA changes the rules associated with NOLs in a manner that makes it likely that an NOL should be avoided, if possible, in most situations, a tax strategy to accomplish that goal may be to elect out of 100 percent bonus depreciation on some or all assets and then claim I.R.C. §179 depreciation to reduce income to the desired amount (e.g., in an amount that fully absorbs the 12 percent rate bracket). Normally, I.R.C. §179 is taken first on an asset, then bonus depreciation, then regular depreciation. However, a taxpayer can elect out of bonus depreciation. Doing so allows the taxpayer to elect the “correct” amount of I.R.C. §179 depreciation. The election out of bonus depreciation applies to all assets in a particular “life” class (e.g., all new farm equipment has a five-year class life and all used farm equipment has a seven-year class life). Thus, a taxpayer could elect out of bonus depreciation with respect to new farm equipment, for example, but not with respect to used farm equipment. Example. Sam and Sue Flay, a married couple, conduct a Schedule F farming operation. Before depreciation, their Schedule F income for 2018 is $300,000. Their plan is to report Schedule F income of $77,400 to completely fill the 12 percent income tax bracket. During 2018, they purchased $400,000 of new farm equipment. 100 percent bonus depreciation on the equipment would result in a $100,000 farm loss for 2018. Thus, Sam and Sue elect out of bonus depreciation on the equipment and then claim I.R.C. §179 depreciation in the amount of $300,000. That will reduce the Schedule F income down to $100,000. Regular depreciation of $22,600 can then be claimed on the remaining $100,000 of cost to reduce their Schedule F income to $77,400. The remaining cost of $77,400 will be depreciated over the next five years.66 LIKE-KIND EXCHANGES
The remaining cost will actually be depreciated over six years rather than five years because one-half of a year’s worth of deprecation is taken in year one and one-half of a year’s worth of depreciation is taken in year six. 66
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For exchanges completed after 2017, the TCJA modifies the provision providing for non-recognition of gain in the case of like-kind exchanges (I.R.C. §1031) by limiting its application to real property that is not held primarily for sale. Example. In 2017, a Frank Farmer traded-in his old tractor worth $150,000 for a new tractor worth $400,000. The $150,000 trade value is essentially ignored and the tax cost basis of the new combine is simply $250,000 (the net cash paid). Had Frank traded-in his tractor after 2017, he will recognize a sale on the old combine of $150,000 (likely all gain). Frank’s income tax basis in the new tractor will be $400,000 which Frank can completely deduct in the year of the “trade” (through 2022). In addition, the gain on the trade will not be subject to self-employment tax. Observation. Through 2022, the new rule eliminating like-kind exchange treatment on personal property trades will trigger less tax than under prior law in states that do not have a state income tax. In states that do have a state income tax, many disallow or limit the amount of I.R.C. §179 depreciation or bonus depreciation. In these states, additional tax compared to pre-TCJA law will be triggered. Example. Assume the same facts as in the immediately prior example. Also, assume that at the time of the trade Frank had already claimed $200,000 of depreciation on the tractor and had an adjusted cost basis in the tractor of $200,000. Thus, the selling price of $150,000 produced a tax loss on the state return of $50,000. If Frank’s state conforms to the federal provision applicable to new farm personal property (5 years; 200 percent declining balance) but doesn’t allow bonus depreciation or I.R.C. §179 depreciation, he can only deduct $80,000. At the federal level, Frank had a gain of $150,000 and a deduction of $400,000 for a net deduction of $250,000. At the state level, Frank will report $50,000 loss and deduct $80,000 for a net deduction of $130,000. NEW IRC §199A – THE QUALIFIED BUSINESS INCOME DEDUCTION BACKGROUND Former IRC §199. For tax years beginning after 2004, a taxpayer could claim a domestic production
activities deduction (DPAD) for a portion of the taxpayer’s qualified production activities income (QPAI). For tax years beginning after 2009, the DPAD was set at 9 percent for all taxpayers except those involved in oil and gas production. For those businesses, the DPAD was set at 6 percent. However, the DPAD was limited to the lesser of 9 percent of “qualified production activities income” (QPAI) or 50 percent of the wages expense allocated to the manufacturing, producing, growing and extracting activities. DPAD application to cooperatives. Agricultural and horticultural cooperatives could also claim the DPAD and allocate any portion of it to the cooperative’s patrons. Any amount that was allocated to a patron was not subject to a wage limitation in the patron’s hands. With the repeal of the DPAD for tax years beginning after 2017, a transition rule applies such that the repeal does not apply to a qualified payment that a patron receives from an ag cooperative in a tax year beginning after 2017 to the extent that the payment is attributable to QPAI with respect to which the former IRC §199 deduction was allowed to the cooperative for the cooperative’s tax year that began
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before 2018.67 That type of qualified payment is subject to the pre-2018 IRC §199 DPAD provision. Any deduction allocated by a cooperative to patrons related to that type of payment can be deducted by patrons in accordance with the pre-2018 DPAD rules. In that event, no post-2017 QBI deduction is allowed for this type of qualified payments. Observation. In late December of 2017, many cooperatives allocated an additional IRC §199 DPAD to patrons as a result of the TCJA. The transition rule was not enacted until March 22, 2018. Ultimately, whether the additional DPAD passed-through from a cooperative in late 2017 is a benefit or not to patron will depend on the tax bracket of the patron for 2017 and 2018. Example. Acme Grain Cooperative allocated an additional $10,000 of DPAD to R. Runner in late
December 2017 that was associated with 2016 patronage. Acme also allocated an additional $20,000 of DPAD to R. Runner in late December of 2017 that was for 2017 patronage. Acme issue Rusty a Form 1099-PATR. Those allocations will be taxed to Rusty at the applicable tax rate and bracket for 2017. Had he received the allocations in 2018, they would have been subject to tax at the 2018 rates, which may have been lower. THE QUALIFIED BUSINESS INCOME DEDUCTION - IN GENERAL For tax years beginning after 2017 and before 2026, an individual business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20% of the individual’s share of qualified business income (QBI) associated with the conduct of a trade or business in the United States.68 The QBI deduction replaces the domestic production activities deduction (DPAD) of IRC §199 which applied for tax years beginning after 2005, but which the TCJA repealed effective for tax years beginning after 2017. The QBI deduction is allowed only for income tax purposes and is allowed against alternative minimum tax (AMT), with no separate computation required.69 It is not allowed for purposes of self-employment tax or the net investment income tax (NIIT), or for determining any NOL.70 The QBI deduction is subtracted from taxable income but does not affect the calculation of adjusted gross income (AGI).71 Because it is an adjustment to taxable income, the QBI deduction is also available to taxpayers who do not itemize deductions.72 Note. The QBI deduction is not affected by whether the taxpayer is materially involved in the business
activity. The taxpayer’s percentage ownership is relevant. QBI is dependent on whether the taxpayer has ordinary income (tentative taxable income less qualified dividends and income taxed as long-term capital gain).73 QBI
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Pub. L. No. 115-141, Sec. 101(c), amending Pub. L. No. 115-97, Sec. 13305(c), enacted into law on March 22, 2018. IRC §§199A(a); 199A(c)(3)(A)(i). QBI does not include income from a specified service business. IRC §199A(d)(2). 69 IRC §199A(f)(2)-(3). 70 IRC §172(d)(8). 71 See IRC §62(a), flush language. Thus, the various phase-ins and phase-outs which are based on AGI are not impacted by IRC §199A. 72 IRC §63(b)(3). 73 IRC §199A(a)(2). 68
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Included and excluded income items. QBI includes net amounts of items of income, gain, deduction and loss with respect to any qualified trade or business.74 However, QBI does not include reasonable compensation paid to an S corporation shareholder and guaranteed payments paid to a partner, or any payment paid to a partner for services rendered with respect to the trade or business of the partnership.75 Note. The QBI deduction for a sole proprietor does not consider any amount as a substitute for a reasonable wage. Thus, the entire bottom line of the Schedule F (or Schedule C) proprietor qualifies to be included in the determination of the QBIA. Example. Julie is a Kansas farmer that anticipates generating $150,000 of net income in 2018. Her QBI deduction will vary depending on the business structure of her farming activity as illustrated below (assumptions included): Sole Proprietorship (Schedule F): Net income - $150,000; tentative QBI - $150,000; less ½ of S.E./payroll tax - $10,135.80; net QBI - $139,864.20; QBIA (20% of QBI) - $27,927.84 S Corporation: Net income - $150,000; less salary of $55,000; tentative QBI - $95,000; less ½ of S.E./payroll tax - $4,207.50; Net QBI - $90,792.50; QBIA (20% of QBI) - $18,158.50 QBI also does not include any:76
Capital gain;
Dividends (or their equivalent, or payment in lieu of a dividend);
Interest income unless it is allocable to the taxpayer’s trade or business;
Any amount received from an annuity that is not in connection with a trade or business;
Certain commodity transactions;
Foreign currency gains or losses; or
Speculative gains.
Example. Porky operates a hog farming business, and hedges his feeds costs in corn and soybeans. In 2018, Porky had hedging gains of $80,000. Porky also recognized a gain on wheat futures of $30,000. Porky’s QBIA is increased by $16,000 ($80,000 x .20) for the hedging gain. The gain associated with the wheat futures is speculative gain and does not increase Porky’s QBIA.
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IRC §199A(c). QBI does not include qualified REIT dividends and qualified publicly traded partnership income. IRC §199A(c)(1). However, they are provided separate treatment as part of the QBID. Thus, income from these sources are not part of the QBI on which the 20 percent deduction is determined. They generate a separate 20 percent deduction that is not subject to other limitations. The QBIA from REITs and publicly traded partnerships is combined with other QBIA to be limited in the overall limitation. 75 IRC §199A(c)(4). 76 IRC §199A(c)(3).
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Note. For a sole proprietor, the entire net profit reported on Schedule F, Profit or Loss From Farming, (or Schedule C, Profit or Loss From Business) qualifies for purposes of the deduction.77 Observation. It is possible that a guaranteed payment could create a partnership loss. That should be distinguished from a preferred allocation of income, which is determined after determining the results of partnership operations. Example. John and Jessica conduct a farming operation as a general partnership. During 2018, the partnership generated $100,000 of farm income. John was paid a guaranteed payment of $110,000 and, as a result, the partnership reported a loss of $10,000. The $10,000 loss is negative QBI. However, if John was specially allocated the first $100,000 of income and then John and Jessica evenly split all partnership income thereafter, all of the farm income would be considered QBI. Note. Regulations could be issued in the future providing that service income of a partner engaging in a transaction with the partnership in a capacity other than as a partner will not qualify as QBI. Until such a time, however, a partnership that pays guaranteed payments will be able to amend the partnership agreement to reclassify guaranteed payments as preferred allocations of income for services performed. As indicated above, QBI includes net amounts of items of income, gain, deduction and loss with respect to any qualified trade or business. Based on the determination of what constitutes an individual’s NOL under IRC §172, business-related income items (that would constitute QBI) also include ordinary gains and losses from Form 4797; state income tax on the taxpayer’s trade and business income;78 deductions that are attributable to a business that is carried on in an earlier year; 79 the deduction for self-employed health insurance;80 and the deductible portion of the self-employment tax.81 Non-business deductions include IRA deductions and deductions for contributions to a health savings account.82 Alimony is also non-business income (deduction).83 Other non-business items (for NOL purposes) include ordinary losses on the sale or exchange of stock in a small business corporation,84 and retirement plan contributions for a sole proprietor or partner.85 Guidance is needed concerning whether these items constitute business income for QBI purposes. Treatment of capital gain or loss. By statute, capital gain or loss is not QBI.86 However, IRC §1231 gain that is taxed at capital gain rates is QBI because it is not a “capital gain” as that term is used in the exclusion list of IRC §199A(c)(3)(B). However, the deduction is limited to 20 percent of taxable income less capital gains (including IRC §1231 gains such as those generated by the sale of culled breeding
77
As a result, the deduction for a sole proprietor may often be larger than if the business were structured as a partnership or S corporation.
78
See Rev. Rul. 70-40, 1970-1 C.B. 50. Penton v. United States, 259 F.2d 536 (6th Cir. 1959). 80 IRC §162(l). 81 IRC §164(f)(2); see also IRS Form 1045, Schedule A instructions. 82 See the instructions to IRS Form 1045, page 6. 83 See, e.g., Monfore v. Comr., T.C. Memo. 1988-197. 84 IRC §1244(d)(3). 85 IRC §172(d)(4)(D). 86 IRC §199A(c)(3)(B)(i). 79
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stock). Thus, if the only source of taxable income on a taxpayer’s return is derived from capital gain (including qualified dividends), the taxpayer cannot claim any QBI. Example. John and Mary (a married couple) operate a cow/calf operation. During 2018, they sell raised breeding stock that they have held for more than two years for a $300,000 capital gain. If their ordinary income for the tax year is zero and they net $300,000 of taxable income, their tentative QBI deduction is $60,000 ($300,000 × 20%) on the sale of the raised breeding stock. However, the QBI deduction is limited to 20 percent of taxable income ($300,000) less capital gains ($300,000). Thus, the QBI deduction for John and Mary is zero. Example. Now assume that John and Mary experience an operating loss for 2018 of $200,000. Their sale of raised breeding stock generates a $300,000 capital gain. Their net QBI is $100,000 and their tentative QBIA is $20,000 ($100,000 x .20). However, because all of their taxable income is taxed as capital gain, the allowed QBI deduction is zero. Rental income. Whether rental income is QBI depends on whether the rental activity by the taxpayer rises to the level of a trade or business. Additional guidance from the IRS is needed. But, as noted above, IRC §199A does not require the taxpayer to materially or significantly participate in the trade or business. Handling negative QBI. QBI of a business may be negative even if the taxpayer has an overall positive QBI.87 If a taxpayer’s net QBI is a loss, the loss carries over to the following year and is treated as a loss from a qualified trade or business in that succeeding year.88 In other words, if the taxpayer’s return reports income from a business activity but the business activity produces a net loss, the taxpayer is not entitled to a QBI deduction.89 However, in any event, the QBI deduction cannot be less than zero. Example. Shorty operates a small animal feed manufacturing business (Schedule C) in addition to his Schedule F farming operation. For 2018, the manufacturing business produces net income of $50,000. Shorty’s farming operation generates a loss of $75,000. Because Shorty’s net business activity is a loss, his negative QBI is $25,000. That negative $25,000 carries forward to 2019. In 2019, Shorty will need a positive QBI of at least $25,000 before QBIA will exceed zero. QBI AMOUNT (QBIA) Tentative QBIA. The taxpayer determines the QBIA from each qualified trade or business.90 Thus, the tentative QBIA is 20 percent of the QBI determined for each of the taxpayer’s separate trades or businesses.91 The tentative QBIA for each of the taxpayer’s trades or businesses is limited to the lesser of the following:
50 percent of the taxpayer’s share of allocable wages of the qualified businesses; or
Example 2 of Senate Amendment, page 37 of the Joint Explanatory Statement of the Committee of Conference (i.e., the “Conference Committee Report”). 88 IRC §199A(c)(2). The effect, therefore, of the net loss is to reduce the next year’s QBI deduction. 89 If the taxpayer has multiple businesses, the income from all of the businesses is netted to determine if QBI is positive for the tax year. 90 IRC §199A(b)(1). The IRC does not provide any guidance on how to distinguish one business from another. However, Treas. Reg. §1.461-4(d)(5)(ii) and Treas. Reg. §1.446-1(d)(2) do provide some guidance. 91 IRC §199A(b)(2)(A). 87
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25 percent of the taxpayer’s share of allocable wages of the qualified business plus 2.5 percent of the unadjusted basis, immediately after the acquisition, of all qualified property.
Example. Joel, who is single, is a farmer with net farm income of $250,000 for the 2018 tax year. Joel paid wages of $50,000, and has $600,000 of qualified property. Joel’s QBI deduction is the calculated as follows.92 The lesser of:
Tentative QBIA is $50,000 (20% × $250,000).
The QBIA is then limited to the greater of: 50% × $50,000 (W-2 wages), or $25,000, or (25% × $50,000 (W-2 wages)) + (2.5% × $600,000 (qualified property), or $27,500
Therefore, Joel’s QBIA is $27,500. Example. Now assume the same facts except Joel also had another business activity that had a net operating loss for the year. Joel custom cuts crops for other farmers, and that business lost $150,000 in 2018. Joel’s negative QBIA from the custom harvesting business is $30,000 ($150,000 × 20%). This negative amount exceeds the positive amount from Joel’s farming activity and will eliminate any QBI deduction for Joel. This is the result even though Joel showed positive overall business income for the year of $100,000 ($250,000 net farm income – $150,000 custom harvesting loss). The negative QBI will carry over to the following year and be treated as a loss from a qualified trade or business in that year. Wages and investment limitation. The wages and investment limitation does not apply to a taxpayer
with taxable income (computed before the IRC §199A deduction) that does not exceed $157,500 (single filer) or $315,000 (married filing jointly).93 The limitation phases-in over a range of $50,000 (single) or $100,000 (MFJ).94 Thus, taxpayers with tentative taxable income less than the applicable threshold amount do not need to compute the wage or investment limitations.95 These taxpayers only need to net all qualified trade or business income from all activities and multiply the result by 20 percent to arrive at QBIA. For taxpayers that are subject to the wages and investment limitation, the limitation reduces the tentative QBIA to arrive at actual QBIA for each business of the taxpayer. The amount of the reduction depends upon the level of the tentative taxable income of the taxpayer relative to the threshold amount. The statute prescribes the manner of the reduction as follows:96
Step one: Determine the tentative QBIA
92
IRC §199A(b)(2). IRC §199A(b)(3)(A). 94 IRC §199A(b)(3)(B)(i)(l) 95 IRC §§199A(b)(2), (b)(3), and (e)(2). 96 IRC §199A(b)(3)(B). 93
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Step two: Determine the amount of the reduction of the QBI deduction if the wages and investment limitation fully applied;
Step three: Determine tentative taxable income less the threshold amount;
Step four: Divide the result of Step three by the amount of the range over which the phase-in applies to arrive at a percentage;
Step five: Multiply the percentage achieved in Step four by the amount of the reduction due to the wages and investment limitation determined in Step two; and
Step six: Subtract the amount determined by Step 5 from the tentative QBIA determined in Step 1.
Example. Ted is a single farmer that farms via his S corporation. In 2018, Ted had net farm income of $300,000. His tentative QBIA is $60,000 ($300,000 x .20). During 2018, he paid $40,000 of qualifying wages and had $500,000 of qualifying property. The 50 percent of wages limitation is, therefore, $20,000, and the 25 percent of wages plus 2.5 percent of qualified property limitation is $22,500 [($40,000 x .25) + (.025 x $500,000)]. The greater of those two limitations is $22,500. The reduced QBIA due to the limitation is $37,500. Assume that Ted’s taxable income is $200,000, which is $42,500 over the threshold for a single person of $157,500. The $42,500 is 85 percent of the $50,000 phase-out range. Thus, the reduction of Ted’s QBIA times 85 percent is $31,875. Subtracting this amount from Ted’s tentative QBI of $60,000 yields a net QBIA allowed of $28,125. Observation. As can be determined from the example, taxpayers with income over $207,500 (or $415,000 for MFJ taxpayers) are fully subject to the wage limit. Note. Excess wages and investment from one business do not spill-over to another business.97 Qualified wages. Wages must be W-2 wages that are allocable to the QBI of the business,98 and must be subject to payroll taxes paid by the taxpayer with respect to employment of employees during the calendar year ending during the taxpayer’s tax year.99 Therefore, wages paid in commodities are not included for this purpose.100 However, wages paid to children under age 18 by the parents are qualified wages even though they are not subject to payroll tax. Note. IRC §199A(b)(4)(A) references IRC §6051(a) for the definition of “W-2 wages.” In particular, IRC §6051(a)(3) sets forth qualifying wages for purposes of IRC §199A. There it is specified as the total wages as defined in IRC §3401(a), which is the definition of wages for withholding purposes. That definition includes all wages, including wages paid in a medium other than cash, except wages paid to agricultural labor unless the wages are for payroll tax purposes under IRC §3401(a)(2). Wages paid to children under age 18 by their parents are not included as an exception contained in IRC §3401(a). They are subject to withholding, but are often exempt because the amount is less than the standard deduction. However, under IRC §3401(a)(2), commodity wages are not “wages” because there are not “wages”
97
IRC §199A(b)(2). IRC §199A(b)(4). 99 IRC §199A(b)(4)(A). 100 The same is true for guaranteed payments paid to partners. 98
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under IRC §3121(a) by virtue of being excluded by IRC 3121(a)(8)(A). Thus, the bottom line is that wages paid to children under age 18 by their parents count as wages for QBI purposes, but ag wages paid in-kind do not. In addition, IRC §199A(b)(4)(A) also references IRC §6051(a)(8) as “W-2 wages.” That provision adds back elective deferrals to wages and is the identical language contained in former IRC §199(b)(2)(A). In other words, wages are Box 1 wages rather than Box 3 or 5 wages. Increasing wages can result in a higher QBI deduction and a resulting lower tax liability. Example. Nippan-Tuck Farm is an S corporation that generated $350,000 of net farm income in 2018. During 2018, the S corporation paid $45,000 of wages subject to payroll tax to its owner, Sally. Assume that the S corporation had no qualified property. Sally’s taxable income is $450,000 (MFJ). Thus, Sally’s tentative QBIA is $70,000. But, the QBIA is limited to 50 percent of wages (.5 x $45,000), or $22,500. If Sally were to increase her wages to $60,000, the additional payroll tax would be $2,295. Her QBIA would now be limited to $50,000. Because Sally is in the 37 percent bracket, she saves $10,312,50 of income tax. Her net tax savings would be $10,312.50 - $2,295, or $8,017.50. Qualified property. “Qualified property” is tangible, depreciable property held by and available for use in a qualified trade or business of the taxpayer as of the close of the tax year. The “unadjusted basis” of qualified property is included in the 2.5 percent computation until the later of the end of the property’s recovery period or ten years. Example. Ronald Chee began farming in 2018. He bought a combine for $300,000, built a machine shed at a cost of $100,000, and paid no wages during 2018. His qualified property is $400,000. 2.5 percent of $400,000 is $10,000. The machine shed, as 20-year property will continue to be qualified property for 20 years. The combine will be qualified property for ten years. It is immaterial that the combine will be fully depreciated after five years. Farm taxpayers that are subject to the wage limitation or have insufficient wages and/or qualified property may benefit from making the election to capitalize repairs and de minimis expenditures rather than taking a current deduction for them. Example. Jeannie is an unmarried farmer with net income of $160,000 and tentative taxable income of $400,000 for 2018. She paid no wages and has no qualified property. For 2018, Jeannie incurred repair expenses of $100,000 and de minimis expenditures of $50,000. Her tentative QBI deduction is $32,000 ($160,000 × 20%), but it is limited to zero because she has no wages and no qualified property and her tentative taxable income exceeds the $207,500 threshold for a single person. However, if Jeannie elects to capitalize repairs and not deduct the de minimis expenses, her qualified property amount would be $150,000. She could then make an IRC §179 election for the $150,000. Jeannie would then have a QBI deduction of $3,750 (2.5% × $150,000). When the farming business is sold, the sale can impact qualified property. Presumably, the qualified property that is held immediately before the sale will be considered in the investment limitation. The Treasury is to provide guidance where the taxpayer acquires or disposes of a major portion of a trade or business or the major portion of a separate unit of a trade or business during the taxable year. 101 Also, the timing of the sale may have a significant impact on wages.
101
IRC §199A(b)(5).
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Example. Cheri’s farm business reports $200,000 of annual wage expense and has $1.5 million of qualified property. Cheri sells her farm on December 31, 2018, for a $3 million gain. Of that $3 million, $1 million is depreciation recapture. During 2018, Cheri’s farm broke even. Her tentative QBIA is $600,000. However, her tentative QBIA is limited to $100,000 (50 percent of the $200,000 wage expense). Her maximum QBI deduction would have been $200,000 (20 percent of ordinary taxable income). However, had Cheri sold her farm on January 1, 2019, her QBIA might be completely eliminated because she would have no wages and, perhaps, no qualified property (or maybe $37,500 of qualified property (2.5 percent of $1.5 million). Note. The same issues with wages and qualified property that are present upon sale of a business early in the tax year can occur when a business is started late in the year. However, when a business is started, the cost of asset acquisitions can be offset (at least in part) by the use of bonus depreciation. COMBINED QBIA A taxpayer’s combined QBIA is the sum of the QBIAs of the taxpayer’s qualified trades or businesses plus 20 percent of the aggregate qualified REIT dividends and qualified publicly traded partnership (PTP) income for the year.102 Under IRC §199A(a), a taxpayer’s QBI deduction is the taxpayer’s combined QBIA limited to 20 percent of the excess of: Tentative taxable income, over The sum of the net capital gain103 for the year. Example. Dan is a Minnesota farmer that has two other businesses in addition to his farming business. In 2018, he had $200,000 of income from his farming business which would yield a tentative QBIA of $40,000. He also had a custom spraying business that lost $10,000 in 2018, yielding a tentative QBIA of -$2,000. Dan also operated a field drainage tile installation business that had $100,000 of income in 2018 providing a $20,000 tentative QBIA. Thus, the combined tentative QBIA of the three businesses is $58,000. In 2018, Dan also received REIT dividends of $3,000, and had $1,000 of PTP net income. His tentative QBIA from those sources of income is $800 (.20 x $4,000). Thus, Dan’s total tentative QBI deduction is $58,800. Dan would need $294,000 or ordinary income to fully utilize the entire deduction ($58,800/.20). Cooperative rule. A special rule applies with respect to farm income received from an agricultural or horticultural cooperative.104 Under the rule, the combined QBIA is reduced by the lesser of 9 percent of the QBI that is allocable to qualified payments from the cooperative, or 50 percent of the W-2 wages associated with the QBI from the cooperative. QBI DEDUCTION (QBID)
102
IRC §199A(b)(1)(A)-(B). Net capital gain is referenced to IRC §1(h) and includes qualified dividends under IRC §1(h)(11). 104 IRC §199A(b)(7). 103
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The QBID establishes an overall limitation. The overall limitation on the deduction is computed as follows:105
Combined QBIA limited to 20 percent of the excess of tentative taxable income over
The sum of the net capital gain for the year.106
Observation. A farmer may have substantial combined QBIA, but the ultimate QBID cannot exceed 20 percent of the farmer’s net ordinary income. Thus, if tentative taxable income is all taxed at capital gain rates, the taxpayer is not entitled to any IRC §199A deduction. Example. Rusty is a Wisconsin dairy farmer. In 2018, Rusty had taxable farm income of $150,000 and another $200,000 of IRC §1231 gain from the sale of culled dairy cows. Thus, Rusty’s tentative taxable income for 2018 is $350,000. Also assume that Rusty’s wages and qualified property are sufficient. The result is that Rusty’s QBIA is $70,000 (.20 x. $350,000). However, Rusty’s QBID is limited to 20 percent of the $150,000 of ordinary income, or $30,000. Observation. In the example, if Rusty had traded the dairy cows for new dairy cows instead of selling them, a better tax result could have been obtained. While a tax-free exchange is no longer available for trades of personal property such as dairy cows, Rusty would have recognized $200,000 of IRC §1231 gain on the “trade” and would have received an income tax basis of $200,000 in the new dairy cows which Rusty could have offset with $200,000 of bonus depreciation. The QBID remains at zero, but the ability to claim bonus depreciation zero’s out Rusty’s ordinary income.
Note. The example above assumes that the unadjusted income tax basis of replacement property received in a trade for purposes of IRC §199A is the selling price of the property given up in the exchange. IRS guidance is needed to ensure this is correct. COOPERATIVES AND PATRONS OF COOPERATIVES Cooperatives. Agricultural and horticultural cooperatives107 are allowed a deduction equal to 9% of the lesser of the cooperative’s qualified production activities income (QPAI) for the year or taxable income (determined without regard to patronage dividends, per-unit retain allocations, and non-patronage distributions).108 The deduction, however, cannot exceed 50% of the cooperative’s W-2 wages for the year that are subject to payroll taxes and are allocable to domestic production gross receipts.109 Observation. The deduction, for most cooperatives, will be limited to 50 percent of W-2 wages. It is unlikely that a cooperative’s wages as a percentage of revenue will exceed 9 percent.
105 106 107 108 109
IRC §199A(a)(1). Net capital gain is defined under IRC §1(h) which is net capital gain under IRC §1222(11), as modified. As defined in IRC §199A(g)(4)(A). IRC §§199A(g)(1)(A) and (C). IRC §199A(g)(1)(B)(i).
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The cooperative may choose to either claim the deduction or allocate the amount to patrons (including other specified agricultural or horticultural cooperatives or taxpayers other than a C corporation).110 Patrons of cooperatives. An eligible patron of an agricultural or horticultural cooperative that receives a qualified payment from the cooperative can claim a deduction in the tax year of receipt in an amount equal to the portion of the cooperative’s deduction for QPAI that is: 11. Allowed with respect to the portion of the QPAI to which such payment is attributable; and 12. Identified by the cooperative in a written notice mailed to the patron during the payment period described in IRC §1382(d).111 A qualified payment to a patron is any amount that meets the following three tests.112 13. The payment must be either a patronage dividend or a per-unit retain allocation. 14. The payment must be received by an eligible patron from a qualified agricultural or horticultural cooperative. 15. The payment must be attributable to QPAI with respect to which a deduction is allowed to the cooperative. The cooperative’s deduction is allocated among its patrons on the basis of the quantity or value of business done with or for the patron by the cooperative. Note. Under IRC §199A(g), a cooperative cannot reduce its income under IRC §1382 for any deduction allowable to its patrons. Thus, the cooperative must reduce its deductions that are allowed for certain payments to its patrons in an amount equal to the IRC §199A(g) deduction allocated to its patrons. A patron is allowed a deduction for amounts allocated without regard to wages expense. The only limitation at the patron level is taxable income.113 Example. Larry and Shellie, a married couple, have taxable income from their farming operation of $200,000. They receive a $10,000 pass-through IRC §199A amount from a cooperative in which they are patrons. Their net farm income is $200,000. They do not pay any W-2 wages. Their QBI deduction is $40,000 ($200,000 × 20%), plus the $10,000 pass-through amount from the cooperative for a total QBI deduction of $50,000. Note. As the example illustrates, a patron of an agricultural or horticultural cooperative that receives a QBI deduction from the cooperative is not subject to the 20 percent of tentative taxable income limit.114 Instead, the patron’s QBI deduction is limited to taxable income.115 In addition, a patron that receives a QBI deduction from a cooperative may offset any character of income, including capital gain.
110
IRC §199A(g)(2)(A) & (D). IRC §199A(g)(2)(A). 112 IRC §199A(g)(2)(E). 113 IRC §199A(g)(2)(B). 114 IRC §199A(g)(2)(B). 115 IRC §199A(g)(1)(A)(ii). 111
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The patron’s deduction may not exceed the patron’s taxable income for the tax year (determined without regard to the deduction but after accounting for the patron’s other deductions under IRC §199A(a)).116 However, for any qualified trade or business of a patron, the QBIA is reduced by the lesser of:
9% of the QBI allocable to patronage dividends and per-unit retains received by the patron, or
50% of the W-2 wages (subject to payroll tax) with respect to the business.117
Example. John and Mary operate a dairy. They realize a gain of $300,000 from the sale of raised breeding stock, but they also receive a $300,000 IRC §199A deduction from the local cooperative that they are patrons of and sell to. In this situation, John and Mary can offset the IRC §1231 gain from the sale of the raised breeding stock by the $300,000 IRC §199A deduction passed through from the cooperative. Thus, their taxable income is zero. For a farmer that reports income and expenses on Schedule F, Profit or Loss From Farming, who is a patron of an agricultural cooperative and pays no qualified wages, there are two steps to calculate the tax benefits. First, the cooperative’s DPAD that is passed through to the patron can be applied to offset the patron’s taxable income regardless of source. Second, the farmer/patron is entitled to a QBI deduction equal to 20% of net farm income, subject to the wage limit that applies to taxpayers with income over the threshold amount ($315,000 for MFJ taxpayers and $157,500 for all others). Example. Michael and Kelsey, a married couple, rent out their land on a crop-share basis. They have taxable income in 2018 of $200,000, all from the crop-share rental. They have no wages expense. They receive a pass-through IRC §199A deduction from their cooperative of $10,000. They can claim a 20% QBI deduction of $40,000 on the crop-share rental income. In addition, they can deduct the $10,000 of the pass-through deduction from the cooperative. Thus, their taxable income for 2018 is $150,000 ($200,000 – $10,000 – $40,000). Example. Now assume that taxable income for Michael and Kelsey is $415,000 and they have no qualified property and paid no W-2 wages during 2018. They cannot claim any QBID. However, they can still claim the $10,000 passed through from the cooperative. Observation. Income from rental arrangements that subject the landlord to risk of production or risk of price change should qualify for the QBI deduction. Cash rentals will likely not qualify unless the rented land is part of an operating entity structure. Further guidance from the IRS is needed in this area. For farmers who pay qualified W-2 wages and sell to agricultural cooperatives that also pay W-2 wages, the QBID is reduced by subtracting the lesser of 50% of W-2 wages or 9% of QBI attributable to the income from the cooperative.118 Thus, for a farmer that has farm income beneath the threshold amount ($315,000 for MFJ taxpayers and $157,500 for all others), the QBID will never be less than 11% (i.e., 20% less 9%). Example. Bart, a married taxpayer who files jointly, receives a $5,000 QBI amount allocated to him from a cooperative. Bart’s Schedule F income is $250,000 and his tentative taxable income is less
116
IRC §199A(g)(2)(B). IRC §199A(g)(7). 118 IRC §199A(b)(7). 117
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than $315,000. Bart pays wages, but they are all paid in commodities. Bart’s QBI deduction for the Schedule F income is $50,000 ($250,000 × 20%). This is reduced by the lesser of the following amounts.
9% of farm income, or $22,500 (250,000 × 9%)
50% of wages, or zero.
Therefore, Bart’s QBI deduction is $55,000 ($50,000 – $0 + $5,000 QBI from cooperative). If the farmer is above the threshold amount, the 50% of W-2 wages limitation is applied before the 9% limitation. The farmer’s QBID cannot exceed 20% of taxable income. To this amount is added any passthrough deduction from the cooperative to produce the total deductible amount. For farmers that sell agricultural products to non-cooperatives and pay W-2 wages, a deduction of 20% of net farm income is available. If taxable income is less than net farm income, the deduction is 20% of taxable income less capital gains. If taxable income before the QBI deduction exceeds the threshold amount, the deduction may be reduced on a phased-in basis. Example. Use the same facts as before except that Bart pays $50,000 of qualified wages. Bart’s QBI deduction is computed as follows. 20% × $250,000 = $50,000, minus the lesser of: 9% of farm income, or $22,500; or 50% of wages, or $25,000. Bart’s QBI deduction is $32,500 ($50,000 – $22,500 + $5,000). Example. Now assume that Bart’s tentative taxable income exceeds $315,000 and he has qualifying property of $700,000. Bart’s QBI deduction is computed as follows. The lesser of:
20% × $250,000 = $50,000, or
25% of wages ($0) + 2.5% of $700,000 qualified property = $17,500
Minus the lesser of:
9% × $250,000 farm income = $22,500, or
50% × $0 wages = $0
Bart’s QBI deduction is $22,500 ($17,500 – $0 + $5,000). Example. Now add in the addition fact that Bart pays qualified wages of $100,000. Bart’s QBI deduction is computed as follows. 20% of $250,000 = $50,000, minus the lesser of: 43
9% of farm income, or $22,500; or 50% of wages ($50,000) Bart’s QBI deduction is $27,500 ($50,000 – $22,500). Observation. Whether a taxpayer receives an advantage from selling agricultural products to a cooperative depends on various factors. In general, a farmer with farm income over the applicable income threshold for their filing status obtains a larger QBID by paying qualified wages if the farmer does not have enough qualified property to generate the full QBID allowed. Conversely, a farmer that is below the applicable income threshold derives a larger QBID by not paying qualified wages, or by paying qualified wages in an amount such that half of the amount of the wages paid is less than 9 percent of the farmer’s Schedule F income that is attributable to the cooperative. TRUSTS AND ESTATES Trusts and estates are eligible for a QBID.119 The QBID applies to income taxed at the trust or estate level, and the apportionment of W-2 wages and qualified property for purposes of the wages and investment limitation applies as it did the purposes of the DPAD under former IRC §199.120 ACCURACY-RELATED PENALTY When a QBID is claimed on a return, an accuracy-related penalty is applied when the understatement of tax exceeds the greater of five percent of the tax required to be shown on the return or $5,000.
SUMMARY – DETERMING THE QBID121 The basic step-by-step approach to determining the QBID for a taxpayer is as follows:122 Step One: Determine if the taxpayer’s taxable income is below zero. If it is below zero then there is no QBID benefit in the current year. However, the net loss as a result of the QBID must be determined for its effect on the following year’s QBID. Step Two: Determine if the taxpayer has a pass-through QBID from a cooperative. If so, the passthrough amount is deductible up to taxable income. In addition, a computation will need to be made of the QBIA based on the lesser of cooperative income or 50 percent of W-2 wages. Step Three: Determine if the taxpayer has tentative taxable income that is comprised of net ordinary income. If the taxpayer’s ordinary income is fully offset by capital gain (or qualified dividends), there is no QBID except for any amount that is passed-through from a cooperative. Step Four: Determine if the taxpayer has tentative taxable income less than the applicable threshold amount.
119
IRC §199A(f)(1)(B). IRC §199A(f)(1)(B). 121 The following step-by-step process assumes that no specified service businesses are involved. 122 This step-by-step analysis is a summary of the discussion of this section of the Chapter and is based entirely on the statutory provisions without the aid of any regulations, forms or IRS guidance. 120
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Step Five: Determine the taxpayer’s overall QBI. This determination should be made irrespective of whether the taxpayer has separate trades or businesses. If there is an overall QBI loss, carryover the loss to the following year. Step Six: If the overall QBI from Step Five is positive, determine if the taxpayer’s tentative taxable income is less than the applicable threshold. If it is, then multiply the net positive QBI by 20 percent to determine the QBIA. If the taxpayer has multiple trades or businesses, aggregate them. The wages and investment limitation is inapplicable. Determine the QBID by limiting the QBIA to 20 percent of the taxpayer’s ordinary income. If the taxpayer’s tentative taxable income exceeds the applicable threshold, proceed to Step Seven. Step Seven: Determine if the taxpayer has only one trade or business. If so, then determine the wages and investment limitation to arrive at QBIA. Then determine the QBID by limiting the QBIA to 20 percent of the taxpayer’s ordinary income. Step Eight: If the taxpayer has multiple trades or businesses, determine whether the taxpayer’s tentative taxable income exceeds the applicable threshold plus the amount of the applicable threshold. Note. Guidance is needed from the IRS on whether a taxpayer with multiple farming businesses can group them for purposes of the QBI deduction. If the taxpayer’s tentative taxable income from multiples trades or businesses exceeds the thresholds, apply the wages and investment limitation to each trade or business to arrive at each business’s QBIA. Determine the combined QBIA. If the taxpayer’s tentative taxable income does not exceed the applicable threshold plus the applicable phaseout range, determine if any of the businesses have a QBI loss. If so, aggregate the QBI’s for the loss businesses and multiply the result by 20 percent. If all of the trades or businesses have a positive QBI, determine the QBIA for each business. Step Nine: Aggregate the taxpayer’s separately determined QBIA’s to arrive at combined QBIA. Step Ten: Determine the QBID by limiting the combined QBIA to 20 percent of the taxpayer’s ordinary income. As noted above, if the taxpayer receives cooperative distributions, the computation of the taxpayer’s QBI deduction takes into account those distributions. New I.R.C. §199A – The Qualified Business Income (QBI) Deduction (Non Ag-Related) Note: The materials in this section are prepared by Chris Hesse and Paul Neiffer, of CliftonLarsonAllen, LLP. The materials are in draft form.
SPECIFIED SERVICE TRADE OR BUSINESS (SSB). 45
1. The 20% deduction does not apply to specified service business income if the taxpayer’s tentative taxable income is above the threshold level plus the phase-out range [Sec. 199A(d)(2)]. a. Specified services are defined in Section 1202(e)(3)(A) [Sec. 199A(d)(2)(A)]: 1) These are trades or businesses involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. 2) Although architect and engineering services are included in Sec. 1202(e)(3)(A), they are specifically excepted from the definition for Section 199A. Architectural and engineering service business income qualify for the 20% deduction [Sec. 199A(d)(2)(A)]. b. Specified services also include businesses which involve the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities [Sec. 199A(d)(2)(B)]. 2. Observation: There is virtually no guidance as to the meaning of the various terms. Although Section 1202 was added to the Internal Revenue Code in 1993, regulations have not been issued to address the meaning of the various service categories. a. Commentary: The authors expect that a business either will or will not be considered an SSB based upon its principal business activity. However, the measure of principal business activity could be based upon gross receipts, assets devoted, or some other measure. b. Commentary: It appears that an entity will not be able to allocate net income between SSB activities and non-SSB activities in a manner similar to that used by now-repealed Section 199 (DPAD), unless the entity has two or more separate trades or businesses. Example
Mixture of Specified Service Business and Other Business
FACTS: Becky is a veterinarian. She nets $300,000 from veterinary care. She also nets $75,000 from boarding and selling pet food. Becky’s tentative taxable income is over the threshold plus the phase-out range. RESULTS: If the boarding activity and selling of pet food are not SSB activities, she could deduct a $15,000 QBID.
c. Section 1202(e)(3)(A) has not been addressed by the courts, nor in revenue rulings or other official guidance. d. The IRS privately ruled that a healthcare laboratory, which provided results of testing to doctors and other healthcare providers, was not in a trade or business (i) involving the performance of services in the field of health, or (ii) where the principal asset of the trade orbusiness is the reputation or skill of one or more of its employees [PLR 201717010]. 46
1) The lab reports did not diagnose or recommend treatment. 2) The company did not take orders from nor explain lab tests to patients. 3) The company’s sole function was to provide lab reports to health care providers. 4) The IRS read the provision narrowly as the performance of health services. e. Other rulings were yet more strictly construed to limit the health care provision as meaning the diagnosis and direct treatment of patients [PLR 201436001]. f.
Another analogous provision provides an exception allowing the use of the cash method regardless of gross receipts for a personal service corporation [Sec. 448(b)(2)]. 1) The provision describes similar activities in its definition of “qualified personal service corporation.” 2) Temporary regulations provide, for example, that the performance of services in the field of health means the provision of medical services by physicians, nurses, dentists, and similar health care professionals. It does not include services that purportedly relate to the health of the recipient, such as athletic clubs, spas or physical exercise [Temp. Reg. 1.448-1T(e)(4)(ii)]. 3) A corporation whose employees perform veterinary services is a qualified personal service corporation due to the veterinarian’s status as a “similar health care professional” [Rev. Rul. 91-30].
g. Accounting services include tax preparation and bookkeeping services, even though the corporation had no CPAs as employee or owners and the services did not require a CPA license. [Rainbow Tax Service, Inc. v. Comm., 128 TC 42, 2007]. h. Further examples of various personal services may be found in the temporary regulations at Temp. Reg. 1.448-1T. 3. The passive activity regulations also use similar categories for the determination of material participation in personal service activities [Temp. Reg. 1.469-5T(d)(1)]. a. Commentary: The authors expect the provision to be limited to services, based upon the heading of the specific paragraph, i.e., Section 199A(d)(3) “Exception for specified service businesses…” 1) Although various businesses may attribute their success to the skill or reputation of employees and owners, only businesses primarily providing services will be considered SSBs. 2) A restaurant, for example, provides meals. The provision of exceptional service, or the reputation of the chef, should not cause a restaurant to be excluded from QBI because of reputation and success in that business. b. Likewise, the authors anticipate that activities described in subparagraphs (B) – (E) of Section 1202(e)(3) also will not be items that will be imported into the definition of an SSB, regardless of reputation or skill. These activities should not be considered SSBs, regardless of reputation or skill: 47
1) Banking, insurance, financing, leasing, investing or similar businesses [Sec. 1202(e)(3)(B)]; 2) Any farming business including the raising or harvesting of trees [Sec. 1202(e)(3)(C)]; 3) Any business involving the production or extraction of products of a character with respect to which a depletion deduction is allowed [Sec. 1202(e)(3)(D)]; and 4) Any business operating a hotel, motel, restaurant or similar business [Sec. 1202(e)(3)(E)]. c. If it was the intention of Congress to include these businesses outside the specific scope of Section 1202(e)(3)(A), the provision would not have been a specific reference to Section 1202(e)(3)(A). 4. SSB denial as QBI does not apply for taxpayers with taxable income below the threshold [Sec. 199A(d)(3)]. a. To the extent taxable income is no more than $157,500 ($315,000 for MFJ), the full deduction is allowed [Sec. 199A(d)(3)(A)]. b. Observation: Although not explicitly stated, these thresholds are the top of the 24% brackets for individuals. However, the $157,500 level also applies to estates and trusts, even though all income above $12,500 is taxed at 37%. c. The allowance of SSB income as QBI phases out over a $50,000 income range ($100,000 range for MFJ) as taxable income exceeds $157,500 ($315,000 MFJ). 1) The applicable percentage of income, etc. and the wages and investment limitation are considered QBI. 2) The applicable percentage is 100% reduced (not below zero) by the ratio of taxable income in excess of the threshold amount divided by $50,000 ($100,000 MFJ) [Sec. 199A(d)(3)(B)]. Commentary: The authors expect that the phase-out of SSB as QBI is subject to two phase-outs. The wages and investment limitation (described below) is also subject to the same phase-out threshold computation.
48
Example
Computation of SSB Income as QBI within Phase-out Range
Section 199A deduction allowed on Pro-Rata Basis SSB Income Tentative Section 199A deduction (20% of SSB-QBI) Times Applicable Percentage Allowed Section 199A deduction allowed on Pro-Rata Basis
$
$
400,000 80,000 70.00% 56,000
Section 199A deduction allowed based on applicable percentage SSB Income Tentative Section 199A deduction (20% of SSB-QBI) Wages Qualified Property 50% wage limitation 25% wage plus 2.5% qualified property limitation Limit Allowed
Gross Amount % Amount $ 400,000 $ 280,000 56,000 20,000 14,000 50,000 35,000 7,000 4,375 $ 7,000
Difference between Tentative and Limit Times amount disallowed Phased-in reduction Actual Section 199A deduction allowed on SSB using applicable percentage
$
49,000 30.00% 14,700
$
41,300
Additional reduction percentage due to applicable percentage Applicable Percentage Calculation: Taxable income Threshold amount Difference Divided by phase-in amount Percentage Applicable Percentage (1-phase-in percentage)
26.25%
$
345,000 315,000 30,000 100,000 30.00% 70.00%
d. The threshold amount is indexed for inflation in $50 increments (Sec. 1(h)(7) via Sec. 199A(e)(2), flush language]. e. Taxable income is determined before the Section 199A deduction [Sec. 199A(e)(1)]. For purposes of this material, we refer to this as “tentative taxable income.”
RECENT RULINGS AND CASES 49
S Corporation Land Rents Not Passive; Trust Shareholder Was ESBT Priv. Ltr. Rul. 201812003 (Dec. 15, 2017) The taxpayer, an S corporation engaged in farming and managing real property had a grantor trust as a shareholder. The taxpayer engaged in four leases involving the farming operation that generated rental income to the taxpayer. The taxpayer sought a ruling on whether the taxpayer’s rental income was passive investment income under I.R.C. §1362(d)(3)(C), and whether the trust would qualify as an electing small business trust (ESBT) under I.R.C. §1361(e). The trust grantor died and the trust beneficiaries were two distributing trusts that are U.S. individuals and two tax-exempt organizations. Each beneficiary received a stepped-up basis under I.R.C. §1014. Three of the leases provide that the taxpayer is a full participant in the farm’s management, and that the tenant could not deviate from the managerial plan without the taxpayer’s approval. The leases were crop-share leases that also split expenses between the taxpayer and the tenant. The fourth lease provided for the tenant’s plowing, land clearing and crop cultivation for a share of the crops. The IRS determined that the taxpayer’s rental income from the leases was not passive investment income under I.R.C. §1362(d)(3)(C), and that the trust qualified as an ESBT because the beneficiaries were qualified beneficiaries and no interest of the trust was acquired by purchase. Court Unfolds Refundable Fuel Credit Scam; 200% Penalty Applied Alternative Carbon Resources, LLC v. United States, No. 1:15-cv-00155-MMS, 2018 U.S. Claims LEXIS 189 (Fed. Cl. Mar. 22, 2018) IRC §6426 provides for several alternative fuel credits. Subsection (d) specifies the details for the alternative fuel credit. The initial version of the credit was enacted in 2004 as part of the American Jobs Creation Act of 2004. That initial version provided credits for alcohol and biodiesel fuel mixtures. In 2005, the Congress added credits to the Code for alternative fuels and alternative fuel mixtures. The credits proved popular with taxpayers. During the first six months of 2009, more than $2.5 million in cash payments were claimed for “liquid fuel derived from biomass.” That’s just one of the credits that were available, and the bulk of the $2.5 million went to paper mills for the production of “black liquor” as a fuel source for their operations (which they had already been using for decades without a taxpayer subsidy). The IRS later decided that “black liquor” production was indeed entitled to the credit because the process resulted in a net production of energy.123 However, later that year new tax legislation retooled the statute and removed the production of “black liquor” from eligibility for the credit. As modified, IRC §6426(d) (as of 2011) allowed for a $.50 credit for each gallon of alternative fuel that a taxpayer sold for use as a fuel in a motor vehicle or motorboat or sold by the taxpayer for use in aviation, or for use in vehicles, motorboats or airplanes that the taxpayer used. In addition, an alternative fuel mixture credit of $.50 per gallon is also allowed for alternative fuel that the taxpayer used in producing any alternative fuel mixture for sale or use in the taxpayer’s trade or business.
123
C.C.M. AM2010-001 (Mar. 12, 2010). 50
For purposes of IRC §6426, “alternative fuel” is defined as “liquid fuel derived from biomass” as that phrase is defined in I.R.C. 45K(c)(3).124 “Liquid fuel” is not defined, but the U.S. Energy Information Administration defines the term as “combustible or energy-generating molecules that can be harnessed to create mechanical energy, usually producing kinetic energy [, and that] must take the shape of their container.” An “alternative fuel mixture” requires at least 0.1 percent (by volume) (i.e., one part per thousand) of taxable fuel to be mixed with an alternative fuel.125 An alternative fuel mixture is “sold for use as a fuel” when the seller “has reason to believe that the mixture [would] be used as a fuel either by the buyer or by any later buyer. Id. In other words, a taxpayer could qualify for the alternative mixture fuel credit by blending liquid fuel derived from biomass and at least 0.1 percent diesel fuel into a mixture that was used or sold for use as a fuel, once the taxpayer properly registered with the IRS. 126 In the case, a Pella, IA firm produced alternative fuel mixtures consisting of liquid fuel derived from biomass and diesel fuel. The plaintiff registered with the IRS via Form 637 and was designated as an alternative fueler that produces an alternative fuel mixture that is sold in the plaintiff’s trade or business. Clearly, the plaintiff’s business model was structured around qualifying for and taking advantage of the taxpayer subsidy provided by the IRC §6426 refundable credit for alternative fuel production. To produce alternative fuel mixtures, the plaintiff bought feedstock from a supplier, with a trucking company picking up the feedstock and adding the required amount of diesel fuel to create the alternative fuel mixture. The mixture would then be delivered to a contracting party that would use the fuel in its business. The plaintiff entered into contracts with various parties that could use the alternative fuel mixture in their anaerobic digester systems to make biogas. One contract in particular, with the Des Moines Wastewater Reclamation Authority (WRA), provided that the plaintiff would pay WRA to take the alternative fuel mixtures from the plaintiff. The plaintiff’s consulting attorney (a supposed expert on energy tax credits from Atlanta, GA) advised the plaintiff that it would “look better” if the plaintiff charged “anything” for the fuel mixtures. Accordingly, the plaintiff charged the WRA $950 for the year for all deliveries. In return, the plaintiff was charged a $950 administrative fee for the same year. The WRA also charged the plaintiff a disposal fee for accepting the alternative fuel mixtures in the amount of $.02634/gal. for up to 50,000 gallons per day. The plaintiff treated the transfers of its alternative fuel mixtures as sales for “use as a fuel.” That was in spite of the fact that the plaintiff paid the fee for the transaction. The plaintiff never requested a formal tax opinion from its Atlanta “expert,” however, the “expert” advised the plaintiff that the transaction qualified as a sale, based upon an IRS private letter ruling to a different taxpayer involving a different set of facts and construing a different section of the Code. The expert did advise the plaintiff that an IRS inquiry could be expected, but that the transaction with the WRA amounted to a sale “regardless of who [paid] whom.” A few months later, the IRS issued a Chief Counsel Advice indicating that if the alternative fuel was not consumed in the production of energy or did not produce energy, it would not qualify for the alternative fuel credit.127 The “expert” contacted the IRS after the CCA was issued and then informed the plaintiff that the IRS might challenge any claiming of the credit, but continued to maintain that the “plaintiff’s qualification for tax credits…was straightforward.”
IRC §6426(d)(2)(G). See Notice 2006-92, 2006-2, C.B. 774, 2006-43 I.R.B. §2(b). 126 I.R.C. 6426(a)(2). 124 125
127
C.C.A. 201133010 (Jul. 12, 2011).
51
The plaintiff claimed a refundable alternative fuel mixture credit in accordance with IRC §6426(e) of $19,773,393 via Form 8849. The IRS initially allowed the credit amount of $19,773,393 for 2011, but upon audit the following year disallowed the credit and assessed a tax of $19,773,393 in 2014. The IRS also assessed an excessive claim penalty of $39,546,786 for claiming excessive fuel credits without reasonable cause (IRC §6675); civil fraud penalty (IRC §6663) and failure-to-file and failure-to-pay penalties (IRC §6651). The court agreed with the IRS. While the court noted that the plaintiff was registered with the IRS and produced a qualified fuel mixture, the court determined that the plaintiff did not sell an alternative fuel mixture for use as a fuel. While the court noted that the term “use as a fuel” is undefined by the Code, the court rejected the IRS claim that the alternative fuel mixtures were not used as a fuel because the mixtures did not directly produce energy. Instead, they produced biogas that then produced energy, and the court noted that the IRS had previously issued Notice 2006-92 stating that an alternative fuel mixture is “used as a fuel” when it is consumed in the energy production process. However, the “production of energy” requirement contained in the “use of a fuel” definition meant, the court reasoned, that the alternative fuel mixture that is sold must result in a net production of energy. As applied to the facts of the case, the WRA could not provide any data that showed which of the feedstock sources from its numerous suppliers was producing energy, and which was simply burned off and disposed of. As such, the plaintiff could not prove that its fuel mixtures resulted in any net energy production, and the “use as a fuel” requirement was not satisfied. In addition, even if the “use as a fuel” requirement was deemed satisfied, the court held that the plaintiff did not “sell” the alternative fuel mixture to customers. The nominal flat fee lacked economic substance. The fee, the court noted was “charged” only for the purpose of receiving the associated tax credit. In addition, no sales taxes were charged on the “sales.” Thus, the plaintiff was not entitled to any alternative mixture fuel credits. The court upheld the 200 percent penalty insomuch as the professional advice the plaintiff received was not reasonably relied upon. The court noted that the plaintiff’s “expert” told the plaintiff that he was not fully informed of the plaintiff’s production process and informed the plaintiff that he did not understand the anaerobic digestion process. In addition, while the plaintiff was informed that there had to be a net production of energy from its production process to be able to claim the credit, the plaintiff ignored that advice. In addition, the court noted that the IRS private letter ruling the “expert” based his opinion on involved a different statute, a distinguishable set of facts, and did not support the plaintiff’s position and, in any event, was ultimately not relied upon. Likewise, a newly admitted local CPA that was hired to track feedstock received from suppliers and alternative fuel mixtures deliveries for the plaintiff provided no substantive tax advice that the plaintiff could have relied upon. The end result was that that plaintiff had to repay the $19,773,393 of the claimed credits and pay an additional penalty of $39,546,786. A large part of the other penalties had already been abated. The court noted that any portion of those penalties that had not been abated may remain a liability of the plaintiff. IRS Denied Summary Judgment on Hobby Loss Claim Against Cattle Operation Wicks v. United States, No. 16-CV-0638-CVE-FHM, 2018 U.S. Dist. LEXIS 9352 (N.D. Okla. Jan. 22, 2018)
52
The plaintiff owned and operated a company that provided mechanical inspection services for major oil refineries and gas plants. Since 2006, the plaintiff had reported approximately $1 million of adjusted gross income on his tax return annually, and had an approximate net worth of $7 million. In addition to his business, the plaintiff, in the late 1990’s, built a cattle ranch that he has maintained ever since as the sole owner and operator, performing all of the labor and spending three to four days weekly working on the ranching activity. However, the cattle ranching activity never showed a year of profitability, with total gross receipts from 1997 through 2015 totaling $32,602 and net losses totaling $807,380. The plaintiff did not establish a written business plan or have any written financial projections, and did not use any accounting software or form a business entity for the cattle operation, although he did use a spreadsheet to track his expenses. He also did not market or promote the cattle operation, insure the herd against catastrophic loss or consult a financial advisor. Before 1997, the plaintiff’s only experience with cattle was feeding and working them as a child. However, the plaintiff did buy 80 acres of land containing a dilapidated barn and unusable fence which he repaired. He purchased two longhorn heifers, built a new barn, bought and adjacent 180-acre tract to increase the herd to make the venture ultimately profitable, and improved the entire property by replacing fence, enlarging an existing pond, installing rural water and constructing a cattle working facility and loafing shed. The plaintiff also consulted with a successful local rancher regarding profitable methods of cattle ranching. He also purchased 20 cows to crossbreed so as to produce quality milk and beef, knowing that obtaining a crossbreed would take at least four years. The plaintiff also purchased new hay baling equipment and feed bins. The plaintiff sold cattle in 2013, after the cattle market had rebounded from prior lows. The plaintiff also attended seminars on cattle breeding and pasture management and read as much as he could about raising cattle. He also joined two different state cattlemen’s associations. For 2010 and 2011, the IRS denied the loss deductions for the plaintiff’s cattle ranching (and horse racing) activity, and assessed penalties with the total amount of tax and penalties (including interest) due being $89,838.09. The plaintiff paid the deficiency (plus interest) and sued for a refund, claiming that he engaged in the cattle ranching activity with profit intent as defined by Treas. Reg. §1.183-2(b). Later, at the plaintiff’s request, the court dismissed the refund claim related to the horse racing activity. The IRS moved for summary judgment on the plaintiff’s remaining claim related to the cattle ranching activity, arguing that the activity was not engaged in for profit and the resulting losses were nondeductible under the hobby loss rules of I.R.C. §183. On an evidentiary question, the court allowed tax return information from post-2011 years into evidence because it was relevant in showing whether the plaintiff had a profit intent for the tax years in issue. The court also denied the plaintiff’s motion to include in evidence an affidavit containing factual statements the plaintiff made concerning the ranching activity that had not been made in previous filings or testimony. The court also allowed into evidence testimony of an ag economist for the plaintiff to the extent the testimony bore on economic conditions and their impact on the plaintiff’s cattle ranching activity. The court examined each of the nine factors in Treas. Reg. §1.183-2(b) in its analysis of the issue. The court determined that the plaintiff’s lack of the uses of sophisticated businesses practices weighed in the favor of the IRS. On the issue of the plaintiff’s expertise, either personally or via advisors, the court determined that the factor was neutral. He neither zealously pursued nor neglected chances to gain opportunities to gain expertise in cattle ranching. The court, however, did note that the plaintiff put in a substantial amount of time on the ranching activity without any substantial recreational benefit, which 53
weighed in the plaintiff’s favor. The court reasoned that the plaintiff also had a reasonable expectation of the appreciation in value of the capital improvements that he made to the land. On the issue of whether the plaintiff had experienced success in carrying on similar (or dissimilar activities), the court noted that the factor was neutral. The court pointed out that the evidence showed that the plaintiff expended a substantial amount of time in the ranching activity, even though he didn’t operate it with great sophistication, and was successful in running a highly profitable mechanical inspection service business which could provide an inference that he engaged in the cattle ranching activity with profit intent. The many years of consecutive losses from the ranching activity weighed in the favor of the IRS although, as the court noted, the factor was mitigated to a degree by the fact that small farming operations are not generally lucrative. While the court noted that the taxpayer was wealthy, which would allow him to participate in the cattle ranching activity without a profit intent, the court noted that the IRS had not provided any evidence that the plaintiff received any personal or recreational benefit from the ranching activity – which made it less likely that the plaintiff engaged in the activity without a profit intent. Thus, the factor involving elements of personal pleasure or recreation weighed in the plaintiff’s favor. The court concluded that, based on the totality of the circumstances, and viewing the evidence in the light most favorable to the plaintiff, that a reasonable jury could conclude that, for 2010 and 2011, the plaintiff engaged in the cattle ranching activity with a profit intent. The court denied the IRS motion for summary judgment. The court also denied summary judgment to the IRS on the penalty issue.
Ranching Corporation Not Treated Separately From Owners With Result That Losses Not Deductible. Barnhart Ranch Co. v. Comr., No. 16-60834, 2017 U.S. App. LEXIS 25789 (10th Cir. Dec. 20, 2017), aff’g., T.C. Memo. 2016-170 The petitioners, two brothers, owed cattle, land and oil operations in Texas. Their father had established a C corporation in the 1950s to pursue the various ranching and oil and gas operations. The corporation handled all of the sales, expenses and payroll of the ranching/oil and gas activities. The petitioners inherited the business interests from their father upon his death. The petitioners also owned two ranches individually that they leased to the corporation and also had numerous other oil and gas interests and real estate holdings that they owned together in partnerships, LLC and other corporations. The C corporation developed a “joint interest accounting system” and had 17 employees and held the employees’ workers’ compensation and employers’ liability policies for the cattle operation and bought farm and ranch insurance in the corporate name. The corporation was the record owner of various farming/ranching assets. Under the “joint interest accounting system”, which the petitioners’ counsel testified at trial was common in the oil and gas industry, the corporation would account for all of the income and expense and then on a monthly basis write a check to each brother for each brother’s onehalf share of the net income of the corporation. If there was a loss for a month, the brothers would write a check to the corporation. The corporation experienced losses for 2010-2012 and reported not gross receipts or taxable income for 2012-2013, but the petitioners reported six-figure losses on their personal returns (via Schedule C) derived from the cattle operation. Upon audit in 2014 for the 2010-2012 tax years, the IRS determined that the cattle losses should have been reported by the corporation (where the losses were not deductible) rather than on the petitioners’ personal returns. The IRS also determined that penalties under I.R.C. 54
§6662(a) applied. The total tax deficiency and penalties that the IRS asserted exceeded $1 million. The Tax Court ruled for the IRS and the appellate court affirmed. The appellate court rejected the petitioners’ agency argument under which they claimed that the C corporation acted as their agent by merely holding title to assets for the petitioners who owned the assets and ran the operation. They claimed that the corporation was merely an accounting entity that acted on behalf of the petitioners rather than on its own behalf. On appeal, the petitioners claimed that the corporation was simply the “manager” of the operation. However, the appellate court disagreed. The appellate court noted that the petitioners failed to provide the Tax Court with their “controlling law” cases for the proposition that cattle ownership is not relinquished when another entity manages the daily cattle operations. In addition, the appellate court noted that the petitioners had not argued their “manager” theory (based on Jones Livestock Feeding Co. v. Comr., T.C. Memo. 1967-57) at the Tax Court, and had waived the argument. The appellate court noted that the petitioners’ “agency” argument and “manager” argument were fundamentally different. The appellate court, agreeing with the Tax Court, noted that all ranching operations were conducted by the corporation and the corporation publicly appeared to be conducting the all business activity, not the petitioners individually. Thus, all of the income and loss of the ranching and oil/gas activity should have been reported at the corporate level where the losses weren’t deductible. The appellate court also upheld the IRS-imposed accuracy-related penalties which exceeded $200,000. The appellate court noted that the petitioners’ “substantial authority” for reporting the ranching transactions in the manner that they did was based on their theory that the corporation was the “manager” of the operations. However, that argument was not raised at the Tax Court and was deemed waived. The petitioners did not present the Tax Court with any authority for their tax reporting position. Thus, the appellate court held that the Tax Court’s determination of negligence was proper. The appellate court also held that the Tax Court did not err in determining that the petitioners lacked reasonable cause for the manner in which they reported their income. The petitioners had represented themselves as “savvy” businessmen that were experienced in complex business entities, but didn’t try to determine the correctness of their income tax reporting. Thus, the Tax Court’s ruled properly in rejecting the petitioners’ good-faith and reasonable-cause defenses even though they been consistent in their accounting and tax reporting for numerous years. Consistently wrong is still wrong. Ranching Activity Not a Hobby – Simply Incurring Net Losses Doesn’t Mean An Activity Is Conducted Without a Profit Intent Welch v. Comr., T.C. Memo. 2017-229 The petitioner, confined to a wheelchair since his freshman year of college, went on to obtain his Ph.D. and teach at several universities over a 40-year span. In the 1970s he founded a consulting business. In the early 1980s he formed another business that provided software to researchers, and developed a statistical program in 2007 to assist businesses in their hiring practices. In 1987, he purchased 130 acres that would become the ranching activity at the center of the case. The petitioner grew the ranch to 8,700 acres comprised of seven tracts and various divisions. The headquarters of the ranch contains two duplexes on 20 acres and were used to house ranch hands when needed and leased out when the ranch hands were not needed. 55
The petitioner’s original intent was to grow hay as a cash crop and to raise some cattle on the first 130 acres he had purchased. Over time, the ranch grew to become a multi-operational, 8,700-acre ranch with 25 full-time employees who received annual salaries ranging from $25,000 to $115,000. Center Ranch also had a vet clinic that provided services for large and small animals. Construction on the vet clinic began in 2003; it was originally built to support Center Ranch's horse operation. All of the vet clinic's employees—except the veterinarians—were Center Ranch employees. There was a licensed veterinarian on site during each of the years in issue. Petitioner rented the vet clinic facilities to the veterinarians and had management services agreements and licensing agreements with them. The vet clinic provided services for Center Ranch animals under the management services agreements. It provided services for animals owned by the public for a fee. The vet clinic was a separate entity and filed its own tax returns for the years in issue. The ranch also had a trucking operation and owned numerous 18-wheel trucks that were used to move cattle and hay around the ranch and to transport cattle to and from market and perform backhauls. The ranch also conducted timber operations and employed a timber manager. The petitioner also subscribed to numerous professional publications. The petitioner changed the type of cattle that the ranch raised to increase profitability. Steadily increasing herd size. The hay operation was also modified to maximize profitability due to weather issues. In addition, the ranch built its own feed mill that was used to chopping and dry storage of the hay. In 2003, the petitioner also started construction of a horse center as part of the ranch headquarters, including a breeding facility that operated in tandem with the veterinary clinic. Ultimately, the petitioner’s horses were entered in cutting competitions, with winning increasing annually from 2007 to 2010. The IRS issued notices of deficiency for 2007-2010. For the years in issue the petitioner had total losses of approximately $15 million and gross income of approximately $7 million. For those years, the petitioner’s primary expense was depreciation. The IRS claimed that the ranching activity was not engaged in for profit and the expenses were deductible only to the extent of income. The Tax Court determined that all of the petitioner’s activities were economically intertwined and constituted a single ranching activity. On the profit issue, the court determined that none of the factors in the Treasury Regulations §1.183-2(b) favored the IRS. While IRS claimed that mistakes in the petitioner’s books and records were highly relevant, the court disagreed noting that some mistakes on the books and records of a multi-million-dollar activity does not negate that the activity was carried on in a business-like manner. In addition, the court noted that the ranch had separate bank accounts from the petitioner’s bank accounts. The court also noted that the petitioner made changes in the activity upon realizing that certain aspects of the ranch were not profitable. The ranch also paid ranch hands, when needed, and paid some of its employees above median wages in the area so as to attract the best managers and employees. The court also noted that the petitioner had been involved in agriculture for practically all of his life, and that his time spent on weekends at the ranch and daily communications with ranch managers was sufficient to show a profit intent. The court also determined that the petitioner showed that the expected the ranch assets to appreciate in value, and that the IRS argument that the assets would not appreciate as much as the petitioner and his experts claimed they would was inadequate. It was not necessary that the petitioner have a profit motive that expects recoupment of all of the ranch’s past losses. While the court found that the ranch’s history of income and losses and the amount of occasional profits, if any, favored the IRS, the court did not give these factors as much weight because the cattle and horse operations were in their startup phases during the years in issue. The petitioner’s financial status and whether personal pleasure or recreation were present were held to be neutral factors. The court noted that the petitioner had put over $9 million of his own funds into the ranch and had been in a wheelchair 56
since college which restricted his ability to derive personal pleasure from the ranch. Accordingly, the petitioner’s ranching activity was held to be conducted for-profit and the losses were fully deductible. The court specifically rejected the IRS argument that a profit motive could not be present when millions of dollars of losses were generated. IRS Says There Is No Exception From Filing A Partnership Return C.C.A. 201733013 (Jul. 12, 2017) On a question raised by an IRS Senior Technician Reviewer, the IRS Chief Counsel’s Office has stated that Rev. Prov. 84-35, 1984-2 C.B. 488, does not provide an automatic exemption from the requirement to file Form 1065 (U.S. Return of Partnership Income). Under Rev. Proc. 84-35, IRS noted that domestic partnerships with 10 or fewer partners that fall within the I.R.C. §6231(a)(1)(B) exceptions are deemed to meet the reasonable cause test and are not liable for the I.R.C. §6698 penalty. IRS explained that IRC §6031 requires partnerships to file Form 1065 each tax year and that failing to file is subject to penalties under IRC §6698 unless the failure to file if due to reasonable cause. Neither I.RC §6031 nor IRC §6698 contain an automatic exception to the general filing requirement of IRC §6031(a) for a partnership as defined in IRC §761(a). IRS noted that it cannot determine whether a partnership meets the reasonable cause criteria or qualifies for relief under Rev. Proc. 84-35 unless the partnership files Form 1065 or some other document. IRS also noted that the returns of partners are not linked together during initial processing, and IRS does not know the number of partners in the partnership or whether the partners timely filed individual income tax returns until either a partner or the partnership is audited. The reasonable cause requirement can be met, IRS noted, if the partnership or any of the partners establishes (if required by the IRS) that all partners have fully reported their shares of the income, deductions and credits of the partnership on their timely filed income tax returns. Reasonable cause under Rev. Proc. 84-35 is determined on a case-by-case basis and I.R.M. Section 20.1.2.3.3.1 sets forth the procedures for applying the guidance of Rev. Proc. 84-35. Court Determines Meaning of “Qualified Farmer” for Conservation Easement Donation Purposes Rutkoske, et al. . Comr., 149 T.C. No. 6 (2017) Under I.R.C. §170, a taxpayer can claim a charitable deduction for a qualified conservation contribution to a qualified charity. The amount of the deduction is generally limited to 50 percent of the taxpayer’s contribution base (adjusted gross income (AGI) computed without regard to any net operating loss for the year, less the amount of any other charitable contributions for the year).128 Any amount that can’t be deducted because of the limitation can be carried forward to each of the next five years, subject to the same 50 percent limitation in each carryforward year.129 However, for a taxpayer that is a “qualified farmer” for the tax year of the contribution, the limit is 100 percent of the taxpayer’s contribution base, with a 15-year carryforward provision applying. A “qualified
128 129
IRC §170(b)(1)(G). IRC §170(d)(1). 57
farmer or rancher” is a taxpayer whose gross income from the trade or business of “farming” exceeds 50 percent of the taxpayer’s gross income (all income from whatever source derived, except as otherwise provided) for the tax year.130 However, income from farming does not include income derived from hunting and fishing activities131 or income from the sale of a conservation easement.132 But, the income from hunting, fishing and sale of a conservation easement is included in the taxpayer’s gross income.133 Income from timber sales is included in both computations.134 “Farming” for this purpose is the I.R.C. §2032A(e)(5) definition. There, the term is defined as meaning: “…cultivating the soil or raising or harvesting any agricultural or horticultural commodity…on a farm; handling, drying, packing, grading, or storing on a farm any agricultural or horticultural commodity in its unmanufactured state, but only if the owner, tenant or operator of the farm regularly produces more than half of the commodity so treated; and … planting, cultivating, caring for, or cutting of trees, or the preparation…of trees for market.”135 The contributed property need not be actually used or available for use in crop or livestock production to allow the donor to claim a deduction for the full value, but the property must be subject to a restriction that it remain available for use in either crop or livestock production.136 That means the entire property, including any improvements.137 The Rutkoske case involved a limited liability company (LLC) that owned various tracts of land that it leased to a farming general partnership. Two brothers owned the LLC equally and also had ownership interests in the farming general partnership along with other farming entities. The complex structure was established for the purported reason of maximizing farm program payment limitations. In 2009, the LLC conveyed a conservation easement on a 355-acre tract to a land conservancy on the East Coast. There was no question that the conservancy was a qualified charity under I.R.C. §501(c)(3) that could receive the conveyance and allow the donors a charitable deduction. The conveyance placed development restrictions on the property in exchange for $1,504,960. A simultaneous appraisal valued the property without the easement restriction at $4,970,000 and at $2,130,00 with the development restrictions. The claimed conservation contribution deduction was $1,335,040, which the brothers split evenly between them on their individual returns in accordance with I.R.C. §§702(a)(4); 702(b) and I.R.C. §703(a) and Treas. Reg. §1.703-1(a)(2)(iv). The LLC then sold its interest in the tract to a third party for $1,995,040. The charitable contribution deduction of $1,335,040 was computed by taking the difference between the pre and post-easement restriction value of the property ($2,840,000) and subtracting the payment received for the conveyance ($1,504,960). The brothers claimed the deduction at 100 percent of their contribution base. The IRS disagreed, claiming that the deduction was limited to only 50 percent of their contribution base (i.e., their adjusted gross income).
IRC §170(b)(1)(E)(v); IRS Notice 2007-50, 2007-1 C.B. 1430, Q&A No. 4. IRS Notice 2007-50, 2007-1, Q&A No. 8. 132 IRS Notice 2007-50, 2007-1, Q&A No. 6. 133 IRS Notice 2007-50, 2007-1 C.B. 1430, Q&A Nos. 6 and 8. 134 IRS Notice 2007-50, 2007-1 C.B. 1430, Q&A No. 7. 135 I.R.C. §§2032A(e)(5)(A)-(C)(ii). 136 I.R.C. §170(b)(1)(E)(iv)(II). 137 IRS Notice 2007-50, 2007-1 C.B. 1430, Q&A No. 11. See also Treas. Reg. §1.170A-14(f), Example 5. 58 130 131
Each brother, on their respective 2009 returns, each claimed a charitable contribution deduction attributable to the easement of $667,520 along with their respective shares of long-term capital gain from the sale of the LLC’s interest in the tract to the third party – approximately $900,000 each. Each brother had a small amount of wage income along with a miniscule amount of interest income along with about a $200,000 loss from partnerships and S corporations. They claimed that their respective share of sale proceeds from the sale of the tract to the third party, and the proceeds from the sale of the development rights constituted farm income within the definition of I.R.C. §2032A(e)(5). Accordingly, their farm income exceeded the 50 percent mark entitling each of them to a 100 percent of contribution base deduction for the conservation easement donation. Their argument was a novel one – farming requires investment in physical capital such as land and, as an “integral asset” to the farming operation the sale proceeds of the 355-acre tract counted as farm income. The IRS disagreed based on a strict reading of I.R.C. §2032A(e)(5) as applied to I.R.C. §170(b)(1)(E)(v). The Tax Court upheld the IRS determination. Neither brother was a qualified farmer, although each one was (as the Tax Court noted) unquestionably a farmer. The Tax Court held that the income from the sale of the property wasn’t farm income. The Tax Court reached the same conclusion as to the income from the sale of the development rights. The income from those sales weren’t specifically enumerated in I.R.C. §2032A(e)(5) and didn’t fit within the same category of activities enumerated in that provision. In addition, the Tax Court said that I.R.C. §170(b)(1)(E) was “narrowly tailored” to provide a tax benefit to a qualified farmer which had a specific definition that they wouldn’t broaden. In any event, the Tax Court also determined that the LLC structure doomed the brothers because the character of the deduction flowed through to them from the LLC and the LLC was not in the business of farming. Instead, the Tax Court noted, the LLC was engaged in the business of leasing land. But, on this point, the Tax Court is arguably incorrect (and didn’t need to make the statement; it was unnecessary as to the outcome of the case). As the Tax Court noted, the contribution itself was properly claimed by each brother at the individual level on their respective returns. Each brother did use the 355-acre tract in their farming business. Partnerships don’t pay tax and should be viewed under the aggregate theory. Indeed, the IRS stated in 2007 that when a qualified conservation contribution is made by a pass-through entity (such as a partnership or S corporation) the determination of whether an individual who is a partner or shareholder is a qualified farmer for the tax year of the contribution is made at the partner or shareholder level. 138 The Tax Court made no reference to the 2007 IRS statement. A pass-through entity that owns land on which a conservation easement is conveyed to a charity must be engaged in the trade or business of agriculture. That was a problem in Rutkoske. Also, when a passthrough entity is involved, the computation of the taxpayer’s true gross income must include all of the pass-through income, from farming activities and non-farming activities. It’s not just simply AGI as reported on the return. In Rutkoske, it does not appear that the Tax Court took that into account (even though it wouldn’t have made a difference in the outcome of the case). From purely a tax planning standpoint, assuming the LLC was engaged in the trade or business of farming, the land sale income would have still presented a problem for the brothers in reaching the 50 percent gross income threshold. To deal with that problem, structuring both the conveyance of the conservation easement and the LLC’s sale of its remaining interest as an installment sale with the reporting of the gain in the tax year after the tax year of the contribution would have allowed the brothers to meet the 50 percent test.
138
Notice 2007-50, 2007-1 C.B. 1430, Q&A No. 5. 59
Also, from a broader, more general perspective, the 100 percent of contribution base limit can work against a qualified farm taxpayer. For instance, if a qualified farmer’s contribution exceeds the qualified farmer’s AGI, some of the tax savings of the contribution will be realized at the lower tax brackets (presently 10 percent and 15 percent (federal)). In addition, the charitable contribution can have the impact of eliminating all of the taxpayer’s taxable income. Thus, if the taxpayer has other Schedule A itemized deductions, they, along with the taxpayer’s personal exemptions, won’t produce any tax benefit. The statute does not provide any way for the qualified farmer taxpayer to decline the 100 of contribution base limit and fall back to the 50 percent level. This all means that, in certain situations, it might be better from a tax standpoint, for a qualified farmer to make a qualified contribution in a year when they do not meet the 50 percent test. The Rutkoske decision illustrates a significant limitation for farmers – it is very difficult to get a 100 percent of AGI deduction (as a “qualified farmer”) when property is disposed of at a gain in the same year in which a conservation easement is donated unless an installment sale is structured. In addition, entity structuring for USDA farm program payment limitation purposes can work to eliminate the deduction in its entirety. Attorneys familiar with USDA farm program payment limitation rules are often not well-versed in farm taxation, and that can be the case even if they anticipate that a client might make a conservation easement donation.
FARM INCOME AVERAGING A. Background. 1.
Individuals engaged in farming are allowed to elect to average farm income back three years, to obtain the benefit of applying lower income tax rates from prior years to current taxable income attributable to farming [Sec. 1301].
2.
The statute was supplemented by final regulations issued in early 2002 [Reg. 1.1301-1, T.D. 8972, 1/8/02].
B. Farming business. 1.
A farming business for income averaging purposes is defined by cross-reference to Sec. 263A(e)(4).
2.
Accordingly, a farming business includes the cultivating of land or raising or harvesting of any agricultural or horticultural commodity. This includes:
3.
a.
Operating a nursery or sod farm,
b.
Raising or harvesting of trees bearing fruits, nuts, or other crops,
c.
Raising ornamental trees (but not evergreen trees that are more than six years when cut), and
d.
The raising, shearing, feeding, caring for, training, and managing of animals.
The IRS Instructions for Schedule J, Farm Income Averaging, state that a farming 60
business does not include the contract harvesting of an agricultural commodity grown or raised by another, nor does it include merely buying or reselling plants or animals grown or raised by another. C. Eligible taxpayers. 1.
An individual engaged in a farming business as a proprietor, partner in a partnership, or shareholder in an S corporation may use income averaging, without regard to whether the individual was engaged in a farming business in any prior base year [Sec. 1301(a); Reg. 1.1301-1(b)].
2.
Corporations, partnerships, S corporations, estates and trusts are not permitted to use farm income averaging [Sec. 1301(b)(2)].
3.
According to the IRS, a beneficiary of a trust or an estate is not considered to be engaged in a farming business [IRS Publ. 553, Highlights of 1998 Tax Law Changes].
4.
Commentary: An individual who does not meet the two-thirds gross receipts test as a farmer for March 1 filing purposes may still use Schedule J farm income averaging. The two-thirds gross receipts test applies only for purposes of eliminating quarterly estimated income tax payments and the tradeoff of an early March 1 filing under Sec. 6654(i). Sec. 1301 has no requirements regarding a threshold percentage of farm income or any prior tax return history of farming income as a condition for electing the use of income averaging.
D. Electable farm income (EFI). 1.
Electable farm income, which may be averaged over the prior three years, is the amount of taxable income attributable to any farming business that is specifically elected by the taxpayer as subject to the three year averaging method. Any portion of taxable income attributable to farming may be designated as elected farm income for averaging purposes.
2.
Farming taxable income includes gain from the sale or disposition of property (other than land) regularly used by a farmer for a substantial period in a farming business.
3.
a.
EFI does not include income, gain or loss from the sale of development rights, grazing rights, or similar rights [Reg. 1.1301-1(e)(1)].
b.
While land gains are not eligible for farm income averaging, the regulations clarify that a structure affixed to the land (barns, bin systems, etc.) would give rise to gain eligible for farm income averaging. Gains from the sale of equipment and other personal property are eligible.
c.
The regulations state that farm income does not include wages [Reg. 1.13011(e)(1)(i)]. However, the regulations state that wages may be included to the extent received as a shareholder in an S corporation engaged in a farming business.
Income from a fishing business also is eligible [Sec. 1301(a)]. Eligible income includes that from a fishing business in which the fish are harvested, either in whole or in part, for 61
commerce. The activity is to include the catching, taking, or harvesting of fish, or any operations at sea in support of such an activity [IRS Instructions, Schedule J]. 4.
Taxable income from farming includes all income, gains, losses, and deductions attributable to any farm business. Per the Schedule J instructions, this includes items reported on Schedule D, Schedule E Part II (pass-through items from partnerships and S corporations), Schedule F and Form 4797. a.
Crop share rental activities. 1) The regulations state that rental income based on a share of production from a tenant’s farming business is eligible for farm income averaging in the landlord’s return [Reg. 1.1301-1(b)(2)]. This occurs whether or not the landlord materially participates in the tenant’s farming business (i.e., whether or not the crop share rental income is reported on Schedule F as subject to SE tax or on Form 4835 as not subject to SE tax). 2) There must be a written crop share lease agreement entered into before the tenant begins significant activities on the land in order for the share rent income to qualify for averaging. If a landlord receives fixed rent or a rent payment under an unwritten agreement or late written agreement, the income is ineligible for averaging.
62
3) Commentary: This IRS position indicating that a Form 4835 crop share landlord is eligible for income averaging indirectly confirms that a crop share landlord is required to use the 150% declining balance depreciation method with respect to farm assets. The definition of a farmer under Sec. 168(b)(2)(B) for purposes of the limitation of the 150% declining balance method is the same definition as is used for defining eligibility for income averaging [i.e., a cross-reference to Sec. 263A(e)(4)]. b.
The regulations clarify that all income and loss items attributable to farming must be netted together to determine overall taxable income from farming. This overall amount would represent a limit on the amount available for the election to income average [Reg. 1.1301-1(e)(2)].
c.
In addition, electable farm income from net capital gains attributable to the farming business cannot exceed total net capital gains. An individual who has both ordinary and net capital gain farm income may elect (up to electable farm income) any combination of the ordinary and capital gain farm income.
Example 1
Farm capital gain limited by nonfarm capital loss
FACTS: Charlie has a farm capital gain of $50,000 from culled breeding stock and a capital loss of $40,000 from security sales. Charlie also has ordinary Schedule F farm income of $60,000. RESULT: Charlie’s electable farm income is $70,000 (net farm capital gain of $10,000 + Schedule F ordinary income of $60,000). Assuming that Charlie has at least $70,000 of overall taxable income, he could elect up to $10,000 of farm capital gain and up to $60,000 of farm ordinary income for farm income averaging. 5.
In the case of liquidation of a farming business, the regulations state that gain on property (other than land) sold within a reasonable time after operations cease may be designated as EFI. A sale within one year of cessation of farming is presumed to be within a reasonable time. Whether a sale occurring more than one year after cessation qualifies depends on facts and circumstances [Reg. 1.1301-1(e)(1)(ii)(B)].
6.
EFI may include both ordinary income and capital gains. a.
If EFI includes both ordinary income and capital gains, the IRS requires that an equal portion of each type of income must be carried to each prior year (i.e., all of the capital gain subject to averaging cannot be carried to a single prior year).
b.
Commentary: An election of farm income averaging on ordinary income may reduce the effective tax rate on non-farm capital gains. 63
Example 2
Electing averaging to reduce capital gain rate
FACTS: Fred, a joint filer, has 2017 taxable income of $81,000, consisting of $76,000 of ordinary farm income and $5,000 of capital gains from securities sales. For the prior three base years, joint taxable income has been consistently about $50,000. Without a 2017 income averaging election, Fred’s $5,000 of long-term capital gains will be taxed at 15% (i.e., the ordinary income is considered to first fill up the lower 15% tax rate which currently ends at $75,900 of taxable income (for 2017), and the capital gain, considered to be the last income, is then entirely taxed at 15%). RESULT: If Fred chooses to use farm income averaging, and designates $5,000 of his ordinary farm income as his EFI, it will reduce his current year taxable income from $81,000 to $76,000. Fred saves no ordinary income tax, because all ordinary income is taxed at 15% in both the current and three base years. However, by reducing the current year taxable income to below the top of the 15% ordinary bracket, the $5,000 of capital gains are taxed at 0% rather than 15%. Thus, the income averaging election saves $750 of federal tax.
E. Calculating the income averaging tax. 1.
The tax imposed for the year in which income averaging is elected is the sum of the tax for that year on income reduced by the amount of elected farm income, plus the increase in tax which would have occurred if taxable income for each of the three previous tax years was increased by an amount equal to one-third of elected farm income [Sec. 1301(a)].
2.
Any adjustment to taxable income for a prior year because of the “elected farm income” amount averaged to that tax year is taken into account in applying the income averaging provision for any subsequent taxable year (i.e., the income of the past years must be adjusted upward for a future year’s computation after income averaging has been used).
3.
Commentary: It is important to recognize that income averaging is not actually altering the taxable income or tax of any of the three base years. Averaging is not a “carryback” of current income to the base year, but rather a reference to the base year’s marginal income tax rate for the sole purpose of applying that rate to a portion of current year taxable income. Thus, income averaging does not change any phase-outs or percentage limitations of the base year tax returns [Reg. 1.1301-1(d)(1)].
64
Example 3
Illustration of successive use of Schedule J
Don, a joint filer who is eligible for income averaging, elected to apply Schedule J to $27,000 of income in 20X4, and to $66,000 of income in 20X5. His base income for the 20X5 averaging must reflect the changes from his prior income averaging. This is illustrated as follows:
Base income 20X6 averaging 20X7 averaging
4.
20X3 20X4 $ 20 $ 20 +9 +9 29 29 ____22 51
20X5 $ 20 +9 29 +22 66 51 51
20X6 $ 55 -27 28 _ +22
20X7 $ 117
_
-
50
Practice Pointer: Don’s decision to elect on $27,000 of income in 20X6 saved no tax directly (i.e., the 20X6 income was all taxable at a 15% ordinary rate prior to the Schedule J election, and moving the $27,000 out of 20X6 to be taxable at the prior three year rates also resulted in a 15% marginal rate). However, the 20X6 election had the result of providing a level income averaging base for Don's subsequent 20X7 election. In fact, the 20X6 election may have been made via an amended return at the time of preparing the 20X7 tax return (see Late or changed elections, following).
F. Farm income averaging and increasing maximum tax rates in 2013 and after. 1.
The increased maximum tax rates for years in 2013 and after provide an opportunity for farm income averaging benefits for taxpayers in the highest tax brackets.
2.
Income averaging for 2013, 2014 and 2015 will always provide a tax benefit to a top rate filer from reduction in rates, in that some amount of income will be moved from the 39.6% bracket to the 35% bracket.
3.
Commentary: If the taxpayer has sufficient electable farm income (EFI), the optimal averaged income will lower the taxable income of the taxpayer to the b o t t o m of the 35% bracket in each of 2013, 2014 and 2015. The tax savings for 2013 will be a minimum of 4.6% of EFI that is ordinary. For 2014, the tax savings will be at least 2/3rds of 4.6% of EFI. For 2015, the tax savings will be at least 1/3 of 4.6% of EFI.
4.
Similarly, with the addition of the 20% capital gain rate effective in 2013, a farm income averaging election of eligible capital gain income, such as a capital gain attributable to raised breeding stock sales, will effectively lower the capital gain rate to 15%, and possibly 0%.
65
Example 4
Use of Schedule J in 2014 for top rate filer
FACTS: Fred and Pam are joint filers with taxable income of $1,000,000 for 2014. They have EFI of $50,000 capital gain from the sale of raised breeding stock and $300,000 ordinary farm income. Their taxable income in the three base years (2011, 2012 and 2013) exceeds $500,000 in each year. RESULT: Electing farm income averaging will reduce their tax liability by $10,867 ($50,000 capital gain x 5% x 2/3 plus $300,000 ordinary income x 4.6% x 2/3). The farm income averaging election has no effect on their 3.8% net investment income tax.
Example 5
Amending 2013 Schedule J to improve 2014 averaging
FACTS: Joe is a top bracket joint filer with $700,000 of ordinary farm taxable income annually. For 2013, Joe’s preparer used Schedule J, reducing 2013 taxable income to the top of the 35% bracket at $450,000, saving $11,500 in federal income tax. For 2014, averaging saves nothing for the 2013 base year because 2013 is at the top of the 35% bracket. Joe’s 2013 Schedule J should be amended to reduce 2013 income from the top of the 35% bracket ($450,000) to the bottom of that bracket ($400,000). RESULT: Amending the 2013 Schedule J saves no tax directly. After amending 2013, the 2014 Schedule J saves an additional $2,300. Original Taxable income Sch. J: 2013 (orig.) Rate on added income Sch. J: 2014
2010 $ 700K
2011 $ 700K
2012 $ 700K
2013 $ 700K
83K $ 783K
83K $ 783K 35% $ 78K
83K $ 783K 35% $ 78K
(250K) $ 450K 39.6% $ 78K
Amended 2013 $ 700K $ 700K $ 700K Sch. J: 2013 amended 100K 100K 100K $ 800K $ 800K $ 800K Rate on added income 35% 35% Sch. J: 2014 $ 78K $ 78K 78K A
2014 $ 700K
Tax Savings $ 11,500
(235K)
$ 700K (300K) $ 400K 35% on 50K $(235)
$
7,300
$ 11,500
$
A
9,600
A
B
$250,000 x 4.6% = $11,500 ($250,000 taken out of 2014 rate of 39.6% to 2010-13 rate of 35%). B Tax savings from Schedule J improve by $2,300, because of $50,000 amount ($450,000 - $400,000) in 2013 taxable at 35% instead of 39.6% (4.6% x $50,000 = $2,300).
66
Example 6
Software not optimizing Schedule J
FACTS: Greg is a Schedule F proprietor whose taxable income has consistently been in the middle of the 33% joint bracket, which ranges from about $227,000 to $405,000. For 2014, Greg has taxable income of $566,000; this includes $41,000 of capital gains. For 2014, the tax software used by Greg’s CPA “optimized” Schedule J by selecting $120,000 of elected farm income, decreasing 2014 ordinary income to the top of the 33% bracket ($446K taxable less $41K of capital gains = $405K top of 33% bracket). Greg’s base for future averaging can be improved by electing a 2014 averaging amount that takes the earliest base year to the bottom of the 33% bracket. RESULT: Greg’s 2014 tax is unchanged, but his base years for 2015 averaging are improved.
Taxable income before Sch. J
2011 $ 315K
Sch. J: per software Taxable income after Sch. J
40K $ 365K
Sch. J to increase earliest base yr. to top of 33% bracket Taxable income after Sch. J
$ 65K $ 380K
2012 $ 315K 40K $ 365K
$ 65K $ 380K
2013 $ 300K
2014 $ 566K
2014 Tax $ 163K
40K $ 340K
(120K) $ 446K
$ 155K
$ 65K $ 365K
$(195K) $ 371K
$ 155K
G. Effect of AMT. 1.
Income averaging has no direct impact on the calculation of the Alternative Minimum Tax (AMT) [Reg. 1.1301-1(f)(4)]. That is, a taxpayer may not “average” in calculating AMT.
2.
The comparison of regular tax to AMT occurs prior to the use of farm income averaging. If regular tax exceeds AMT before the use of farm income averaging, no AMT is incurred for the year [Sec. 55(c)(2)].
3.
Practice Pointer: Because interaction with AMT is independent of electing farm income averaging, a taxpayer is permitted to reduce regular tax through use of farm income averaging even where AMT applies before applying the farm income averaging calculation.
67
Example 7
Electing farm income averaging in an AMT year
FACTS: Jed, a rancher, has several dependent children and resides in a state with a substantial income tax. Because of personal exemptions and state income tax deductions, Jed has $27,000 of regular income tax and $30,000 of tentative minimum tax, before considering the benefits of farm income averaging. Jed is required to report $3,000 of AMT (excess of tentative minimum tax of $30,000 over regular tax before considering Schedule J of $27,000). Jed elects to use Schedule J, reducing his regular tax from $27,000 to $20,000. RESULTS: Jed’s total tax for the year will be $23,000 (regular tax after considering Schedule J farm income averaging of $20,000 + $3,000 of AMT). The AMT is determined by comparing tentative minimum tax and regular tax before considering reductions in the regular tax from farm income averaging [Sec. 55(c)(2)].
4
Commentary: Without this rule freezing AMT based on regular tax before averaging, any reduction in regular tax from averaging would be offset by increased AMT.
5.
Decreasing AMT through averaging. Because the AMT amount locks in based on the gap between Tentative Minimum Tax and regular income tax before averaging, there are circumstances where increasing taxable income can actually decrease the AMT. This can result in a greatly diminished marginal tax rate for top bracket farmers. The savings occur when two factors are present: a.
The AMT income (AMTI) has exceeded the phase-out of the AMT exemption, so that adding income increases the AMT at a 28% rate, not the 35% phase-out rate. 1) This occurs for 2017 if AMTI is over $498,900 joint. 2) For single filers, AMTI must be over $337,900.
b.
The Tentative Minimum Tax exceeds the regular income tax before averaging, both before and after adding incremental income, so that AMT decreases. 1) Tentative Minimum Tax increases at 28%. 2) Regular tax, without averaging, increases at a rate of 33% to 39.6%, thereby decreasing AMT, but having no other application because actual regular tax is at lower income averaging rates.
68
Example 8
Decreasing AMT through income averaging
FACTS: Sam, who files jointly, has a year-end tax planning projection that indicates $500,000 of Schedule F income. Sam has $48,000 of state income tax and property tax deductions, and as a result Sam is in an AMT position. Sam is at the top of the AMT exemption phase-out range; an increase in income would produce a 28% increase in AMT. Sam’s tax preparer adds $80,000 to his projected income, expecting a 28% tax increase due to the prevailing AMT. RESULT: Sam’s tax before averaging increases, as expected, at a 28% rate ($22,600 AMT increase on $80,000 of income). Assuming Sam can utilize income averaging because of lower base taxable income of $300,000 each year, his actual tax will increase only $18,200, or 23% of the $80,000 income increase. Sam’s AMT decreased based on the increase in regular tax before averaging, but the actual tax Sam paid is based on a lower increase in regular tax from Schedule J.
Sch. F/AMTI
Tentative minimum tax - Regular tax (before ave.) AMT
Regular tax: Sch. J Total tax
Case 1 $ 500,000
Case 2 $ 580,000
$ 131,900 122,400) 9,500
$ 154,500 (153,600) $ 900
121,800
148,600
$ 131,300
$ 149,500
$
$
Increase $ 80,000
22,600 31,200
39% $ (8,600) 11%
$
%
28%
-
26,800
+ 34%
18,200
+ 23%
H. Effect on other tax determinations. 1.
Income averaging has no effect on the calculation of the self-employment tax, either in the current averaging year or any of the base years [Reg. 1.1301-1(f)(3)].
2.
If a taxpayer has a child subject to kiddie tax who has investment income of more than $2,100 (2017 amount), the child’s tax is calculated by use of the parent’s tax rates. If income averaging is used in the parent’s tax return, the child’s tax on investment income is applied by using the parent’s rate after shifting the elected farm income. With respect to a base year, however, the kiddie tax is not affected by a farm income averaging election [Reg. 1.1301-1(f)(5)].
3.
Losses and carrybacks. a.
Any net operating loss carryovers or net capital loss carryovers to an election year are applied to the election year income before EFI is subtracte 69
I.
J.
b.
In the case of a base year, any net operating loss carryover that was only partially applied in the base year is not refigured to offset the EFI that is added to that prior year via income averaging.
c.
The determination of whether, in the aggregate, the sales and other dispositions of business property produce long-term capital gain or ordinary loss under Sec. 1231 is made before EFI is subtracted for income averaging purposes.
d.
If capital gains are included in EFI and shifted to a base year that had a capital loss, the capital gains do not offset that prior unused capital loss. The gains are taxed at the prior year’s maximum capital gains tax rates (or, if lower, the regular tax rate) [Reg. 1.1301-1(d)(1)].
Change in filing status. 1.
If the taxpayer is filing a separate return for the current year and filed a joint return for any base year, when one-third of the EFI is carried to that prior joint year under income averaging, the joint rate for that base year is applied to calculate the averaging tax [2014 instructions for Schedule J].
2.
If the taxpayer is filing jointly for the current election year and filed a separate return for any base year, the one-third share of the EFI which is carried to that separate base year is taxed at the applicable separate return rate for that base year [2014 Pub. 225, Ch. 3, page 18].
3.
Commentary: Presumably, the base year return(s) used for the Schedule J computations are those of the farmer that generated the EFI for the current year. However, we have no guidance on this matter. Also note that in community property states, the income is likely community income. No guidance is provided as to whether to split the income to compute Schedule J one-half for each taxpayer, or if the tax returns with the lowest tax brackets may be used. The authors recommend attaching an explanation of “out of the ordinary” Schedule J computations.
Late or changed elections. 1.
The final regulations permit a taxpayer to elect income averaging in a late or amended return. Also, a taxpayer may amend to change the amount of elected farm income in a prior election, or to revoke a previously filed averaging election [Reg. 1.1301-1(c)].
2.
Commentary: This ability to make an income averaging election for an earlier year via an amended return is particularly valuable in leveling out base years to improve a current year income averaging election. In the course of preparing a current return, it may be advantageous to amend a base year (for no income tax savings) to better position the base years all at the same capacity to accept lower rate income for purposes of a current income averaging election. The amended return saves no tax directly, but improves the capacity of the three base years to absorb current income at lower marginal rates. In preceding Example 3, Don's 20X4 income averaging election may have been made via an amended return in 20X5, when it became apparent that the 20X5 averaging election could have benefited from an earlier election to level the base years. 70
K. Dealing with a negative base year. 1.
The IRS Instructions for Schedule J and IRS Publ. 225, Farmers Tax Guide, state that in preparing Schedule J, a negative amount may be used for any of the three base years where a taxable loss was incurred, rather than limiting the base year on Schedule J to a zero amount.
2.
The IRS instructions remind taxpayers that amended returns for any base year should be completed before using Schedule J for the current year, as prior income averaging elections affect current income averaging calculations.
3.
The regulations confirm that a base year amount may be negative, but add the requirement that any base year loss that provided a benefit in another taxable year must be added back in determining base year taxable income [Reg. 1.1301-1(d)(2)(i)]. Accordingly, net operating losses and capital loss deductions that carry to other years to provide tax benefit must be adjusted in calculating a negative base year amount.
4.
The Schedule J Instructions contain a worksheet (Taxable Income Worksheet) for each of the three base years to allow calculation of negative taxable income after adjusting for NOL carrybacks and carryovers.
5.
The Tax Court applied this “no double benefit” principle to taxpayers who attempted to carry Schedule J farm income averaging elected income to a negative base year, where that base year loss had produced loss carryback benefit. This case involved facts prior to issuance of the final regulations confirming this point [Haugen v. Comm., TC Summary Opinion 2004-97, 7/27/2004].
L. Observations. 1.
The fact that income averaging has no effect on self-employment tax creates interesting planning opportunities. In the base years prior to income averaging, a farmer could report income beneath the first tier social security base ($127,200 for 2017), and subsequently report substantial farm self-employment income exceeding the SE base. Income averaging would smooth out the income tax costs of the high tax year, and having much of the income exceeding the SE base would save significant selfemployment tax.
2.
The fact that there is no AMT floor on the use of income averaging greatly increases the significance of the use of Schedule J. In years when a farmer recognizes exceptionally large income, such as from a machinery auction at retirement or selling a significant amount of carryover grain at a time of high commodity prices, farm income averaging will potentially allow a substantial decrease in the marginal tax rate applicable to that high current year income. And if that large income is subject to SE tax, it may be exposed only to the 2.9% or 3.8% Medicare rate if the lower tier base is exceeded. a.
The difference may be especially dramatic for a taxpayer with substantial nonbusiness expenses in excess of nonbusiness income in the base years. In such a situation, the base year loss will be in excess of the personal exemptions disallowed for net operating loss purposes. 71
3.
Income averaging will need to be considered in virtually every individual farm return. To the extent that the prior three years contain any lower bracket years, averaging a sufficient amount of income to fill the lower bracket availability will be appropriate. Recognize the significant flexibility that occurs because any portion of current year net farm income can be elected for averaging, although whatever portion is selected as EFI must always be divided by 3.
4.
Paper-filed returns with farm income averaging elections have generated IRS notices of discrepancy in the tax computation, due to IRS personnel failing to note the election. E-filed returns have not generated such notices.
5. The Tax Cuts and Jobs Act of 2017 has reduced marginal tax rates and the reductions in some cases can be substantial. This may reduce the value of farm income averaging for 2018-2020 due to the phase-out of larger marginal tax rates from 2015-2017. M. Summary. 1.
Opportunities with farm income averaging. a.
Retiring farmer with carryover grain.
b.
Machinery auctions.
c.
High grain prices.
d. Strategically spike Schedule F every three or four years to avoid SE tax, but lower income tax costs through Schedule J.
FINANCIAL DISTRESS AND TAX-RELATED ISSUES Thursday, March 23, 2017
Farm-Related Casualty Losses and Involuntary Conversions – Helpful Tax Rules in Times of Distress Farm and ranch property is exposed to weather-related events that can seriously damage or ruin the property. The massive wildfires in parts of Kansas and the horrific pictures have illustrated the devastation that the affected farmers and ranchers have suffered. It’s truly gruesome to see the pictures of dead livestock and the burned-up fences and pastures, not to mention the buildings, structures and homes that were lost. The financial losses are large, but there are some tax provisions that can be utilized to at least partially soften the blow. A blog post last fall visited this issue, at least in part. Today’s post revisits the issue. Casualty Losses 72
A casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Casualty losses are deductible regardless of whether the property is used in the trade or business, held for the production of income or held for personal purposes although the rules differ slightly on how the loss is calculated. Sometimes, the issue in a particular case comes down to drawing a line between what is a casualty and what is ordinary wear and tear. For purposes of this post, a casualty is assumed. The recent Kansas wildfire situation, for example, leaves no doubt that the losses are casualty losses for tax purposes. The amount of the deduction for casualty losses is the lesser of the difference between the fair market value before the casualty or theft and the fair market value afterwards, and the amount of the adjusted income tax basis for purposes of determining loss. The deduction can never exceed the basis in the item that suffers the casualty. In effect, the measure of the loss is the economic loss suffered limited by the basis (and any insurance recovery). Here's a simple example: -----------------Assume a rancher has five Hereford cows and one Hereford bull in a pasture. A lightning strike ignites a wildfire, and the wildfire spreads rapidly by high winds and the cows and bull are caught in the fire and are killed. The cows were raised and have a basis of $0.00 and a fair market value of $4,500. The bull, which was purchased for $5,000, had a fair market value of $6,000 at the time of death. The amount of the casualty loss is the difference in the fair market value before and after the loss is $10,500 ($10,500 - $0.00). However, the total basis in all of the animals is only $5,000 - the basis of the bull. Since the deductible loss can never exceed the basis, the amount of the deduction is limited to $5,000. -----------------In addition, any casualty loss must be reduced by any insurance recovery. Thus, returning to the example, if the rancher collected $4,500 of insurance on the dead cattle, the deductible loss would be limited to $500. The deduction is to be taken in the year in which the loss was incurred. It is claimed on Section B of Form 4684 and on Form 4797. Note: If the rancher’s casualty loss causes his deductions to exceed his income for the year in which he claims the loss, the rancher may have a net operating loss (NOL) for the year of the casualty that is entitled to a two-year carryback and a 20-year carryforward. However, the portion of the NOL arising from the casualty loss has a three-year carryback period. I.R.C. §172(b)(1)(E). Involuntary Conversion What if, in the example above, the rancher’s pasture was destroyed by the wildfire but he had other livestock that survived? But, without usable pasture, the rancher had to sell the livestock. That’s where another tax provision can apply. When a farmer sells livestock (other than poultry) held for draft, dairy or breeding purposes in excess of the number that would normally be sold during the time period, the sale or exchange of the excess number may be treated as a nontaxable involuntary conversion if the sale occurs because 73
of drought, flood or other weather-related condition. The livestock sold or exchanged must be replaced within two years after the year in which proceeds were received with livestock similar or related in service or use (in other words, dairy cows for dairy cows, for example), and be held for the same purpose that the animals given up were held. Thus, dairy cows can be replaced with dairy cows, but they can’t be replaced with breeding animals. The tax on the sale is triggered when the replacement animals are sold. If it is not feasible to reinvest the proceeds in property similar or related in use, the proceeds can be reinvested in other property used for farming purposes (except real estate). Similarly, if it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into property that is not like-kind or real estate used for farming purposes. I.R.C. §1033(f). If the replacement property is livestock, the new livestock must be held for the same purpose as the animals disposed of because of the weather-related condition. Treas. Reg. § 1.1033(e)1(d). The two-year replacement period is extended to four years in areas designated as eligible for assistance by the federal government (i.e., by the President or any agency or department of the federal government). I.R.C. §1033(e)(2)(A). Presumably, any livestock sales that occur before the designation of an area as eligible for federal assistance would also qualify for the extended replacement period if the drought, flood, or other weather-related conditions that caused the sale also caused the area to be so designated. The replacement property must be livestock that is similar or related in service or use to the animals disposed of. Also, the Treasury Secretary has the authority to extend, on a regional basis, the period for replacement if the weather-related conditions continue for more than three years. I.R.C. §1033(e)(2)(B). The election to defer the gain is made by attaching a statement to the return providing evidence of the weather-related condition that caused the early sale, the computation of the gain realized, the number and kind of livestock sold and the number and kind of livestock that would have been sold under normal business practices. The election can be made at any time within the normal statute of limitations for the period in which the gain is recognized, assuming that it is before the expiration of the period within which the converted property must be replaced. If the election is filed and eligible replacement property is not acquired within the applicable replacement period (usually four years), an amended return for the year in which the gain was originally realized must be filed to report the gain. But, if the animals are replaced, for the tax year in which the livestock are replaced, the taxpayer should include information with the return that shows the purchase date of the replacement livestock, the cost of the replacement livestock and the number and kind of the replacement livestock. The election must be made in the return for the first tax year in which any part of the gain from the sale is realized. It’s also very important for a taxpayer to maintain sufficient records to support the nonrecognition of gain. Note: For livestock that are partnership property and are sold by the partnership, the election is the responsibility of the partnership. The partners do not individually make the election to defer recognizing the gain. See Rosefsky v. Comr., 599 F.2d 515 (2d Cir. 1979). The Interaction of the Two Rules Returning to the example above, assume that the rancher received insurance proceeds exceeding $5,000, the net book value of the animals. For instance, if the rancher received $6,000 of insurance proceeds, the $1,000 exceeding the tax basis of the dead animals would be taxable. That is a 74
potential taxable gain that can be deferred if the rancher makes a valid election to defer the gain, and the livestock are replaced within the applicable timeframe. In that instance, the $1,000 casualty gain can be deferred until the replacement animals are sold. However, it may be advantageous from a tax standpoint for the rancher to report the gain on the animals in order to claim ordinary depreciation on the replacement animals. Another Rule – One-Year Deferral Under another rule, if farm and ranch taxpayers on the cash method of accounting are forced because of drought or other weather-related condition to dispose of livestock (raised or purchased animals that are held either for resale or for productive use) in excess of the number that would have been sold under usual business practices, they may be able to defer reporting the gain associated with the excess until the following taxable year. I.R.C. §451(e). The taxpayer's principal business must be farming in order to take advantage of this provision. This brings up a key observation – at the time the tax return is due for the year of the casualty, the livestock owner may not be sure of which election is the best one to make. In that event, a “protective” election can be made under I.R.C. §1033 for that tax year. If the livestock can be replaced within the applicable replacement period, the involuntary election can be revoked and the return for the casualty year can be amended to make the election to defer the gain for one year. In that instance, the return for the year after the casualty would also have to be amended to report the deferred gain. Relatedly, a taxpayer can make an election under I.R.C. §451(e) until the four-year period for reinvestment of the property under I.R.C. §1033 expires. That means that if a livestock owner elects involuntary conversion treatment and fails to acquire the replacement livestock within the four-year period, the I.R.C. §451(e) election to defer the gain for one year can still be made. If that happens the livestock owner will have to file an amended return for the casualty year to make the I.R.C. §451(e) election and revoke the I.R.C. §1033(e) election, and the next year to report the gain deferred to that year. Other Points Farming operations organized in a form other than as a C corporation which have received “applicable subsidies” are subject to an overall limitation on farming losses of the greater of $300,000 ($150,000 in the case of a farmer filing as married filing separately) or aggregate net farm income over the previous five-year period. Farming losses from casualty losses or losses by reason of disease or drought are disregarded for purposes of figuring this limitation. I.R.C. §461(j). Farm income averaging can also be a useful tool as an election in a tax year in which a substantial casualty has been sustained. The interaction of the income averaging election, casualty loss rules, the tax treatment of livestock sold on account of weather-related conditions and loss carryback rules can provide some significant tax planning opportunities. Conclusion Sustaining a casualty loss can be extremely difficult for a farmer or rancher, or any other taxpayer for that matter. But, there are tax rules that can be used to soften the blow.
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Wednesday, March 29, 2017
Qualified Farm Indebtedness – A Special Rule for Income Exclusion of Forgiven Debt Overview The drop in crop prices in recent months has introduced financial strain for some producers. Bankruptcy practitioners are reporting an increase in clients dealing with debt workouts and other bankruptcy-related concerns. An important part of debt resolution concerns the income tax consequences of any debt relief to the debtor. One of those rules concerns the tax treatment of discharged “qualified farm indebtedness.” The rule can be a useful tool in dealing with the income tax issues associated with debt forgiveness for farmers that are not in bankruptcy. There’s also another option that might come into play in certain situations – a purchase price adjustment. That’s the focus of today’s post. Recourse Debt Except for debt associated with installment land contracts and Commodity Credit Corporation loans, most farm debt is recourse debt. With recourse debt, the collateral stands as security on the loan. If the collateral is insufficient to pay off the debt, the debtor is personally liable on the obligation and the debtor's non-exempt assets are reachable to satisfy any deficiency. When the debtor gives up property, the income tax consequences involve a two-step process. Basically, it is as if the property is sold to the creditor, and the sale proceeds are applied on the debt. There is no gain or loss (and no other income tax consequence) up to the income tax basis on the property. Then, the difference between fair market value and the income tax basis is gain or loss. Finally, if the indebtedness exceeds the property's fair market value, the debtor remains liable for the difference and if it is forgiven, the amount is discharge of indebtedness income. However, special rules can apply to minimize the tax impact of discharge of indebtedness income. General Rules Under I.R.C. §108(a)(1)(A)-(C), a debtor need not include in gross income any amount of discharge of indebtedness if the discharge occurs as part of a bankruptcy case or when the debtor is insolvent, or if the discharge is of qualified farm debt. If one of these provisions applies to exclude the debt from income, Form 982 must be completed and filed with the return for the year of discharge. Qualified Farm Indebtedness What is it? The qualified farm debt rule applies to the discharge of qualified farm indebtedness that is discharged via an agreement between a debtor engaged in the trade or business of farming and a “qualified person.” A qualified person includes a lender that is actively and regularly engaged in the business of lending money and is not related to the debtor or to the seller of the property, is not a person from which the taxpayer acquired the property, or is a person who 76
receives a fee with respect to the taxpayer’s investment in the property. I.R.C. §49(a)(1)(D)(iv). Under I.R.C. §108(g)(1)(B), a “qualified person” also includes federal, state or local governments or their agencies. In addition, qualified farm debt is debt that is incurred directly in connection with the taxpayer’s operation of a farming business; and at least 50 percent of the taxpayer’s aggregate gross receipts for the three tax years (in the aggregate) immediately preceding the tax year of the discharge arise from the trade or business of farming. I.R.C. §§108(g)(2)(A)-(B). Off-farm income and passive rental arrangements can cause complications in meeting the gross receipts test. Solvency. The qualified farm debt exclusion rule does not apply to the extent the debtor is insolvent or is in bankruptcy. Farmers are also under a special rule – for all debtors other than farmers, once solvency is reached there is income from the discharge of indebtedness. The determination of a taxpayer’s solvency is made immediately before the discharge of indebtedness. “Insolvency” is defined as the excess of liabilities over the fair market value of the debtor’s assets. Both tangible and intangible assets are included in the calculation. In addition, both recourse and nonrecourse liabilities are included in the calculation, but contingent liabilities are not. The separate assets of the debtor’s spouse are not included in determining the extent of the taxpayer’s insolvency. Property exempt from creditors under state law is included in the insolvency calculation. Carlson v. Comr., 116 T.C. 87 (2001). Maximum amount discharged. There is a limit on the amount of discharged debt that can be excluded from income under the exception. The excluded amount cannot exceed the sum of the taxpayer’s adjusted tax attributes and the aggregate adjusted bases of the taxpayer’s depreciable property that the taxpayer holds as of the beginning of the tax year following the year of the discharge. Reduction of tax attributes. The debt that is discharged and which is excluded from the taxpayer’s gross income is applied to reduce the debtor’s tax attributes. I.R.C. §108(b)(1). Unless the taxpayer elects to reduce the basis of depreciable property first, I.R.C. §108(b)(2) sets forth the general order of tax attribute reduction (which, by the way occurs after computing tax for the year of discharge (I.R.C. §108(b)(4)(A)). The order is as follows: net operating losses (NOLs) for the year of discharge as well as NOLs carried over to the discharge year; general business credit carryovers; minimum tax credit; capital losses for the year of discharge and capital losses carried over to the year of discharge; the basis of the taxpayer’s depreciable and non-depreciable assets; passive activity loss and credit carryovers; and foreign tax credit carryovers. Those attributes that can be carried back to tax years before the year of discharge are accounted for in those carry back years before they are reduced. Likewise, any reductions of NOLs or capital losses and carryovers first occur in the tax year of discharge followed by the tax year in the order in which they arose. The tax attributes are generally reduced on a dollar-for-dollar basis (i.e., one dollar of attribute reduction for every dollar of exclusion). However, any general business credit carryover, the minimum tax credit, the foreign tax credit carryover and the passive activity loss carryover are reduced by 33.33 cents for every dollar excluded. If the amount of income that is excluded is greater than the taxpayer’s tax attributes, the excess is permanently excluded from the debtor’s gross income and is of no tax 77
consequence. Alternatively, if the taxpayer’s tax attributes are insufficient to offset all of the discharge of indebtedness, the balance reduces the basis of the debtor’s assets as of the beginning of the tax year of discharge. Discharged debt that would otherwise be applied to reduce basis in accordance with the general attribute reduction rules specified above and also constitutes qualified farm indebtedness is applied only to reduce the basis of the taxpayer’s qualified property. I.R.C. §1017(b)(4)(A). The basis reduction is to the qualified property that is depreciable property, then to the qualified property that is land used or held for use in the taxpayer’s farming business, and then to any other qualified property that is used in the taxpayer’s farming business or for the production of income. This is the basis reduction order unless the taxpayer elects to have any portion of the discharged amount applied first to reduce basis in the taxpayer’s depreciable property, including real property held as inventory. I.R.C. §§108(b)(5)(A); 1017(b)(3)(E). Purchase Price Adjustment Instead of triggering discharge of indebtedness income, if the original buyer and the original seller agree to a price reduction of a purchased asset at a time when the original buyer is not in bankruptcy or insolvent, the amount of the reduction does not have to be reported as discharge of indebtedness income. I.R.C. §108(e)(5)(A). The seller also doesn’t have immediate adverse tax consequences from the discharge. Instead, the profit ratio that is applied to future installment payments is impacted. Priv. Ltr. Rul. 8739045 (Jun. 20, 1987). Conclusion Farmers often have favorable tax rules. The qualified farm indebtedness rule is one of those. In the right situation, it can provide some relief from the tax consequences of financial distress.
Friday, March 31, 2017
Livestock Indemnity Payments – What They Are and Tax Reporting Options Overview Recent wildfires in Kansas, Oklahoma and Texas have resulted in thousands of livestock deaths and millions of dollars of losses to the agricultural sector in those states. Last week, one of the blog posts was devoted to casualty losses and involuntary conversions. Today, I tackle another related subject – the USDA Livestock Indemnity Program (LIP) and how to report LIP payments. 2014 Farm Bill – The LIP Program The LIP program, administered by USDA’s Farm Service Agency (FSA), was created under the 2014 Farm Bill to provide benefits to livestock producers for livestock deaths that exceed normal mortality caused by adverse weather, among other things. The amount of a LIP payment is set at 75 percent of the market value of the livestock at issue on the day before the date of death, as the Secretary determines. Eligible livestock include beef bulls and cows, buffalo, beefalo and dairy cows and bulls. Non-adult beef cattle, beefalo and buffalo are also eligible livestock. The livestock must have died within 60 calendar days from the ending date of the “applicable adverse weather event” and in the calendar year for which benefits are requested. To be eligible, the 78
livestock must also have been used in a farming (ranching) operation as of the date of death. Contract growers of livestock are also eligible for LIP payments. However, ineligible for LIP payments are wild animals, pets, or animals that are used for recreational purposes (i.e., hunting dogs, etc.). As previously noted, LIP payments are set at 75 percent of the market value of the livestock as of the day before their death. That market value is tied to a “national payment rate” for each eligible livestock category as published by the USDA. For contract growers, the LIP national payment rate is based on 75 percent of the average income loss sustained by the contract grower with respect to the livestock that died. Any LIP payment that a contract grower is set to receive will be reduced by the amount of monetary compensation that the grower received from the grower’s contractor for the loss of income sustained from the death of the livestock grown under contract. As for FSA payment limitations, a $125,000 annual payment limitation applies for combined payments under the LIP, Livestock Forage Program, and the Emergency Assistance for Livestock, Honey Bees and Farm-Raised Fish program. In addition, to the payment limitation, and eligible farmer or rancher is one that has average adjusted gross income (AGI) over a three-year period that is less than or equal to $900,000. For 2017, the applicable three-year period is 20132015. For a particular producer, that could mean that tax planning strategies to keep average AGI at or under $900,000 need to be implemented. That could include the use of deferral strategies, income averaging and amending returns to make or revoke an I.R.C. §179 election. An eligible producer can submit a notice of loss and an application for LIP payments to the local FSA office. The notice of loss must be submitted within the earlier of 30 days of when the loss occurred (or became apparent) or 30 days after then end of the calendar year in which the livestock loss occurred. For contract growers, a copy of the grower contract must be provided. For all producers, it is important to submit evident of the loss supporting the claim for payment. Photographs, veterinarian records, purchase records, loan documentation, tax records, and similar data can be helpful in documenting losses. Of course, the weather event triggering the livestock losses must also be documented. In addition, certification of livestock deaths can be made by third parties on Form CCC-854, if certain conditions can be satisfied Tax Reporting Given that the wildfires occurred in the early part of 2017, it is likely that any LIP payments will also be received in 2017. That’s not always the case. Sometimes LIP payments are not paid until the calendar year after the year in which the loss was sustained. For example, livestock losses in South Dakota a few years ago occurred late in the year, but payments weren’t received until the following year. In any event, for LIP payments that are paid out, the FSA will issue a 1099G for the full amount of the payment. Death of breeding livestock. While the 1099G simply reports the gross amount of any LIP payment to a producer for the year, there may be situations where a portion of the payment is compensation for the death loss of breeding livestock. If the producer would have sold the breeding livestock, the sale would have triggered I.R.C. §1231 gain that would have been reported on Form 4797. That raises a question as to whether it is possible to allocate the portion of the disaster proceeds allocable to breeding livestock from Schedule F to Form 4797. This is an issue that many producers that have sustained livestock losses will have. While it is true that gains and losses from the sale of breeding livestock sales are reported on Form 4797, the IRS will look for 79
Form 1099-G amounts paid for livestock losses to show up on Schedule F – most likely on line 4a. Income inclusion and deferral. The general rule is that any benefits associated indemnity payments (or feed assistance) are reported in income in the tax year that they are received. That would mean, for example, that payments received in 2017 for livestock losses occurring in 2017 will get reported on the 2017 return. Likewise, payments for livestock losses occurring in 2016 that were received in 2017 would also be reported in 2017. The receipt and inclusion in income of LIP payments could also put a livestock producer in a higher income tax bracket for 2017. In that instance, there might be other tax rules that can be used to defer the income associated with the livestock losses. Under I.R.C. §451(e), the proceeds of livestock that are sold on account of weather-related conditions can be deferred for one year. Under another provision, I.R.C. §1033(e), the income from livestock sales where the livestock are held for draft, dairy or breeding purposes that are involuntarily converted due to weather can be deferred if the livestock are replaced with like-kind livestock within four years. The provision applies to the excess amount of livestock sold over sales that would occur in the course of normal business practices. While I.R.C. §451(e) requires that a sale or exchange of the livestock must have occurred, that is not the case with the receipt of indemnity payments for livestock losses. So, that rule doesn’t provide any deferral possibility. The involuntary conversion rule of I.R.C. §1033(3) is structured differently. It doesn’t require a sale or exchange of the livestock, but allows a deferral opportunity until the animals acquired to replace the (excess) ones lost in the weather-related event Thus, only the general involuntary conversion rule of I.R.C. §1033(a) applies rather than the special one for livestock when a producer receives indemnity (or insurance) payments due to livestock deaths. Thus, for LIP payments received in 2017, they will have to be reported unless the recipient acquires replacement livestock within the next two years – by the end of 2019. Any associated gain would then be deferred until the replacement livestock are sold. At that time, any gain associated gain would be reported and the gain in the replacement animals attributable to breeding stock would be reported on Form 4797. Conclusion Livestock losses due to weather-related events can be difficult to sustain. LIP payments can help ease the burden. Having the farming or ranching operation structured properly to receive the maximum benefits possible is helpful, as is understanding the tax rules and opportunities for reporting the payments.
Monday, February 12, 2018
Livestock Sold or Destroyed Because of Disease Overview Although the loss of livestock due to disease does not occur that frequently, when it occurs the loss can be large. Fortunately, the tax Code provides a special rule for the handling of the loss. The rule is similar to the rules that apply when excess livestock are sold on account of weather-related conditions. 80
Today’s post takes a look at the tax rule for handling sale of livestock on account of disease. Treatment as an Involuntary Conversion Gain deferral. Similar to the drought sale rules, livestock that are sold or exchanged because of disease may not lead to taxable gain if the proceeds of the transaction are reinvested in replacement animals that are similar or related in service or use (in other words, dairy cows for dairy cows, for example) within two years of the close of the tax year in which the diseased animals were sold or exchanged. I.R.C. §1033(d). More specifically, the replacement period ends two years after the close of the tax year in which the involuntary conversion occurs and any part of the gain is realized. I.R.C. §1033(a)(2)(B)(i). In that event, the gain on the animals disposed of is not subject to tax. Instead, the gain is deferred until the replacement animals are sold or exchanged in a taxable transaction. The taxpayer's basis in the new animals must be reduced by the unrecognized gain on the old animals that were either destroyed, sold or exchanged. Treas. Reg. §1.1033(b)-1. _______________ Note: Involuntary conversion treatment is available for losses due to death of livestock from disease. It doesn’t matter whether death results from normal death loss or a disease causes massive death loss. Rev. Rul. 61-216, 1961-2 C.B. 134. In addition, involuntary conversion treatment applies to livestock that are sold or exchanged because they have been exposed to disease. Treas. Reg. §1.1033(d)-1. _______________ When is gain recognized? Gain is realized to the extent money or dissimilar property is received in excess of the tax basis of the livestock. For farmers on the cash method of accounting, raised livestock has no tax basis. Therefore, gain is realized upon the receipt of any compensation for the animals. See, e.g., Decoite v. Comr., T.C. Memo. 1992-665. Thus, if there is gain recognition on the transaction, it occurs to the extent the net proceeds from the involuntary conversion are not invested in qualified replacement property. I.R.C. §1033(a)(2)(A). The gain (or loss) is reported on Form 4797. A statement must be attached to the return for the year in which gain is realized (e.g., the year in which insurance proceeds are received). Treas. Reg. 1.1033(a)-2(c)(2). The statement should include the date of the involuntary conversion as well as information concerning the insurance (or other reimbursement) received. If the replacement livestock are received before the tax return is filed, the attached statement must include a description of the replacement livestock, the date of acquisition, and their cost. If the animals will be replaced in a year after the year in which the gain is realized, the attached statement should evidence the taxpayer’s intent to replace the property within the two-year period. Disease is not a casualty. Under the casualty loss rules, a deduction can be taken for the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Rev. Rul. 72-592, 1972-2 C.B. 101. Livestock losses because of disease generally would not be eligible for casualty loss treatment because the loss is progressive rather than sudden. Thus, casualty loss treatment under I.R.C. §165(c)(3) does not apply. However, this provision doesn’t apply to losses due to livestock disease. I.R.C. §1033(d). Stated another way, the “suddenness” test doesn’t have to be satisfied to have involuntary conversion treatment apply. See Rev. Rul. 59-102, 1959-1 C.B. 200.
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What is a “disease”? While a livestock disease need not be sudden in nature for the sale or exchange of the affected livestock to be treated under the involuntary conversion rules, a genetic defect is not a disease. Rev. Rul. 59-174, 1959-1 C.B. 203. However, livestock that consume contaminated feed and are lost as a result can be treated under the involuntary conversion rules. Rev. Rul. 54-395, 1954-2 C.B. 143. What qualifies as “replacement animals”? I.R.C. §1033(d) says that if “livestock” are destroyed, sold or exchanged on account of disease then involuntary conversion treatment can apply. But, what is the definition of “livestock” for involuntary conversion purposes? The definition of “livestock” under I.R.C. §1231 applies for involuntary conversion treatment. Treas. Reg. §1.1231-2(a)(3). Under that regulation, “livestock” 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, reptiles, etc.” The IRS has ruled that honeybees destroyed due to nearby pesticide use qualified for involuntary conversion treatment. Rev. Rul. 75-381, 1975-2 C.B. 25. Environmental contamination. If it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into non-like-kind farm property or real estate used for farming purposes. I.R.C. §1033(f). A communicable disease may not be considered to be an environmental contaminant. Miller v. United States, 615 F. Supp. 160 (E.D. Ky. 1985). Conclusion While the destruction, sale or exchange of livestock on account of disease is uncommon, it does occur. When it does, the financial impact on the farming or ranching business can be substantial. Fortunately, there is a tax rule that helps soften the blow. Wednesday, December 6, 2017
Are Taxes Dischargeable in Bankruptcy? Overview For Chapter 7 and 11 filers, there is a possibility that taxes could be dischargeable in bankruptcy. That’s because under those bankruptcy code provisions, a new tax entity is created at the time of bankruptcy filing. That’s not the case for individuals that file Chapter 12 (farm) bankruptcy or 13 and for partnerships and corporations under all bankruptcy chapters. In those situations, the debtor continues to be responsible for the income tax consequences of business operations and disposition of the debtor's property. Thus, payment of all the tax triggered in bankruptcy is the responsibility of the debtor. The only exception is that Chapter 12 filers can take advantage of a special rule that makes the taxes a non-priority claim. A new Tax Court case involving a Chapter 7 filer, illustrates how timing the bankruptcy filing is important for purposes of being able to discharge taxes in a Chapter 7. Taxes discharged in bankruptcy, that’s the focus of today’s post. The Bankruptcy Estate as New Taxpayer
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The creation of the bankruptcy estate as a new taxpayer, separate from the debtor, highlights the five categories of taxes in a Chapter 7 or 11 case.
Category 1 taxes are taxes where the tax return was due more than three years before filing. These taxes are dischargeable unless the debtor failed to file a return or filed a fraudulent return. Category 2 taxes are the taxes due within the last three years. These taxes are not dischargeable but are entitled to an eighth priority claim in the bankruptcy estate, ahead of the unsecured creditors. Category 3 taxes are the taxes for the portion of the year of bankruptcy filing up to the day before the day of bankruptcy filing. If the debtor's year is closed as of the date of filing, the taxes for the first year, while not dischargeable, are also entitled to an eighth priority claim in the bankruptcy estate. If the debtor's year is not closed, the entire amount of taxes for the year of filing are the debtor's responsibility. Category 4 taxes are the taxes triggered on or after the date of filing and are the responsibility of the bankruptcy estate. Taxes due are paid by the bankruptcy estate as an administrative expense. If the taxes exceed the available funds, the tax obligation remains against the bankruptcy estate but does not return to the debtor. Category 5 taxes are for the portion of the year beginning with the date of bankruptcy filing (or for the entire year if the debtor's year is not closed) and are the responsibility of the debtor.
The Election To Close the Debtor’s Tax Year In general, the bankrupt debtor’s tax year does not change upon the filing of bankruptcy. But, debtors having non-exempt assets may elect to end the debtor’s tax year as of the day before the filing. Making the election creates two short tax years for the debtor. The first short year ends the day before bankruptcy filing and the second year begins with the bankruptcy filing date and ends on the bankrupt’s normal year-end date. If the election is not made, the debtor remains individually liable for income taxes for the year of filing. But, if the election is made, the debtor’s income tax liability for the first short year is treated as a priority claim against the bankruptcy estate, and can be collected from the estate if there are sufficient assets to pay off the estate’s debts. If there are not sufficient assets to pay the income tax, the remaining tax liability is not dischargeable, and the tax can be collected from the debtor at a later time. The income tax owed by the bankrupt for the years ending after the filing is paid by the bankrupt and not by the bankruptcy estate. Thus, closing the bankrupt’s tax year can be particularly advantageous if the bankrupt has substantial income in the period before the bankruptcy filing. Conversely, if a net operating loss, unused credits or excess deductions are projected for the first short year, an election should not be made in the interest of preserving the loss for application against the debtor’s income from the rest of the taxable year. Even if the debtor projects a net operating loss, has unused credits or anticipates excess deductions, the debtor may want to close the tax year as of the day before bankruptcy filing if the debtor will not likely be able to use the amounts, the items could be used by the bankruptcy estate as a carryback to earlier years of the debtor (or as a carryforward) and, 83
the debtor would likely benefit later from the bankruptcy estate’s use of the loss, deduction or credits. But, in any event, if the debtor does not act to end the tax year, none of the debtor’s income tax liability for the year of bankruptcy filing can be collected from the bankruptcy estate. Likewise, if the short year is not elected, the tax attributes (including the basis of the debtor’s property) pass to the bankruptcy estate as of the beginning of the debtor’s tax year. Therefore, for example, no depreciation may be claimed by the debtor for the period before bankruptcy filing. That could be a significant issue for many agricultural debtors. Consider the following example: Sam Tiller, a cash method taxpayer, on January 26, 2016, bought and placed in service in his farming business, a new combine that cost $402,000. Sam is planning on electing to claim $102,000 of expense method depreciation on the combine and an additional $150,000 (50 percent of the remaining depreciable balance) of first-year bonus depreciation as well as regular depreciation on the combine for 2016. However, during 2016, Sam’s financial condition worsened severely due to a combination of market and weather conditions. As a result, Sam filed Chapter 7 bankruptcy on December 5, 2016. If Sam does not elect to close the tax year, the tax attributes (including the basis of his property) will pass to the bankruptcy estate as of the beginning of Sam’s tax year (January 1, 2016). Therefore, Sam would not be able to claim any of the depreciation for the period before he filed bankruptcy (January 1, 2016, through December 4, 2016). Recent Tax Court Case In Ashmore v. Comr., T.C. Memo. 2017-233, the petitioner claimed that his 2009 tax liability, the return for which was due on April 15, 2010, was discharged in bankruptcy. He filed Chapter 7 on April 8, 2013. That assertion challenged whether the collection action of the IRS was appropriate. As indicated above, the Tax Court noted that taxes are not dischargeable in a Chapter 7 bankruptcy if they become due within three years before the date the bankruptcy was filed. Because the petitioner filed bankruptcy a week too soon, the Tax Court held that his 2009 taxes were dischargeable and could be collected. As a result, the IRS settlement officer did not abuse discretion in sustaining the IRS levy. In addition, the Tax Court, held that the IRS did not abuse the bankruptcy automatic stay provision that otherwise operates to bar creditor actions to collect on debts that arose before the bankruptcy petition was filed. Conclusion The Tax Court’s conclusion in Ashmore is not surprising. The three-year rule has long been a part of the bankruptcy code. Indeed, in In re Reine, 301 B.R. 556 (Bankr. W.D. Mo. 2003), the debtor filed the Chapter 7 bankruptcy petition more than three years after filing the tax return, but within three years of due date of return. The court held that the debtor’s tax debt was not dischargeable.
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Monday, October 9, 2017
Tough Financial Times in Agriculture and Lending Clauses – Peril for the Unwary Overview The farm economy continues to struggle. Of course, certain parts of the country are experiencing more financial trauma than are other parts of the country, but recent years have been particularly difficult in the Corn Belt and Great Plains. Aggregate U.S. net farm income has dropped by approximately 50 percent from its peak in 2011. It is estimated to increase slightly in 2017, but it has a long way to go to get back to the 2011 level. In addition, the value of farmland relative to the value of the crops produced on it has fallen to its lowest point ever. A dollar of farm real estate has never produced less value in farm production, and real net farm income relative to farm real estate values have not been as low as presently since 1980 to 1983. A deeper dive on farm financial data indicates that after multiple years of declining debt-to-asset ratios, there was an uptick in 2015 and 2016. Relatedly, default risk remains low, but it also increased in 2015 and 2016. Also, there has been a decline in the ratio of working capital to assets, and a drop in the repayment capacity of ag loans. As a financial fitness indicator, repayment capacity is a key. At the beginning of the farm debt crisis in the early 1980s, it dropped precipitously due to a substantial increase in interest payments and a decline in farm production. That meant that land values could no longer be supported, and they dropped substantially. Consequently, many farmers found themselves with collateral value that was lower than the amount borrowed. Repayment capacity is currently a serious issue that could lead to additional borrowing. While financial conditions may improve a bit in 2017 and on into 2018, working capital may continue to erode in 2017 which could lead to increased debt levels. That’s because average net farm income will remain at low levels. This could lead to some agricultural producers and lenders having to make difficult decisions before next spring. It also places a premium on understanding clause language in lending document and the associated rights and obligations of the parties. Two clauses deserve close attention. One clause contains “cross collateralization” language. “Cross-collateralization” is a term that describes a situation when the collateral for one loan is also used as collateral for another loan. For example, if a farmer takes out multiple loans with the same lender, the security for one loan can be used as cross-collateral for all the loans. A second clause contains a “co-lessee” provision. That’s a transaction involving joint and several obligations of multiple parties. Today’s post takes a deeper look at the implications of cross-collateral and co-lessee language in lending documents. My co-author for today’s post is Joe Peiffer of Peiffer Law Office in Hiawatha, Iowa. Joe brought the issues with cross-collateralization and co-lessee clause language to my attention. Joe has many years of experience working with farmers in situations involving lending and bankruptcy, and has valuable insights. Cross-Collateralization Language
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As noted above, clause language in lending and leasing documents should be carefully reviewed and understood for their implications. This is particularly true with respect to crosscollateralization language. For example, the following is an example of such a clause that appears to be common in John Deere security agreements. Here is how the language of one particular clause reads: “Security Interest; Missing Information. You grant us and our affiliates a security interest in the Equipment (and all proceeds thereof) to secure all of your obligations under this Contract and any other obligations which you may have to us or any of our affiliates or assignees at any time and you agree that any security interest you have granted or hereafter grant to us or any of our affiliates shall also secure your obligations under this Contract. You agree that we may act as agent for our affiliates and our affiliates may as agent for us, in order to perfect and realize on any security interest described above. Upon receipt of all amounts due and to become due under this Contract, we will release our security interest in the Equipment (but not the security interest for amounts due an affiliate), provided no event of default has occurred and is continuing. You agree to keep the Equipment free and clear of all liens and encumbrances, except those in favor of us and our affiliates as described above, and to promptly notify us if a lien or encumbrance is placed or threated against the Equipment. You irrevocably authorize us, at any time, to (a) insert or correct information on this Contract, including your correct legal name, serial numbers and Equipment descriptions; (b) submit notices and proofs of loss for any required insurance; (c) endorse your name on remittances for insurance and Equipment sale or lease proceeds; and (d) file a financing statement(s) which describes either the Equipment or all equipment currently or in the future financed by us. Notwithstanding any other election you may make, you agree that (1) we can access any information regarding the location, maintenance, operation and condition of the Equipment; (2) you irrevocably authorize anyone in possession of that information to provide all of that information to us upon our request; (3) you will not disable or otherwise interfere with any information gathering or transmission device within or attached to the Equipment; and (4) we may reactivate such device.” So, what does that clause language mean? Several points can be made:
The clause grants Deere Financial and its affiliates a security interest in the equipment pledged as collateral to secure the obligations owed to it as well as its affiliates.
When all obligations (including debt on the equipment purchased under the contract and all other debts for the purchase of equipment that Deere Financial finances) to Deere under the contract are paid, Deere Financial will release its security interest in the equipment. That appears to be straightforward and unsurprising. However, the release does not release the security interest of the Deere’s affiliates. This is the cross-collateral provision.
The clause also makes Deere Financial the agent of its affiliates, and it makes the affiliates the agent of Deere Financial for purposes of perfection. What the clause appears to mean is that if a financing statement was not filed timely, perfection by possession could be pursued.
The clause also irrevocably authorizes John Deere to insert or correct information on the contract.
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The clause allows John Deere to access any information regarding the location, maintenance, operation and condition of the collateral.
The clause also irrevocably authorizes anyone in possession of that information to provide it to John Deere upon request.
Also, under the clause, the purchaser agrees not to disable or interfere with any information gathering or transmission device in or attached to the Equipment and authorizes John Deere to reactivate any device.
Example. Consider the following example of the effect of cross-collateralization by machinery sellers and financiers:
Assets
Value
Creditor
Amount
Equity by Item
JD 4710 Sprayer 90' Boom
60,000
JD Finance
84,000 (24,000)
JD 333E Compact Track Loader
50,000
JD Finance
35,000 15,000
JD 8410T Crawler Tractor
70,000
JD Finance
50,000 20,000
JD 612C 12 Row Corn Head
70,000
JD Finance
25,000 45,000
Farm Plan
58,571 (58,571)
Total Value
250,000
Total Liabilities
252,571
Equity with Cross Collateralization
(2,571)
Equity without Cross Collateralization
80,000
(2,571)
The equity in the equipment without cross-collateralization is the sum of the equity in the Compact Track Loader, the Crawler Tractor and the Row Corn Head. Sellers that finance the purchase price of the item(s) sold (termed a “purchase money” lender) seem to be using cross-collateralization provisions with some degree of frequency. As noted, the cross-collateralization provisions of the John Deere security agreement will allow John Deere to offset its under-secured status on some machinery by using the equity in other financed machines to make up the unsecured portion of its claims. Other machinery financiers (such as CNH and AgDirect) are utilizing similar cross-collateral provisions in their security agreements. 87
Can A “Dragnet” Lien Defeat a Cross-Collateralization Provision? Would a bank’s properly filed financing statement and perfected blanket security agreement be sufficient to defeat a cross-collateralization provision? It would seem inequitable to allow an equipment financier’s subsequently filed financing statement to defeat the security interest of a bank. So far, it appears that when a purchase money security interest holder has sought to enforce a cross-collateralization clause, the purchase money security interest holder has always backed down. For example, in one recent scenario, John Deere Financial sought to enforce its cross-collateralization agreement against a Bank in a situation similar to the one set forth above. The Bank properly countered that its blanket security interest in farm equipment perfected before any of the Deere Financial purchase money security interests were perfected defeated the Deere Financial cross-collateralization. Deere Financial backed down thereby allowing the Bank to have all the equity in the equipment, $80,000, be paid to the Bank by the auctioneer after the liquidation auction. A “Co-Lessee” Clause When a guarantee on a loan cannot be obtained, a proposal may be made for “joint and several obligations.” In that situation, the lessor tries to compel one lessee to cover another lessee’s obligations or joint obligations. It’s a lease-sublease structure, with the original lessee becoming the sublessor. While the original lessee/sublessor has no rights to use the equipment (those rights are passed to the sublessee), the original lessee/sublessor remains legally obligated for performance. The sublease can then be assigned as collateral to the original lessor. While a co-borrower situation is not uncommon, a transaction involving co-lessees is different inasmuch as a lease involves the right to use and possess property along with the obligation to pay for the property. A loan document simply involves the repayment of debt. So, what if a colessee arrangement goes south and the lessor tries to compel one lessee to cover another lessee’s joint obligation? What is the outcome? That’s hard to say simply because there aren’t any litigated cases on the issue with published opinions. But, numerous legal (and (tax) issues would be involved. For instance, with a true lease (see an earlier post on the distinction between a true lease and a capital lease), what if the lessees argue over the use and possession of the equipment or the removal of liens or maintenance of the property or the rental or return of the property? What about the payment of taxes? Similar issues would arise in a lease/purchase situation that encounters problems. What is known is that in such a dispute numerous Uniform Commercial Code issues are likely to arise under both Article 2 and Article 9. The following is an example of John Deere’s co-lessee clause when it has an additional party sign on a lease: “By signing below, each of the co-lessees identified below (each, a “Co-Lessee”) acknowledges and agrees that (1) the Lessee indicated on the above referenced Master Lease Agreement (the “Master Agreement”) and EACH CO-LESSEE SHALL BE JOINTLY AND SEVERALLY LIABLE FOR ANY AND ALL OF THE OBLIGATIONS set forth in the Master Agreement and each Lease Schedule entered into from time to time thereunder including, but not limited to, the punctual payment of any periodic payments or any other amounts which may become due and payable under the terms of the Master Agreement, whether or not said Co-Lessee signs each Lease Schedule or receives a copy thereof, and (2) it has received a complete copy of the Master Agreement and understands the terms thereof. 88
In the event (a) any Co-Lessee fails to remit to the Lessor indicated above any Lease Payment or other payment when due, (b) any Co-Lessee breaches any other provision of the Master Agreement or any Lease Schedule and such default continues for 10 days; (c) any Co-Lessee removes any Equipment (as such term is more fully described in the applicable Lease Schedule) from the United States; (d) a petition is filed by or against any Co-Lessee or any guarantor under any bankruptcy or insolvency law; (e) a default occurs under any other agreement between any Co-Lessee (or any of Co-Lessee's affiliates) and Lessor (or any of Lessor's affiliates); (f) or any Co-Lessee or any guarantor merges with or consolidates into another entity, sells substantially all its assets, dissolves or terminates its existence, or (if an individual) dies; or (g) any Co-Lessee fails to maintain the Insurance required by Section 6 of the Master Agreement, Lessor may pursue any and all of the rights and remedies available to Lessor under the terms of the Master Agreement directly against any one or more of the Co-Lessees. Nothing contained in the Addendum shall require Lessor to first seek or exhaust any remedy against any one Co-Lessee prior to pursuing any remedy against any other Co-Lessee(s). Capitalized terms not defined in this Addendum shall have the meaning provided to them in the Master Agreement.” Clearly, a party signing on as a co-lessee on a John Deere lease is assuming a great deal of risk. Conclusion Times are tough for many involved in production agriculture. The same is true for many agribusiness and agricultural lenders. If a producer is presented with a lending transaction that involves either a cross-collateralization or a co-lessee clause, legal counsel with experience in such transactions should be consulted. Fully understanding the risks involved can pay big dividends. Failing to understand the terms of these clauses can lead to the financial failure of the farmer that signs the document. Thursday, January 12, 2017
Farm Financial Stress – Debt Restructuring Overview The current financial situation in agriculture is difficult for many producers. Low crop and livestock prices, falling land values and increasing debt levels are placing some ag producers in a serious bind. Chapter 12 bankruptcy is an option for some, although the current debt limits of Chapter 12 are barring some from utilizing its relief provisions. When dealing with financial distress, restructuring debt is often involved. Debt Restructuring Negotiations Debt restructuring negotiations do not involve a formal, specifically prescribed process with one exception – mediation. Rather, debt restructuring negotiations take place informally. However, when mediation is utilized, it is a formal process that is often prescribed by state law. So, what makes for a successful debt restructuring negotiation? As with any negotiation on any subject, it is critical to understand what each party views as important. What are their priorities? For a creditor, collecting on a delinquent debt is always of supreme importance. Likewise, if there is a non-delinquent, marginal loan, the creditor will be interested in obtaining guarantees, either 89
private or via government entities such as the USDA or the Small Business Administration. The creditor will also likely attempt to obtain additional collateral so that the farm debtor’s line of credit can continue and any projected loss to the creditor is minimized or eliminated. On the other side, a farmer’s goals typically include staying on the farm and continuing the farming business. The farmer probably also wants to maintain ownership of assets and their lifestyle. Also, another common goal of farm debtors is to get the farming operation to the most economical size (often downsizing) without triggering a tax bill that can’t be paid. Once the goals of the creditors and the farmer are identified, they must be prioritized. That’s when reality begins to set in. Are the goals realistic? Are there any that can’t be achieved? Those that can’t be achieved must be eliminated and the realistic goals focused on. Creditors have to realize that debts won’t be paid in full and on time. Farm debtors have to understand that they can’t retain all of their farm assets. So, the parties should strive to find common ground somewhere in the middle. There probably are some areas of agreement that can be reached. But, to get there, both parties will likely have to compromise. Neither the creditors nor the farm debtor should view negotiations in absolutist terms. Still, even if a mediation agreement is reached and a release obtained, that doesn’t meet that the parties still won’t end up in court. To avoid litigation, some “out-of-the-box” thinking will likely be required. Being creative. Joe relates a matter that he dealt with a few years ago. He was representing a farm debtor and the banker showed a great willingness to be creative in dealing with the farmer’s debt situation. The balance on the loan owed the bank exceeded the collateral values by well over $1,000,000. The farm debtor had a dairy operation that was losing money to the tune of more than $70,000 every month, and there was virtually no likelihood of a successful reorganization. At mediation, the banker suggested that if the farmer would immediately surrender the cows, calves, grain, sileage and other personal property securing the loan, and agree to surrender the farm under non-judicial foreclosure he would pay Joe's clients $100,000. The banker's reasoning was that by paying the farm debtor $100,000, the amount he expected to pay his attorney if the farmer filed a Chapter 12 bankruptcy, the farmer could have a fresh start and he would speedily obtain control of the collateral minimizing his losses. The farm debtor put a great deal of thought into the prospect of getting $100,000 and not having the uncertainty of a bankruptcy. They opted to take the money offered to them. The deal was structured so that the bank’s $100,000 payment was in consideration for them selling their homestead to the Bank. Because the money constituted proceeds from the sale of their homestead, the funds were exempt under state (IA) law from the claims of their other creditors for a reasonable time to allow purchase of a later homestead. After closing, the farm debtor held the proceeds in a “Homestead Account” separate from all other money they. They did not add other money to that account, nor did they spend the money in that account until they purchased a new homestead. Non-Judicial Foreclosure Can be Beneficial The use of a non-judicial foreclosure provided under state law (in Iowa, the procedure is set forth in Iowa Code § 654.18) allows farmers and their creditors to fashion remedies that can be mutually beneficial. This remedy can be utilized either before or as a part of a mediated settlement. The creditor gets possession and ownership of the real estate collateral much quicker than would be the case in a traditional foreclosure. The right of redemption and right of first 90
refusal present in a traditional foreclosure are eliminated. The creditor waives any deficiency that could exist if the collateral cannot cover the indebtedness. But, of course, a farm debtor must be mindful of the potential for discharge of indebtedness income if this procedure is utilized and the farmer has exempt assets that could make them solvent once a deficiency is forgiven. A benefit to a farm debtor of non-judicial foreclosure is that the creditor is generally able to make other beneficial concessions. Also, under a non-judicial foreclosure, the farmer deeds the farm to the creditor subject to a period of time (typically five-business days) during which the transaction can be cancelled. If the transaction is not cancelled, the creditor gives notice of the non-judicial foreclosure to junior lien holders who then a period of time (generally 30 days) to redeem from the creditor and each other. Deed Back to Bank with Sale of Homestead Back to Farmer on Real Estate Contract During the farm financial crisis of the 1980s in many parts of the Midwest and Great Plains, farm and ranch debt restructurings often involved debtors deeding back their farms to the creditor with the creditor then selling back the house and an acreage on a real estate contract. This approach allowed the farmer to retain the homestead while allowing the bank to realize cash from the balance of its real estate collateral. But, if the debtor missed a payment, the bank, could institute a contract forfeiture procedure that would take only 30 days to finish once the Notice of Forfeiture was properly served after mediation. Sale of Non-Essential Assets in the Tax Year Before Filing Chapter 12 The “right-sizing” of a farm operation must always be considered as a part of a debt restructuring negotiation. If the farmer has over-encumbered assets it can be in his best interest to liquidate some assets, reduce debt and restructure the farming operation. The liquidation of assets that are not absolutely necessary to the “newer” farming operation can also have the effect of decreasing the farmer’s level of debt beneath the maximum allowable so that the farmer is eligible to file Chapter 12. However, selling-off of farm assets often leads to incurring significant income taxes. But, in a Chapter 12 farm bankruptcy, a special tax provision, 11 U.S.C. §1222(a)(2)(A), can be utilized to move taxes from a priority to a non-priority position which can then result in the taxes being discharged. Formal Written Agreements Contained in Bank Minutes are Essential Under federal law, to be enforceable in the event the institution is declared insolvent, debt restructuring agreement involving federally insured institutions must be in writing, approved by the board of directors, sealed and included in the bank’s minutes. Reliance on any oral agreements with a bank is not wise as they are unenforceable (see, e.g., Iowa Code § 535.17 and 12 U.S.C. §1823(e)). If the bank goes broke and the Debt Settlement Agreement is not memorialized as is required by 12 U.S.C. § 1823(e), the FDIC or the purchaser of the notes from the FDIC will not be bound by the Debt Settlement Agreement. Thus, if any agreement with a bank is to be enforced, it must be in writing signed by the proper parties and comply with any statutorily-required formalities. Conclusion As Joe has pointed out on numerous occasions, debt restructuring negotiations provide farmers and their creditors with substantial opportunities to reach an agreement that satisfies both parties’ 91
needs. Preparation is the key to a successful negotiation for both creditors and farmers. Consideration of the other party’s priorities and needs can lead to opportunities for cooperation that will minimize the need for court intervention and bankruptcies. Frequently, the need to “right-size” a farming operation will lead to significant income tax consequences that can only be addressed in a Chapter 12 bankruptcy. When this occurs, cooperation between the creditor and farmer can allow the creditor to receive the liquidation proceeds of most of its collateral in the tax year before filing the bankruptcy while allowing the farmer to avail himself of the favorable tax provisions of 11 U.S.C. § 1222(a)(2)(A). All parties to debt restructuring negotiations should be prepared to accept reality, make reasonable concessions and consider the needs of the other party to reach agreement.
Wednesday, October 26, 2016
Do You Have To Be A Farmer To Be Eligible For Chapter 12? Overview The economic circumstances in agriculture presently are disturbing. The financial situation in the agricultural economy has changed considerably over the past 18 months to two years. For instance, in Kansas, 2015 average net farm income was the lowest since 1985. Crop prices are down and the cost of production has gone up. This has had a significant impact on many farmers’ ability to repay debt. Repayment capacity is an important issue, and an erosion of a farmer’s working capital negatively impacts financing. This all means that some farmers (and their lenders) either have already made or will soon be making some very difficult decisions before the spring of 2017. One possible decision is to restructure debt via the filing of a Chapter 12 bankruptcy petition. That’s the bankruptcy reorganization provision that was enacted during the throes of the last significant debt crisis in agriculture 30 years ago. But, what does it take to be eligible for Chapter 12 bankruptcy? Do you really have to be a farmer? It seems like an obvious question. But, is the answer simple? That’s the subject of today’s topic. What is a “Family Farmer”? To be eligible for Chapter 12 bankruptcy, a debtor must be a “family farmer” or a “family fisherman” with “regular annual income.” The term “farming operation” includes farming, tillage of the soil, dairy farming, ranching, production or raising of crops, poultry, or livestock, and production of poultry or livestock products in an unmanufactured state. 11 U.S.C. §101(21). A “family farmer” is defined as an individual or individual and spouse who earned more than 50 percent of their gross income from farming either for the taxable year preceding the year of filing or during the second and third tax years preceding filing (a different rule applies to a “family fisherman) and whose aggregate debts do not exceed $4,153,150 (a lower threshold applies for a “family fisherman”). In addition, more than 80 percent of the debt must be debt from a farming operation that the debtor owns or operates. To be eligible, more than 50 percent of an individual debtor’s gross income must come from farming in either the year before filing or in both the second and third tax years preceding filing (a different rule applies to a “family fisherman”). This provision seeks to disqualify tax shelter and recreational farms from Chapter 12 protection. 92
The Need For Farm Income The farm income test is to be applied at the time of bankruptcy filing. That means that the determination of whether a debtor is a farmer that is engaged in farming is made at the time the bankruptcy petition is filed. Likewise, the determination of whether the debtor has the intent to continue farming is made at the time of filing also. See, e.g., In re Nelson, 291 B.R. 861 (Bankr. D. Idaho. 2003). Indeed, 11 U.S.C. §101(18), says that a “family farmer” is an individual and spouse “engaged in in a farming operation…”. Or, at least that was the thinking… In a recent case, In re Williams, No. 15-11023(1)(12), 2016 Bankr. LEXIS 1804 (Bankr. W.D. Ky. Apr. 22, 2016), the court reached the conclusion that a debtor that was not currently actively engaged in farming and did not intend to return to farming was eligible to file Chapter 12. Shortly after the petition was filed, the debtors (a married couple) had last farmed two years earlier and notified the creditors that they had no intent of farming again. Instead, their son planted and harvested the crops. Based on those facts, the bankruptcy trustee claimed the debtors were ineligible for Chapter 12. But, the debtors claimed that they had just made a reasonable choice to end a farming business that was no longer profitable. But, you say, “I thought the purpose of Chapter 12 is to keep farmers on the farm by allowing them to scale their operation down, write off some debt and pay off the balance over time while continuing farming?” You are correct. That is the legislative intent behind Chapter 12. Take a look at 132 Cong. Rec. at S15076 (Oct. 3, 1986). However, the Williams court took note that there was no specific requirement in the Bankruptcy Code that the regular income to fund the Chapter 12 reorganization plan need come specifically from farming. It just had to be stable and regular. The court noted that 11 U.S.C. §101(19) requires a debtor to have regular income sufficient enough to enable the debtor to make plan payments, and that its definition of “family farmer with regular income” meant that the income only be sufficiently stable and regular to enable the debtor to make plan payments. It didn’t require the income to be generated from farming activities. So, the debtors didn’t have to be engaged in farming at the time they filed Chapter 12 and, apparently, they also didn’t have to have any intent to return to farming. What about funding the reorganization plan? Do the funds required to fund the plan have to derive from farming? Williams would indicate that the answer to that question is “no” and there is some support for that. For example, one court has held that the bankruptcy code does not require that a farmer who meets the pre-petition farm income test must have sufficient farm income to fund the Chapter 12 plan. In In re Sorrell,386 B.R. 798 (Bankr. D. Utah 2002), the debtors, husband and wife, owned two farms which were used for crops and raising livestock. Their Chapter 12 plan provided for modified payment of secured claims and about 10 percent of the unsecured claims. The plan was funded with the wife’s income as a loan officer, the husband’s income from off-farm employment, disability payments, farm subsidies and some cash from asset liquidation. A secured creditor objected to the plan, arguing that the debtors were not eligible for Chapter 12 because the plan was not funded from farm operations. The farm had a profit of only $19 per month. The court held that the definition of family farmer required only that the debtor have regular income, not that the income be necessarily derived from the farm. Another court has held that a Chapter 12 debtor whose reorganization plan proposed the debtor’s discontinuing farming and enrollment of all of the debtor’s farmland in the Conservation Reserve Program was not ineligible for Chapter 12 relief. In re Clark, 288 B.R. 237 (Bankr. D. Kan. 2003). 93
Conclusion These seem to be odd results based on the legislative intent behind Chapter 12. However, for farmers that are experiencing severe financial difficulties that are not likely to actually continue in farming, reorganization of debts under Chapter 12 might still be a possibility. That could be a more favorable option than utilizing a different reorganization provision of the bankruptcy code or filing a liquidation bankruptcy. Just something to think about for those that might have to make a difficult decision come spring.
INCOME TAX DEFERRAL OPPORTUNITIES DEFERRAL OF LIVESTOCK SALES Two statutory deferral strategies are available to livestock owners when livestock are sold.
1-year deferral
Involuntary conversion treatment
A third option involves the use of a deferred sale contract. Deferred payment contracts for grain and livestock sales are discussed later in this section.
One-Year Deferral IRC §451(e) provides for a 1-year deferral of the income that is derived from the sale of excess livestock to the extent that the sale occurs because of drought, flood, or other weather-related conditions. Five conditions must be satisfied to be eligible for a 1-year deferral. 1. The taxpayer’s principal business is farming. Note. Farming, as defined by IRC §6420(c)(3), includes the raising or harvesting of any agricultural or horticultural commodity, including the raising, shearing, feeding, caring for, training, and management of livestock, bees, poultry, and fur-bearing animals and wildlife by an owner, tenant, or farm operator. The taxpayer may request a letter ruling from the IRS if it is necessary to determine whether the taxpayer’s principal business is farming.139 2.
The taxpayer uses the cash method of accounting.
3. Under normal business practices, the sale would not have occurred in the current year except for the drought, flood, or other weather conditions. 4. The drought, flood, or other weather condition resulted in the area being designated as eligible for assistance by the federal government.140
a. b.
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139 The
IRS ruled favorably that an individual’s principal business was farming when the individual had off-farm income of $65,000 and also earned $121,000 from a cattle ranching business. Ltr. Rul 8928050 (Apr. 18, 1989). 140 The livestock need not be raised within the actual area of drought or other weather-related condition, and the sale does not need to occur within the designated area. However, the early sale must have occurred solely on account of the drought or other condition and its impact on water, grazing, or other requirements of the animals
5. Only livestock in excess of the number that normally would have been sold under usual business practices is eligible for the deferral. The livestock may be either raised or purchased animals, and may be held either for resale (inventory livestock), or for productive use (depreciable livestock). Depreciable livestock includes dairy, breeding, draft, or sporting-purpose animals. Caution. Treas. Reg. §1.451-7 provides the details of attaching a statement to the tax return when electing to defer income from the sale of livestock. The regulation incorrectly states that livestock held for draft, breeding, dairy, or sporting purposes are ineligible for the 1-year deferral. However, this regulation was adopted before the enactment of legislation that expanded the 1-year deferral privilege to include draft, dairy, breeding, and sporting animals. The regulation also incorrectly refers to drought conditions as the only cause of sale that is eligible for deferral. After the regulation was written, the statute was amended in 1997 to extend the deferral to sales because of floods and other weather-related conditions. The gain to be postponed is equal to the total income realized from the sale of all livestock divided by the total head sold, multiplied by the excess number of head sold because of the drought or other weather condition. The excess is determined by comparing actual number of head sold to those that would have been sold under usual business practices in the absence of the weather condition. Observation. It is common practice to use the client’s most recent 3-year average in determining the number of livestock that would be sold under normal business practices. However, that is not the actual rule. Treas. Reg. §1.451-7(b) states that "The determination of the number of animals which a taxpayer would have sold if it had followed its usual business practice in the absence of drought will be made in light of all facts and circumstances." The regulation requires the taxpayer to disclose the number of animals sold in each of the three preceding years, but if the prior three years' sales activity is not representative of normal business practice, an appropriate adjustment should be made. If the taxpayer makes a deferral election in successive years, Treas. Reg. §1.451-7(f) specifies that the amount deferred from one year to the next is not considered to have been received from the sale of livestock during the later year. In addition, in determining the taxpayer's normal business practice for the later year, earlier years for which a deferral election was made should not be considered. Thus, if a taxpayer defers excess livestock sales from 2014 to 2015 under an IRC §451(e) election, those deferred sales are not taken into account again in 2015 in making a determination as to whether excess head were sold in 2015. The statement of election to postpone gain for one year under IRC §451(e) must include the taxpayer’s name and address and the following information.
A statement that the election is made under IRC §451(e)
within the area. Treas. Reg. §1.451-7(c); IRS Notice 89-55. The disaster area designation can be made by the president, [shouldn’t “President” start with a capital p?] the Department of Agriculture or any of its agencies, or by other federal departments or agencies.
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Evidence of the drought or other weather-related condition that forced the early sale or exchange of the livestock and the date, if known, on which the area was designated as eligible for assistance by the federal government because of the conditions
A statement explaining the relationship of the area of drought or other condition to the early sale or exchange of the livestock
The number of animals sold in each of the three preceding years
The number of animals that would have been sold in the tax year had normal business practices been followed in the absence of drought or other weather-related conditions
The total number of animals sold and the number sold because of drought and other conditions during the year
A calculation of the income to be postponed for each class of livestock
A taxpayer who sells livestock early on account of weather-related conditions that are given federal disaster status may make the 1-year deferral election at any time within the four years following the close of the first tax year in which any gain is recognized.141
Involuntary Conversion Treatment IRC §1033 applies the involuntary conversion rollover rule in two broad situations, allowing taxpayers who are forced to sell livestock involuntarily to defer the gain into replacement property. Under either of the following circumstances, gains from livestock sales can be deferred by reinvesting the proceeds. 1. Livestock were destroyed by disease.142 2. Livestock (other than poultry) held by a taxpayer for draft, breeding, or dairy purposes were sold in excess of usual business practices due to drought, flood, or other weather-related conditions.143 Note. The sale or exchange of the excess livestock must be solely on account of drought or weather conditions that affect the water, grazing or other needs of the livestock. However, it is not necessary that the livestock be held in a drought or flood area, or that the actual sale occurred in the affected area.144 Like the provisions for the 1-year deferral related to weather conditions, the involuntary conversion treatment is limited to the livestock sold in excess of the number that would have been sold under the taxpayer’s usual business practice.145 [Carolyn, yes, that is the point.] IRC §1033 allows taxpayers to elect to defer gains that are realized from involuntary conversions (the destruction, theft, seizure, or condemnation of property) if the taxpayer has properly complied with the
141
IRC §451(e)(3). IRC §1033(d). 143 IRC §1033(e). 144 Treas. Reg. §1.1033(e)-1(b). 145 Treas. Reg. §1.1033(e)-1(c). 142
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election requirements. In addition, the taxpayer must make a timely purchase of qualified replacement property. In general, the replacement property must be “similar or related in service or use.”146 This means, for example, that dairy cows should be replaced by dairy cows.147 However, this general provision was amended in certain situations as a result of 2004 legislation that applies to livestock sales reported on returns with a due date after 2002. A taxpayer can replace involuntarily converted livestock sold early due to drought, flood, or other weather-related conditions or soil or other environmental contamination with other farm property, if it is not feasible for the taxpayer to reinvest the proceeds in similar or related-use livestock. As a result of this provision, a taxpayer can satisfy the §1033 replacement rule by reinvesting in farm equipment or other tangible personal property for farming use. This applies to a taxpayer who is forced to sell cattle early because of drought or other weather-related conditions in a federally designated disaster area and who is unable to reinvest the proceeds in replacement livestock due to extended drought or other weather conditions. Likewise, if it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environment contamination, the proceeds can be invested into property that is not like kind or real estate used for farming purposes.148 Example 16. Bart is a cattle rancher. Due to an extended drought in the areas where his special feed is grown, the price of feed increases to such a level that Bart can no longer afford to feed his livestock. In 2012, he was forced to sell three times as many cattle as he would have under normal business circumstances. Because the drought continues to affect the cost of feed, it is not feasible for Bart to reinvest in more cattle. In 2015, instead of buying replacement cattle, he reinvests the proceeds into soil cultivators. This farm equipment qualifies as replacement property because it is not feasible for Bart to reinvest in more cattle during the replacement period. Example 17. Jethro is a cattle rancher. In 2012, he was forced to sell his entire herd of cattle because his grazing land was contaminated by an oil spill. It is not feasible for Jethro to replace the herd because the entire environment on his ranch is contaminated. In 2015, he reinvests the proceeds into farmland in a distant state. This farmland qualifies as replacement property because the herd was sold due to environmental factors. Observation. Farmers that sell raised breeding or dairy animals that can be taxed at the capital gain rates may prefer to recognize the gain rather than deferring it. This is particularly true if depreciation deductions on the replacement animals reduce income subject to higher income tax rates (and potentially SE tax). This might be especially applicable when the replacement animals qualify for expensing under IRC §179. Replacement Period. In general, the purchase of replacement property under the involuntary conversion rules of §1033 must occur within two years after the close of the first year in which any gain is realized. This rule also applies to gains on livestock that are sold because of disease.149 However, the applicable replacement period for draft, breeding, or dairy livestock sold early because of drought, flood, or other weather-related conditions in an area designated as eligible for federal disaster assistance is four years after the close of the first tax year in which any part of the gain on conversion is
146
IRC §1033(a)(1). Treas. Reg. §1.1033(e)-1(d). 148 IRC §1033(f). 149 IRC §1033(a)(2)(B). 147
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realized.150 In addition, the IRS is given authority on a regional basis to extend the replacement period if the weather-related conditions that resulted in the application of this provision continue for more than three years.151 Making the Election to Defer the Gain. To make the election to defer the gain, the taxpayer should include the following information with the tax return for the year that the gain on the conversion is first realized and deferred under §1033.152
Evidence of the drought, flood or weather-related condition that caused the early sale
The computation of the gain realized
The number and kind of livestock sold
The number of each kind of livestock that would have been sold under normal business practices
The election can be made at any time within the normal statute of limitations for the period in which the gain is recognized, assuming it is before the expiration of the period within which the converted property must be replaced.153 If the election is filed to defer gain and eligible replacement property is not acquired within the 4-year replacement period, an amended return for the year in which the gain was originally realized must be filed to report the gain. Reporting the Purchase of Replacement Property. For the tax year in which the livestock are replaced, the taxpayer should include the following information with the tax return.
The date of the purchase of replacement livestock
The cost of the replacement livestock
The number and kind of replacement livestock
DEFERRED PAYMENT ARRANGEMENTS Agricultural producers typically have income streams that are less consistent from year to year than do nonfarm salaried individuals. Because of this, agricultural producers often try to structure transactions to smooth out income across tax years and for other tax-related purposes. One technique used to accomplish these goals involves the use of deferral arrangements. These transactions can be structured in various ways but to properly defer income, some form of a “deferred payment contract” must be utilized. The general rule for cash-basis taxpayers is that income is accounted for in the tax year that it is either actually or constructively received. The IRS has published regulations specifying when income is deemed to be constructively received. The constructive receipt doctrine is the primary tool that the IRS uses to challenge deferral arrangements. Under the regulations, a taxpayer is deemed to have constructively received income when any of the following occurs.154
150
IRC §1033(e)(2). §1033(e)(2)(B). 152 Treas. Reg. §1.1033(e)-1(e). 153 IRC §1033(a)-2(c)(2). See also CCA 200147053 (Sept. 28, 2001). 154 Treas. Reg. § 1.451-2(a). 151IRC
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The income has been credited to the taxpayer’s account.
The income has been set apart for the taxpayer.
The income has been made available for the taxpayer to draw upon it, or it could have been drawn upon if notice of intent had been given. Note. Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.155
A deferred payment contract is taxed under the installment payment rules. IRC §453(b)(2) disallows the installment method of accounting for dealer dispositions of personal property, and farmers normally are considered “dealers” because they regularly dispose of personal property such as grain and livestock. However, IRC §453(l)(2)(A) excludes the disposition of “any property used or produced in the trade or business of farming” from being treated as a dealer disposition. Thus, farmers can sell grain and livestock via deferred payment contracts and the gain is not included in income in the year of sale. Recognition of gain can be postponed until the year of receipt. Note. Chapter 9 of the IRS Farmers Audit Technique Guide (ATG) provides a summary of income deferral and constructive receipt rules. The ATG provides a procedural analysis for examining agents to use in evaluating deferred payment arrangements. The ATG is available at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/FarmersATG.
Straightforward Deferral Arrangements The most likely way for a farmer to avoid an IRS challenge of a deferral arrangement is for the farmer to enter into a sales contract with a buyer that calls for payment in the next tax year. This type of contract simply involves the buyer’s unsecured obligation to purchase the agricultural commodities from the seller on a particular date. Under this type of deferral contract, the price of the goods is set at the specified time for delivery, but payment is deferred until the next year. If the contract is bona fide and entered into at arm’s length, the farm seller has no right to demand payment until the following year, and the contract (as well as the sale proceeds) is nonassignable, nontransferable and nonnegotiable, the deferral will not be challenged by the IRS.156 The following criteria for a deferred payment contract should be met in order to successfully defer income to the following year.
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The seller should obtain a written contract that under local law binds both the buyer and the seller. A note should not be used;
The contract should state clearly that under no circumstances would the seller be entitled to the sales proceeds until a specific date (i.e., a date in a future tax year). The earliest date depends on the farmer’s tax yearend.
Ibid. See, e.g., Rev. Rul. 58-162, 1958-1 CB 234 (Deferral of income from sale of grain effective to delay income recognition until year of actual receipt. IRS noted that if taxpayer could control timing of payment, then constructive receipt would be present). 156
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The contract should be signed before the seller has the right to receive any proceeds, which is normally before delivery.
The buyer should not credit the seller’s account for any goods the seller may want to purchase from the buyer during the year of the deferred payment contract (such as seed and/or fertilizer). Instead, such transactions should be treated separately when billed and paid.157
The contract should state that the taxpayer has no right to assign or transfer the contract for cash or other property.
The contract should include a clause that prohibits the seller from using the contract as collateral for any loans or receiving any loans from the buyer before the payment date;
The buyer should avoid sales through an agent in which the agent merely retains the proceeds. Receipt by an agent usually is construed as receipt by the seller for tax purposes.
If the third party guarantee or standby letter of credit is issued to secure the contract, the guarantee or letter of credit should be nonnegotiable, nontransferable, and only eligible to be drawn on in the event of default.
Price-later contracts should state that in no event can payment be received prior to the designated date, even if a price is established earlier.158
The contract may provide for interest. Interest on an installment sale is reported as ordinary income in the same manner as any other interest income. If the contract does not provide for adequate stated interest, part of the stated principal may be recharacterized as imputed interest or as interest under the original issue discount rules, even if there is a loss. Unstated interest is computed by using the applicable federal rate (AFR) for the month in which the contract is made.
Deferral Contracts Coupled with Letters of Credit or Escrow Accounts After an agricultural commodity is delivered to the buyer but before payment is made, the seller is an unsecured creditor of the buyer. In an attempt to provide greater security for the transaction, a farmer-seller may use letters of credit or an escrow arrangement. This could lead to a successful challenge by the IRS on the basis that the letters of credit or the escrow can be assigned, with the result that deferral is not accomplished. Although the general rule is that funds placed in escrow as security for payment are not constructively received in the year of sale, it is critical for a farmer-seller to clearly indicate that the buyer is being looked to for payment and that the escrow account serves only as security for this payment. Note. The funds held in escrow, and the accrued interest on those funds, is taxable as income in the year that it provides an economic benefit to the taxpayer. Simply because an escrow account bears interest does not mean that the account constitutes an economic benefit.159
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For example, the sale of corn to the local cooperative from which the seller also buys fertilizer should not result in the fertilizer purchase being applied against the amount owed to the seller. The fertilizer must be separately billed and paid for. 158 Crop-share landlords can use installment reporting to report the sale and income of their crop-share rentals under a “price later” contract in the year following the year of crop production. Applegate v. Comm’r, 980 F.2d 1125 (7th Cir. 1992). 159 See, e.g., Stone v. Comm’r, TC Memo 1984-187 (Apr. 16, 1984).
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The key case law regarding letters of credit or escrow accounts used in the context of deferral arrangements includes the following.
In Watson v. Comm’r,160 the court held that the receipt of a letter of credit was synonymous with receiving cash in the year of sale. The taxpayers sold cotton bales under a deferred payment agreement in return for a letter of credit that was to be honored and accepted after the end of the tax year in which it was received. The court noted that the letter of credit could be assignable under state (Texas) law and also could be readily marketable.
In Griffith v. Comm’r,161 16,000 bales of cotton were sold in 1973 under a deferral contract specifying that the buyer would pay the selling price in five annual installments beginning in 1975. The interest rate on unpaid installments was set at 7% annually. The buyer was given a warehouse receipt for the cotton, and the seller received a letter of credit for the full face amount of the cotton’s total deferred purchase price. The letter of credit specified that prepayment was not allowed and that the letter of credit was not transferable. The letter of credit allowed the seller to draw on the buyer’s account but only after a certification had been received that the buyer was in default on the contract. The court ruled that the full contract amount was constructively received in the year the contract was executed. Importantly, even though the standby letter of credit was nontransferable, the proceeds were transferable under state law. The court also determined that the seller had no nontax business purposes for entering into the deferral arrangement.
In Reed v. Comm’r,162 the court held that a taxpayer’s “unconditional right to future payment from an irrevocable escrow account” did not constitute taxable income in the year the escrow account was created. The key, the court said, was whether the taxpayer received a present beneficial interest in the escrow funds such that the funds were, in reality, the same as investment income. An unconditional promise that the taxpayer would ultimately be paid was not enough to create a beneficial interest that would cause the funds in the account to be presently taxable.
In Busby v. Comm’r,163 the taxpayer set up a deferred payment arrangement with a cotton gin. The gin created an irrevocable escrow account. The court held that deferral was achieved because the taxpayer did not have any right to the funds in the account until the year after the year of sale of the cotton. In addition, the deferral arrangement resulted from an arm’s-length negotiation between the parties.
In Scherbart v. Comm’r,164 the IRS challenged a deferral arrangement that a member of a farmer’s cooperative had with the cooperative regarding value-added payments paid late in the tax year. The taxpayer entered into a “uniform marketing agreement” with the cooperative that served as the taxpayer’s agent under the agreement. The agreement obligated the taxpayer to deliver corn to the cooperative in a specified amount. The cooperative made “value-added” payments to members in the year after the year in which corn deliveries were made. However, the cooperative also had the discretion to issue value-added payments near the end of the year in which the corn deliveries were made. The court held that the deferral of the value-added payments involved self-imposed limitations on the receipt of income and that the cooperative was the taxpayer’s agent. The court
Watson v. Comm’r, 613 F.2d 594 (5th Cir. 1980). Griffith v. Comm’r, 73 TC 933 (1980). 162 Reed v. Comm’r, 723 F.2d 138 (1st Cir. 1983). 163 Busby v. Comm’r, 679 F.2d 48 (5th Cir. 1982). 164 Scherbart v. Comm’r, 453 F.3d 987 (8th Cir. 2006). 160 161
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also held that the value-added payments were not installment payments. Therefore, the taxpayer could not report the receipt of the payments under the installment method.165
Third-Party Sales When a deferral arrangement is structured by using a third party such as a broker or cooperative, agency principles are important to determine whether the farmer-seller could be held to be in constructive receipt of the sale proceeds in the year the arrangement is entered into. The following is a summary of some of the key cases and rulings involving deferral arrangements with a third party.
U.S. v. Pfister,166 involved the sale of cattle through a commission company. The commission company sold the cattle and mailed the net proceeds to the farmer on December 12, 1946. The check was in the farmer’s post office box before the end of 1946, but the farmer did not check the box until January 1, 1947. The court held that the commission company acted as the farmer’s agent and their receipt of the sale proceeds was attributable to the farmer. Thus, the farmer was deemed to be in constructive receipt of the sale proceeds in 1946. Note. Livestock deferral arrangements can be difficult due to the Packers and Stockyards Act (PSA).167 The Pfister court noted that under the PSA, a livestock market cannot buy consigned animals for resale via its owners, officers, agents, or employees. The IRS has taken the position that livestock sales under the PSA are consignment contracts that create an agency relationship.168 However, one court has held that a deferral arrangement involving the sale of livestock was effective in spite of the PSA provision because the arrangement imposed “substantial qualifications and restrictions” that defeated constructive receipt and amounted to a substantial limitation.169 The IRS does not agree with the court’s opinion.170
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In Warren v. U.S.,171 the taxpayers grew cotton that they marketed to separate cotton gins in 1969 and 1970. The cotton gins also accepted bids from buyers at the taxpayer’s request. The cotton buyer paid a set fee per bale purchased, and the farmer paid the cost to gin the cotton. The taxpayer accepted bids and then instructed the gin to complete the sale. The taxpayer had the option to receive the sale proceeds in the following year. One gin deposited the sale proceeds in its own account and later paid the grower directly. The other gin deposited the funds in an escrow account from which the bank later issued a check to the grower. For both 1969 and 1970, the taxpayer reported the income from these sales in the following year. The IRS determined that the income from the sales should have been reported in 1969 and 1970, respectively. The court held that the gins acted as the taxpayer’s agent, with the result that the taxpayer recognized the income from the cotton sales in the year of the sale. The only limitation on receipt of the funds was self-imposed.
IRC §453. U.S. v. Pfister, 205 F.2d 538 (8th Cir. 1953). 167 42 Stat. 159 (1921). 168 Rev. Rul. 70-294, 1970-1 CB 13. 169 Levno v. U.S., 440 F.Supp. 8 (D. Mont. 1977). 170 Rev. Rul. 79-379, 1979-2 CB 204. 171 Warren v. U.S., 613 F.2d 591 (5th Cir. 1980). 166
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In.Rev. Rul. 72-465,172 a farmer entered into a deferred-payment arrangement with a livestock market corporation. The farmer received the amount of the sale proceeds in the subsequent year. Deferral was not permitted because the farmer could reclaim the livestock before their resale, and the buyer could return the livestock if they failed to sell.
In Rev. Rul. 73-210,173 a farmer was a member of a farmers’ cooperative and was required to market his cotton through the cooperative after it was ginned. Upon delivery to the cooperative, the farmer had the option of deferring payment for the cotton. The farmer entered into a deferral arrangement on October 1, 1970, with payment to be made in January 1971. The deferral arrangement was effective because at the time the farmer entered into the deferred-payment contract, he had no unqualified right to receive any payments in the year the contract was entered into and the contract was a bona fide arm’s-length transaction.
Installment Reporting For farmers that use the cash method of accounting, income deferral can be achieved for the sale of farm products by using the installment method of reporting income. 174 Installment reporting is available for income derived from the sale of property that is not required to be included in inventory under the taxpayer’s method of accounting. Crops and livestock are inventory-type property but are eligible for installment reporting if they are not required to be reported in inventory under the taxpayer’s method of accounting (which is the case with those on the cash method of accounting). For eligible transactions, installment reporting is automatic, unless the taxpayer makes an election not to use it. An installment sale is a sale of property with the taxpayer receiving at least one payment after the tax year of the sale. Thus, if a farmer sells and delivers grain in one year and defers payment until the next year, that transaction constitutes an installment sale. If desired, the farmer can elect out of the installmentsale method and report the income in the year of sale and delivery. Example 18. Tom harvests his grain crop in the fall of 2015 and delivers and sells it in accordance with a deferred sales contract in December 2015. The contract calls for Tom to be paid in January 2016. This contract qualifies for installment sale treatment, but Tom could elect to report the income he receives under the contract in 2015. The election out of installment sale reporting is on an all-or-nothing basis. Therefore, in the preceding example, Tom must either report income using the installment method or elect out of installment reporting for all the grain covered by the contract. The election must be made by the due date, including extensions, of the tax return for the year of sale and not the year in which payment is to be received. The election is made by recognizing the entire gain on the taxpayer’s applicable form (i.e., Schedule D or Form 4797), rather than reporting the installment sale on Form 6252, Installment Sale Income. Observation. Because of the all-or-nothing feature (on a per-contract basis) of electing out of installment reporting, it may be advisable for farm taxpayers to utilize multiple deferred payment sales contracts in order to better manage income from year to year. The election out is made by simply reporting the taxable sale in the year of disposition.
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Rev. Rul. 72-465, 1972-2 CB 233. Rev. Rul. 73-210, 1973-1 CB 211. 174 IRC §453(b). 173
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Once made, the election can only be revoked with IRS approval. A revocation of an election out of the installment method is retroactive, and it is not permitted when one of its purposes is the avoidance of federal income taxes.175 However, in a recent letter ruling, the IRS granted a request to amend a tax return in order to elect out of the installment method. The request was granted because the taxpayers convinced the IRS that the installment sale election had been incorrectly filed on the original return based on erroneous information.176 Note. The practitioner (or farmer-seller) must ensure that the amount of gain recognized in the year of disposition is not also recognized in the year of receipt. For this reason, it is suggested that a receivable be recorded for the amount of accelerated sales, with the entry being reversed after yearend. Generally, if the taxpayer elects out of the installment method, the amount realized at the time of sale is the proceeds received on the sale date and the fair market value of the installment obligation (future payments). If the installment obligation is a fixed amount, the full principal amount of the future obligation is realized at the time of the acquisition. Manufacturers and sellers of farm equipment are not eligible for installment reporting.177 In addition, the statute specifies that the Treasury can issue regulations denying installment sale treatment for property that is of a kind “regularly traded on an established market.”178 If such regulations were issued, they could have potential application to a wide array of agricultural products. Installment Sales and the Death of the Seller. If a seller dies before receiving all of the payments under an installment obligation, the installment payments are treated as income in respect of a decedent (IRD).179 Therefore, the beneficiary does not get a stepped-up basis at the seller’s death. The beneficiary of the payments includes the gain on the beneficiary’s return subject to tax at the rate applicable to the beneficiary. The character of the payments is tied to the seller. For example, if the payments were long-term capital gain to the seller, they are long-term capital gain to the beneficiary. Caution. Grain farmers often carry a large inventory that may include grain delivered under a valid deferred payment agreement. Grain included as inventory but more properly classified as an installment sale may not qualify for stepped-up basis if the farmer dies after delivering the grain but prior to receiving all payments. The only way to avoid possible IRD treatment on installment payments appears to be for the seller to elect out of installment sale treatment. IRD includes sales proceeds “to which the decedent had a contingent claim at the time of his death.”180 The courts have held that the appropriate inquiry regarding installment payments is whether the transaction gave the decedent at the time of death the right to receive the payments.181 This means that the decedent holds a contingent claim at the time of death that does not require additional action by the decedent. In that situation, the installment payments are IRD.182
175
Treas. Reg. §15a.453-1(d)(4). Ltr. Rul. 200627012 (Apr. 4, 2006). 177 Thom v. U.S., 134 F.Supp. 2d 1093 (D. Neb. 2001), aff’d 283 F.3d 939 (8th Cir. 2002). 178 IRC §453(k)(2). 179 IRC §691(a)(4). 180 Treas. Reg. §1.691(a)-1(b)(3). 181 See, e.g., Estate of Bickmeyer v. Comm’r, 84 TC 170 (1985). 182 See, e.g., Lindeman v. Comm’r, 213 F.2d 1 (9th Cir. 1954), cert. den, 348 U.S. 871 (1955) (Grapes delivered to cooperative that had not been marketed at time of decedent’s death were IRD). 176
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Monday, August 29, 2016
Proper Reporting of Crop Insurance Proceeds One of the issues of interest at the farm income tax seminars in North Dakota last week involved how to report crop insurance proceeds on the tax return. This was particularly the case at the Grand Forks seminar because the sugar beet crop in that area and points north has been exceedingly wet with the result that producers will likely be receiving payments under their policies. I mentioned to the group that one of the blogposts this week would address the issue. So, here goes. In general, the proceeds from insurance coverage on growing crops are includible in gross income in the year actually or constructively received. In effect, destruction or damage to crops and receipt of insurance proceeds are treated as a “sale” of the crop. But, taxpayers on the cash method of accounting may elect to include crop insurance and disaster payments in income in the taxable year following the crop loss if it is the taxpayer's practice to report income from sale of the crop in the later year. I.R.C. §451(d). Included are payments made because of damage to crops or the inability to plant crops. The deferral provision applies to federal payments received for drought, flood or “any other natural disaster.” The election is made by attaching a separate, signed statement to the income tax return for the tax year of damage or destruction or by filing an amended return, and it covers insurance proceeds attributable to all crops representing a trade or business. Based on Rev. Rul. 74-145, 1974-1 C.B. 113, to be eligible to make an election, the taxpayer must establish that a substantial part of the crops (more than 50 percent) has been carried over into the following year. If multiple crops are involved, the “substantial portion” test must be met with respect to each crop if each crop is associated with a separate business of the taxpayer. Otherwise, the 50 percent text is computed in the aggregate if the crops are reported as part of a single business. Also, a taxpayer may not elect to defer only a portion of the insurance proceeds to the following year. A significant issue is whether the deferral provision also applies to new types of crop insurance such as Revenue Protection (RP), Revenue Protection with Harvest Price Exclusion (RPHPE), Yield Protection (YP) and Group Risk Plan (GRP). As mentioned above, to be deferrable, payment under an insurance policy must have been made as a result of damage to crops or the inability to plant crops. Other than the statutory language that makes prevented planting payments eligible for the one-year deferral, the IRS position as stated in Notice 89-55, 1989-1 C.B. 698 is that agreements with insurance companies providing for payments without regard to actual losses of the insured, do not constitute insurance payments for the destruction of or damage to crops. Accordingly, payments made under the types of crop insurance that are not directly associated with an insured's actual loss, but are instead tied to low yields and/or low prices, may not qualify for deferral depending upon the type of insurance involved. For example, RP policies insure producers against yield losses due to natural causes such as drought, rain, hail, wind, frost, insects and disease, as well as revenue losses tied to the difference between harvest price and a projected price. Only the portion attributable to physical damage or destruction to a crop is eligible for deferral. RPHPE, YP and GRP policies tie payment to price and/or yield and amounts paid under such policies are less likely to qualify for deferral. While the IRS has not specified in 105
regulations the appropriate manner to be utilized in determining the deferrable and nondeferrable portions, the following is believed to be an acceptable approach: Consider the following example:
Al Beback took out an insurance policy (RP) on his corn crop. Under the terms of the policy the approved corn yield was set at 170 bushels/acre, and the base price for corn was set at $6.50/bushel. At harvest, the price of corn was $5.75/bushel. Al’s insurance coverage level was set at 75 percent, and his yield was 100 bushels/acre. Al’s final revenue guarantee under the policy is 170 bushels x $6.50 x .75 = $828.75/acre. Al’s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($5.75/bushel) which equals $575/acre. Al’s insurance proceeds is the guaranteed amount ($828.75/acre) less the calculated revenue ($575/acre), or $253.75/acre. His physical loss is the 170 bushel/acre approved yield less his actual yield of 100 bushels/acre, or 70 bushels/acre. Multiplied by the harvest price of $5.75/bushel, the result is a physical loss of $402.50/acre. Al’s price loss is computed by taking the base price of $6.50/bushel less the harvest price of $5.75/bushel, or $.75/bushel. When multiplied by the approved yield of 170 bushels/acre, the result is $127.50/acre. So, to summarize, Al has the following:
Total loss: (1) anticipated income/acre [170 bushels/acre @ $6.50/ bushel = $1105/acre] less (2) actual result [100
bushels/acre @ $5.75/acre = $575.00] for a result of $530.00/acre.
Physical loss: 70 bushels/acre x $5.75/bushel harvest price = $402.50/acre Price loss: 170 bushels/acre x $.75/bushel = $127.50 Physical loss as percentage of total loss: $402.50/530 = .7594 Insurance payment: $253.75/acre Insurance payment attributable to physical loss (which is deferrable): $253.75 x .7594 = $192.70/acre Portion of insurance payment that is not deferrable: $253.75 – $192.70 = $61.05/acre
But, what if the harvest price exceeds the base price? Then the above example can be modified as follows: Assume now that the harvest price of corn was $7.50/bushel. Al’s final revenue guarantee under the policy is 170 bushels/acre x $7.50 x.75 = $956.25/acre. Al’s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($7.50/bushel) which equals $750.00/acre. Al’s insurance proceeds are the guaranteed amount ($956.25/acre) less the calculated revenue ($750.00), or $206.25/acre. His yield loss is the 70 bushels/acre which is then multiplied by the harvest price of $7.50/bushel, for a physical loss of $525/acre. Al’s price loss is zero because the harvest price exceeded the base price. So, to summarize, Al has the following:
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Total loss (per acre): $525.00 (physical loss) + $0.00 (price loss) Physical loss as percentage of total loss: $525/525 = 1.00 Insurance payment: $206.25/acre Insurance payment attributable to physical loss (which is deferrable): $206.25 x 1.00 = $206.25/acre Portion of insurance payment that is not deferrable: $206.25 – 206.25 = $0.00
Reporting crop insurance on the return can be tricky. Fertilizer and Lime Fertilizer and lime are allowable business deductions, but are only deductible as an election. There is no dollar limit on the deductible amount, and the election is not binding for subsequent years. The election is made by entering it as a deduction on the taxpayer’s return with a notation in the margin that the taxpayer is electing to deduct fertilizer and lime costs currently. If the election is not made, costs associated with fertilizer and lime are not currently deductible, but are capitalized over the period soil fertility is affected. In addition, in order to deduct costs associated with fertilizer and lime, the taxpayer must be in the trade or business of farming which requires either that the taxpayer be an operator or a landlord under a crop or livestock share lease. Also, the fertilizer or lime must be applied to land used in farming. Expenditures on land brought into production for the first time are not eligible for the election to deduct the expense currently. A landlord under a cash rent lease cannot deduct the cost of fertilizer and lime unless the landowner is materially participating under the lease.
SELF-EMPLOYMENT TAX PRIMER – STRUCTURING LEASES AND ENTITIES Friday, September 29, 2017
Self-Emmployment Tax on Farm Rental Income – Is the Mizell Veneer Cracking? Overview Self-employment tax applies to income that is derived from a “trade or business.” That’s a factbased determination. In addition, by statute, “rentals from real estate and from personal property leased with the real estate” are excluded from the definition of net earnings from self-employment. I.R.C. §1402(a)(1). Likewise, income from crop share and/or livestock share rental arrangements for landlords who are not materially participating in the farming or ranching operation will not be classified as self-employment income. Only if the rents are produced under a crop or livestock share lease where the individual is materially participating under the lease does the taxpayer generate self-employment income. Income received under a cash rental arrangement is not subject to self-employment tax. 107
But, what is “material participation”? A lease is a material participation lease if (1) it provides for material participation in the production or in the management of the production of agricultural or horticultural products, and (2) there is material participation by the landlord. Both requirements must be satisfied. While a written lease is not required, a written lease certainly makes a material participation arrangement easier to establish (or not established, if that is desired). But, what about leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity? Does the real estate exemption from the definition of net earnings from self-employment apply in that situation? Does the type of lease or the rate of rent charged under the lease matter? In 1995, the Tax Court rendered an important decision on the first question that, apparently, also answered the second question. Mizell v. Comr., T.C. Memo. 1995571. Later, the U.S. Court of Appeals for the Eighth Circuit carved out an exception from the 1995 Tax Court decision for fair market leases. McNamara, et al. v. Comr., 263 F.3d 410 (8th Cir. 2000), rev’g., T.C. Memo 1999-333. Now, the Tax Court, in a full Tax Court opinion, has applied the Eighth Circuit’s analysis and holding to a case with similar facts coming from Texas – a jurisdiction outside the Eighth Circuit. Martin v. Comr., 149 T.C. No. 12 (2017). The Mizell Case In Mizell, the petitioner was a farmer who, in 1986, structured his farming operation to become a 25 percent co-equal partner in an active farming partnership with his three sons. In addition, in 1988, leased about 730 acres of farmland to the farm partnership. The lease called for the petitioner to receive a one-quarter share of the crop, and the partnership was responsible for all expenses. The petitioner reported his 25 percent share of partnership income as self-employment earnings. However, the crop share rent on the land lease was treated as rents from real estate that was exempt from self-employment tax. The IRS disagreed with that tax treatment of the land rent, assessing self-employment tax on the crop share lease income for the years 1988, 1989 and 1990. The parties agreed that he materially participated in the agricultural production of his farming operation. The IRS took the position that the crop share rental and the farming partnership constituted an “arrangement” that needed to be considered in light of the entire farming enterprise in measuring self-employed earned income. Thus, the IRS position was that the landlord role could not be separated from the employee or partner role. That meant that any employee or partner-level participation by the landowner triggered self-employment tax on the rental income. On the other hand, the petitioner, argued that the crop share lease did not involve material participation and that the crop share rental income should be exempt from self-employment tax. In other words, the IRS looked to the overall farming arrangement to find a sufficient level of material participation on the petitioner’s part, but the petitioner confined the analysis to the terms of the lease which wasn’t a material participation lease. While, rents from real estate, whether cash rent or crop share, are excluded from the definition of self-employment income, there is an exception, however, if three criteria are met:
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The rental income is derived under an arrangement between the owner and lessee which provides that the lessee shall produce agricultural commodities on the land;
The arrangement calls for the material participation of the owner in the management or production of the agricultural commodities; and
There is actual material participation by the owner.. I.R.C. §1402(a)(1)(A); Treas. Reg. §1.1402(a)-4(b)(1).
The Tax Court, agreeing with the IRS, focused on the word "arrangement" in both the statute and the regulations, noting that this implied a broader view than simply the single contract or lease for the use of the land between the petitioner and the farming partnership. By measuring material participation with consideration to both the crop share lease and the petitioner’s obligations as a partner in the partnership, the court found that the rental income must be included in the petitioner’s net earnings for self-employment purposes. Following its win in Mizell, the IRS privately ruled in 1996 that a married couple who cash-rented land to their agricultural corporation were subject to self-employment tax on the cash rental income, because both the husband and wife were employees of the corporation. T.A.M. 9637004 (May 6, 1996). Implications of Mizell. The Mizell decision was a landmine that posed a clear threat to the common set-up in agriculture where an individual leases farmland to an operating entity in which the individual is also a material participant. Importantly, the type of lease was apparently immaterial to the court. On that point, the wording of Treas. Reg. § 1.1402(a)-4(b)(2) appears to be broad enough to include income in any form, crop share or cash, if received in an arrangement that contemplates the material participation of the landowner. Exception to the Mizell “Arrangement” Theory The Tax Court, in 1998, decided three more Mizell-type cases. In Bot v. Comr., T.C. Memo. 1999256, the court determined that rental income (at the rate of $90 per acre) received by a wife for 240 acres of land, paid to her by her husband’s farm proprietorship, was subject to self-employment tax. The wife also received an annual salary from the proprietorship of approximately $15,000, and the court said that the rental amount and the salary amounted to a single arrangement. In Hennen v. Comr., T.C. Memo1999-306, the court again held that self-employment tax applied to rental income that a wife received on land leased to her husband’s farming business. Like Mrs. Bot, Mrs. Hennen worked for the farming business and was paid a salary ($3,500/year). McNamara v. Comr., T.C. Memo. 1999-333, also involved a husband and wife who owned land that they leased to their farming C corporation under a written, cash rent lease. The rent payment averaged about $50,000 per year. The husband was employed full time by the corporation, and the wife was employed doing part-time bookkeeping and farm errand duties. She was paid a nominal amount – about $2,500 annually. The court again determined that the rental arrangement and the wife’s employment were to be combined, which meant that the rental income was subject to selfemployment tax. All three cases were consolidated on appeal to the U.S. Court of Appeals for the Eighth Circuit. The Eighth Circuit, reversing the Tax Court, determined that the lessor/lessee relationship was to be analyzed separate and distinct from the employer-employee relationship. The Eighth Circuit interpreted I.R.C. §1402(a)(1) as requiring material participation by the landlord in the rental 109
arrangement itself in order to subject the arrangement to self-employment tax. The court stated that, “The mere existence of an arrangement requiring and resulting in material participation in agricultural production does not automatically transform rents received by the landowner into selfemployment income. It is only where the payment of those rents comprise part of such an arrangement that such rents can be said to derive from the arrangement.” The Eighth Circuit remanded the case to the Tax Court for the purpose of giving the IRS an opportunity to illustrate that there was a connection between the rental amount and the labor arrangement. The IRS could not establish a connection. The rents were cash rents that were at or slightly below fair market value. However, the IRS later issued a non-acquiescence to the Eighth Circuit’s decision. A.O.D. 2003-003, I.R.B. 2003-42 (Oct. 22, 2003). That meant that the IRS would continue to litigate the issue outside of the Eighth Circuit. More Litigation As the non-acquiescence indicated, the IRS continued to litigate the matter and two more cases found their way to the Tax Court. In Johnson v. Comr., T.C. Memo. 2004-56, the petitioners verbally cash leased 617 acres of land to their farm corporation. They also had a verbal employment agreement with the corporation and received a nominal salary. The farming operation was located within the Eighth Circuit, which meant that the if the land rental and the employment agreement were two separate arrangements the land rental income would not be subject to self-employment tax. Ultimately, the Tax Court determined that the rental amount under the lease was representative of a fair market rate of rent, and the rental payments were not tied to any services the petitioners provided to the farming corporation. The compensation paid to the petitioners was also not understated. However, in Solvie v. Comr., T.C. Memo. 2004-55, the Tax Court reached a different conclusion on a set of facts similar to those involved in Johnson. In Solvie, the petitioners leased real estate to their controlled corporation and also received compensation as corporate employees. Later, an additional hog barn was constructed which increased the total rent paid to the petitioners which the IRS claimed was subject to self-employment tax. The Tax Court agreed because the additional rent was much greater than the rental amounts the received from the corporation for the other hog buildings even though the new building had a smaller capacity. In addition, the court noted that the petitioners’ wages did not increase even they overall hog production increased, and the additional rent was computed on a per-head basis which meant that no building rent would be paid if there was no hog production. The Downfall of Mizell? In Martin v. Comr., 149 T.C. No. 12 (2017), the Tax Court (in an opinion authored by Judge Paris) delivered its most recent opinion concerning the self-employment tax treatment of leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity. Under the facts of the case, the petitioners, a married couple, operated a farm in Texas – a state not located within the Eighth Circuit’s jurisdiction. In late 1999, they built the first of eight poultry houses to raise broilers under a production contract with a large poultry integrator. The petitioners formed an S corporation in 2004, and set up oral employment agreements with the S corporation based on an appraisal for the farm which guided them as to the cost of their labor and 110
management services. They also pegged their salaries at levels consistent with other growers. The wife provided bookkeeping services and the husband provided labor and management. In 2005, they assigned the balance of their contract to the S corporation. Thus, the corporation became the “grower” under the contract. In 2005, the petitioners entered into a lease agreement with the S corporation. Under the agreement, the petitioners rented their farm to the S corporation, under which the S corporation would pay rent of $1.3 million to the petitioners over a five-year period. The court noted that the rent amount was consistent with other growers under contract with the integrator. The petitioners reported rental income of $259,000 and $271,000 for 2008 and 2009 respectively, and the IRS determined that the amounts were subject to self-employment tax because the petitioners were engaged in an “arrangement” that required their material participation in the production of agricultural commodities on their farm. The Tax Court noted that the IRS agreed that the facts of the case were on all fours with McNamara. In addition, the court determined that the Eighth Circuit’s rationale in McNamara was persuasive and that the “derived under an arrangement” language in I.R.C. §1402(a)(1) meant that a nexus had to be present between the rents the petitioners received and the “arrangement” that required their material participation. In other words, there must be a tie between the real property lease agreement and the employment agreement. The court noted the petitioners received rent payments that were consistent with the integrator’s other growers for the use of similar premises. That fact was sufficient to establish that the rental agreement stood on its own as an appropriate measure as a return on the petitioners’ investment in their facilities. Similarly, the employment agreement was appropriately structured as a part of the petitioners’ conduct of a legitimate business. Importantly, the court noted that the IRS failed to brief the nexus issue, relying solely on its non-acquiescence to McNamara and relying on the court to broadly interpret “arrangement” to include all contracts related to the S corporation. Accordingly, the court held that the petitioner’s rental income was not subject to self-employment tax. Implications The cases point out that leases should be drafted to carefully specify that the landlord is not providing any services or participating as part of the rental arrangement. Services and labor participation should remain solely within the domain of the employment agreement. In addition, leases where the landlord is also participating in the lessee entity must be tied to market value for comparable land leases. If the rental amount is set too high, the IRS could argue that the lease is part of “an arrangement” that involves the landlord’s services. If lessor does provide services, a separate employment agreement should put in writing the duties and compensation for those services. A dissenting judge complained that the IRS should not have the burden of producing evidence of establishing a nexus between the land lease and the employment agreement once the petitioner establishes a that the land lease is a fair market lease. Another dissenter would have continued to apply the Mizell arrangement theory outside of the Eighth Circuit. Conclusion The Martin decision, a full Tax Court opinion, is a breath of fresh air for agricultural operations that are structured with leases of farmland to an operating entity in which the lessor is also a material participant. Proper structuring of the land lease and a separate employment agreement 111
can provide protection from an IRS claim that self-employment tax applies to the land rental income. Now there is substantial authority for that proposition outside the Eighth Circuit. Management Structure and Self-Employment Tax Member-Managed LLC. An LLC may be member-managed or manager-managed. By default, state LLC statutes treat LLCs as member-managed. The owners of the LLC are responsible for managing the company in a member-managed LLC. Thus, all of the members are treated as general partners and have self-employment tax liability on their respective distributive shares. Manager-Managed LLC. A manager-managed LLC is operated by managers who are appointed to run the company. Manager-managed LLCs are designated as such in the LLC formation documents or the LLC operating agreement, and operate in a similar fashion to a corporation that has a board of directors to control the company's affairs. A manager-managed LLC has at least one member that takes a passive role in terms of operating the company. That feature can provide self-employment tax savings while maintaining limited liability. In addition, the managers of the LLC can be members, but they don’t have to be.183 However, only the designated manager (or managers) in a manager-managed LLC has self-employment tax liability on their distributive share of LLC earnings. Thus, a manager-managed LLC may provide separate classes of membership for managers (who have the authority to bind the LLC under a contract) and non-managers (who have no such authority). From an SE tax perspective, the use of a manager-managed LLC with two classes of membership provides SE tax savings to the non-managing members. Note. Both the manger interest and the non-manager interest provide liability protection to the members in their capacity as members. Self-Employment Tax and NIIT Implications. In general, income that is subject to self-employment tax is not subject to the NIIT effective for tax years beginning after 2012. 184 With respect to an LLC, business income allocated to the general partners of an LLC taxed as a partnership is generally subject to self-employment tax even if it flows to a partner who does not participate in the operations of the LLC.185 There is no guidance on the self-employment tax treatment of income flowing to LLC (and limited liability partnership (LLP)) owners who do not participate in the operations of the business. However, to the extent a limited liability owner (either an LLC member or an LLP partner) receives a guaranteed payment for services, the law is clear that this payment is subject to self-employment tax. Thus, guaranteed payments for services or capital would always appear to be subject to self-employment tax, even if paid to an individual holding a limited liability interest. Presumably, LLC members (in an LLC that is taxed as a partnership) have selfemployment tax liability on their distributive share unless the member is a treated as a limited partner.186
183 184
In a manager-managed LLC, unless state law provides otherwise, a manager can be an entity such as an LLC or a corporation. IRC §1411.
185
Treas. Reg. §1.1402(a)-2(g).
186
IRC §1402(a)(13); Prop. Treas. Reg. §1402(a)-2(g). IRC §1402(a)(13) specifies that the distributive share of a limited partner in a limited partnership is not subject to self-employment tax.
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In the 1990s, the Treasury Department issued proposed regulations in an attempt to clarify the selfemployment tax status of LLC members.187 The proposed regulations were withdrawn in early 1997 and new proposed regulations were issued. Under the 1997 proposed regulations, a partnership (or LLC taxed as a partnership) member is subject to self-employment tax under any one of three circumstances.188 1. The individual has personal liability for the debts of, or claims against, the partnership by reason of being a partner or member. 2. The individual has authority under the statutes of the state in which the partnership is formed to contract on behalf of the partnership (i.e., the individual has management authority). 3. The individual participated in the entity’s trade or business for more than 500 hours during the entity’s taxable year.189 If an LLC member in a manager-managed LLC is treated under the proposed regulations as being subject to self-employment tax on their distributive share, there remain two possible exceptions by which the member can still be treated as a limited partner and avoid self-employment tax. Both exceptions are tied to the fact that a manager-managed LLC may provide separate classes of membership for managers (who have the authority to bind the LLC under a contract) and nonmanagers (who have no such authority). The first exception applies if the members who didn’t meet the tests of the proposed regulations (i.e., are mere investors) own a “substantial continuing interest” in a specific class of interests in the LLC, and these members’ rights and obligations in that class of interests are the same as the rights and obligations that other members (who do meet the requirements of the proposed regulations) hold in that class.190 A “substantial interest” requires an ownership interest in a class of interest exceeding 20 % .191 The second exception applies to those members who don’t satisfy the 500-hour test of the proposed regulations. In other words, the member participates in the LLC business for more than 500 hours during the entity’s taxable year. Such a person can still be treated as a limited partner (and escape self-employment tax on their distributive share) if there are other members that meet the requirements of the first exception. To Summarize. Non-managers who do not meet the 500-hour participation test are not subject to SE tax, except to the extent of any guaranteed payments they receive. Non-managers who exceed the 500-hour test are s t i l l not subject to SE tax if they own a substantial continuing interest (i.e., at least 20%) in a class of interest and the individual’s rights and obligations of that class are identical to those held by persons who satisfy the general definition of limited partner (i.e., less than 500 hours for a non-manager).
187
59 Fed. Reg. 67,253 (Dec. 29, 1994).
188
Prop. Treas. Reg. §1.1402(a)-2(h)(2). The IRS is bound by any proposed regulation that a taxpayer reasonably relies upon. See Elkins v. Comr., 81 T.C. 669 (1983). Also, a taxpayer that reasonably relies on a proposed regulation will avoid taxpayer penalties. See United States v. Boyle, 469 U.S. 241 (1985). The same is true for a tax practitioner. 189
This is not to be confused with the 500-hour test for material participation under the passive activity rules of IRC §469. Prop. Treas. Reg. §1.1402(a)-2(h)(3). 191 Prop. Treas. Reg. §1.1402(a)-2(h)(6). 190
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LLC managing-members are subject to SE tax on income from that interest. If there are nonmanagers who spend less than 500 hours with the LLC and such members own at least 20 % of the LLC interests, those non-managers who spend more than 500 hours are not subject to SE tax on the pass-through income, but are subject to SE tax on the guaranteed payments.192 It is possible to structure a manager-managed LLC with the taxpayer holding both manager and non-manager interests. In this type of structure, individuals with non-manager interests who spend less than 500 hours with the LLC must own at least 20% of the LLC interests. As a result, the individual who holds both manager and non-manager interests is exempt from SE tax on the nonmanager interest,193 but remains subject to SE tax on the pass-through income and guaranteed payments of the manager interest. Structuring the Manager-Managed LLC. In an LLC that is structured to minimize self-employment tax and avoid the NIIT, all of the LLC interests can be owned by non-managers (investors) with a third party non-owner named as manager. In this structure, some or all of the investors may work on behalf of the manager. The manager could be an S corporation or a C corporation, with the LLC investors owning part or all of the corporation. The manager must be paid a reasonable management fee and the LLC owners who provide services to the LLC must be paid reasonable compensation from the corporation (the manager). The LLC owners who do not render services to the LLC do not have income that is subject to self-employment tax. Summary points:
LLC non-managers working fewer than 500 hours annually are subject to self-employment tax only on guaranteed payments.
Non-managers who work more than 500 hours annually are subject to self-employment tax only on guaranteed payments if the non-managers who work fewer than 500 hours annually make up at least 20% of the membership.
Although the managers and non-managers own interests commensurate with their investment (i.e., non-manager interests), the managers also receive manager interests as a reward for their services.
Managers recognize self-employment income on the pass-through income associated with the manager interests.
Note. With respect to the NIIT, there is a special rule that comes into play when spouses are involved. While a non-manager’s interest in a manager-managed LLC is normally considered passive and is subject to the NIIT,194 a spouse may take into
192 193
Prop. Treas. Reg. §1.1402(a)-2(h)(4). Prop. Treas. Reg. §1.1402(a)-2(h)(3).
194
IRC §1411(c)(2)(A).
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account the material participation of a spouse who is the manager.195 Thus, if the manager spouse materially participates, then all non-manager interest(s) owned by both spouses avoid the NIIT. That gives even more power to the manager-managed LLC with bifurcated interests. Entity Structuring and Farm Program Benefits Under the 2014 Farm Bill, the per-person payment limitation in $125,000. That’s the general rule. Peanut growers are allowed an additional $125,000 payment limitation, and the spouse of a farmer is entitled to an additional $125,000 payment limit if the spouse is enrolled at the local Farm Service Agency (FSA) office. These payment limits are applied at both the entity level and then the individual level (up to four levels of ownership). Thus, general partnerships and joint ventures have no payment limits. Instead, the payment limit is calculated at the individual level. However, an entity that limits the liability of its shareholders/members is limited to one payment limitation. That means that the single payment limit is then split equally between the shareholders/members. To be eligible for a payment limit, an adjusted gross income (AGI) limitation must not be exceeded. That limitation is $900,000. The AGI limitation is an average of the three prior years, with a one-year delay. In other words, farm program payments received in 2015 are based off of the average of AGI for 2011, 2012 and 2013. The AGI limitation applies to both the entity and the owners of the entity. Example 19. Assume that FarmCo receives $100,000 of farm program payments in 2015. FarmCo’s AGI is $850,000. Thus, FarmCo is entitled to a full payment limitation. But, if one of FarmCo’s owners has AGI that exceeds the $900,000 threshold, a portion of FarmCo’s payment limit will be disallowed in proportion to that shareholder’s % age ownership. So, if the shareholder with income exceeding the $900,000 threshold owns 25 % of FarmCo, FarmCo’s $100,000 of farm program payment benefits will be reduced by $25,000. From an FSA entity planning standpoint, the type of entity structure utilized to maximize payment limits will depend on the size/income of the operation.
195
For smaller producers, entity choice for FSA purposes is largely irrelevant. Given that the limitation is $125,000 and that payments are made either based on price or revenue (according to various formulas), current economic conditions in agriculture indicate that most Midwestern farms would have to farm somewhere between 3,000 and 4,000 acres before the $125,000 payment limit would be reached. Thus, for smaller producers, the payment limit is not likely to apply and the manner in which the farming business is structured is not a factor.
For larger operations, the general partnership or joint venture form is likely to be ideal for FSA purposes. If creditor protection or limited liability is desired, the partnership could
IRC §469(h)(5).
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be made up of single-member LLCs. For further tax benefits, the general partnership’s partners could consist of manager-manager LLCs with bifurcated interests. Wednesday, May 9, 2018
Purchase and Sale Allocations to CRP Contracts In General Under the typical Conservation Reserve Program (CRP) contract, farmland is placed in the CRP for a ten-year period. Contract extensions are available, and the landowner must maintain a grass cover on the ground which may involve planting appropriate wild grasses and other vegetation and to perform mid-contract maintenance of the enrolled land in accordance with USDA/FSA specifications. But, what happens if the CRP land is sold even though several years remain on the contract? This is particularly the case when crop prices are relatively high and there is an economic incentive to put the CRP-enrolled land back into production. The possible penalties and tax consequences of not keeping land in the CRP for the duration of the contract – that the topic of today’s post. Consequences of Early Termination When a landowner doesn’t keep land in the CRP for the full length of the contract, the landowner of the former CRP-enrolled land must pay back to the USDA all CRP rents already received, plus interest, and liquidated damages (which might be waived). That’s synonymous with a lessee’s termination of a lease when the obligations under the lease exceed the benefits. When that happens, and the lessee pays a cancellation fee to get out from underneath the lease, the lessee is generally allowed a deduction. The rationale for allowing a deduction is that the lessee does not receive a future benefit, as long as the lease cancellation payment is not integrated in some manner with the acquisition of another property right. If, however, the termination payment is part of a single overall plan involving the acquisition of an affirmative benefit, the taxpayer must capitalize the payment. See Priv. Ltr. Rul. 9607016 (Nov. 20, 1995). That would be the case, for instance, when a lessee terminates a lease by buying the leased property. I.R.C. §167(c)(2) bars an allocation of a portion of the cost to the leasehold interest. Thus, allocations to lease contracts by real estate purchasers of real estate are not effective. The taxpayer must allocate the entire adjusted basis to the underlying capital asset. Sale Price Allocation To CRP Contract The IRS has ruled that a taxpayer who sold the right to 90 percent of the revenue from three CRP contracts that had approximately 11 years remaining was required to report the lump sum payment as ordinary gross income in the year of receipt. C.C.A. 200519048 (Jan. 27, 2005). The taxpayer agreed to comply will all of the provisions of the CRP contract, with damage provisions applying if he failed to comply. The taxpayer’s return for the year of sale reported the entire amount received for the sale on Form 4835. On the following year’s return, the taxpayer included the annual CRP payment from the remaining 10 percent on Form 4835 and claimed a deduction for the part which sold the prior year. On the next year’s return, the taxpayer included 116
the total CRP payment and did not offset it with the amount he received from the buyer. The taxpayer later filed amended returns to remove the amount reported as income on Form 4835 in the year of sale, and to remove the expense deduction that was claimed on the following year’s return. The taxpayer claimed that the lump-sum was not income in the year of sale because he did not have the unrestricted right to the funds (due to the damage clause applying in the event of noncompliance), and only held them as a conduit. The IRS disagreed, noting that the taxpayer had received the proceeds from the sale of the CRP contracts, with the risk of nonpayment by the USDA shifted to the purchaser. The IRS also stated that amounts received under a claim of right are includable in income, even though the taxpayer may have to repay some portion at a later date. In addition, the IRS noted that a lump sum payment for the right to future ordinary income generally results in ordinary income in the year of receipt. See, e.g., Cotlow v. Comr., 22 T.C. 1019 (1954), aff’d., 228 F.2d 186 (2nd Cir. 1955). The acquiring farmer may pay the early termination costs. In such case, the payment should be considered part of the land, as an additional cost incurred to acquire full rights in the property (i.e., a payment made to eliminate an impediment to full use of the property). Early Termination Payments Generally. A lessor’s payment to the lessee to obtain cancelation of a lease that is not considered an amount paid to renew or renegotiate a lease is considered a capital expenditure subject to amortization by the lessor. Treas. Reg. §1.263(a)-4(d)(7). The amortization period depends on the intended use of the property subject to the canceled lease. If the lessor pays a tenant for early termination to regain possession of the land, the termination costs should be capitalized and amortized over the lease’s remaining term. Rev. Rul. 71283. However, if early termination costs are incurred solely to allow the sale of the farm, the costs should be added to the basis of the farmland and deducted as part of the sale. As applied to CRP contracts. A landlord paying early CRP termination costs to enter into a new lease of farmland with another farmer will capitalize and amortize the costs over the remaining term of the CRP contract that is being terminated. That’s the case where a lease cancelation is not tied to substantial improvements that are to be made to the property. However, the IRS might claim that such costs should be amortized over the term of the new lease if the new lease is for a longer period that the remaining term of the CRP contract. However, the U.S. Court of Appeals for the Ninth Circuit has questioned this position, noting that the Tax Court decision seeming to bolster the IRS position relied on court cases that seemed to alternate between using the unexpired lease term versus the new lease term. Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir. 1981). Thus, the general rule that lease cancelation costs should typically be written off over the unexpired term of the canceled lease. Conclusion The early disposition of a CRP contract carries with it some substantial consequences, both financial and tax. It’s important to understand what might happen if early termination is a possibility. Passive Activities
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It is not uncommon for a higher-income taxpayer to invest in various activities in which they do not materially participate which generates passive activity income to the taxpayer. Under the passive activity rules, a taxpayer can deduct losses from a passive activity, but only to the extent the taxpayer has passive income in the current year.196 Another concern for high-income taxpayers beginning in 2013 is that income from passive activities is generally included in NII and is potentially subject to the additional 3.8 percent NIIT. A passive activity is defined as any activity which involves the conduct of a trade or business in which the taxpayer does not materially participate.197 Note. A taxpayer is considered to have materially participated in an activity if one of seven tests set forth in Treas. Reg. §1.469-5T(a) is met. In determining whether any of the seven tests of material participation are satisfied, the participation of the individual’s spouse is taken into account.198 Real Estate Professional. A passive activity generally includes any rental activity. Thus, rental real estate losses are passive and are deductible only to the extent of other passive income, until the activity is sold. But, if a taxpayer qualifies as a “real estate professional,” the taxpayer’s rental real estate activities will not automatically be considered to be passive.199 To be a real estate professional, most of the taxpayer’s personal services rendered in businesses during the year must be in real property businesses (property development, construction, rental, management or brokerage activities) in which the taxpayer materially participates, and the total hours that the taxpayer materially participates in such businesses must exceed 750 hours for the year.200 Note. A real estate professional may elect to treat all of the taxpayer’s interests in rental real estate as a single rental activity in order to facilitate the material participation test.201 The IRS had taken the position that the 750-hour test applied to each activity, which would make it practically impossible for a taxpayer with multiple activities to qualify, absent an election to treat all rental real estate activities as a single activity. However, in 2014, the IRS clarified that hours in each rental activity, even though those activities may be passive and regardless of whether a grouping election
Losses are also deducted in the taxpayer’s final year of the investment. I.R.C. §469(c)(1). 198 I.R.C. §469(h)(5). Proof of an individual’s participation in an activity may be established by any reasonable method. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of participation is established by other reasonable means (e.g., based on appointment books, calendars, or narrative summaries). Treas. Reg. §1.469-5T(f)(4). 199 I.R.C. §469(c)(7). The IRS has determined that a trust cannot attain the status of real estate professional because, in the IRS view, the tests are intended to apply only to individuals. C.C.A. 201244017 (Aug. 3, 2012). However, the IRS position was rejected by the Tax Court in Frank Aragona Trust v. Comr., 142 T.C. 165 (2014)(rental losses of trust not disallowed as passive activities under the passive loss rules because a trustees, as individuals, can render personal services that meet the material participation test, and trust materially participated in the real estate business via trustees acting in their capacity as trustees and in their capacity of employees of the trust’s wholly-owned LLC that managed rental properties; Tax Court implied that non-trustee employees could also satisfy the material participation test). 200 The more-than-50 percent personal services test and more-than-750 hour tests must be satisfied by only one spouse in the case of joint filers. Treas. Reg. §1.469-9(c)(4). 201 Treas. Reg. §1.469-9(g)(3). 196 197
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has been made, can be counted toward the 750 hours and the 50 percent texts for meeting eligibility as a real estate professional.202 This is an important interpretive change for taxpayer’s with multiple activities. Example. Clem is the 100% owner of a real estate development company and two rental properties. Clem performs more than 750 hours of personal services in these combined businesses. Clem does not provide personal services to any other trade or businesses. A grouping election under Treas. Reg. §1.4699(g) to aggregate his rentals has not been made. However, Clem will qualifies as a real estate professional (more than 50% of his personal services are performed in the combined real property business, and total hours in that business exceed 750 hours). Even though Clem did not make a grouping election, for purposes of the eligibility tests all real estate businesses are combined. Note. Even though Clem is treated as a real estate professional, he may still fail the test requiring that he materially participate in each rental property. If he fails this test, he will not be able to claim the losses from the rental properties as non-passive. This result may be avoided by making an election under Treas. Reg. §1.469-9(g), which would allow Clem to aggregate all rental properties for purposes of attaining one of the material participation tests.
Grouping activities. A taxpayer may electively group multiple businesses or multiple rentals as a single activity for purposes of the passive loss restrictions. 203 Grouping multiple activities is permitted if the activities constitute an “appropriate economic unit.” A taxpayer may use any reasonable method to make the grouping determination, although the following factors are given the greatest weight:204 Similarities and differences in types of business;
The extent of common control;
The extent of common ownership;
Geographical location; and
Interdependence between the activities
This is an example of a grouping statement that is filed with the return:
SAMPLE GROUPING STATEMENT
CCA 201427016 (Apr. 28, 2014). The new IRS position squares with the Tax Court’s opinion in Miller v. Comr., T.C. Memo. 2011-219. See also Lamas v. Comr., T.C. Memo. 2015-59. 203 Treas. Reg. §1.469-4. 204 Treas. Reg. 1.469-4(c)(2). 202
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NAME ________________________________________ TAXPAYER ID NUMBER______________ YEAR ENDED ______________________
ELECTION TO GROUP ACTIVITIES PURSUANT TO TREAS. REG. §1.469-4 The taxpayer hereby elects to group the following activities together so that the grouped activities are treated as a single activity for the year ended _____, and all years thereafter. The taxpayer represents that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for the purposes of I.R.C. §469. The following activities are to be grouped together and treated as one activity: Name of Activity
Address and Employer I.D. No.
__________________________ _______________________________________________
__________________________ _______________________________________________
__________________________ _______________________________________________ Note. If the election statement is confirming a prior unwritten grouping position, modify the first line to read: “The taxpayer hereby confirms its existing election to group the following activities…” A rental activity ordinarily cannot be combined with a business activity, although such grouping is allowed if either the business or rental activity is insubstantial in relation to the other, or each owner of the business activity has the same proportionate ownership interest in the business activity and rental activity.205 Note. A failure to properly group activities may result in passive status for an activity. This can be particularly detrimental because a passive loss from a business (lacking material participation by the taxpayer) or a rental activity loss is suspended and, beginning in 2013, a 3.8% net investment income tax applies to net rental income and other passive business income of upper income taxpayers.
205
Treas. Reg. §1.469-4(d)(1).
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Grouping disclosure. The IRS has issued final guidance on the disclosure reporting requirements of groupings and regroupings.206 Under the guidance, a written tax return statement is required for:
New groupings, such as in the first year of grouping two activities;
The addition of a new activity to an existing grouping; and
Regroupings, such as for an error or change in facts.
However, no written statement is required for:
Existing groupings prior to the effective date of the guidance, unless there is an addition of an activity;
The disposition of an activity from a grouping; and
Partnerships and S corporations (because the entity’s reporting of the net result of each activity as separate or as combined to each owner serves as the grouping election.
Note. If a taxpayer is engaged in two or more business activities or rental activities and fails to report whether the activities have been grouped as a single activity, then each business or rental activity is treated as a separate activity. Despite the default rule that treats unreported groupings as separate activities, a taxpayer is deemed to have made a timely disclosure of a grouping if all affected tax returns have been filed consistent with the claimed grouping, and the taxpayer makes the required disclosure in the year the failure is first discovered by the taxpayer.207 However, if the IRS first discovers the failure to disclose, the taxpayer must have reasonable cause. Observation. The practical implication of this relief rule is that where proper disclosure has not yet occurred, the taxpayer “needs to win the race with the IRS” in completing proper disclosure. Although prior groupings are grandfathered under the reporting rule, practitioners need to recognize that there is a requirement of consistency under Treas. Reg. §1.469-4(e). Accordingly, it is prudent to document a grouping position with a written tax return statement, so as to assist the preparation process in future years. Other Grouping Rules and Restrictions. An activity conducted through a closely-held C corporation may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially participates in the other activity. For example, a taxpayer involved in both a closely-held C corporation and an S corporation could group those two activities for purposes of achieving material participation in the S corporation. However, the
206 207
Rev. Proc. 2010-13, 2010-1 C.B. 329. Id.
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closely-held C corporation could not be grouped with a rental activity for purposes of treating the rental activity as an active business.208 An activity involving the rental of real property and an activity involving the rental of personal property may not be treated as a single activity, unless the personal property is provided in connection with the real property or the real property in connection with the personal property. 209 Note. A rental activity owned by one spouse may be grouped with a pass-through business owned by the other spouse.210
Miscellaneous Issues Associated With Grouping Activities Grouping a rental and a business. Where a taxpayer has the same proportionate ownership in a rental activity and in a business (other than operated in C corporation form), grouping of the activities may result in a Schedule E rental activity being treated as part of the business activity for Section 469 passive activity status only.211
1.
Observation. The rental activity is still reported on Schedule E. Although treated as a material participation business activity for passive purposes, any Schedule E income or loss does not affect self-employment income. The Schedule E result flows directly to page 1 of the Form 1040 rather than flowing to the Form 8582 passive schedule. Example. Al and Alena are married and file a joint return. Al is the sole owner of an S corporation conducting a business in which he materially participates. Alena is the sole shareholder of an S corporation that owns a building leased exclusively to Al’s S corporation. Because Al and Alena are considered to be one under the passive loss rules,212 the S corporation business and the rental activity have the same proportionate ownership and can be grouped together as a single activity. But, any Schedule E loss from the rental activity would not be treated as a passive loss. Observation. If the facts of the example were changed such that a portion of the building owned by Alena is rented to Al’s business and another portion is rented to an independent third party, the portion not rented to Al’s business would remain a passive activity.213 If there is not the same proportionate ownership in a rental activity and in a business, grouping can still occur if one activity is insubstantial in relation to the other.214 The regulations do not define the term “insubstantial,” but three court cases have addressed the “insubstantial” definition, with all allowing the taxpayer to adopt grouping. In summary, those cases allow grouping when the
208
Treas. Reg. §1.469-4(d)(5)(ii). Treas. Reg. §1.469-4(d)(2). 210 Treas. Reg. §1.469-4(d)(1)(ii) Example (1). 211 Treas. Reg. §1.469-4(d)(1)(C). 209
212
Treas. Reg. §1.469-1T(j)(1) and Reg. 1.469-4(d)(1)(ii) Example (1).
213
Treas. Reg. §1.469-4(d)(1)(ii), Example (1); Reg. 1.469-2T(c)(2)(i)(D), Example (4). 214 Treas. Reg. §1.469-4(d)(1).
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rental property is leased to the business activity and where the gross receipts of one activity (usually the rental) are insubstantial (generally under 10% of total gross receipts).215 Example. Assume the same facts as the initial example except that Alena’s S corporation is 90 percent owned by her and 10 percent by their two children. The business activity and the rental activity cannot be grouped under the same proportionate ownership test because of the 10 percent owned by the children. However, if the gross rent is less than 20 percent of the combined gross receipts, the opportunity to group the rental with the business may still exist under the “insubstantial” test. Grouping by pass-through entities. Partnerships and S corporations are not subject to the written grouping requirements of Rev. Proc. 2010-13. Rather, those entities are to comply with the Form 1065 and Form 1120S instructions with respect to grouping activities. The instructions for both the partnership and S corporation forms indicate that the entity is to report separately information for each business or rental activity (income, loss, credits, etc.) on an attached statement to Schedules K-1. Each owner is then to make a determination as to whether separate activities are grouped or reported separately for Section 469 purposes. The instructions also allow the partnership or S corporation to make a grouping determination. If the activities are grouped at the entity level, they are reported to the owner as an aggregated net income or loss amount on the attached statement to Schedules K-1. A shareholder or partner may not treat activities grouped together by the entity as separate activities.216
2.
Caution. S corporations and partnerships reporting rental real estate activity are required to prepare and attach Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation, to the Form 1120S or Form 1065. The instructions to Form 8825 state that each rental property is to be shown separately on the Form 8825, even if the activities are combined for purposes of the passive activity rules. The instructions for Form 8825 state the following: “However, if the partnership or S corporation has more than one rental real estate activity for purposes of the passive activity limitations, attach a statement to Schedule K that reports the net income (loss) for each separate activity. Also, attach a statement to each Schedule K-1 that reports each partner’s or shareholder’s share of the net income (loss) by separate activity.” Observation. The Form 8825 instructions make it clear that separate reporting on that form is not determinative of whether the entity has grouped or not grouped various rental properties. That
215
Glick v. U.S., 96 F. Supp. 2d 869 (S.D. Ind. 2000); Schumacher v. Comm., T.C. Sum. Op. 2003-96; Candelaria v. United States, 518 F. Supp. 2d 852 (W.D. Tex. 2007); Stanley v. United States, No. 5:14-CV-05236, 2015 U.S. Dist. LEXIS 153166 (W.D. Ark. Nov. 12, 2015). 216
Treas. Reg. §1.469-4(d)(5)(i); Rev. Proc. 2010-13, sec. 4.05.
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determination is made by the entity’s disclosure in supplemental Schedule K and Schedule K-1 data. A partner or shareholder is not required to make a separate disclosure of any groupings that are made by a pass-through entity, unless the owner:
Groups together any of the activities that the entity does not group;
Groups the entity’s activities with other activities conducted directly by the partner or shareholder; or
Groups the entity’s activities with activities conducted through other pass-through entities [Rev. Proc. 2010-13, sec. 4.05].
Caution. Preparers of an individual Form 1040 who receive a Schedule K-1 from a partnership or S corporation should carefully review the supplemental schedules that are provided with the K1. If there is data reporting separate income or loss information for multiple activities, the passthrough entity has not elected a grouping position with regard to those activities. In this case, the practitioner needs to consider whether the individual owner would benefit from a grouping position. Example. Joe, an engineer, has been a full-time employee of Designco. In early 2016, Joe acquires 10 percent ownership of Designco, and receives a Schedule K-1 reporting $200,000 of business income. Information attached to Joe’s Schedule K-1 discloses Designco with net income of $300,000 and Fabrico (single-member LLC owned by Designco) with a $100,000 loss. Joe explains to his CPA that Fabrico is a manufacturing facility in a distant state and is an activity in which Joe has no personal involvement. Designco has reported two activities to Joe - its engineering net income of $300,000 and Fabrico’s manufacturing loss of $100,000. Without a grouping election, Joe’s Fabrico loss would be suspended as a passive activity. By preparing a written grouping statement within Joe’s 1040 to treat Designco and Fabrico as a single activity, Joe is entitled to report the Fabrico loss as nonpassive. Example. Leo and Liz are 50/50 partners in a partnership that owns two real estate rental activities. Property 1 shows a $200,000 rental loss and Property 2 shows $100,000 of rental income. Liz is the 100 percent shareholder of an S corporation that operates an active business in which she materially participates. The S corporation occupies all of Property 1, with rent paid to the partnership. Form 1065 Schedules K and K-1 attachments do not contain the statement providing the detail for the two properties, but rather show an aggregate net loss of $100,000 on line 2 of Schedule K.
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The result is that the rental real estate loss is a passive loss to both Leo and Liz. Liz is unable to group the Property 1 rental activity with her business activity, because the grouping of her business with the aggregate Property 1 and Property 2 rental, as shown on line 2 of Schedule K, does not represent an appropriate economic unit. Had the partnership attached the statement with the details for Property 1 and Property 2 to the Form 1065 Schedules K and K-1, Liz would have been able to group the Property 1 rental results with her S corporation business and avoid the passive loss limitations. Material participation by LLC members. Limited partners are able to establish material participation only by using three of the seven material participation tests:217
3.
The individual participates in the activity for more than 500 hours during the year;
The individual has materially participated in the activity for any five taxable years, whether or not consecutive, during the 10 years immediately preceding the current year; or
The activity is a personal service activity, in which the individual materially participated in the activity for any three taxable years, whether or not consecutive, preceding the current year.
Several courts determined that LLC and LLP members are not treated as a limited partner under the regulation for purposes of determining material participation218 The courts found that LLC and LLP members have the ability to participate in management, and that differentiates those members from limited partners who cannot participate. However, the IRS then issued regulations that provide a new definition of a limited partnership interest for purposes of the measurement of the partner’s material participation.219 The regulations describe an interest in a limited partnership as applying if: (1) the entity is classified as a partnership for federal income tax purposes; and (2) the partner does not have rights to manage the entity at all times during the entity’s taxable year under the state law in which the entity is organized and under the governing agreement. An individual holding a limited partner interest, is not subject to the more restrictive material participation test if the individual also holds an interest in the partnership that has a management authority interest or other general partner interest.220 Note. Under these regulations (which apply only for purposes of I.R.C. §469) an LLC or LLP member would have all seven tests of material participation available if the member had management authority under the agreement or under state law. Grouping and the NIIT. Upon the enactment of the NIIT effective with the 2013 tax year, a regrouping election could be made on the 2013 return for taxpayers subject to the NIIT in 2013. 217
Temp. Treas. Reg. §1.469-5T(e)(2). Garnett v. Comr., 132 T.C. 368 (2009); Thompson v. United States, 87 Fed. Cl. 728 (2009), A.O.D. 2010-2 (Apr. 5, 2010); Newell v. Comm., TC Memo 2010-23. 219 Prop. Treas. Reg. §1.469-5(e). 218
220
Prop. Treas. Reg. §1.469-5(e)(3)(ii).
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If the election was not made for 2013, the taxpayer can make the election for the first year after 2013 that the taxpayer was subject to the NIIT. Regrouping allows the taxpayer to treat net income from the combined activities as non-passive business income that is not subject to the NIIT. Caution. The regrouping can convert passive income that could be offset with passive losses to non-passive income that cannot be offset by passive losses.
REPAIR/CAPITALIZATION REGULATIONS – AN UPDATE AND REVIEW A. Background 1.
2.
On September 13, 2013, the IRS issued final regulations providing guidance on the application of Secs. 162(a) and 263(a) to amounts paid to acquire, produce, or improve tangible property [TD 9636]. a.
These regulations replace the temporary and proposed regulations issued in December 2011. The new regulations are generally effective for taxable years beginning on or after January 1, 2014. However, taxpayers did have the option to early adopt the regulations for taxable years beginning on or after January 1, 2012.
b.
Also issued on September 13, 2013 were proposed regulations [REG110732-13] providing guidance on the application of general asset account and disposition rules under Sec. 168. Final regulations on dispositions were issued in August of 2014 [T.D. 9689].
Commentary: The line where repairs deductible under Sec. 162(a) ends and improvements required to be capitalized under Sec. 263(a) begins has always been far from clear and has led to much controversy between taxpayers and the IRS. The new final regulations generally follow the 2011 proposed regulations, applying facts and circumstances based rules rather than bright-line quantitative tests. Consequently, the precise location of the line to differentiate the two is still often unknown, but substantive changes have been made in determining the location of the line.
B. Unit of property.
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1.
The unit of property determination plays a large role in determining whether an amount paid is properly deducted as a repair or must be capitalized as an improvement to property. The unit of property is the base on which determinations are made as to whether there has been an improvement which requires capitalization. Generally, the larger the unit of property is determined to be, the more likely the amount paid will be considered a deductible repair.
2.
Under the new regulations, for real and personal property except buildings, a unit of property is comprised of all components that are functionally interdependent.
a.
Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer [Reg. 1.263(a)-3(e)(3)(i)]. 1) However, the taxpayer must treat a component as a separate unit of property if, at the time the unit of property was initially placed in service by the taxpayer, the taxpayer: a)
Treated the component as being within a different class of property under Sec. 168(e); or
b) The taxpayer has properly depreciated the component using a different depreciation method than the depreciation method of the unit of property of which the component is a part [Reg. 1.263(a)3(e)(5)(i)]. b.
For buildings, each building and its structural components is a single unit of property [Reg. 1.263(a)-3(e)(2)(i)]. For application of the improvement rules, however, “building systems” constitute units of property separate from the building structure. Consequently, for the purpose of improvement analysis the units of property for a building are: 1) The building structure (exterior walls, roof, windows, doors, etc.); and 2) Each of the following building systems: HVAC, plumbing, electrical, escalators, elevators, fire-protection and alarm systems, security, gas distribution, and other structural components yet to be identified as building systems in published guidance [Reg. 1.263(a)3(e)(2)(ii)].
c.
Commentary: This componentizing of a building into several units of property is a significant change from earlier regulations (pre-2011 regulations). Consequently, taxpayers who deducted as repairs in prior years expenditures relating to any of these identified building systems will need to determine whether that treatment is still appropriate. If not appropriate, it may be necessary to execute a change in accounting method, discussed below at J.
C. Materials and supplies as deductible expenses. 1.
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Materials and supplies are separated into two categories: incidental and non-incidental. a.
Incidental materials and supplies may be deducted when purchased as long as no record of consumption is kept and expensing those items does not distort income [Reg. 1.162-3(a)].
b.
Non-incidental materials and supplies, however, are not expensed until they
are used or consumed. 2.
An expenditure is defined as a material or supply if it is tangible personal property used or consumed in the taxpayer’s operations, other than inventory, that is: a.
A component acquired to maintain, repair, or improve a unit of tangible property and that is not acquired as part of any single unit of tangible property;
b.
Fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less;
c.
A unit of property with an economic useful life of 12 months or less;
d.
A unit of property with an acquisition cost or production cost of $200 or less; or
e. Property identified in the Federal Register or in the Internal Revenue Bulletin as materials and supplies [Reg. 1.162-3(c)(1)]. Thursday, March 8, 2018
Deductible Repairs Versus Capitalization Overview The rules as to what is a “repair” and, therefore, is deductible, and what must be capitalized and depreciated have never provided a bright line for determining how an expense should be handled. The basic issue is finding the line between I.R.C. §162(a) and I.R.C. §263(a). I.R.C. §162(a) allows a deduction for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, including amounts paid for incidental repairs. Conversely, I.R.C. §263(a) denies a current deduction for any amount paid for new property or for permanent improvements or betterments that increase the value of any property, or amounts spent to restore property. The line between a currently deductible repair and an expense that must be capitalized is one that farmers and ranchers often deal with. A recent court decision involving a Colorado grapegrowing operation illustrates the difficulty in determining the correct tax classification of expenses. Basic Principles In general, any expense of a farmer associated with the business with a useful life of less than one year is deductible against gross income. Depreciation is required if an asset has a useful life of more than one year. Expenses are current costs, and any cost that produces a benefit lasting for more than one year (such as expenses for improvements that increase the property’s value) is generally not currently deductible. Instead, those items must be depreciated or amortized over the period of benefit or use. Indeed, Treas. Reg. §§1.263(a)-1, (b)-2, 1.461-1(a)(2), an expense must be capitalized if the item has a benefit to the taxpayer extending substantially over one year or adapts the property to a new or different use.
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A big issue for farmers and ranchers is whether major engine or transmission overhauls are currently deductible as repairs. Fortunately, there are cases that provide useful authority for the position that major engine or transmission overhauls should be currently deductible as repairs. See, e.g., Ingram Industries, Inc. & Subs. v. Comm’r, T.C. Memo. 2000-323; FedEx Corp. & Subs. v. United States, 121 Fed. Appx. 125 (6th Cir. 2005), aff’g, 291 F. Supp. 2d 699 (W.D. Tenn. 2003). Under these court opinions, engines and transmissions are generally treated as part of the larger machine. This means that the economic life of the engine or transmission is to be treated as co-extensive with the economic life of the larger machine (e.g., a tractor or combine). Because the larger machine cannot function without an engine or transmission, overhaul of the engine or transmission while affixed to the machine can give rise to a current deduction. Recent Case In Wells v. Comr., T.C. Memo. 2018-11, the petitioner owned and lived on a 265-acre farm. She had lived there off-and-on since 1965, but continuously from 1983 forward. Before the petitioner came into ownership of the property, her father owned it. She cultivated about 700 white French hybrid rind grapevines on a part of the property. In the good years, the vines produced up to four tons of grapes, but in the lean years production could be as low as one-half ton. The petitioner normally sold the grapes, but when production declined, she began crushing the grapes and selling the juice to local buyers. She grazed animals on other parts of the farm. Her gross farm income for 2010 and 2011 was $305 and $255 in 2010 and 2011 respectively, and her total farming expenses were $208,265 in 2010 and $54,734 in 2011. Many of those claimed deductible expenses were associated with her grape growing activity. Upon audit, the IRS denied a large portion of the petitioner’s claimed expenses, asserting that the they were improvements that should be capitalized. Underground water line. In 1965, the petitioner’s father installed an underground pipe to convey water from a spring on one part of the farm to supply water to a pasture where animals were grazed as well as to irrigate the grapes. Over time, portions of the two-inch pipe were replaced with new two-inch pipe that was of higher quality and could withstand higher water pressure. The pipeline was completely replaced in 2009 with new pipe, but then started leaking and a section of it was replaced later in 2009. More leaks occurred in 2010 and additional sections of the pipe were replaced and joints repaired. The court determined that the entire water line was replaced at least one time during 2009 and 2010. The petitioner claimed that neither the pipeline’s useful life was extended nor the value increased. Instead, the petitioner asserted that the pipeline replacement cost was deductible because floods destroyed parts of the pipeline in 2009 and 2010 and she had no other option but to replace the pipeline, and that doing so was simply an accumulation of repairs into 2009 and 2010. She claimed to not have the funds in prior years to make repairs in those earlier years. The IRS maintained that the pipeline “repair” expense was properly capitalized as an improvement, and the court agreed. The court determined that the pipeline work was part of a “general plan of rehabilitation, modernization, and improvement” to completely repair the pipeline. The court noted that the pipeline was completely replaced, its life was extended and its value was increased (because of the use of higher quality pipe). It was immaterial, the court held, that flooding might have destroyed part of the pipeline leaving replacement as the petitioner’s only option. The court noted that an analogous situation was present in Hunter v. 129
Comr., 46 T.C. 477 (1966), where the cost of a replacement dam had to be capitalized when the old dam had been washed out by flooding. The court also held that costs associated with work on “road maintenance” and around a barn were also not currently deductible expenses. However, the IRS conceded that $9,000 allocated to repair a culvert, cut trees and spread manure were currently deductible. Storage yard. The petitioner also deducted over $16,000 for the construction of a storage yard, including funds for fencing work related to the storage yard. The storage yard did not previously exist. The IRS claimed that the amounts expended to create the storage yard was a capital improvement which had to be capitalized. The court agreed. It was new construction on top of previously unimproved land and, as such, was an improvement. The associated costs were not currently deductible. Burn area. In 2010, a wildfire burned about 26 acres of the petitioner’s property that the petitioner had used, at least in part, for grazing animals. After the fire, it was determined that the fire had made the burned area unable to absorb water. As a result, the petitioner, paid to have burned tree stumps removed along with boulders. The soil of the burned area was cultivated so that the tract could be used for forage. The cost of this work was slightly less than $50,000, which the petitioner deducted on her 2011 return. The IRS denied the deduction claiming instead that the amount was an expense that had to be capitalized as a “plan of rehabilitation.” The court agreed with the IRS. The evidence, the court determined, showed that the petitioner had a plan to rehabilitate the burn area, and believed that the expenses would improve the land and its value. In addition, the court noted that the work on the burn area was extensive and that a large portion of the burn area, before the fire, had no relation to the petitioner’s business. After the fire, the court noted that the petitioner testified that the entire area would be used as forage. Thus, the burn area was adapted for a new use which meant that the expenses associated with it had to be capitalized. Conclusion The case points out how expenses that a taxpayer thinks might be currently deductible may actually be expenses that must be capitalized. The Wells case is a good illustration of how these issues can play out with respect to an agricultural set of facts.
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