FARM AND RANCH INCOME TAX/ESTATE & BUSINESS PLANNING

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1 SEMINAR & WEBINAR FARM AND RANCH INCOME TAX/ESTATE & BUSINESS PLANNING JULY 13-14, 2017 SHERIDAN COLLEGE SHERIDAN, WYOMING

2 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. 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 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. 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. Continuing Education Upcoming events include: Farm Income Tax/Estate and Business Planning CLE - 6/15-6/16/2017: Public Accountants Society of Colorado (Loveland, Colorado) Rules and Developments in Agriculture Taxation - 6/26/2017: Lorman Education Services live webinar MU Extension Summer Tax School - 7/6/2017: University of Missouri Extension (Columbia, Missouri) Farm and Ranch Income Tax/Estate and Business Planning Seminar/Webinar - 7/13-7/14/2017: Washburn University School of Law CLE, Sheridan College (Sheridan, Wyoming) 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, is forthcoming in the summer of 2017, published by West You Tube Ag Law & Tax Blog (signup for alert)

3 Roger A. McEowen Kansas Farm Bureau Professor of Agricultural Law and Taxation Washburn University School of Paul Neiffer Principal CliftonLarsonAllen LLP Yakima, TABLE OF CONTENTS RECENT DEVELOPMENTS IN AG TAXATION 1 DEPRECATION-RELATED ISSUES FOR FARM ASSETS FARM INCOME AVERAGING 82 FINANCIAL DISTRESS TAX ISSUES 95 FARM INCOME DEFERRAL OPPORTUNITIES.. 99 THE IRS ATTACK ON THE CASH METHOD OF ACCOUNTING FOR FARMERS 119 REPAIR/CAPITALIZATION REGULATIONS AN UPDATE AND REVIEW 126 CORPORATE-PROVIDED MEALS AND LODGING 143 GIFTS OF RAISED COMMODITIES 149 SELF-EMPLOYMENT TAX ON FARM RENTAL INCOME C CORPORATE PENALTY TAXES. 169 POTPOURRI... THE INTEREST-CHARGED DOMESTIC INTERNATIONAL SALES CORPORATION 172 DPAD..175 USDA GRANTS INCOME TAXATION OR EXCLUSION.196 INCOME TAX TREATMENT OF CO-OPS AND THEIR MEMBERS..198 FARM LOSS ISSUES 200 INCOME TAX ISSUES ASSOCIATED WITH OIL AND GAS..207 TAX AND LEGAL ISSUES ASSOCIATED WITH GRAIN CONTRACTING..219 SELF-EMPLOYMENT TAX ON FARM RENTAL INCOME.230

4 PASSIVE ACTIVITIES.234 IRS AUDIT ISSUES IN AGRICULTURE 242

5 RECENT DEVELOPMENTS IN AG TAXATION 1. Meals Provided to NHL Players While on Road Trips Fully Deductible. The petitioners, a married couple, own the Boston Bruins NHL franchise via two S corporations. During the hockey season, the team plays approximately one-half of its games away from Boston throughout the United States and Canada. The players stay in hotels during the road trips and the franchise contracts with the hotels to provide the players and team personnel pre-game meals. The petitioners deducted the full cost of the meals, and the IRS limited the deduction in accordance with the 50 percent limitation of I.R.C. 274(n)(1). The NHL has specific rules governing travel to out-of-town games which requires a team to arrive at the away city the night before the game whenever the travel requires a plane trip of longer than 2.5 hours. To satisfy the travel requirement, the petitioners contracted with host city hotels for meals and lodging to be served in meal rooms. Player attendance at the meals is mandatory and specific food is ordered for the players to meet their specific needs. The court noted that the 50 percent limitation is inapplicable if the meals qualify as a de minimis fringe benefit and are provided in a nondiscriminatory manner. The court determined that the nondiscriminatory requirement was satisfied because all of the staff that traveled with the team were entitled to use the meal rooms. The court also determined that the de minimis rule was satisfied if the eating facility (meal rooms) was owned or leased by the petitioner, operated by the petitioner, located on or near the petitioner s business premises, and the meals were furnished during or immediately before or after the workday. In addition, the court noted that the annual revenue from the eating facility would need to normally equal or exceed the direct operating cost of the facility. The IRS conceded that the meals were provided during or immediately before or after the employees workday, but claimed that the other requirements were not satisfied. However, the court determined that the petitioners did satisfy the other requirements on the basis that they can be satisfied via contract with a third party to operate an eating facility for the petitioners employees. As for the business purpose requirement, the court noted that the hotels where the team stayed at while traveling for road games constituted a significant portion of the employees responsibilities and where the team conducted a significant portion of its business. The court also noted that the revenue/cost test is satisfied if the employer can reasonably determine that the meals were excludible from income under I.R.C. 119, and are furnished for the employer s convenience on the business premises. The court determined that those factors were also satisfied. Thus, the cost of the meals qualified as a fully deductible de minimis fringe benefit. Jacobs v. Comr., 148 T.C. No. 24 (2017). 2. No Deduction For Business Expenses Unless Activity Engaged For Profit. The petitioner was a minister that, on occasion performed weddings and conducted seminars. He was not paid for being a minister and did not have income from his writings and seminars. However, he did incur expenses associated with the activities which the IRS disallowed. The court agreed with the IRS, noting that under Comr. v. Groetzinger, 480 U.S. 23 (1987), to be engaged in a trade or business within the definition of I.R.C. 162, the taxpayer s primary purpose for engaging in an activity must be for income or profit. In addition, the court noted that the petitioner had no accounting records or bank statements, and no invoices or any other business-related records. The petitioner only submitted to the court credit card statements and a summary of expenses. Thus, the petitioner s deductions were limited to the income from his activities of which there was none. Lewis v. Comr., T.C. Memo Evidence Fails to Convince Court That Real Estate Professional Test. The petitioner owned multiples residential rental properties. She kept logs and calendars of her time spent working at the properties, but the court believed that they were inconsistent and the logs did not provide a specific description of services rendered. The court also did not find credible the petitioner s claim of hours spent based on her non-rental activities. Accordingly, the court held that the petitioner failed to meet 1

6 the 750-hour test or the 50% test of I.R.C. 469(c)(7)(B) and her losses from the rental activities were passive. Ostrom v. Comr., T.C. Memo Tax Prep Business May Have Tort Action Against IRS For Botched Sting Operation. The plaintiff, an affiliate of a tax return preparation business, loaned money to taxpayers who were awaiting federal income tax refunds. The business prepared the taxpayers returns and referred those that wanted an advance on their refund to the plaintiff. The plaintiff loaned the funds based on the anticipated tax refund with the taxpayer then telling the IRS to send the refund check to the plaintiff. Another tax preparer, working secretly with IRS Criminal Investigations Division, referred several clients to the plaintiff for refund anticipation loans. When a client tried to cash the plaintiff s check, the bank notified the plaintiff that the client was using a fake I.D. and the plaintiff had the bank hold the check. The plaintiff told the other preparer of the matter and then learned that the other prepared was working undercover with the IRS. The plaintiff then requested that the bank stop payment on all checks that the plaintiff had issued to the other preparer s clients, but the IRS refused to allow the checks to be stopped due to interference with the criminal investigation, assuring the plaintiff that it would be repaid. An IRS supervisor confirmed the sting operation and the plaintiff issued additional checks with further assurance that it would be made whole. However, the bank had not been informed of the sting operation and the plaintiff incurred additional cost to keep its bank accounts open. IRS ignored repeated requests to confirm in writing the promise to repay the plaintiff s costs, and didn t make the plaintiff whole after the sting operation and revoked the e-filing privilege of the affiliated business at the beginning of the tax prep season, forcing the plaintiff and the affiliated business into bankruptcy. The plaintiff (and the affiliated business) sued IRS under the Federal Tort Claims Act (FTCA), and the IRS claimed it was immune from suit, but the plaintiff claimed that IRS was neither assessing tax nor collecting it, but simply trying to find tax cheaters and, as a result, sovereign immunity did not apply. The trial court granted the IRS motion to dismiss, but the appellate court reversed. The appellate court determined that the FTCA does not grant absolute immunity to the IRS when IRS is not taking action to assess or collect tax, and that the plaintiff had properly made out claims for conversion under state (CA) law as well as abuse of process. Snyder & Associates Acquisitions, LLC v. United States, No , 2017 U.S. App. LEXIS (9th Cir. Jun. 16, 2017). 5. Taxpayers Could Not Substantiate Claims of Time Spent on Rental Activities. The petitioners, married couple, had various rental properties for which they claimed substantial losses for the two years at issue. They did maintain a journal of their activity with respect to the rental properties, but the court held that the journal failed to substantiate the time spent in the rental activities. Thus, the petitioners were not able to meet the 750-hour test or the 50 percent test of I.R.C. 469(c)(2) or the material participation test of I.R.C. 469(c)(1)(B). As a result, the petitioners were not real estate professionals. The petitioners also did not elect to treat their rental activities as a single rental activity. Thus, the petitioners could not offset losses arising from the rental activities against their other income. McNally v. Comr., T.C. Memo IRS Can Require PTINs, But Can t Charge For Them. In 2010 and 2011, the Treasury Department developed regulations that imposed certain requirements that an individual had to comply with to be able to prepare tax returns a person had to become a registered tax return preparer. These previously unregulated persons had to pass a one-time competency exam and a suitability check. They also had to (along with all other preparers) obtain a Preparer Tax Identification Number (PTIN) and paying a user fee to obtain the PTIN. The plaintiff class challenged the authority of the government to require a PTIN and charge a fee for obtaining it. The IRS claimed that the regulations were necessary for the need to oversee tax return preparers to ensure good service. I.R.C. 6109(a)(4), in existence prior to the regulations at issue, requires a preparer to provide identification and state that the preparer s social security number shall be used as the required 2

7 identification. The regulations at issue, however, required preparers to obtain (at a fee paid to the Treasury) a PTIN as the identifying number. Preparers without a PTIN could no longer prepare returns for a fee. The IRS argued that by creating the PTIN requirement, it had created a thing of value which allowed it to charge a fee, citing 31 U.S.C. 9701(b). However, the plaintiffs claimed that the PTIN requirements are arbitrary and capricious under the Administrative Procedure Act or, alternatively is unlawful as an unauthorized exercise of licensing authority over tax return preparers because the fee does not confer a service or thing of value. The court determined that the IRS can require the exclusive use of a PTIN because it aids in the identification and oversight of preparers and their administration. However, the court held that the IRS cannot impose user fees for PTINs. The court determined that PTINs are not a service or thing of value because they are interrelated to testing and eligibility requirements and the accuracy of tax returns is unrelated to paying a PTIN fee. A prior federal court decision held that the IRS cannot regulate tax return preparers (Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2014), thus charging a fee for a PTIN would be the equivalent of imposing a regulatory licensing scheme which IRS cannot do. Prior caselaw holding that the IRS can charge a fee for a PTIN were issued before the Loving decision, and are no longer good law. Steele v. United States, No. 14-cv-1523-RCL, 2017 U.S. Dist. LEXIS (D. D.C. Jun. 1, 2017). 7. Crop-Share Rent Was Not Passive to S Corporation Landlord. An S corporation was engaged in farming and leased its land to a tenant via a crop-share lease. The S corporation and the tenant split all taxes, assessments or charged levied or assessed on products of the land in proportion to the split of the crops between the parties under the lease. The parties split the cost of fertilizer and soil conditioners equally, and the corporation paid the cost of the power and fuel necessary to operate drainage pumping plants, as well as the cost of maintaining irrigation and drainage canals and irrigation pipe line. The corporation also is responsible for the box rent and the grower s share of the state inspection fee. Crop processing expenses incurred to prepare them for sale that relate to the corporation s crop share are paid by the corporation. In addition, the corporation determined the percentage of the land to be farmed and the types of crops to be planted. The corporation is at risk for crop yields and marketing. For a later year, a new crop-share lease was executed with similar terms and specifically requiring the corporation to provide insurance on all improvements and fixtures that the corporation owns. The corporation also pays all maintenance and repair costs of the drainage pumps. The IRS determined that under I.R.C. 1362(d)(3)(C) and Treas. Reg (c)(5)(ii)(B)(1) the lease income was not passive in the hands of the S corporation. Thus, the corporation was not at risk of having its S election terminated by having too much passive investment income pursuant to I.R.C. 1362(d)(3)(C). Priv. Ltr. Rul (Mar. 2, 2017). 8. Horse Activity Not Engaged In With Profit Intent. The petitioner was a dressage trainer and rider and tried to deduct her horse-related expenses. Based on the nine-factor analysis of the regulations, the court concluded that the petitioner did not conduct the activity with a profit intent. Importantly, the petitioner had only tack as an asset in the activity and there was no expectation that it would increase in value. The petitioner had no other successes in relevant businesses, and the horse-related expenses were far greater than income from the activity. The petitioner also had significant income from other sources and derived pleasure from the horse activity. McMillan v. Comr., No , 2017 U.S. App. LEXIS 8540 (9th Cir. May 15, 2017), aff g., T.C. Memo Estate Allowed to Make Late Election To Claim Charitable Contributions, and Rules for Estate and Trust Donations Outlined. An estate or trust can claim a deduction for charitable contributions via I.R.C. 642(c) in the year in which the contribution was paid, on the return for the year before the year the contribution was paid if the trust elects under I.R.C. 642(c)(1), or in the year in which amounts are permanently set aside by the trust for charitable purposes (if the estate or trust was created before Oct. 9, 1969). Under the facts of the ruling, the estate did not elect to claim the charitable deduction in the year before the year of the donation, and the estate sought IRS permission 3

8 to make a late election to do so in accordance with Treas. Reg (c). The IRS granted relief of 120 days to file the election if the estate files amended returns for each year in which the estate makes the election. The amended returns must be filed within the 120-day period. The IRS noted that I.R.C. 642(c) allows a charitable deduction on Form 1041 if the charitable contribution is made from gross income (as defined under I.R.C. 61) and the amount is paid pursuant to the governing instrument. Once those requirements are satisfied, the deduction is allowed with no percentage limitation. Priv. Ltr. Rul (Feb. 6, 2017). 10. NOL Carryforward Disallowed For Lack of Substantiation. In 2007, the petitioner obtained a $500,000 loan, pledging his house as collateral, to pay on a judgment that had been entered against him. Due to general economic issues, the petitioner could not pay off the loan. The petitioner and his wife divorced, and he orally agreed to pay his ex-wife $2,000/month. The petitioner later increased the amount he paid her to $5,000/month. The petitioner claimed $130,000 in alimony deductions, but the IRS denied the deductions for lack of substantiation. The court agreed on the basis that the oral agreement did not suffice for documentation needed to substantiate the deduction for the two years at issue. The petitioner also claimed over $70,000 in interest deductions associated with the loan, but was not able to substantiate the amount of principal payments that he made or the interest payments. Thus, the court disallowed the purported interest deductions. The petitioner also claimed a net operating loss carryforward exceeding $185,000. The court disallowed the carryforward loss even though the petitioner asserted that it was merely put on the wrong line of the tax form by mistake and that his TurboTax software was responsible for the error (as well as other errors on his returns). The court disagreed, noting that tax preparation software is only as good as the information one inputs into it. Bulakites v. Comr., T.C. Memo IRS Confirms That Form 7004 Is Correct. Under the Surface Transportation and Veteran s Health Care Choice Improvement Act, signed into law on July 31, 2015, set the due date for Form 1120 (U.S. Corporation Income Tax Return) as the 15th day of the fourth month after the close of the corporation s tax year. A five-month extension is provided for calendar year C corporations (until 2026), via an amendment to I.R.C. 6081(b). However, the IRS instructions to Form 7004 states that a calendar year C corporation has a six-month filing extension. Via its website, the IRS explains that the instructions are not incorrect because IRS has the authority under I.R.C. 6081(a) to grant a longer extension period. Fiscal year C corporations have a six-month extended due date by virtue of I.R.C. 6081(b), except that C corporations with a June 30 year-end are allowed a seventh month extension (until 2026). 12. Employee Not Entitled To Deduct Unreimbursed Business Expenses. The petitioner s employer required employees to get permission before incurring a reimbursable business expense. The petitioner incurred reimbursable expenses, but did not seek reimbursement. The petitioner deducted the expenses, but the IRS denied the deductions and the court agreed with the IRS. The court noted that the petitioner bore the burden of establishing that the employer would not have reimbursed the expenses had they been submitted. In addition, the court noted that once an employer has a policy of reimbursing, the employee must seek reimbursement. Humphrey v. Comr., T.C. Memo No Residential Energy Credit For New Windows. The petitioner installed energy-efficient new windows at his residence and claimed a residential energy credit of $1,500. The IRS disallowed the credit for lack of substantiation, and the court agreed. The court noted that the petitioner s invoice did not contain the petitioner s name such that it could be determined whether the petitioner was the party that paid for the windows. The petitioner s home had suffered a casualty, and the court also disallowed a casualty loss deduction due to the petitioner s lack of substantiation of the insurance reimbursement amount. Wainwright v. Comr., T.C. Memo Affiliated Corporation Can t Join Consolidated Return. The plaintiff is a holding company that owns and operates subsidiaries that engage in retail sales in Iowa. One subsidiary serves as a 4

9 management company, and all revenue is transferred to it and is used to pay the expenses of the various subsidiaries. Another subsidiary owns an airplane that is use for business travel. The plaintiff does not, by itself, sell products or provide services in Iowa. At issue was the 2009 and 2010 consolidated income tax returns of the Iowa subsidiaries. The 2009 return included the plaintiff and all of its subsidiaries, including the non-iowa subsidiaries. The 2010 consolidated return included the Iowa subsidiaries, but not the plaintiff. The 2009 consolidated return did not include the interest and amortization as an expense for the subsidiaries because all of it had been allocated to the plaintiff. For 2010, the interest and amortization expense was allocated to the Iowa subsidiaries based on a percentage of revenue approach. The Iowa Department of Revenue disallowed the expenses and the plaintiff filed a protest. An ALJ reversed on the expenses and the IDOR appealed to the Director of Revenue. The Director ruled that the plaintiff should not be included on the Iowa subsidiaries consolidated returns. On further review, the court agreed. The plaintiff did not establish a taxable nexus with Iowa and merely owned and controlled subsidiary corporations within the meaning of Iowa Code A(5). The court also determined that the plaintiff did not establish that the expenses in issue were paid by the subsidiaries in Iowa. Romantix Holdings, Inc., et al. v. Iowa Department of Revenue, No , 2017 Iowa App. LEXIS 426 (Iowa Ct. App. May 3, 2017). 15. Vacation Home Rules Sink Deductions for Bed and Breakfast. The petitioner, and Alaska resident, created an LLC which purchased a home in Indiana that the petitioner operated as a bed and breakfast using on-site managers to run the bed and breakfast. The on-site managers were provided with an apartment on the premises to use as their personal residence. The bed and breakfast ceased operating in 2010, but deduction associated with the business continued into The IRS disallowed associated losses under the vacation home rules of I.R.C. 280A(a) which disallows deductions associated with a dwelling unit that the taxpayer uses as a residence during the taxable year. A dwelling unit is used as a residence if the taxpayer uses it for personal purposes for more than the greater of 14 days or 10 percent of the number of days during the taxable year that the unit is rented at a fair rental value. The petitioner s pass-through entity, the LLC, is considered to have made personal use of a dwelling unit on any day on which any beneficial owner would be considered to have made personal use of the unit. Days count toward the 14 day/10 percent limit if they are not personal use days (days spent primarily repairing and maintaining the property). The evidence showed that the petitioner stayed at the home 26 days in 2010 and 33 days in 2011, and the petitioner couldn t establish evidence to the contrary. The petitioner s daily activity logs were created during the IRS examination of the matter, and didn t provide specific details about the activities that he performed. The petitioner also employed a landscaping firm during the tax years in issue. Thus, all of the losses associated with the home were disallowed, a worse result that had they been disallowed under the passive loss rules of I.R.C. 469 which would be deferred until the home is disposed of in a taxable transaction. The court also imposed a 20 percent accuracy-related penalty. Cooke v. Comr., T.C. Memo Real Estate Professional Test Satisfied For Purposes of Passive Loss Rules. The petitioner had been a stock broker for over 30 years and continued to work in a brokerage department for the tax year in issue, working approximately 15 hours per week. The petitioner submitted evidence that she worked approximately 900 hours on a real estate activity during the tax year. The court determined that she worked at least 750 hours in the real estate business and that more time was spent on real estate activities than on non-real estate activities. Thus, the petitioner s losses weren t automatically passive. The court also determined that the petitioner had materially participated in the real estate activities based on the fact that the petitioner was the sole person that rendered all of the participation in the activity. As for other deductions, the court disallowed automobile expenses due to the petitioner not having a mileage log. The petitioner also did not keep records to substantiate business and charitable deductions, but the court allowed one-third of the claimed deductions for office 5

10 supplies, stamps and calendar expenses under the Cohan rule. Windham v. Comr., T.C. Memo Home Sale Proceeds Retained By Wife Not Reachable to Pay Husband s Tax Debt. In 2002, the defendant and his business partner sold his business for approximately $15 million, which included stock in another business that the defendant later sold for $3.4 million. The defendant used a tax shelter to reduce his taxable gain on the transaction, and reported a $2.5 million loss on his 2002 return. The 2002 return was filed separately from the defendant s wife. He then filed amended returns for and carried back the loss. The IRS refunded almost all of the taxes that the defendant and his wife had paid for the tax years. The defendant deposited the proceeds from the sale of the stock in a trust in the Cayman Islands with instructions for the trustee to invest the corpus in a hedge fund that turned out to be a Ponzi scheme that lost all of the money by Later in 2005, the defendant and his wife bought a house in Massachusetts and took title as tenants by the entirety. The couple paid slightly over $1.6 million. The couple remortgaged the home in 2007 with the defendant as the sole mortgagor. They also established a trust naming the wife as the trustee and transferred the home s title to the trust. They established a second trust that named the wife as trustee and the two children as co-beneficiaries. They transferred a beach house to the second trust. The wife sold the beech house in late 2007 and deposited the $433,000 of sale proceeds into a bank account that the second trust owned. The wife used the funds to pay down loans that the Massachusetts house secured and living expenses. The couple divorced in 2008 and the settlement agreement gave most of the assets to the wife and the liabilities to the defendant and that the defendant could continue to live in the Massachusetts home. A court entered a $5 million tax judgment against the defendant in 2015, and the trial court set aside the divorce settlement as a fraudulent transfer. The trial court divided the assets 50/50 in accordance with Massachusetts common law that divides property equitably in divorce, and the IRS liens attached to the assets allocated to the defendant. However, the IRS claimed that their liens attached indirectly to certain assets allocated to the wife. As a result, the trial court ordered the Massachusetts home to be sold and the proceeds split evenly between the IRS and the wife. The IRS claimed entitlement to the wife s half of the proceeds via a lien-tracing theory. The trial court rejected this claim and the IRS appealed. The appellate court noted that Massachusetts law required 14 factors to be utilized to determine how to divide the marital property, and that the trial court had not split the property in accordance with that analysis. The court vacated and remanded on the property division issue. However, the appellate court upheld the trial court s determination that the IRS lien did not attach to the wife s house sale proceeds because the IRS failed to show the amount or number of mortgage payments made to support its lien-tracing theory simply based on the testimony of the defendant and his wife which was deemed not credible. United States v. Baker, 852 F.3d 97 (1st Cir. 2017), vac g. and remanding, No RGS, 2016 U.S. Dist. LEXIS (D. Mass. Feb. 16, 2016). 18. Real Estate Professional Status Not Obtained Under Passive Loss Rules. The petitioner was fully employed as an entry-level field sterilization technician and also worked as a sales account representative in the fall of each year. While he often worked from home, he did travel to clients on an as-needed basis. During 2012, the petitioner worked 2,194 hours for his employer. The petitioner was also a licensed real estate broker and marketed commercial and residential properties for several clients. He was also engaged in a rental real estate activity through his S corporation. For 2012, the IRS recharacterized about $56,000 of non-passive losses from the S corporation as a passive loss on the basis that the petitioner did not qualify as a real estate professional under I.R.C. 469(c). The IRS claimed that the petitioner did not put more hours into his real estate activities than he did in his other activities. The result was that the petitioner s deduction for passive real estate losses was denied in full. The IRS also asserted an accuracy-related penalty. The court upheld the IRS determination based on the inability to substantiate the hours that the petitioner spent on real estate 6

11 activities in The court believed that the petitioner s monthly calendars greatly exaggerated the hours he spent on real estate activities which the petitioner claimed to be four to six hours each weekday and hours on each Saturday and Sunday in addition to the hours spent on his fulltime job. The court did not believe that the petitioner was working a total of 90 hours per week on average. The calendar entries were rounded to the nearest half-hour and did not specify a start or end time or include the time spent driving to and from a property. Penley v. Comr., T.C. Memo IRS Provides Guidance on Bonus and Expense Method Depreciation. The IRS has provided guidance clarifying that, effective for property placed in service in a tax year after 2015, I.R.C. 179 is available on heating and air conditioning units that qualify as I.R.C property (such as portable air conditioning and heating units). However, IRS stated that if a component of a central air conditioning or heating system of a building is qualified real property under I.R.C. 179(f)(2), and the component is placed in service in a tax year that begins after 2015, then the component can qualify for I.R.C. 179 if the qualified real property is elected to be treated as I.R.C. 179 property. The IRS also again stated that an I.R.C. 179 election can be made or revoked on an amended return for an open tax year. As for the eligibility of qualified improvement property specified in I.R.C. 168(k) that is placed in service after 2015, bonus depreciation can be claimed on it if it is an improvement to the interior portion of a building that is nonresidential real property if the improvement is placed in service after the date the building was first placed in service which means the first time the building was placed in service b any taxpayer. IRS stated that the rules of Treas. Reg (k)-1(c) apply to qualified improvement property. Qualified restaurant improvements that are 15-year property under I.R.C. 168(e)(7) are also treated as qualified improvement property, but restaurant buildings do not qualify for bonus depreciation. The IRS also reiterated that then bonus depreciation is elected out of, no AMT adjustment is required on property for which bonus depreciation is claimed. As for specified plants, the IRS stated that for a 2015/2016 fiscal-year taxpayer who planted or grafted a specified plant in 2016, the taxpayer will be treated as having made a valid election if bonus depreciation was claimed on the plant. In addition, the IRS noted that if bonus depreciation is elected for a specified plant, the adjusted basis of the plant is reduced by the greater of the amount of the bonus depreciation allowed or allowable. The remaining adjusted basis is the cost of the specified plant for purposes of I.R.C Rev. Proc , I.R.B (eff. Apr. 20, 2017). 20. Modifications to Variable Prepaid Forward Contracts Not Taxable. The petitioner is the estate of the deceased founder and CEO of Monster Worldwide, Inc. Before death, the decedent had entered into contracts to sell stock in corporate stock to Bank of America and Morgan Stanley & Co., International. The contracts were structured as variable prepaid forward contracts (VPFC) that required the banks to pay a forward price (discounted to present value) to the decedent on the date the contracts were executed, rather than the date of contract maturity. Accordingly, the decedent received a cash prepayment from Bank of America of approximately $51 million on September 14, On September 27, 2017, the decedent received a cash prepayment from Morgan Stanley & Co. of slightly over $142 million. The prepayments obligated the decedent to deliver to the banks stock shares pledged as collateral at the time of contract formation, and certain other stock shares that weren t pledged as collateral or an equal amount of cash. The actual number of shares or their cash equivalent is determined via a formula that accounts for stock market changes. Under the contracts as originally executed in September of 2007, the decedent was to deliver to the banks every day for 10 consecutive business days in September of Each day, one tenth of the total number of shares agreed to be transferred was to be delivered as determined by adjusting the number of shares by the ratio of an agreed floor price over the stock closing price for that particular day, or a cash equivalent to the stock. However, in July of 2008, the banks agreed to extend the settlement dates to early To get the extension, the decedent paid Morgan Stanley & Co. slightly over $8 million 7

12 on July 15, 2008, for delivery over 10 consecutive days in early January of 2010, and paid Bank of America approximately $3.5 million on July 24, 2008, for delivery over 10 consecutive days in early February of For tax purposes, the decedent treated the original transactions as open transactions in accordance with Rev. Rul , C.B. 363 and did not report any gain or loss for 2007 related to the contracts. In addition, the decedent did not report any gain or loss related to the contract extensions that were executed in 2008 on the basis that the extensions also involved open transactions. The decedent died in late 2008, and on July 15, 2009, the decedent s estate transferred shares of stock to settle the Morgan Stanley & Co. contracts. The estate filed a Form 1040 for the decedent s taxable year 2008, and the IRS issued a deficiency notice for over $41 million claiming that when the decedent executed the extensions in 2008 that triggered a realized capital gain of slightly over $200 million comprised of a short-term capital gain of $88 million and $112 of longterm capital gain from the constructive sale of shares pledged under the contracts. The IRS claimed that the decedent had no tax basis in the stock pledged as collateral. The court disagreed with the IRS on the basis that the open transaction doctrine applied because of the impossibility of computing gain or loss with any reasonable accuracy at the time the contracts were entered into. In addition, the court rejected the argument of the IRS that the extensions of the original contracts closed the contracts which triggered gain or loss at the time the extensions were executed. The court specifically noted that, in accordance with Rev. Rul , VPFCs are open transactions at the time of execution and don t trigger gain or loss until the time of delivery because the taxpayer doesn t know the identity or amount of property to be delivered until the future settlement date arrives and delivery is made. Until delivery, the only thing that the decedent had was an obligation to deliver and not property that could be exchanged under I.R.C The court also noted that the open transaction doctrine applied because the identity and adjusted basis of the property sold, disposed of or exchanged was not known until settlement occurred. The court also stated that an option is a familiar type of open transaction from which we can distill applicable principles. Estate of McKelvey v. Comr., 148 T.C. No. 13 (2017). 21. No Joint and Several Liability Because Wife Didn t Know That Husband Did Not Have Profit Objective for Ranching Activity. The IRS determined a deficiency in the petitioner s joint 2011 return of over $30,000 primarily attributable to disallowed depreciation associated with a 6,000 square-foot barn. The petitioner sought relief from joint and several liability with her spouse to the extent the deficiency related to the disallowed Schedule C deductions. The petitioner and her spouse bought a 5.5-acre tract on which they built their home and run-in shed for their horses. In 2008, the husband purchased a 14.8-acre tract adjacent to their home parcel with the intent to use it for cattle ranching. He built the barn on the tract, researched various breeds of cattle and maintained records for the activity. The barn was not customarily used to stable horses, and the husband never participated in ranching activity. On their 2011 joint return, the couple attached two Schedule Cs. One for the wife realtor business and the other for the cattle ranching activity. The cattle activity reported gross income of $1,598 and a net loss of $133,277 resulting largely from depreciation deductions of $123,681 attributable to the barn. The couple separated in 2011, divorced in 2012 and the IRS examined the 2011 return in 2013, issuing the notice of deficiency in The court allowed the petitioner to be treated as having filed a separate return in 2011 pursuant to an I.R.C. 6015(c) election because the IRS failed to prove that the petitioner had actual knowledge of the erroneous deduction due to the husband s lack of profit motive. Harris v. Comr., T.C. Sum. Op Sales Tax Definition of Agricultural Machinery or Equipment Determined. The petitioners are two cooperatives that buy and sell agricultural products and inputs. They also provide on-farm services and products. In 2014, they submitted forms to the state (NE) Department of Revenue (NDOR) seeking refunds of sales and use taxes paid on agricultural machinery and equipment repairs 8

13 and parts. In early 2015, the NDOR denied a portion of the requested refund attributable to the purchase of nondeductible repairs or parts such as alternators, bolts, gaskets, sensors and an air conditioner. The plaintiffs claimed the NDOR s definition of depreciable repair or replacement parts used was incorrect. Under Neb. Rev. Stat , any purchaser of depreciable repairs or parts for agricultural machinery or equipment used in commercial agriculture may apply for a refund of all of the Nebraska sales or use taxes and all of the local option sales or use taxes paid before October 1, 2014, on the repairs or parts. The NDOR published an information guide interpreting the phrase depreciable repairs or parts. The guide defined repairs and parts as depreciable if they appreciably prolonged the life of the property, arrested its deterioration, or increased its value or usefulness and is an ordinary capital expenditure for which a deduction is allowed through depreciation. The court found the phrase depreciable repairs or parts to be ambiguous, but noted that Neb. Rev. Stat (3) requires the payment of property taxes on tangible personal property which is not depreciable tangible personal property, and that personal property tax must be paid on depreciable repair parts even if sales tax is paid on the item. In addition, repairs and replacement parts for ag machinery and equipment are subject to sales tax. Because the petitioners didn t provide the NDOR with the necessary information to verify that the claimed repairs and parts were taxed as personal property, the petitioners didn t establish entitlement to the refund of taxes for the amounts disallowed. Farmers Cooperative, et al. v. Nebraska, 296 Neb. 347 (2017). 23. IRS Claim That Building Not Placed in Service Until Store Open For Business "Totally Without Merit," But IRS Then Issues Non-Acquiescence. The petitioner operated a retail business that sold home building materials and supplies. The petitioner built two new retail stores. As of December 31, 2008, the buildings were substantially complete and partially occupied and the petitioner had obtained certificates of completion and occupancy and customers could enter the stores. However, the stores were not open for business as of the end of The petitioner claimed the 50 percent GoZone depreciation allowance for 2008 on the two buildings which created a tax loss for 2008 and allowed the petitioner to carry back the losses for the tax years and received a refund. The IRS disallowed the depreciation deduction on the basis that the petitioner had not put the buildings in service and assessed a deficiency of over $2.1 million for tax years The petitioner paid the deficiency and sued for a refund. The IRS argued that allowing the depreciation would offend the "matching principle" because the petitioner's revenue from the buildings would not match the depreciation deductions for a particular tax year. The court held that this argument was "totally without merit." As to the government's "placed in service" argument, the court noted that Treas. Reg. Sec (a)-11(e)(1) says that placed in service means that the asset is in a condition of readiness and availability for its assigned function. With respect to a building, the court noted that this meant that the building must be in a state of readiness and availability without regard to whether equipment or machinery housed in the building has been placed in service. The court held that there was no requirement that the petitioner's business must have begun by yearend. Cases that the IRS cited involving equipment (in one case an airplane) being placed in service were not applicable, the court determined. The court also noted that the IRS's own Audit Technique Guide for Rehabilitation Tax Credits stated that "[A] 'Certificate of Occupancy' is one means of verifying the 'Placed in Service' date for the entire building (or part thereof)". The court noted that the IRS had failed to cite even a single authority for the proposition that "placed in service" means "open for business," and that during oral arguments admitted that no authority existed. The court granted summary judgment for the petitioner and noted that the petitioner could pursue attorney fees if desired. However, the IRS later issued a non-acquiescence to the court s decision without giving any reason(s) why it disagreed with its own regulation and audit technique guide on the matter. Stine, LLC v. United States, No. 2: , 2015 U.S. Dist. LEXIS 9850 (W.D. La. Jan. 27, 2015), nonacq., (Apr. 10, 2017). 9

14 24. Tax Return Preparation Is Not Practice Before the IRS. The plaintiff prepared a client s 2010 and 2011 federal income tax returns and offered to provide the client with a written memo than analyzed her tax options. However, the client learned that the plaintiff learned that the plaintiff had been disbarred and suspended from practice before the IRS before accepting the plaintiff s offer. The client fired the plaintiff and filed a complaint with the IRS Office of Professional Responsibility (OPR). The OPR sent the plaintiff a request for information and the plaintiff asserted that the OPR had no right to demand information from him because he was no longer engaged in practicing before the IRS in accordance with 31 U.S.C. 330 and the regulations thereunder (i.e., Circular 230). The plaintiff claimed that the court s decision in Loving v. Internal Revenue Service, 742 F.3d 1013 (D.C. Cir. 2014) controlled. In that case, the court held that practice before the IRS did not include tax return preparation. The court, in this case, agreed. The court rejected the IRS claim that suspended practitioners remained under jurisdiction of the OPR, and also rejected the OPR s claim that it had inherent authority over practitioners lacking credentials. The court then agreed with the Loving court that tax return preparation activities do not constitute practice before the IRS. The court also held that the while the IRS can impose standards on providing written advice, it cannot sanction the advice or its offering to clients. Sexton v. Hawkins, No. 2:13-cv RFB-VCF, 2017 U.S. Dist. LEXIS (D. Nev. Mar. 17, 2017). 25. Affiliated Corporation Can t Join Consolidated Return. The plaintiff was incorporated in Delaware and had its primary place of business in Texas. The plaintiff also had ownership interests in several subsidiary companies which included two Delaware LLCs that engaged in natural gas pipeline transmission and storage and did business in Iowa. The plaintiff owned 80 percent of one LLC and 100 percent of the other LLC. The companies filed a consolidated return for federal and state tax purposes for The state (IA) return showed an apportioned net loss exceeding $10 million and an estimated tax overpayment of approximately $2.2 million for The Iowa Department of Revenue (IDOR) took the position that the petitioner should be excluded from the consolidated return, because the petitioner had no taxable nexus with Iowa as a result of not receiving any income subject to Iowa corporate tax under Iowa Code (1). The petitioner s exclusion from the consolidated return resulted in an increase in tax of almost $2.6 million. The trial court agreed and the petitioner appealed. Under Iowa law, an affiliated corporation can only join a consolidated return to the extent its income is taxable in Iowa. An out-of-state corporation lacks a sufficient taxing nexus with IA if its only activities amount to owning and controlling a subsidiary corporation and the company has no physical presence in IA. The petitioner claimed that is provision of significant management, administration, strategic planning and financial support to the IA LLCs was sufficient to cause the petitioner to be taxed in IA. On further review, the Iowa Supreme Court affirmed the trial court. The Court noted that the petitioner s distributed earnings that it received were tied to its activities that were exclusively associated with owning and controlling a subsidiary corporation under Iowa Code A and did not amount to doing business in the state or deriving income from sources within the state as defined by Iowa Code (1). In addition, the petitioner s decision to allow the LLCs to make payments on a quarterly basis was insufficient to cause the petitioner to be subject to tax in Iowa. The Court also determined that the petitioner s ownership of stock shares and money did not create a taxable nexus with Iowa. Myria Holdings, Inc. & Subsidiaries v. Iowa Department of Revenue, No , 2017 Iowa Sup. LEXIS 28 (Iowa Sup. Ct. Mar. 24, 2017). 26. Waiver of Sales and Use Tax on Property and Services Required to Repair or Replace Fences in Wildfire Area. Effective March 23, 2017 and continuing through 2018, Kansas sales and use tax 10

15 is waived on the sale of tangible personal property and services purchased during 2017 and 2018 that is necessary to reconstruct, repair or replace any fence used to enclose land devoted to agricultural use that was destroyed by wildfires occurring during 2016 and If the fence in issue also encloses a residence, the exemption may only be utilized for the property devoted to agricultural use the portion of the fence around the residence does not qualify for the exemption. To get the sales tax refund, buyers of fencing material will need a sales receipt or invoice showing the amount of tax paid on purchases and a completed Form ST-3. Under the exemption approach, anyone contracting for reconstruction, repair or replacement must get an exemption certificate from the Kansas Department of Revenue for the particular project. The program also requires parties performing such fence work to provide the certificate number to all suppliers at the time materials are purchased. To get the certificate, Form PR-70FEN will need to be filled-out. The Form can be obtained by calling (785) or ing Kathleen Smith at kathleen.smith@ks.gov. In turn, suppliers must execute invoices with the certificate number. When a project is complete, the contractor must provide the person obtaining the exemption certificate a sworn statement on a form to be provided by the Director of Taxation. The statement must certify that all purchases made are entitled to the exemption. Exempt items include barbed wire, T-posts, concrete mix, post caps, T-post clips, screw hooks, nails, staples, gates, electric fence posts, and electric insulators. Items not qualifying for the exemption or refund include gloves, sandpaper, sand sponges, welding tools, oil for chainsaws, magnetic levelers, ratchet ties and pallets. Also, tools and new, non-agricultural machinery and equipment (e.g., a skid-steer, that is purchased to replace and repair fencing) does not qualify for the exemption. However, machinery and equipment rented or leased to replace, repair or rebuild agricultural fencing is exempt from sales tax. H.B. 2387, signed into law on Mar. 22, K-1 Amounts Must Be Reported Even Though No Distribution Received. The petitioner was an S corporation shareholder along with his brother. Eventually, the petitioner wanted out of the S corporation and ended up in litigation with his brother. Ultimately, the lawsuit was settled and the petitioner transferred his shares to his brother. The S corporation filed a final 1120S for its short tax year and issued a K-1 to the petitioner reporting the petitioner s share of ordinary business income as $451,531. The petitioner filed a return for the same year reporting the $451,531 of pass-through income on Schedule E. However, the petitioner also indicated on line 17 of his Form 1040 Schedule E income of $323,777 and also stated that line 17 was incorrect and would be amended. No amended return was filed and the petitioner didn t pay the amount shown on the return. The IRS assessed the amount indicated on the return and added penalties. In Tax Court, the petitioner claimed that he didn t owe the amount of tax because he didn t receive a distribution. The court disagreed, noting that it was immaterial that the petitioner didn t receive a distribution. Dalton v. Comr., T.C. Memo No Constructive Dividend For S Corporation Shareholder But Basis to Deduct Losses. The petitioner was the sole owner of an S corporation and reported an ordinary business loss of $501,488 in 2007 and a shareholder loan beginning balance of $218,342 and an ending balance of zero was the corporation s final year. During 2007, the S corporation owed its lender almost $2 million. That petitioner guaranteed the loan and during 2007 the lender took some of the S corporation s assets and sold them in partial satisfaction of the debt. After the asset sales, the petitioner still owed $500,000 on the debt. The petitioner reported pass-through losses of $343,939 in 2007 and $107,298 in The petitioner also owned a second S corporation and reported a pass-through loss in 2008 of $187,503. The IRS claimed that the petitioner had received a constructive dividend and could not deduct the losses due to insufficient basis. The court disagreed. The court held that the petitioner had not received a constructive dividend as a result of the discharge of the petitioner s debt owed to 11

16 the corporation. There also was no constructive dividend, the court held, when the petitioner s debt of $218,342 was discharged because the S corporation did not have any earnings and profits. On this point, the court noted that S corporation distributions are not included in the shareholder s income to the extent they don t exceed the shareholder s stock basis. The court also determined that that sale of S corporation assets in partial satisfaction of the S corporation s debt increased the petitioner s basis by $496,000. That meant that the petitioner s basis was sufficient to allow the deduction of the passed-through losses in The court denied the 2008 pass-through losses because 2007 was the final year of the S corporation and the petitioner had no basis. Franklin v. Comr., T.C. Memo Lack of Authority To Practice Law Has No Impact on Settlement with IRS. The petitioners sustained a $435,751 loss on a 2009 real estate sale. The petitioners consulted an attorney (who they did not hire to represent them) who advised the petitioners that they could claim 50 percent of the loss as a deduction. The petitioners stipulated with the IRS as to the 50 percent deduction. But, upon learning that the attorney was not authorized to practice law in the jurisdiction (IL) at the time for failure to pay bar dues, the petitioners claimed that the stipulation was not valid and they should be entitled to a 100 percent loss deduction. The Tax Court ruled for the IRS, upholding the stipulation to a 50 percent loss deduction. On appeal, the appellate court vacated the Tax Court s opinion and remanded the case for a determination of whether the attorney was competent to advise the petitioners. On remand, the Tax Court again upheld the stipulation to a 50 percent loss deduction. The Tax Court noted that the lawyer had never been disciplined or disbarred, but was simply not authorized to practice in IL because, after 2009, he had not paid annual bar dues. The Tax Court noted that the attorney s advice was competent, valuable, diligent and effective assistance. The Tax Court noted that the failure to pay bar dues did not strip the attorney of his years of technical knowledge, training, and experience and was not longer competent to practice law merely because he failed to pay those required dues. The petitioners appealed and the appellate court affirmed. The appellate court cited the maxim of no harm, no foul and the fact that there isn t even any right to counsel in a Tax Court proceeding. Shamrock v. Comr., No , 2017 U.S. App. LEXIS 4423 (7th Cir. Mar. 14, 2017). 30. No Equitable Interest In Home Means No Mortgage Interest Deduction. For tax years , the petitioner lived with his girlfriend in a residence that she had purchased in She financed the purchased with a mortgage and was listed on the deed as the sole owner. She was also the only person responsible on the mortgage. The petitioner claimed a mortgage interest deduction and the IRS disallowed it. The petitioner claimed to have transferred $1,000 in cash to the girlfriend every month to make interest only mortgage payments on the residence. But, he couldn t substantiate the alleged transferred amounts. The girlfriend paid all of the homeowners insurance premiums and property taxes on the residence. There also was no showing that the petitioner could make improvements to the property without her consent or that the petitioner could obtain legal title by paying off the mortgage. The court agreed with the IRS and determined that without her testimony, there was no way to establish that the petitioner held an interest in the property similar to a community property interest under state (NV) law. Jackson v. Comr., T.C. Sum. Op Rodeo Not Tax-Exempt. A member-based organization conducted rodeo events. The organization applied for tax-exempt status under I.R.C. 501(c)(3) and stated that it is organized and operates for the purpose of fostering national or international sports competitions. The participants pay a fee to enter events and compete for prizes. The IRS noted that I.R.C. 501(c)(3) is available for the purpose of fostering amateur sports competition only if no part of the activities involve the provision of 12

17 athletic facilities or equipment. A qualified amateur sports organization must meet the requirements of I.R.C. 501(j)(2) and must be both organized and operated for an exempt purpose. Here, the IRS determined that the organization was a professional rodeo organization and it did not meet both the organizational and operational tests for tax exemption under I.R.C. 501(c)(3). Priv. Ltr. Rul (Nov. 18, 2016). 32. Mixer-Feeder Trucks Are Tax-Exempt Farm Machinery and Equipment. The petitioner operated a cattle feedlot and owned several mixer-feeder trucks to mix feed ingredients in and then haul the feed to the cattle in the feedlot. The trucks were equipped with augers that blended the feed ingredients as well as a hydraulic system that operates the augers. The trucks were capable of a maximum speed of 17 miles/hour while mixing feed and 20 miles/hour when not mixing feed. If the governor were removed, the trucks could reach a speed of 45 miles/hour. The trucks exceeded the legal vehicle width for road use by four inches, and almost always remained within the feedlot with the only exception being when they were taken out for maintenance off-site. Although even in those situations, most of the time they were loaded on trailers and taken off-site. The local county appraiser assessed an escaped property tax penalty on the petitioner for failing to pay tax on the feeder trucks for 2013 and 2014 tax years. The petitioner paid the penalty under protest and filed an appeal with the Board of Tax Appeals (BOTA) claiming that the trucks were exempt from tax as farm machinery and equipment under K.S.A The BOTA determined that the mixer-feeder trucks were tax-exempt as farm machinery and equipment and the county sought reconsideration. The BOTA denied the county s request for reconsideration. The county appealed. On review, the court determined that the BOTA did not err. The mixer-feeder trucks did not meet the definition of truck contained in K.S.A (nn). They were not used to deliver freight or merchandise, nor were they used to transport 10 or more persons. Instead, they were regularly used in a farming operation. In re Reeve Cattle Co., No. 116,005, 2017 Kan. App. LEXIS 25 (Kan. Ct. App. Mar. 17, 2017). 33. IRS Grants Transition Relief for Small Employers. The IRS has extended the period of time a small employer (one with less than 50 full-time employees that does not offer a group health plan to any of its employees) to furnish an initial written notice to its eligible employees regarding a qualified small employer health reimbursement arrangement (QSEHRA). The period is extended until no earlier than 90-days after the IRS issues guidance with respect to the contents of such a notice. Employers that provide written notice earlier can rely on a reasonable good faith interpretation of I.R.C. 9831(d)(4). Under legislation enacted in late 2016, a QSEHRA can be offered to eligible employees of a small employer without the $100/day penalty under Obamacare. But, the employer must furnish a written notice containing specified information to eligible employees at least 90 days before the beginning of a year for which the QSEHRA is provided. However, the legislation said that for a year beginning in 2017, the notice will not be treated as failing to timely furnish the initial written notice if the notice is furnished to its eligible employees no later than 90 days after the date of enactment. That 90-day timeframe expired on March 13, IRS did not publish guidance by March 13 and, thus, extended the timeframe. IRS Notice No Charitable Deduction for Lack of Written Acknowledgement. The petitioner donated his one-half interest in a vintage airplane to a museum. The petitioner didn t claim a charitable contribution on his original returns for the years at issue, but later claimed the deduction on an amended return. The petitioner attached a letter with his amended return that he had received from the museum, but the court determined that the letter was not a contemporaneous written acknowledgement because the letter was not addressed to the petitioner, did not include his taxpayer I.D. number and did not acknowledge the gift or state whether the donee provided any goods or 13

18 services in consideration for the airplane. In addition, the petitioner did not sign the airplane donation agreement and, thus, it couldn t qualify as a written acknowledgement. That agreement also did not contain the petitioner s I.D. number. In addition, the petitioner did not file his amended return until five years after the donation. Also, the donee did not file Form 1098-C on a timely basis resulting in no contemporaneous document that could cure the defects in the donation agreement. Thus, the requirements of I.R.C. 170(f)(12)(B) had not been satisfied. Izen v. Comr., 148 T.C. No. 5 (2017). 35. Dentist is Real Estate Pro for Hobby Loss Purposes. The petitioner was a dentist that worked in a dental practice with his wife. The petitioner also spent many hours on brokerage-related activities and managing the couple s four rental properties. During each year at issue, the petitioner spent over 1,000 hours on the real estate activities and materially participated in those activities by performing substantially all of the participation in the activities in accordance with Treas. Reg T(a)(2). The hours were supported by the petitioner s records and testimony that the court viewed as credible. The court also determined that the petitioner s records also showed that he spent more time on real estate activities than he did on the dental practice. Zarrinnegar v. Comr., T.C. Memo Transaction Did Not Give Rise to Bad Debt Deduction. The petitioner s friend had a business that negotiated reduced interest rates for credit card borrowers having high balances. However, the business needed to establish a merchant account with a bank so it could charge its fees to customers credit cards. Because of the business s poor credit, the business could not obtain a merchant account on its own. Consequently, the petitioner allowed his better credit status to help the friend s business get a merchant account via a partnership established with a third party. Ultimately, the petitioner s girlfriend provided $84,000 to the petitioner with no evidence that the funds were ever received by the friend s business. The petitioner later claimed a business bad debt deduction (ordinary loss), on the basis of lack of evidence ever went to the friend s business and because the transaction appeared to be a gift rather than a loan entered into in a business context. However, the court noted, in dicta, that even if a business transaction were established, the petitioner was not in the business of lending money to allow ordinary loss treatment. Scheurer v. Comr., T.C. Memo Financial Services Company s Incorrect Rollover of IRA Triggers Tax To Surviving Spouse. Upon the death of an IRA owner, a financial services company (Wachovia) rolled the IRA into an IRA of the decedent s surviving spouse rather than having it paid to his estate. The surviving spouse then distributed funds from the IRA to her stepson. The court held that the IRA distribution rules triggered tax to the surviving spouse on the funds distributed from the IRA even though the funds were derived from the IRA rolled-over from the predeceased spouse. The court refused to unwind the transaction. The surviving spouse was also triggered the additional 10 percent penalty tax of I.R.C. 72(t) as an early distribution. Ozimkoski v. Comr., T.C. Memo Material Participation of Trust Measured under Mattie K. Carter Trust Standard. In a nonbinding, informal opinion, the Iowa Department of Revenue (IDOR) stated that if a trust is the taxpayer, then material participation for purposes of the Iowa capital gain deduction is to be measured at the trust level under the standard set forth in Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003). In that case, the court determined that the material participation test for passive loss purposes is determined by reference to the persons who conducted business on the trust s behalf. However, in pending litigation in another case involving the same issue, the IDOR took the position in a reply brief that, to the extent Taxpayers argue Mattie K. Carter Trust v. United 14

19 States...support the position that a trust may claim the Iowa net capital gain deduction, such argument must be rejected. Federal law may not dictate which categories of taxpayers are entitled to a deduction under Iowa law." The IDOR failed to inform the administrative law judge of the policy letter in which it took the exact opposite position. Iowa Dept. of Rev. Policy Ltr (Oct. 28, 2016). 39. No Deduction for Losses from Rental Real Estate Activity. The petitioner owned and operated an insurance company through which he sold insurance policies. He was paid for 520 hours of work in 2011 and 173 hours in He employed three people in the insurance business. The petitioner also performed personal services for 10 single-home rental real estate properties in 2011 and 11 rental properties in No management company was involved, the petitioner performed numerous personal services himself. The petitioner s logs showed 951 hours in 2011 and 1,040 hours in 2012, with much of the time being travel time. Some of the hours were likely attributable to the petitioner s wife, and the logs provided generalized and abbreviated descriptions of the work the petitioner performed. On his return for 2011 and 2012, the petitioner showed net losses on the rental properties, and about 20,000 business driving miles for the insurance business in those same years. The IRS denied the rental real estate losses for failure to satisfy the requirements of I.R.C. 469(c)(7). The court upheld the IRS determination on the basis that the petitioner did not present evidence of total time spent performing services in the insurance company during the years in issue. Thus, the court couldn t determine whether the petitioner put more time in the rental activities than in the insurance activity. Jones v. Comr., T.C. Sum. Op Once Taxes Are Paid, City Must Pay Tax Rebate to Manufacturer. In 2008, the defendant entered into an agreement with the plaintiff under which the plaintiff would expand its business in the defendant s city if the defendant would rebate a portion of the plaintiff s taxes each year for eight years. The defendant paid the rebates for three years, but hen then stopped paying them and cancelled the agreement. The trial court held the defendant in breach and awarded the plaintiff $494, in damages. On appeal, the appellate court noted that tax increment financing agreements are authorized by state (IA) law under Iowa Code with the stated purpose of encouraging economic development. Under the agreement, the defendant agreed to rebate the plaintiff over eight years the incremental property taxes paid with respect to improvements that the plaintiff made in the defendant s city. After the plaintiff paid its taxes for a particular year, the defendant would rebate a portion of the taxes for that year. The rebate amount would get included in the defendant s budget and then be paid. The defendant stopped paying the rebate on the basis that the plaintiff failed to meet its obligations under the agreement. The trial court awarded damages for tax rebates that the defendant had obligated for appropriation but did not pay. The defendant claimed that the rebates were subject to annual appropriation of the City Council and that any rebate was no appropriated until the moment it was paid. Thus, the defendant claimed it could decide not to pay the rebates obligation for appropriation up until the time they were paid. The court rejected that rationale and held that once the plaintiff paid its taxes for any given year, the contract required the payment of the rebate for that year within 30 days. Thus, the defendant breached the agreement upon declining to pay rebates that it had obligated for appropriation in fiscal years 2013 and 2014 after the plaintiff had paid its taxes for those years. Acciona Windpower North America, LLC v. City of West Branch, No , 2017 U.S. App. LEXIS 2148 (8th Cir. Feb. 7, 2017). 41. No Economic Hardship Exception From Early Withdrawal Penalty. The petitioner and his wife withdrew funds from their IRA before reaching age They did so to cover ordinary family living expenses in a year in which they were partly unemployed and had lower income. They reported the 15

20 withdrawn amounts as income, but did not pay the additional 10 percent penalty tax. The court noted that there is no exception from the early withdrawal penalty for hardship distributions under I.R.C. 72(t). Cheves v. Comr., T.C. Memo IRS Notice of Deficiency Was Unclear, But Good Enough To Give Tax Court Jurisdiction. The Tax Court, sitting en banc, upheld an IRS statutory notice of deficiency (SNOD) even though the SNOD was ambiguous with respect to the amount. The taxpayer claimed the premium assistance tax credit, a refundable credit contained in I.R.C. 36B. The SNOD stated that the petitioner was not entitled to the credit, but then showed a deficiency of zero on page one. A majority of the judges ruled that the only thing a SNOD needs to do to be valid is fairly advise the taxpayer of a deficiency for a particular year and specify the amount. The court said the analysis to determine validity of a SNOD first looks for the required material for facial validity and if it has the required information, it is valid. If the SNOD is not facially valid, then the question is whether the taxpayer either knew or should have known that the IRS was asserting a deficiency. Here, the court determined that the SNOD was ambiguous. Because the SNOD stated that the IRS was disallowing a refundable credit which triggered the deficiency, and a subsequent page of the SNOD stated the amount, the taxpayer was on notice. Thus, the Tax Court had jurisdiction. Dees v. Comr., 148 T.C. No. 1 (2017). 43. Penalty Tied to Reportable Transaction is Not Unconstitutional. The petitioners, a married couple, participated in a distressed asset tax shelter. They contested the penalties imposed under I.R.C. 6662A(c) as unconstitutional under the Eighth Amendment as an excessive fine. The penalty under that Code section is set at 30 percent when the taxpayer fails to disclose what the IRS defines as a reportable transaction. However, the penalty is avoidable if the taxpayer discloses the transaction and has reasonable cause and good faith for the position taken on the return. The court noted that the fine, to be constitutional, must bear some relationship to the gravity of the offense that it is designed to punish. In addition, the court noted that the 30% fine only applies to transactions that the IRS has determined are abusive or have a significant purpose of avoiding or evading tax. As a result, the court determined that the penalty was proportional to the harm that participating in such a listed transaction could impose on the government. Thompson v. Comr., 148 T.C. No. 3 (2017). 44. Legal Fees Are Miscellaneous Itemized Deduction. The petitioner was paid a bonus in mid-2010 and reported it as wage income on the 2010 return. About two months after receiving the bonus, also in 2010, the employer terminated the petitioner, filed a complaint against her and attempted to recover the bonus. The petitioner filed an employment discrimination counterclaim, and in 2011 the parties entered into a settlement agreement and mutual release effective May 17, Under the agreement, neither party owed anything and released all claims against each other. The petitioner incurred $25,000 in legal expenses in 2010 and $55,798 in legal expenses in 2011, and the petitioner reported it as negative other income for those years. The IRS disallowed the amounts as negative other income but allowed them as miscellaneous itemized deductions subject to the limitations in I.R.C. 67(a). That limitation had the effect of reducing the deductions to $4,525 in 2010 and $50,579 in After noting that the burden of proof did not shift to the IRS, the court noted that none of the amount included in income was a result of an unlawful discrimination claim. In addition, the legal fees were associated with her employment and not her personal business. Thus, they were itemized deductions and not ordinary and necessary business expenses. Sas v. Comr., T.C. Sum. Op No Passthrough Loss Deduction From Defunct S Corporation. The petitioner owned an S corporation and an LLC. The S corporation allegedly made a payment for salary and wages. However, the S corporation did not conduct any trade or business in the year the deduction was claimed, and was not in existence. In any event, the court noted that the deduction would have been disallowed anyway because the payment was actually made by the LLC to the trust account of the 16

21 lawyer of the petitioner, and then were paid to the IRS. The S corporation was not involved in the payment stream. In addition, the court determined that the payment appeared to be on account of the taxpayers individual trust fund tax recovery penalty liabilities. As such, the payments would not have been deductible under I.R.C. 162(f). Brown v. Comr., T.C. Memo Changes to Separation Agreement Wiped Out Alimony Deduction. The petitioner and his spouse executed a separation agreement that was poorly drafted and contained inconsistencies. It characterized payments the petitioner made under the agreement to the deductible alimony, but also referred to child support payments that the petitioner needed to make. The agreement also stated that the petitioner and spouse agreed to designated all payments to be paid to the spouse as excludable and non-deductible payments. The IRS asserted that the payments were designated as child support and were non-deductible. The petitioner claimed that one portion of the agreement provided for unallocated support payments as opposed to alimony or child support payments. The Tax Court determined that the intent of the parties didn t matter and that the result was based on the interpretation of the settlement agreement. On that point, the court noted that I.R.C. 71(b)(1)(B) requires that the settlement agreement not state that the payment is neither includible in gross income nor allowable as a deduction. As a whole, the various exhibits had to be read in tandem and that the unallocated support payments are subject to the entire agreement. Accordingly, the provision that the unallocated support payments are excludible from income and not allowable as deductions violated I.R.C. 71(b)(1)(B). Quintal v. Comr., T.C. Sum. Op California Franchise Tax Does Not Apply to Out-Of-State Corporation. The plaintiff is an Iowa corporation operated farmland in Kansas where it fed cattle for sale in Nebraska. The plaintiff had no physical presence in California no physical plant, no employees no real estate and no personal property. The plaintiff does not sell or market products or services in or to CA and is not registered with the CA Secretary of State to transact interstate business. The only connection that the plaintiff had with CA was that, in 2007, it invested in a CA manager-managed LLC and became a member. The plaintiff s investment was a 0.2 percent ownership interest. The LLC later elected to be taxed as a partnership under federal and CA law. The CA Franchise Tax Board (FTB) determined that the plaintiff was required to file a CA corporate franchise tax return and pay the $800 minimum franchise tax. The plaintiff paid the tax (along with penalties and interest), but then contested it and sought a refund. The plaintiff challenged the FTB s position based on constitutional due process and commerce clause grounds. The FTB denied the plaintiff s request for refund. The plaintiff appealed and the trial court granted the plaintiff s motion for summary judgment and awarded the refund. On appeal, the appellate court affirmed. The court noted that the plaintiff was a passive investor in the LLC and had no ability to participate in the management of the LLC and the business activities of the partnership cannot be attributed to a limited partner such as the plaintiff. Swart Enterprises, Inc. v. Franchise Tax Board, No. F070922, 2017 Cal. App. LEXIS 21 (Cal. Ct. App. Jan. 12, 2017). 48. IRS Says No AMT Depreciation Adjustment For Property Elected Out of Bonus. The IRS has stated that the instructions for the 2016 tax forms (Form 6251 and For 4626 and Form 1041, Schedule I) that relate to the Alternative Minimum Tax (AMT) will be amended to explain that property for which an election out of bonus depreciation is made will not be subject to an AMT depreciation adjustment. The clarification applies to property placed in service after Section 143 of the 2015 extender bill (P.L , Dec. 18, 205). stated that the AMT adjustment does not apply to qualified property as defined by I.R.C. 168(k)(2). But, if the election out is made for a class of property, then I.R.C. 168(k)(7) specifies that bonus depreciation does not apply. Thus, the status of property for which an election out remained qualified property under I.R.C. 168(k)(2) and the AMT adjustment applied. Before the change in the law, the AMT adjustment was waived only for property for which bonus depreciation was claimed. IRS has said that it will be issuing a Rev. Proc. to explain the rule change. IRS Announcement, Jan. 19,

22 49. Entry Into USPS Tracking System Is Not a Postmark. The petitioner sought a redetermination from the Tax Court that his petition was delivered to the court on the 98th day - 8 days beyond the 90-day deadline of I.R.C. 7502(a)(1) and the corresponding regulation (Treas. Reg (c)(1)(iii)(B)(1)). Normally, the petition is considered to have been filed at the time of mailing. The petition's envelope included a "postmark" by Stamps.com on the 90th day. However, the envelope also had a certified mail label with a tracking number and tracking data of the U.S. Postal Service (USPS) showed that the USPS received the envelope on the 92nd day. The court ignored the Stamps.com "postmark" and held that the petition had not been timely filed. On appeal, the Circuit Court reversed. The appellate court noted that the parties agreed on the facts that determined jurisdiction, and the Tax Court had no sound reason to doubt that the envelope was actually handed to the USPS on the 90th day. IRS had also acknowledged that certified mail sometimes takes eight days to reach the Tax Court. The court determined that the Tax Court was mistaken that Treas. Reg (c)(1)(iii) specifies the result if an envelope has both a private postmark and a USPS postmark. The petitioner s envelope had just one postmark. The regulation at issue does not address whether a date that is not a postmark is the same as a postmark. The regulation only addresses the issue if there are competing postmarks. The appellate court also noted that entry into the USPS tracking system does not indicate when IRS receives an envelope. The appellate court reversed the Tax Court decision and remanded the case for a decision on the merits. Tilden v. Comr., No , 2017 U.S. App. LEXIS 697 (7th Cir. Jan. 13, 2017), T.C. Memo Payments Made Under Employer s Fixed Indemnity Health Plan Not Excludible For Employee. An employer provided all employees with the chance to enroll in coverage under a fixed indemnity health plan that would qualify as an accident and health plan under I.R.C The employees pay premiums for the plan by deducting the amount of the premium each pay period from the employee s salary. The deducted amount is included in gross income and is treated as wages for tax purposes. The fixed indemnity plan pays employees $100 for each medical office visit and $200 for each day in the hospital without regard to the amount of medical expenses otherwise incurred by the employee. Another factual situation stated that the employer provided the coverage to the employees at no cost to the employee. Still another factual situation specified that employees participating in the health indemnity plan pay premiums via a salary reduction through an I.R.C. 125 plan. As for the first situation, the IRS determined that the amounts paid by the plan are excluded from gross income and wages under I.R.C. 104(a)(3). As for the fixed premium amounts, because those are paid with amounts not included in the employee s gross income and wages, they are not excluded from income and wages irrespective of any medical expenses the employee incurs. For the situation where the premiums are paid with amounts that are not included in the employee s gross income and wages, those amounts are also included income and wages. C.C.A (Dec. 12, 2016). 51. Donated Tract Made With Donative Intent. The petitioners, a married couple, gave a fee-simple interest in a 20-acre tract of undeveloped land to the Heritage Conservancy in Pennsylvania. They also donated a conservation easement on a separate 25-acre tract containing their homestead to the township in which the tract was located. They claimed a charitable deduction of $2.35 million for the donation of each tract, spread out over five years. The IRS completely disallowed all deductions for all years associated with the gifts on the basis that the gifts were part of a quid pro quo exchange rather than being an outright gift with no strings attached. The court disagreed with the IRS, and noted that on the valuation issue, the petitioners had relied in good faith on appraisals from a statecertified appraiser who valued the tracts at their highest and best use as residential development property. The court determined that the gift of the fee simple tract could not be clawed back and was not conditioned on the Heritage Conservancy returning any type of benefit to the petitioners. 18

23 The court also disagreed with the contention of the IRS that the petitioners had failed to satisfy reporting requirements. However, the court reduced the total allowed deduction to $3,654,792, but did not hold the petitioners liable for penalties. McGrady v. Comr., T.C. Memo Interest in LLC Is Passive and Not Grouped With Active Business. The petitioner is a plastic surgeon that purchased a 12 percent interest in an LLC that operated a facility in which the plaintiff could conduct surgeries when necessary. The petitioner also conducts surgeries in his own office separate from the LLC facility. The petitioner also owned a separate company run by his wife for his surgical practice. The petitioner is a passive investor in the LLC, but his accountant reported his earnings from his surgical practice business run by his wife and the LLC as subject to selfemployment tax based on the K-1. The accountant, in a later year, reported the petitioner s interest in his surgical practice business as active, the interest in the LLC as passive. This allowed the petitioner to deduct passive losses, including passive losses carried forward from years for which the petitioner reported all of his interests as active. But, the carried forward losses are not allowed, the court determined, because had they been reported in prior years as passive, when carried forward the losses would have absorbed the petitioner s taxable income from that particular source. The petitioner could not utilize equitable recoupment because the petitioner only raised the issue posttrial. The IRS claimed that the petitioner had grouped his interest in his surgical practice and the LLC, making both interests active. However, the petitioner s accountant asserted that no grouping election had been made. The court did not allow the IRS to group the two activities together based on the weight of the evidence that supported treating the two activities as separate economic units. The petitioner did not have any management responsibilities in the LLC, did not share building space, employees, billing functions or accounting services with the LLC. In addition, the petitioner s income from the LLC was not linked to his medical practice. Hardy v. Comr., T.C. Memo Capitalization Required For Interest and Real Property Taxes Associated with Crops Having More Than Two-Year Preproductive Period. The petitioner (three partnerships) bought land that they planned to use for growing almonds. They financed the purchase by borrowing money and paying interest on the debt. They then began planting almond trees. They deducted the interest and property taxes on their returns. The IRS objected to the deduction on the basis that the interest and taxes were indirect costs of the production of real property (i.e., the almonds trees that were growing on the land. The Tax Court agreed with the IRS noting that I.R.C. 263A requires the capitalization of certain costs and that those costs include the interest paid to buy the land and the property taxes paid on the land attributable to growing crops and plants where the preproductive period of the crop or plant exceeds two years. I.R.C. 263A(f)(1) states that interest is capitalized where (1) the interest is paid during the production period and (2) the interest is allocable to real property that the taxpayer produced and that has a long useful life, an estimated production period exceeding two years, or an estimated production period exceeding one year and a cost exceeding $1 million. The corresponding regulation, the court noted, requires that the interest be capitalized under the avoided cost method. The court also noted that the definition of real property produced by the taxpayer for the taxpayer s use in a trade or business or in an activity conducted for profit included land and unsevered natural products of the land and that unsevered natural products of the land general includes growing crops and plants where the preproductive period of the crop or plant exceeds two years. Because almond trees have a preproductive period exceeding two years in accordance with IRS Notice , and because the land was necessarily intertwined with the growing of the almond trees, the interest and tax cost of the land is a necessary and indispensable part of the growing of the almond trees and must be capitalized. Wasco Real Properties I, LLC, et al. v. Comr., T.C. Memo

24 54. No Recapture of Prepaid Expenses Deducted in Prior Year When Surviving Spouse Claims Same Deduction in Later Year. The decedent, a materially participating Nebraska farmer, bought farm inputs in 2010 and deducted their cost on his 2010 Schedule F. He died in the spring of 2011 before using the inputs to put the spring 2011 crop in the ground. Upon his death, the inputs were included in the decedent s estate at their purchase price value and then passed to a testamentary trust for the benefit of his wife. The surviving spouse took over the farming operation, and in the spring of 2011, took a distribution of the inputs from the trust to plant the 2011 crops. For 2011, two Schedule Fs were filed. A Schedule F was filed for the decedent to report the crop sales deferred to 2011, and a Schedule F was filed for the wife to report the crops sold by her in 2011 and claim the expenses of producing the crop which included the amount of the inputs (at their date-of-death value which equaled their purchase price) that had been previously deducted as prepaid inputs by the husband on the couple s joint 2010 return. The IRS denied the deduction on the basis that the farming expense deduction by the surviving spouse was inconsistent with the deduction for prepaid inputs taken in the prior year by the decedent and, as a result, the tax benefit rule applied. The court disagreed, noting that the basis step-up rule of I.R.C allowed the deduction by the surviving spouse which was not inconsistent with the deduction for the same inputs in her deceased husband s separate farming business. The court also noted that inherited property is not recognized as income by the recipient, which meant that another requisite for application of the tax benefit rule did not apply. Estate of Backemeyer v. Comr., 147 T.C. No. 17 (2016). 55. Surviving Spouse Can Deduct Farm Input Cost Deducted by Deceased Spouse in Earlier Year as Pre-Paid Input. The husband was a sole proprietor farmer who purchased crop inputs (herbicides, seeds, fertilizer and lime, fuel, etc.) worth over $200,000 in the fall of 2010 that he planned to use in connection with planting the spring 2011 crops. However, the husband died on March 13, 2011, before using any of the inputs. The inputs were listed in his estate s inventory with their value pegged to their purchase price. Shortly before he died, he sold his 2010 crop in January of 2011 and that income was reported on line 3b of his 2011 Schedule F. His estate did not include any interest in any stored grain. The farm inputs passed to a family trust that named his surviving wife as the trustee. The wife ran the farming operation after her husband s death and took an in-kind distribution of the farm inputs from the trust which she used to grow corn and soybeans in She sold a portion of the crops grown in 2011 later that fall and reported those sale proceeds ($301,000) on line 3b of her 2011 Schedule F. She sold the balance of the 2011 crops in 2012, a year that she filed as a single taxpayer. The couple filed a joint return for 2010 on which they claimed over $230,000 as pre-paid expenses. On the joint 2011 return, which included two Schedule Fs, the wife s Schedule F claimed as expenses the exact same amount that had been claimed as pre-paid expenses on the husband s 2010 Schedule F. The IRS rejected the deduction on the wife s 2011 Schedule F, thereby increasing taxable income by $235,693 and resulting in a tax deficiency of $78,387. The IRS explained its reason for denying the deduction was because the petitioners use the cash method for [their] farming activity, prepaid expenses that were paid in 2010 are deductible in 2010, and are not added to basis. According to the IRS, the taxpayers were getting a double deduction which they were not entitled to, and if the court were to allow the deduction on the wife s 2011 Schedule F, then that same amount should be included in the husband s 2011 Schedule F. If that didn t happen, the IRS claimed, a material distortion of income would result. The IRS also claimed that the surviving wife was not entitled to a step-up in basis under I.R.C in the inherited farm inputs. The IRS also tacked on an accuracy-related penalty under I.R.C. 6662(a) of $15,

25 In its reply brief, the IRS jettisoned all of those arguments and claimed that the tax benefit rule controlled the outcome of the case. Thus, the surviving spouse properly deducted the inputs on her 2011 return because she had received the inputs with a stepped-up basis and proceeded to use them in her farming business. But, IRS claimed, the tax benefit rule required the inclusion in the husband s 2011 return of the amount of the prepaid input expense that had previously been deducted in The IRS claimed that Bliss Dairy, Inc. v. Comr., 460 U.S. 370 (1983) required that outcome. In that case, a cash method corporate dairy deducted the purchase cost of cattle feed. Early in the next year, the corporation liquidated while there was a significant amount of feed remaining on hand. The corporation distributed its assets to its shareholders in a nontaxable transaction. The shareholders continued to operate the dairy and deducted their basis in the feed as an expense of doing business. The U.S. Supreme Court said that the tax benefit rule applied because the liquidation of the corporation changed the cattle feed to being used in a non-business use which was now inconsistent with the earlier deduction. The IRS said the facts of the current case were the same and should produce the same result. The IRS claimed that because the husband died before using the inputs in his farming business, the inputs were converted to a non-business use at the time they were transferred to the trust. Then, upon distribution to the wife for use in her farming business, the inputs were converted back to business use which entitled her to deduct their cost, but also required the husband s return to recognize income because he converted the inputs from one use to another by dying unexpectedly at the wrong time. The Tax Court didn t buy the IRS argument. In Frederick v. Comr., 101 T.C. 35 (1993), the Tax Court laid out a four-factor test for application of the tax benefit rule: (1) a deduction was taken in the prior year; (2) the deduction resulted in a tax benefit; (3) an event occurred in the current year that is inconsistent with the premises on which the deduction was originally based; and (4) a nonrecognition provision of the Code does not prevent inclusion in gross income. While the first two factors were satisfied, the Tax Court determined that factors (3) and (4) were not. As to factor (3), the court noted that neither the husband s death nor the distribution of the inputs to his wife for use in her farming business were inconsistent with the deduction on his 2010 return. The Tax Court noted that had the wife inherited the inputs in 2010 and used them in 2010, the initial deduction would not have been recaptured for income tax purposes because of the estate tax. They were subject to the estate tax on their purchase price, which was the same basis for the income tax deduction. Thus, application of the tax benefit rule would result in double taxation of the value of the inputs. Factor (4) had also not been satisfied. Upon the husband s death, the basis step-up rule applied. Also, the gross income of the recipient of an asset does not include the value of the inherited assets. Upon disposition by the heir, the heir has taxable gain only to the extent the proceeds exceed the stepped-up basis. Also, upon death, depreciation recapture is not triggered under either I.R.C or I.R.C Those rules are a partial codification of the tax benefit rule and don t apply at death. Thus, the tax benefit rule did not apply and require the inclusion in the husband s 2011 Schedule F of the amount that had been deducted for the pre-paid inputs that were claimed on the 2010 Schedule F. In addition, the court also removed the accuracy-related penalty. Estate of Backemeyer v. Comr., 147 T.C. No. 17 (2016). 56. Deduction for Kid Wages Disallowed. The petitioner hired his 10-year old stepson to perform tasks associated with the petitioner s network marketing business. He paid the stepson $6,315 as cash wages for the tax year in issue and deducted the amount on Schedule C as labor expense. The stepson performed such tasks as taking out the trash, cleaning the pool, and setting up chairs, among other 21

26 things. The court did not believe that the records use to substantiate the cash wages had been prepared contemporaneously and, because they were in cash, had doubts as to whether they had actually been paid. The court also questioned whether the amount of the cash wages was reasonable in light of the petitioner s age and skills, and whether the work was ordinary and necessary in relation to the petitioner s business. In addition, the petitioner did not issue a Form 1099-Misc or W-2. The court also disallowed a home office deduction on the basis that the petitioner did not show that the claimed home office space was used regularly and exclusively for his business. Alexander v. Comr., T.C. Memo No Deduction for Permanent Conservation Easement and Accuracy-Reated Penalty Applied. The petitioners, a married couple, donated a permanent façade easement to a qualified trust. A side letter from the trust stated that the easement would be refunded to the petitioners if the deduction was later disallowed. The court ruled that the letter created a subsequent event that could make the easement unenforceable. Thus, the donated easement was a non-deductible conditional gift. The IRS levied a 40-percent gross valuation misstatement penalty and a 20 percent accuracy-related penalty coupled with a computation of zero which barred the penalties from stacking improperly. The court held that the 20 percent penalty was not imposed improperly because the notice clearly informed the petitioners that the 20 percent penalty was an alternative penalty that would only be imposed if the 40 percent penalty were not imposed. The petitioners were not able to show good faith reliance on a tax professional because they didn t inform their CPA of the side letter from the trust, and they did not have substantial authority for their position. Graev v. Comr., 147 T.C. No. 16 (2016). 58. Recourse Debt Not Deductible Until Year of Foreclosure Sale. The petitioner's S corporation claimed a net operating loss (NOL) as a result of writing down real estate holdings due to the collapse of the real estate market. The petitioner claimed that the properties had been abandoned in that same year or had become worthless. The IRS disallowed the NOL and the Tax Court agreed. The petitioner never abandoned the properties and a loss on account of worthlessness of property that is mortgaged, the court noted, means worthless of the petitioner's equity in accordance with I.R.C. Sec The court noted that, with respect to recourse debt, the petitioner could not claim any loss deduction until the year in which a foreclosure sale occurs. Thus, the petitioner was not entitled to any deduction until some point in the future. On appeal, the appellate court affirmed. The appellate court determined that the record did not indicate that any of the properties of the petitioner s corporation had been abandoned and the Tax Court s finding as such was not clearly erroneous. The corporation still had the intent to develop and sell the properties it owned. The corporation s properties still had mortgage debt reduction value. Tucker v. Comr., No , 2016 U.S. App. LEXIS (11 th Cir. Nov. 21, 2016), aff g., T.C. Memo Exchange With Subsidiary Was Not a Qualified Deferred Exchange. The petitioner was a real estate leasing company that attempted to structure a deferred exchange with its subsidiary in an attempt to avoid the application of the I.R.C. 1031(f) related party rules. The transaction was conducted by using a party related to the petitioner that retained the cash proceeds. That had the effect of making irrelevant the use of the qualified intermediary. It also didn t matter that the taxpayer claimed it did not have a prearranged plan and claimed to have sought a replacement property that an unrelated party held and only used its subsidiary when the deadline to complete the deferred exchange was upon it. The court also found it immaterial that the petitioner acquired the replacement property from a related person only after it had already engaged a qualified intermediary. The court viewed that as functionally equivalent to the acquisition of replacement property from a related person before the hiring of a qualified intermediary. The court also determined that the petitioner did not show that avoidance of federal income tax was not one of the principal purposes 22

27 of the exchange. The court also noted that a cashing-out feature of the exchange was apparent. As a result of the transaction, the petitioner and its subsidiary were able to cash out of the investment practically tax-free because the subsidiary could offset the recognized gain with its net operating losses. This allowed the petitioner and the subsidiary (as a whole) to avoid tax without basis shifting. The Malulani Group, Limited and Subsidiary, T.C. Memo Special Real Property Ag Valuation Inapplicable. The county assessed real estate tax on two properties that the plaintiff owned. The tracts total approximately 40 acres with eight of the acres leased to a tenant for hay production and two of the acres leased for the raising of apples. The plaintiff also owned other properties adjacent to the two tracts at issue. The tracts are owned by the plaintiff s single-member LLC. The LLC submitted an application for the two tracts to be classified under the state (MN) Green Acres statute (Minn. Stat ) which would tax the properties at a lower rate applicable to agricultural properties that are owned by individuals. The county denied the application and the state tax court affirmed on the basis that the tracts were not owned individually, but by a single-member LLC. The plaintiff appealed and the MN Supreme Court affirmed. The court noted that the statute applies to parcels owned by individuals except for a family farm entity or authorized farm entity or an entity where a majority of the ownership interests are held by related persons (or at least one of the owners resides on the tract or actively operates the land. The statute also can potentially apply to corporations that derive 80 percent or more of their gross receipts from the wholesale or retail sale of horticultural or nursery stock. The court held that the phrase owned by individuals did not encompass tracts owned by a single-member LLC, but was limited to tracts owned by a natural person or the entities specifically listed in the statute. Further, the court reasoned, because MN law only allows a disregarded entity status only with respect to specific sections of the MN Code which do not include the Green Acres statute. Because the plaintiff did not live on the subject tracts, the Green Acres statutory valuation did not apply. Strib IV, LLC v. Hennepin County, No. A , 2016 Minn. LEXIS 714 (Minn. Sup. Ct. Nov. 9, 2016). 61. For Grant Purposes, Tax Basis in Wind Facility Tied to Purchase Price. The plaintiffs own six wind generation facilities near Los Angeles, CA, and claimed that the federal government underpaid them by over $206 million via a grant under Sec of the American Recovery and Reinvestment Act of 2009 (ARRA). ARRA is known as the 2009 stimulus bill. Sec authorized renewable energy cash grants to owners of renewable energy facilities equal to 30 percent of the basis of specified energy property. The plaintiffs sold five of the facilities in sale-leaseback transactions and one in an outright sale. All of the sales were to unrelated parties. The plaintiff sought grants, but the government challenged the plaintiffs basis determinations and reduced the Sec grants accordingly. The government argued, under the cost segregation theory, that more tax basis should have been allocated to intangible property (ineligible for Sec grants), the investment tax credit and 5-year MACRS depreciation. The government also argued that peculiar circumstances existed in the sales transactions that required the basis to be less than the nominal purchase price. The court rejected the government s arguments. The court determined that no goodwill or going concern value could attach to the wind generation facilities because the facilities had not yet begun selling power under power purchase agreements. While the location of the facilities added to their value, the court held that the added value was part of the basis of the tangible assets rather than a separate intangible asset, citing Tech Adv. Memo (Apr. 30, 1993) and its conclusion that no part of a satellite transponder s purchase price was associated with an intangible asset. The court also opined that turnkey value is the value of a facility valued at the time it is ready for immediate use after purchase. That value, the court determined, is part of the property s basis and is not a separate intangible asset citing Tech. Adv. Memo (Nov. 10, 2008) and the caselaw referenced therein. The court also concluded that because each power purchase agreement was specified to a specific facility and noted that each agreement could not be assigned or transferred. 23

28 Thus, the value of the power purchase agreement was part of the basis of the tangible assets involved and was not a separate intangible asset. The court also determined that the purchase price allocation of the plaintiffs was reasonable insomuch that it allocated costs consistent with the majority of cost segregation studies which allocated indirect costs among the assets on a pro rata basis in accordance with the direct costs of both eligible and ineligible property. Also, the court determined that no peculiar circumstances existed that would require anything other than the purchase price to be used for computing basis. The court noted that the government failed to present evidence that the saleleaseback transactions had been adjusted to inflate the purchase price as the government had claimed via pre-payments of rent. Relatedly, the court held that the Sec grant indemnities (seller agrees to indemnify buyer for shortfalls of the Sec grant) did not alter the purchase price as basis determination. The court also disqualified the government s expert witness on the basis that he lied about his credentials by failing to disclose articles that he wrote for Marxist and East German publications and that he had been an editorial board member and a contributing editor to a publication of Marxist though and analysis that touted itself as the longest continuously published Journal of Marxist scholarship in the world, in any language. Alta Wind I Owner-Lessor C v. United States, No T, 2016 U.S. Claims LEXIS 1593 (Fed. Cl. Oct. 24, 2016). 62. Subscription Packages Weren t Qualified Film For DPAD Purposes. The taxpayer was a multichannel video programmer distributor and a question arose as to whether such subscription packages qualified for the domestic production activities deduction (DPAD) of I.R.C. 199 under I.R.C. 199(c)(6) or Treas. Reg (k)(1). The IRS determined that the packages didn t qualify for the DPAD under those provisions, because they didn t qualify as property under I.R.C. 168(f)(3) or Treas. Reg (k)(1), but that a portion of the taxpayer s gross receipts from the subscription packages could qualify as DPGR under I.R.C. 199(c)(4)(A)(i)(III) and Treas. Reg (k) to the extent the receipts were derived from individual film included in packages that was qualified film, and where each film that the taxpayer produced is considered to be an item under Treas. Reg (d)(1)(ii). Tech. Adv. Memo (Aug. 5, 2016). 63. Casualty Loss To Farmland From Tornado For One Tract But Not the Other. The petitioners, a married couple, sustained damage to two separate tracts of land. One tract contained the couple s residence and barns and the husband testified as to the value of the property before it was damaged by a tornado and the value after the tornado. The court viewed the husband s testimony to be credible, and allowed a deduction for a casualty loss after making adjustments for the tract s income tax basis and the net amount of reimbursement that the couple received from insurance for the loss. As to a second tract, however, the court upheld the IRS determination of no deductible loss because the pre-tornado value was based on the value of the property as undeveloped woodland and the posttornado value was based on the tract being grazing land. Also, as to the second tract, the court held that the petitioners failed to establish their basis in the tract. While the husband claimed that he purchased the second tract from his mother, he could not establish the purchase price or when he purchased the tract from her. Coates v. Comr., T.C. Memo Improper Retained Right in Easement Deed Ruins Multi-Million Dollar Deduction. The plaintiff donated a permanent easement on a building to a qualified charity and claimed a $4 million charitable deduction. Under I.R.C. 170(h)(4)(B) the donated interest must include a restriction that preserves the entire exterior of the building (including the front, sides, rear, and height of the building), and bar any change in the exterior of the building which is inconsistent with the historical character of the exterior. The easement deed contained language that allowed the plaintiff to conduct additional construction on the donated building if the donee approved. The donor wanted to add two or three floors to the roof of the building and possibly extend the ground floor. The IRS asserted that this reserved right permitted changes to the building exterior and denied the entire deduction. The court agreed with the IRS noting that I.R.C. 170(h)(4)(B)(i)(l) requires that the contributed property 24

29 must be exclusively for conservation purposes and must include a restriction which preserves the entire exterior of the building (including the front, sides, rear and height of the building). The court noted that there is no qualification of this language and does not allow for a restriction that could allow construction above the roof or new construction that does not extend vertically beyond the highest point of the building. The entire exterior of the building must be preserved. The plaintiff argued that the retained right did not impact the front, sides, rear and height of the building, but the court noted that the word including did not limit the exterior solely to those features. Partita Partners, LLC, et al. v. United States, No. 1:15-cv-02561, 2016 U.S. Dist. LEXIS (S.D. N.Y. Oct. 25, 2016). 65. Taxpayer Was Not Away From Home and Couldn t Deduct Travel Expenses. The petitioner and his family lived north of Sacramento and he worked alternate weeks in areas just north of Los Angeles, some 440 miles away. On his off-weeks, the petitioner traveled home to be with his family. While his employer reimbursed him for his hotels stays during his work weeks, it did not reimburse mileage or meals and other incidental costs incurred during his work weeks. The petitioner deducted the mileage he incurred from his residence to the hotel he stayed at while working, and the meal and incidental costs for the days he was working. The IRS disallowed the deductions because he was not temporarily away from home due to the employment situation exceeding a year. Thus, his tax home became his place of business and he was not away from home when he paid expenses for meals, incidentals and automobile trips between his hotel and worksites. Thus, the petitioner s deductions for mileage, meals and incidentals were non-deductible under I.R.C. 162(a)(2). Collodi v. Comr., T.C. Memo Taxpayer Was A Developer With Land Sale Gains Taxed As Ordinary Income. The petitioner was a self-described real estate real estate professional that received income from the sale of land. The petitioner reported the income as capital gain, but the Tax Court held that it was ordinary income because the petitioner held the property primarily for sale to customers in the ordinary course of the petitioner's real estate business. The court noted that the issue of whether the petitioner was a developer (ordinary income treatment) or an investor (capital gain treatment) was fact dependent, and that the facts supported developer status. The petitioner held his business out to customers as a real estate business and engaged in development and frequent sales of numerous tracts over an extended period of time. In prior years, the petitioner had reported the income from sales as ordinary income and had deducted the expenses associated with the tracts. On appeal, the appellate court affirmed. Boree v. Comr., No , 2016 U.S. App. LEXIS (11th Cir. Sept. 2, 2016), T.C. Memo Car Donation Charity Loses Exempt Status. A tax-exempt charity handled car donations and became the subject of IRS scrutiny. The IRS determined that the charity didn t operate exclusively for an exempt purpose as required by I.R.C. 501(c)(3), but operated in substantial part to facilitate the selling of automobiles for a fee. The IRS noted that the charity did not maintain sufficient records to substantiate that it actually engaged in any program of granting of funds to charitable organizations or for charitable purposes. There was no documentation to support the charity s claim that funds were used for the exempt purpose of providing middle and lower income families with emotional and financial assistance while they care for hospitalized family members. The IRS also noted that the deduction for donors is limited to the fair market value of the donated car, rather than full used value in a used car pricing guide and is tied to the sales price the charity receives. UIL (Jun. 1, 2016). 68. Penalty Tax Imposed For Improper IRA Withdrawals. The petitioner needed cash to pay for a medical procedure that he had to pay $11,000 for. So, he canceled an annuity contract and received the cash surrender value of $140, He paid a surrender fee of $20, No federal tax was 25

30 withheld. Because he felt that additional medical procedures would be required, the petitioner retained the remaining funds and didn t roll them over into an IRA with 60-days from the distribution. On his tax return, the petitioner reported only $16,199 as the taxable amount of the distributions, and treated the balance as a non-taxable rollover amount. As a result, the IRS imposed the 10 percent early distribution penalty and also noted that the full amount of the distribution was taxable. A 20 percent underpayment penalty was also imposed. Peterson v. Comr., T.C. Sum. Op Computer Purchase Does Not Qualify American Opportunity Tax Credit (AOTC). The petitioner was enrolled in college and traveled to Algeria where he bought a computer at a retail store that he used in his coursework. A letter from an instructor indicated that most of the work for an English class could be performed on library computers, but that the library had limited operational hours. The petitioner claimed that the $1,288 computer cost qualified for the AOTC. The IRS disallowed the credit because it was not purchased from an educational institution, and the institution did not require him to buy the computer as a condition of enrollment. Mameri v. Comr., T.C. Sum. Op Rollover Limitations For IRAs Apply to Coverdell ESAs. In accordance with the Tax Court s opinion in Bobrow v. Comr., T.C. Memo , the IRS has determined that once a taxpayer has completed a rollover from a Coverdell Education Savings Account, the taxpayer must wait 12- months before completing another rollover from the same Coverdell ESA to another Coverdell ESA. Program Manager Technical Advice (Dec. 14, 2015). 71. Grouping of Activities Not Appropriate With Result That Passive Income Netted Against Passive Losses. The petitioner was a medical doctor that was a partner in a partnership with other doctors. The partnership owned an interest in a second partnership which provided outpatient surgery facilities for qualified licensed physicians including the petitioner. The petitioner also sustained losses from a rental property and netted the losses with his income from the second partnership on his return. On audit, the IRS disallowed the losses on the basis that the partnership income should be grouped with the income from the petitioner s medical practice. Such grouping made the partnership income non-passive due to the petitioner s material participation in the medical practice, thereby disallowing the partnership income from being netted against the petitioner s passive rental losses. The National Office of IRS, on review, determined that the forced grouping was not appropriate because the petitioner did not enter into the partnership to bypass the passive activity loss rules. Tech. Adv. Memo (Apr. 5, 2016). 72. Buy-Back of S Corporate Stock Means No S Election for Five Years. The petitioner owned 100 percent of the stock in an S corporation and sold it to another corporation. The sale terminated the S corporation s S status, resulting in the corporation being a C corporation. Less than five years later, the petitioner bought the stock back from the buyer. The IRS determined that the petitioner, in accordance with I.R.C. 1362(g) could not make another S election until the five-year period from the date of the first election. Priv. Ltr. Rul (Jun. 6, 2016). 73. S Corporation Not Required To Pay Reasonable Compensation In Loss Situation. The petitioner, an S corporation, operated a business servicing, repairing and modifying recreational vehicles. The petitioner established a $224,000 home equity line of credit in 2006, but the petitioner s sole owner had quickly drawn on the entire line and advanced the funds to the corporation. The owner refinanced his home mortgage and established another line of credit for $87,443 and advance the full amount to the corporation. In 2008, the sole owner established a general 26

31 business line of credit for $115,000 and advanced the funds to the corporation. The sole owner also borrowed $220,000 from his mother (and her boyfriend) and advanced the funds to the corporation in 2007 and The total amount advanced to the corporation between 2006 and 2008 was $664,443. All of the advances were reported as loans to the corporation and were treated as such on the corporation s general ledgers and Forms 1120S. No promissory notes between the corporation and the owner were executed, and no interest was charged, and no maturity dates were imposed. The owner borrowed another $513,000 from 2009 through 2011, with the corporation reporting a $103,305 loss for 2010 and another $235,542 for In those years, the corporation paid the owner s personal creditors $181, The corporation treated the payments as non-deductible repayment of shareholder loans. The IRS claimed that the sole owner was an employee that should be paid a reasonable wage subject to employment tax (plus penalties). The basic IRS argument was that the advanced funds were contributions to capital and the corporate payments made on the owner s behalf were wages. The Tax Court disagreed. The court noted that the corporation reported the advanced as loans on its books and Forms 1120S and showed the advanced as increases in loans and the expenses paid on the owner s behalf as repayments of shareholder loans. Thus, the court reasoned that the parties intended to form a debtor/creditor relationship and that the corporation conformed to that intent. This was supported by the fact that the corporate payments were made when the corporation was operating at a loss. Thus, the S corporation was not forced to pay a wage to the owner/employee while it was suffering losses. Scott Singer Installations, Inc. v. Comr., T.C. Memo In early 2017, the IRS announced that it was acquiescing in result only. The IRS noted that unless a taxpayer objectively substantiates both the existence of a loan and that payments were in repayment of that loan, that it would continue to assert that the payment of personal expenses by an S corporation on behalf of its corporate officer/employee constitute wages that are subject to federal employment taxes. A.O.D , I.R.B NOL Disallowed Due to Lack of Substantiation. The petitioner operated his business in the S corporate form. He claimed that the S corporation sustained a $518,088 net operating loss (NOL) carryforward and continual S corporate losses. The $518,088 loss was allegedly sustained in tax years and would have been available to offset the petitioner s taxable income beginning with tax year However, the petitioner did not maintain sufficient records to substantiate the NOL carryover or establish that they were not absorbed from The petitioner relied solely on tax returns to establish the NOLs, but the court held that tax returns alone to not establish that there was a loss. The court also determined that the Forms 1120S did not provide sufficient information to establish the petitioner s basis in the S corporate stock. The court also noted that the petitioner had stipulated that he was compensated exclusively via distributions rather than wages or salary and that he used the S corporate checking account to pay substantial expenses for tax years Thus, the court held that the petitioner s stock basis was zero. The court also upheld a 20 percent accuracy-related penalty. Power v. Comr., T.C. Memo Start-Up Expenses Denied and $5,000 Election Not Made. The petitioner, a retired military pilot was nearing retirement from a major airline and purchased a small jet in late 2010 and had additional equipment put in it. She intended to use the plane in her new business. Late in 2010, the petitioner took an acquaintance, as a potential client, for a flight in the jet. The petitioner did not invoice the acquaintance for the flight, and the acquaintance moved out-of-state and a business relationship did not develop. The petitioner flew the jet two more times in 2010 and drafted a business plan for her new business, but had no revenue or customers in The petitioner claimed over $13,000 in Schedule C deductions associated with the business for the 2010 tax year. The IRS disallowed the deductions on the basis that the business activity had not yet begun in 2010 and, thus, deductions 27

32 were not allowed under I.R.C. 162 as an ordinary and necessary business expense or I.R.C Instead, the IRS determined that the petitioner s expenses were start-up expenses. The court agreed with the IRS, noting that the petitioner s business had no clients in 2010 and did no formal advertising in 2010 that she was open for business, and had no gross receipts from business operations. The petitioner also did not elect under I.R.C. 195(b) to deduct up to $5,000 in the year the business begins with the balance deductible over 180 months. Thus, the start-up costs had to be capitalized. Tizard v. Comr., T.C. Sum. Op Bank deposit method used to reconstruct income. The IRS believed that the petitioner had unreported income, and the petitioner claimed the amounts were reimbursements from an estate for his work as the executor. The petitioner had receipts, but couldn t explain the relationship of the receipts to the estate or his business. The IRS used the bank deposit method to reconstruct the petitioner s income. The court upheld the IRS position, finding that the petitioner intentionally evaded payment of a known tax obligation. The court imposed a civil fraud penalty. Schwartz v. Comr., T.C. Memo Abnormal reverse exchange allowed. The petitioner estate operated a drugstore chain and sought a new drugstore before it sold the store that was presently being operated. An intermediary took title to the land on which the new store was being built. The petitioner leased the store from the intermediary until the store it was operating was sold, and used the sale proceeds to buy-out the intermediary. The transaction took place in 1999, before the IRS issued Rev. Proc where IRS said it would not challenge reverse exchanges if the intermediary holds the property for 180 days or less. The intermediary held the property for more than 180 days in any event. The IRS disallowed tax-deferred exchange treatment, but the Tax Court disagreed. The court noted that caselaw established no fixed limit on which an intermediary can hold title to the exchange property. Estate of Bartell, 147 T.C. No. 5 (2016). 78. Credible Testimony Carries the Day in Passive Loss Case. The petitioner bought and leased residential properties. Her ventures were not financially successful and she sustained losses from , deducting the losses for those years on Schedule E. The IRS asserted that the petitioner was not a real estate professional and the losses were, therefore, passive. The petitioner did not elect to group all of her rental activities as a single activity for purposes of the 750-hour test. IRS claimed that she failed to materially participate in each of her rental activities, and the petitioner did not maintain any log or calendar documenting the time she spent in each activity. The Tax Court, however, held that the petitioner s testimony was persuasive in satisfying the facts and circumstances test of Treas. Reg T(a)(7). The court found it convincing that the petitioner did not have other employment and spent well in excess of 40 hours per week doing work related to the rental properties. The court concluded that the petitioner s testimony established that she materially participated in each rental activity and met the 750-hour test. Thus, the petitioner was a real estate professional and the losses from the rental activities were not passive. Hailstock v. Comr., T.C. Memo Real Estate Pro Lacked Material Participation Passive Loss Rules Apply. The petitioners, a married couple, consisted of a husband that was a corporate executive and his wife that was a real estate agent. They sustained losses on two rental real estate properties that they owned. The wife s status as a real estate agent meant that she was a real estate professional. Thus, the rental losses were not automatically per se passive (which is the case for non-real estate professionals). The IRS denied the deductibility of the losses on the basis that the petitioners did not materially participate in the rental activities. The petitioners, however, asserted that they did materially participate in the rental activities on the basis of grouping the wife s real estate agent activities with the rental activities. The trial court agreed with the IRS, citing Treas. Reg (e)(3) which provides that a qualifying taxpayer cannot group a rental real estate activity with another type of real estate activity. Thus, for 28

33 real estate professionals, grouping of real estate activities with real estate rental activities is not allowed for purposes of determining material participation. Consequently, the losses from the petitioner s real estate rental activity were disallowed. On appeal, the appellate court affirmed on the basis that the petitioners could not meet a material participation test under I.R.C Gragg v. United States, No , 2016 U.S. App. LEXIS (9th Cir. Aug. 4, 2016), aff g., No. 4:12- cv ygr (N.D. Cal. Mar. 31, 2014). 80. Year-End Bonus Paid to Taxpayers Children Disallowed Along With Some Expenses Associated With Cattle and Deer Activity. The petitioners, a married couple, bought 176 acres of agricultural land on which to raise cattle. However, they changed their minds and decided to use the property for a deer hunting preserve rather than cattle raising. Upon learning of their legal liability issues associated with a hunting preserve they scrapped the plans for the preserve. They also enrolled 22.5 acres of the tract in a Federal conservation program (probably the CRP, but unclear from the opinion) that barred crop production activities. The petitioners later improved the tract for the purposes of creating a resort. While substantial improvements were made, the petitioners did not market the resort and had only limited and occasional income from camping sights they had created on the tract. They filed Schedule F for the years in issue, reporting their income from the entire 176 acres on Schedule F. They incurred a loss from the activity on the 176-acre tract which the IRS disallowed on the basis that the activity was not conducted with profit intent in accordance with a preponderance of the factors contained in Treas. Reg (a). Specifically, the court determined that the activity was not conducted in a businesslike manner due to the lack of recordkeeping, no deer or cattle were raised, and the petitioners had no prior experienced in operating a resort or raising deer or cattle. The court also noted that the petitioners did not devote much time to the activity, littleto-no income was produced from the activity, and the petitioners enjoyed the activity and they had substantial income from other sources. The petitioners also failed to substantiate their claimed charitable deductions with receipts and appraisals. The petitioners also could not claim a deduction for unreimbursed travel for charitable purposes that was undocumented. The petitioners also claimed a deduction for wages paid to their children during the tax year for work done in the family embroidery business. While the court upheld deductions for the amounts paid during the year (the first eleven months), the Court disallowed a bonus paid to the children at year-end due to the lack of documentation of the hours of work performed. The amounts paid throughout the year (which were much smaller and were rounded) were substantiated under the rule set forth in Cohan v. Comr., 39 F.2d 540 (2d Cir. 1930) which allowed the court to estimate the amount allowable. The petitioners were unable to establish that an unrelated party would have been paid a similar bonus, which made up the largest portion of the children s wages. In addition, there was no written plan in place at the beginning of the year setting forth the conditions for a bonus to be paid at year end. Embroidery Express, LLC v. Comr., T.C. Memo Ownership of Oil and Gas Interests Not Required For Deducting Survey Costs. The petitioner didn t own any oil or gas interests, but did conduct marine surveys of the outer continental shelf of the Gulf of Mexico in an attempt to detect where oil and gas deposits were located. The petitioner gathered the data, and then licensed its use to customers on a non-exclusive basis. Those customers then used the data identifying deposits to drill for oil and gas. The petitioner deducted the cost associated with the surveys under I.R.C. 167(h) as geological and geophysical expenses incurred in connection with the exploration for, or development of, oil and gas. The IRS disallowed the deduction because the plaintiff did not own the oil and gas interests, but the Tax Court allowed the deduction. The Tax Court determined that the deduction under I.R.C. 167(h) is not limited to taxpayers that own the oil and gas interests being surveyed because all that I.R.C. 167(h) requires 29

34 is that the expenses were incurred in connection with the exploration for, or development of, oil and gas. CGG Americas, Inc. v. Comr., 147 T.C. No. 2 (2016). 82. Credit for Producing Fuel From Landfill Gas Largely Denied. The petitioner is a tax matters partner for Delaware statutory trusts that were engaged in the production and sale of landfill gas to a third party that had entered into landfill license agreements with the owners and operators of 24 landfills. One trust claimed I.R.C. 45K credits for producing fuel from a nonconventional source (landfill gas) that was produced from 23 landfills in Another trust claimed the same credits producing fuel from landfill gas from one landfill in 2006 and The court noted that the landfills had various types of equipment, monitoring capabilities and production levels, and that the documentation of gas rights and sales varied as did the operation and maintenance agreements between the trusts and the third party. The court also noted that the documentation of landfill gas production and expenses for which the trusts claimed deductions varied. While untreated landfill gas is a qualified fuel under I.R.C. 45K, the court determined that the trusts could not claim the credits due to the lack of substantiation of production and sale of landfill gas except with respect to one landfill each and only for the time period during which gas-to-electricity equipment was running at those particular landfills. In Green Gas Delaware Statutory Trust, Methane Bio, LLC, Tax Matters Partner, 147 T.C. No. 1 (2016). 83. No Casualty Loss For Wall Collapse That Suffered Progressive Deterioration. The petitioner suffered a collapse of a retaining wall at the taxpayer's cooperative housing complex and claimed a casualty loss associated with the collapse of the wall. The wall separated the housing complex from public roads. The taxpayer, as a shareholder, was assessed a portion of the damage and claimed a casualty loss. The IRS denied the deduction because the collapse was gradual in nature and did not result from an event that was of a sudden, unusual or unexpected nature. The Tax Court upheld the IRS position and granted summary judgment on the basis that the collapsed wall was on property owned by the cooperative rather than the shareholder. As a result, the taxpayer did not have sufficient property rights in common areas under I.R.C. 165(c)(3), and no "equitable easement" was present. On appeal, the appellate court noted that state (NY) law recognized that the petitioner had a right to use the cooperative s common areas, and such right was a property interest in the grounds that satisfied the property element of I.R.C. 165(c)(3). As such, the court vacated the Tax Court s opinion and remanded the case for a determination of whether the loss was a casualty loss. On remand, the Tax Court determined that the evidence showed that the wall had been suffering deterioration for approximately 20 years before the collapse occurred. Thus, the casualty loss deduction was properly denied. Alphonso v. Comr., T.C. Memo , on remand from 708 F.3d 344 (2d Cir. 2013), vacating and remanding, Alphonso v. Comr., 136 T.C. 247 (2011). 84. Farming Activity Not Conducted With Profit Intent. The plaintiff was born and raised on a ranch until he left for college. He did not return to the ranch, but instead became an architect. After about a decade, the plaintiff bought 40 acres of pasture to start a ranch and took a year to clean the property up and buy equipment. He then began raising hay for sale. The hay sales were not profitable so he stopped selling hay, but continued to raise hay for his own animals. He started a horse breeding business, but it was not successful and he discontinued the business but continued to deduct expenses associated with the horses. A few years later he bought an 80-acre tract with a house. In 2011, he had $242,240 in gross receipts from his architecture business, but only $6,000 in gross receipts from farming and about $50,000 in farm-related expenses. The state department of revenue disallowed the farming loss due to the lack of a profit motive, using the same factors contained in Treas. Reg (b). The state tax court affirmed on the basis that the plaintiff did not operate the farming operation in a businesslike manner, had no expectation in an increase in asset values, had no prior business success, had 16 consecutive years of losses and the losses offset substantial non-farm 30

35 income. Horton v. Department of Revenue, No. TC-MD, D, 2016 Ore. Tax LEXIS 85 (Ore. Tax Ct. Jun. 14, 2016). 85. No Deductions For Expenses Related To Hop Crop Because No Business Conducted. The petitioners, a married couple, had an S corporation with an office in Virginia. The husband was also an employee of the S corporation. The husband worked full time in the oil industry, but bought a 79-acre tract in North Carolina in 2004 and completed the construction of a warehouse on part of the property. The warehouse was built to store hops for distribution to local breweries. In 2008 and 2009, the husband planted hop seeds, but weather problems stalled crop growth and no hops were harvested or sold during these years. During this time, the husband also called local breweries to determine their interest in buying hops. The petitioners deducted business losses on Schedule C for both 2008 and 2009 related to the hop crop. The court upheld the IRS denial of Schedule C deductions because the court determined that the North Carolina activity was not functioning as a going concern in either 2008 or 2009 due to the petitioners failing to engage in the activity with the requisite continuity and regularity, and with the primary purpose of deriving a profit. However, the court agreed with the IRS that some related expenses were deductible as personal expenses related to their investment in the North Carolina property. The S corporation also claimed deductions for health insurance benefits paid on the husband s behalf that were upheld due to the husband holding more than two percent of the S corporate stock. Those amounts were included in the husband s taxable income. The Tax court also held that the S corporation failed to adequately substantiate the business of three vehicles used in the S corporation s business. On appeal, the appellate court largely affirmed, but did modify some of the deductions allowed/disallowed. Powell v. Comr., No , 2016 U.S. App. LEXIS (4th Cir. Jun. 14, 2016), aff g., in part, vacating in part and remanding, T.C. Memo Unexpected Birth of Child Results in Allowance of Reduced Gain Exclusion. Married taxpayers had one child at the time that they purchased their first residence. The residence had two small bedrooms and two baths. The child s bedroom also served as the home office for the husband as well as a guest room. The couple had a second child and sold the residence before residing in it as their principal residence for two years. They sought to exclude a portion of the gain attributable to the sale of the residence under I.R.C. 121(c)(2)(B) on account of the pregnancy of the wife and the birth of the second child being an unforeseen circumstance. Based on the taxpayers facts, the IRS determined that the pregnancy qualified as an unforeseen circumstance and was the primary reason why they sold the residence before residing in it for two years. Priv. Ltr. Rul (Apr. 11, 2016). 87. Cancelled Income Is Not Taxable Due to Insolvency Exception. The petitioner had a deficit in his bank account in The bank issued the petitioner a Form 1099-C in 2011 reporting $7,875 in cancelled debt which the taxpayer did not report on his 2011 return. The court determined that the petitioner had cancelled debt income in 2011, but that the petitioner had established that he was insolvent at the time of the discharge to the extent of $14,500. Accordingly, none of the discharged debt was taxable. Newman v. Comr., T.C. Memo Oil and Gas Investment Generated Self-Employment Taxable Income. The petitioner was a CEO of a computer company with no knowledge or expertise in oil and gas. In the 1970s, the petitioner acquired working interests in several oil and gas ventures of about 2-3 percent each. The ventures were not part of any business organization, but were established by a purchase and operating agreement with the actual operator of the interests. The operator managed the interests and allocated to the petitioner the income and expense from the petitioner's interests. The petitioner had no right to be involved in the daily management or operation of the ventures. Under the agreement, the owners of the interests elected to be excluded from Subchapter K via I.R.C. 761(a). For the year at 31

36 issue, the petitioner's interests generated almost $11,000 of revenue and approximately $4,000 of expenses. The operator classified the revenues as non-employee compensation and issued the petitioner a Form 1099-Misc. (as non-employee compensation). No Schedule K-1 was issued and no Form 1065 was filed. The petitioner reported the net income as "other income" on line 21 of Form 1040 where it was not subject to self-employment tax. The petitioner believed that his working interests were investments and that he was not involved in the investment activity to an extent that the income from the activity constituted a trade or business income, and that he was not a partner because of the election under I.R.C. 761(a) so his distributive share was not subject to selfemployment tax. The IRS agreed with the petitioner s position in prior years, but chose not to for 2011, the year in issue. The IRS claimed that the income was partnership income that was subject to self-employment tax. The Tax Court agreed with the IRS because a joint venture had been created with the working interest owners (of which the petitioner was one) and the operator. Thus, the petitioner's income was partnership income under the broad definition of a partnership in I.R.C. I.R.C. 7701(a)(2). The trade or business was conducted, the court determined, by agents of the petitioner, and simply electing out of sub-chapter K did not change the nature of the entity from a partnership. Also, the fact that IRS had conceded the issue in prior years did not bar IRS from changing its mind and prevailing on the issue for the year at issue. On appeal, the Tenth Circuit affirmed, noting that the petitioner did not hold a limited partner interest which would not be subject to self-employment tax pursuant to I.R.C. 1401(a)(13). The Tenth Circuit also noted that the fact that the IRS had conceded the self-employment tax issue in prior years did not preclude the IRS from pursuing the issue in a subsequent tax year. Methvin v. Comr., No , 2016 U.S. App. LEXIS (10th Cir. Jun. 24, 2016), aff g., T.C. Memo IRS Determination Illustrates Care Must Be Taken in Naming IRA Beneficiaries. The taxpayer and spouse lived in a community property state at the time of the spouse s death. The spouse named their child as the sole beneficiary of three IRAs. After the spouse died, the taxpayer (surviving spouse) filed a claim in the estate seeking her one-half community property that they owned, including the IRAs. The taxpayer entered into a settlement with the estate, which the state probate court approved, that ordered the IRA custodian to assign an amount to the taxpayer as a spousal rollover IRA. The taxpayer asked the IRS to rule that the settlement amount be designated as the taxpayer s community property interest and that the taxpayer be treated as the payee of the inherited IRAs. The taxpayer also asked the IRS to rule that the distributed amount of the IRA to the spouse be treated as a spousal rollover such that it would not be taxable. The IRS ruled against the taxpayer on all of the requests. The IRS noted that I.R.C. 408(d)(3)(C) bars rollovers from non-spousal inherited IRAs and that the rule applies irrespective of state community property laws. However, the IRS refused to rule on whether the settlement amount was community property because that issue was a matter of state law. The IRS also pointed out that the child was the named beneficiary of the IRA and it had been retitled in the child s name and community property law didn t matter. Consequently, the taxpayer could not rollover anything from the IRAs. That meant that any amount that was assigned to the taxpayer would be a taxable distribution. Priv. Ltr. Rul (Mar. 3, 2016). 90. Structured Deal Doesn t Avoid Corporate Income Tax. The shareholders of a C corporation wanted to liquidate the corporation and entered into a transaction with an intermediary to reduce or avoid the tax liability that the liquidation would trigger. The court determined that the transaction lacked economic substance and had no effect other than the creation of a loss. As such, the transferees were liable for the corporate tax triggered on the liquidation. In addition, the transaction was classified as a listed transaction that required disclosure. Estate of Marshall, et al. v. Comr., T.C. Memo

37 91. Lack of Substantiation Costs Charitable Deductions. The taxpayer claimed a charitable deduction for non-cash donations to charity. The amounts exceeded $25,000 for and $79,000 for 2010, $90,000 for 2011, $80,000 for 2012, $36,000 for 2013 and $52,000 for Of those amounts, the taxpayer claimed $56,600 for clothing. The taxpayer did not substantiate the deductions with any evidence of purchases or acquisition dates. There also was no written acknowledgement. The taxpayer also did not have any qualified appraisals. Payne, T.C Sum. Op Failure to Properly Substantiate Costs Charitable Deductions. A couple each made $20 contributions to their respective churches each week. They did not provide any documentation to substantiate their cash contributions. They claimed a $2,000 deduction for the cash donations, but had no written acknowledgment from either church and had no records to substantiate the amounts donated. The court sustained the IRS denial of the deduction. The couple also claimed a charitable donation for non-cash contributions of various household items to the Salvation Army including clothing, furniture and kitchenware. The couple attached form 8283 to their return and used comparative sales to determine the fair market value of the donated items. On a supplemental schedule, they assigned a value of $2,082 to the clothing and $1,087 to donated furniture and kitchenware. They didn t receive a contemporaneous written acknowledgement for the non-cash donations and they didn t maintain any written records. However, the IRS allowed a $250 deduction for the non-cash donated items. The court sustained the IRS $250 deduction. Haag v. Comr., T.C. Sum. Op Sale of Business Interests Were Non-Taxable As Incident To Divorce. A married couple started a dance school in 1989 for which they reported the income on Schedule C. They incorporated the business in 1996 with the wife established as the sole shareholder. They created an LLC in 1997 for the sale of dancewear and related accessories with each of them being equal 50 percent shareholders and both of them operating the business equally. They formed a real estate LLC in 1999 that was taxed as a partnership which held and leased real estate. The wife was a 49 percent owner and the husband a 51 percent owner. They divorced in 2007 and pursuant to the divorce agreement, they equalized their ownership interests in the entities. After the transfers were complete, they each owned 50 percent of each entity. Later in 2007, the ex-wife sued the ex-husband for alleged mismanagement of the dancewear/accessory business and sought an order requiring him to sell his shares either to the corporation or to her. They entered into a settlement agreement in 2008 under which he sold all of his interests in the entities to her for $1.58 million and that amount was allocated among the businesses. The IRS claimed that the sale triggered taxable gain, but the ex-husband claimed it was non-taxable under I.R.C as being incident to a divorce. The IRS asserted that the 2007 divorce agreement resolved all of the issues between the couple and that the later lawsuit was a separate business dispute that was not brought in family court. The court noted that I.R.C did not limit its application to a single division of marital property, and that Treas Reg T(b) established a presumption that that non-recognition provision does not apply to any transfer pursuant to a divorce or separation agreement, but that it can be rebutted by a showing of a transfer to effect the division of property owner by former spouses at the time of the divorce. The court noted that the couple had made unsuccessful attempts to divide the businesses and there was nothing in I.R.C that limited it from applying to sales or business-related property. The court also determined that the type of court the lawsuit was filed in was immaterial. Belot v. Comr., T.C. Memo

38 94. New Rules on Qualified Real Property Debt. The IRS has provided guidance on debt forgiveness with respect to property that is used in a taxpayer s trade or business. Under the fact scenario presented, an individual borrowed $10 million from a bank to build an apartment building that would be used in the taxpayer s rental business. Before the loan maturity date, the taxpayer had paid down $2 million of loan principal, but failed to pay off the balance in a timely manner. At the time of maturity, the fair market value of the apartment building was $5 million and the taxpayer s adjusted basis in the building was $9.4 million. The lender agreed to accept $5.25 million in return for forgiving the $8 million outstanding loan balance. At the time of loan forgiveness, the taxpayer was not insolvent or in bankruptcy. Accordingly, the taxpayer chose to exclude $2.75 million of debt forgiveness as qualified real property business debt under I.R.C. 108(a)(1)(D). The IRS agreed, and the taxpayer s basis in the building would be reduced by the amount of the debt forgiven in accordance with I.R.C Under another fact scenario, the taxpayer borrowed $10 million for the construction of a residential community which the taxpayer then subdivided and held for resale. Assuming the same set of facts as the first situation, the indebtedness was not qualified real property business debt because the property was held primarily for sale to customers in the ordinary course of business. Thus, the forgiven debt could not be excluded from income. Rev. Rul Cancelled Insurance Policy Triggers Income. The petitioner bought a modified single premium variable life insurance policy in the 1980s. Under the policy, if the invested premium makes money the cash surrender value and cover increases. Otherwise, the petitioner would have to pay the actuarial value of any loss or lose the entire investment. The value increased significantly and the petitioner borrowed heavily against the policy, to an extent that the borrowings plus unpaid accrued interest exceeded the cash value. The petitioner failed to pay the interest on the borrowed amounts. The insurer cancelled the policy, treating the eliminated debt and interest as a distribution under I.R.C. 72 and issued the petitioner a 1099-R. The petitioner s wife wrote a note to the IRS on the 1099 stating that they didn t know how to compute the tax and seeking IRS guidance. However, the note was sent in with a late-filed return, and it was revealed at trial that the IRS had provided the petitioner with regularly issued statements concerning the policy and the loans, and informing the petitioner that any unpaid interest would be capitalized. The court determined that the interest was nondeductible personal interest. The court also held that because the amount borrowed was nontaxable, that when the insurer wrote them off the write-off constituted income to the petitioner. The court also imposed late filing and accuracy-related penalties. Mallory v. Comr., T.C. Memo AOTC Inapplicable When Tuition Paid with Tax Subsidies. The petitioner s tuition and related expenses were paid directly to the educational institution. The court determined that while the petitioner was an eligible student, the tuition and related expenses were not qualified because they were paid directly to the educational institution by the U.S. Department of Veterans Affairs as taxfree educational assistance under the Post-9/11 G.I. Bill. Lara v. Comr., T.C. Memo Employees of Homecare Provider Were Independent Contractors. The plaintiff sought to recover $4,000 in employment taxes it had paid for tax years 2008 through 2012, plus costs and attorney s fees. The IRS claimed that the plaintiff had improperly classified its non-medical homecare service providers as independent contractors rather than employees. The plaintiff, however, claimed it had a reasonable basis for treating the workers as independent contractors under the Section 530 safe harbor provisions. But, the IRS claimed that prior audits did not provide reasonable reliance because those audits were not employment tax audits. But, while the purpose of the prior IRS audit involved an analysis of the personal tax problems of the plaintiff s owner, the IRS 34

39 did review numerous documents involving the contracts with independent contractors. Thus, the court determined that it was reasonable for the plaintiff to interpret the silence of the IRS on the worker classification issue as acquiescence. Thus, the plaintiff had a reasonable basis to classify the workers as independent contractors. The plaintiff was entitled to relief. Nelly Home Care, Inc. v. United States, No , 2016 U.S. Dist. LEXIS (E.D. Pa. May 10, 2016). 98. Taxpayer Entitled to AOTC Even Though 1098-T Inaccurate. The petitioner was enrolled as a full-time student at a University during 2011, having registered for the spring 2011 semester during the fall of She was billed $2,340 for the spring 2011 classes in late 2010, and on Jan. 10, 2011, the university billed to her account additional tuition of $1,230 on the basis of her final course selections for that semester. The petitioner s student loans in the amount of $10,199 were disbursed to the University on Jan. 20, 2011, which accredited her account and the excess over tuition and fees were refunded directly to her. The University filed Form 1098-T for 2011 with no entry in Box 1 (payments received) and an entry of $1,180 in Box 2 representing amounts billed for qualified tuition and related expenses. The petitioner claimed an American Opportunity Tax Credit (AOTC) of $2,500 on her 2011 return. The IRS disallowed the AOTC because the University reported a zero amount in Box 1. However, an account statement from the University showed an itemized schedule of the petitioner s tuition charges for the spring 2011 semester that reflected net charges to the petitioner exceeding $2,500 in The court determined that the petitioner could claim a $2,410 AOTC equating to $2,000, plus 25 percent of the $1,640 balance of tuition and related charges that she paid in While the University charged a portion of the spring 2011 tuition in 2010, the loan proceeds weren t disbursed and credited to her account until 2011 which meant that the petitioner was treated, for purposes of the AOTC of paying the qualified expenses in The court determined that the evidence showed what the petitioner actually paid in 2011 and that the 1098-T was inaccurate. Terrell v. Comr., T.C. Memo Mortgage Not Subordinated at Time of Donation No Charitable Deduction for Conservation Easement. The petitioner made a charitable contribution a permanent conservation easement on two private golf courses in the Kansas City area in 2003 valued at $16.4 million. The IRS challenged the charitable contribution deduction on numerous grounds, and in an earlier action, the petitioner conceded that the donation did not satisfy the open space conservation test, granting the IRS summary judgment on that issue, with other issues remaining in dispute. At the time of the donation, two banks held senior deeds of trust on the land at issue. Subordination agreements were not recorded until approximately three months after the donation stating that they were effective at the time of the donation. In addition, the petitioner had no power or authority to enforce the easement with respect to a portion of the property due to its lack of ownership of the property. The Tax Court cited Mitchell v. Comr., 775 F.3d 1243 (10th Cir. 2015) and Minnick v. Comr., 796 F.3d 1156 (9th Cir. 2015) as precedent on the issue that the donor must obtain a subordination agreement from the lender at the time the donation is made. Here, the court held that the evidence failed to establish that the petitioner and the lenders entered into any agreements to subordinate their interests that would be binding under state (MO) law on or before the date of the transfer to the qualified charity. As a result, the donated easement was not protected into perpetuity and failed to qualify as a qualified conservation contribution. RP Golf, LLC v. Comr., No , 2017 U.S. App. LEXIS (8 th Cir. Jun. 26, 2017), aff g., T.C. Memo Wearing Expensive Clothing Doesn t Necessarily Make Them Tax Deductible. The petitioner s employer, a Ralph Lauren retail outlet, required him to wear Ralph Lauren clothing while at work. As a result, the petitioner purchased Ralph Lauren clothing and deducted the cost as an unreimbursed employee expense on his 2010 and 2011 returns. The IRS denied the deductions on 35

40 the basis that the clothing purchases could be worn for everyday usage. The Tax Court upheld the IRS determination noting that for the cost of the clothing to be deductible the clothing must satisfy three tests (1) be required or essential as a condition of employment; (2) be unsuitable for everyday wear; and (3) not be worn outside the workplace. The Tax Court noted that simply wearing Ralph Lauren clothing, while distinctive, is insufficient to make the clothing deductible. The clothing at issue was suitable for everyday use and, therefore, non-deductible. Barnes v. Comr., T.C. Memo Conservation Easement Not Protected in Perpetuity; Deduction Limited. The petitioner contributed a conservation easement on a tract of land to two qualified organizations. The easement provided that if the conservation purpose was extinguished because of changed circumstances surrounding the donated property, the that donees were entitled to a proportionate share of extinguishment proceeds. If extinguishment occurred, the donees were entitled to receive at least the amount allowed as a deduction to the donor for federal income tax purposes over the fair market value of the property at the time of the contribution. The plaintiff claimed a charitable contribution for the year of the contribution and carried forward the remaining balance to tax years Under Treas. Reg A(g)(6)(i), when a change in conditions extinguishes a perpetual conservation restriction, the donee, on later sale, exchange or conversion of the property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction. Because the easement at issue provided that the value of the contribution for purposes of the donees right to extinguishment proceeds is the amount of the petitioner s allowable deductions rather than the fair market value of the easement, the court determined that the easement violated the Regulation and was not protected in perpetuity under I.R.C. 170(h)(5)(A). The court also imposed an accuracy-related penalty. Carroll, et al. v. Comr., 146 T.C. No. 13 (2016) You Can Take it With You Your Carried-Over Credits, That Is. The petitioner was a surviving spouse that utilized an unused I.R.C. 53 minimum tax credit carryover from her deceased spouse. The deceased spouse had exercised incentive stock options (ISOs) in 1998 (when married to a different spouse) which triggered alternative minimum tax for the year of $708,181 and also gave rise to the credit. However, the pre-deceased spouse did not have sufficient regular tax liability for the year to use the credit, and the credit carried forward. The deceased spouse divorced that spouse and then married the petitioner in Apparently, there was no question that the divorce allocated the credit carryover amount to the deceased spouse. On the 2003 joint return (filed while both spouses were alive), the Form 8801 attached to the return claim an AMT of zero and an AMT credit carryforward of $304,442. The petitioner s husband died in 2004 and the petitioner filed a joint return as a surviving spouse for the year. No portion of the AMT credit carry forward was claimed until an amended return was filed for 2007 claiming $29,172 of credit which the IRS refunded. More AMT credit carryforward was claimed in 2008 in an amount exceeding $150,000. The IRS disallowed the credit. The same occurred for the 2009 tax year. The court agreed with the IRS disallowance of the AMT credit, pointing out that deduction carryovers allocable to a deceased spouse die to the extent they cannot be used on the final joint return. While the case involved a credit and not a deduction, the court concluded that the tax treatment was the same, citing Rev. Rul and Treas. Reg A-10(d)(4)(iii). The court also cited net operating loss cases for the proposition that a taxpayer could not deduct for a post-marital year an NOL incurred by the other spouse during the marriage. No accuracy-related penalty was imposed because the petitioner had filed Form 8275 with the original claim for refund. Vichich v. Comr., 146 T.C. No. 12 (2016). 36

41 103. Business Engaged in With Profit Intent, But Expenses Not Substantiated. The petitioner operated a hair braiding business in a booth at a mall under a five-year lease with the mall that had an automatic renewal clause. When the lease was up, it was in the midst of the financial crisis in 2009 and the business was doing poorly, but the petitioner renewed the lease out of fear of damaging her credit rating. The landlord renewed the lease for three years. The petitioner never reported a profit from the business for any year. The petitioner maintained a website, kept distinct business records and a separate business bank account from The petitioner also had a full-time job making over $80,000 annually and worked the booth at nights and on weekends. The petitioner believed the business failed because of the financial crisis, the non-interest in hair braiding and a saturated market. The petitioner was also not licensed to provide associated salon services. For the year at issue, the petitioner reported $ in income from her employment, and gross receipts of $325 from the hair braiding business with associated expenses of $16,131. The court believed that the petitioner was engaged in the activity with a profit intent based on an analysis of the nine factors contained in the I.R.C. 183 regulations. However, the petitioner failed to substantiate $1,441 of her expenses. The court imposed a 20 percent accuracy-related penalty on the portion of the underpayment of tax attributable to the unsubstantiated expenses. Delia v. Comr., T.C. Memo Partnership Income Must Be Reported Even If Not Distributed. The petitioner created a financially successful blog and created a partnership to further its success. The petitioner had a 41 percent interest in the partnership. The partnership filed its return by the extended due date, but didn t issue a Form K-1 to the petitioner for the petitioner s share of partnership income. The petitioner did not report his share of partnership income and the IRS asserted a deficiency. The court, agreeing with the IRS, noted that a partner must report his share of partnership income whether or not a distribution is received. In addition, the court pointed out that the petitioner actually filed a return before the partnership filed its return and could have requested an extension of time to file. The court did not impose an accuracy-related penalty. Lamas-Richie v. Comr., T.C. Memo From Strip Club to Horses Appellate Court Says Profit Intent Present For All of the Years Involved. The petitioner bought an abandoned restaurant building in the late 1960s and operated it successfully until a kitchen fire shut it down. The petitioner later reopened the business as a bar which eventually became a strip club. The petitioner sold that business for moral reasons and opened a pizza parlor about five miles away. He later reclaimed the strip club because the buyer defaulted on payments. He continued to operate the club (having apparently jettisoned his prior moral concerns) successfully and opened other strip clubs and restaurants and participated in strip club trade organizations. In the late 1980s, petitioner bought farmland adjacent to the strip club and bought additional farmland in the late 1990s near the strip club on which a stable was located. With the purchases, the petitioner created a 95-acre contiguous plot. Petitioner relinquished control of the strip club businesses to his children and started an insulation business and used car dealership. He ultimately terminated involvement in both of those businesses, and turned the 95-acre tract into a horse training facility to support his interest in horse racing. He expanded the business and obtained a trainer's license. The petitioner got crosswise with county officials with respect to building codes and his horse activities and ultimately sold the 95-acre tract in 2005 to an unrelated party for $2.2 million in a part-sale part like-kind exchange transaction. The next year, petitioner bought a 180- acre parcel 16 miles from his home for horse-related activities, where he built a first-class training facility. Petitioner was deeply involved in the activities, but due to mishaps in the early years involving, in part, disease and death of numerous horses, and his deductions for the four years in issue far exceeded his income from horse-related activities with cumulative losses just shy of $1.5 37

42 million. The court determined that the taxpayer conducted the horse activities in a business-like manner, consulted experts, but significant time into the activities, had a legitimate expectation that the new property would appreciate in value, had successfully conducted other activities that were relevant to an expectation of profit in horse activities, was neutral on the history of loss issue, had a legitimate expectation of future profit, was not an "excessively wealthy" individual and had elements of personal please or recreation for only the first two of the four tax years under review, and while initially started the horse activities without profit objective, turned that intent into one with a profit objective. As a result, the petitioner had the requisite profit intent for the last two years at issue, but not the first two. Accuracy-related penalty not imposed, but petitioner liable for addition to tax for one of the tax years under review. On appeal, the Seventh Circuit reversed. The court stated that the Tax Court s conclusion was untenable inasmuch as the Tax Court opinion amounted to saying that a business s start-up costs are not deductible business expenses and amounted to saying that every business starts up as a hobby and becomes a business only when it achieves a level of profitability. The appellate court stated that the Tax Court s finding that the petitioner s land purchase and improvements were irrelevant to the issue of profit motive until he began using the new facilities is unsupported and an offense to common sense. Thus, the petitioner had a profit intent for 2005 and 2006 also. Roberts v. Comr., No , 2016 U.S. App. LEXIS 6865 (7th Cir. Apr. 15, 2016), rev g., T.C. Memo Inflation-Adjusted Percentages for 2016 Announced for Schoolteacher Deduction and Expense Method Depreciation. The IRS has provided inflation-adjusted amounts for several tax provisions for For tax years beginning in 2016, the deduction for certain expenses of elementary and secondary school teachers cannot exceed $250.00, the maximum I.R.C. 179 deduction will be $500,000 and will be reduced dollar-for-dollar for qualified property placed in service during 2016 that exceeds $2,010,000. Rev. Proc IRS Explains Contributing to an HSA in the Year of Medicare Enrollment. Contributions to a Health Savings Account (HSA) cannot be made by otherwise eligible individuals starting with the first month the individual becomes eligible for Medicare. I.R.C. 223(b)(7). Simply turning age 65 is insufficient, by itself, to become eligible for Medicare. Registration is required. Thus, an individual who is 65 and has Medicare equivalent coverage remains eligible to make an HSA contribution. IRA, in two Information Letters, has addressed the issue of HSA contributions in the year of Medicare eligibility. One situation involved a married couple where each spouse had an HSA with one taxpayer having family coverage at the beginning of the year. The other spouse enrolled in Medicare on May 1. Then, the spouse with family coverage turned 65 after that and enrolled in Medicare on October 1. The IRS stated that, assuming the couple otherwise qualified to make HSA contributions during the year, they could contribute 1/3 of the maximum amount allowed, reflecting January-April and the spouse turning 65 and enrolling in Medicare on May 1 could make and additional catch-up contribution of one-third of the maximum catch-up amount. The spouse turning 65 later in the year and enrolling in Medicare on October 1 could make an additional contribution of 5/12 of the maximum amount (reflecting May-September), and a catch-up contribution of 75 percent of the maximum amount for a catch-up contribution reflecting the months of January-September. In the other Information letter, the IRS dealt with the situation of a single person that enrolled in Medicare on October 1. The IRS stated that the individual would be entitled to a contribution of 75 of the maximum annual amount (reflecting the months of January through September) and a catchup contribution of 75 percent of the maximum catch-up amount for the year. IRS Info. Ltrs (Jan. 29, 2016) and (Feb. 17, 2016) Paying Tuition In Different Tax Year Than Academic Semester Begins Blows AOTC. The petitioner paid his college tuition for the Spring 2012 semester in December of He graduated in May of On this 2012 return, he claimed an American Opportunity Tax Credit. The IRS 38

43 disallowed the credit, except for the $ in textbook rental that the petitioner incurred in The court upheld the disallowance based on the statutory requirement of I.R.C. 25A that the credit is only allowed for payment of qualified tuition and related expenses for an academic period beginning in the same taxable year as the payment is made. The limited exception of I.R.C. 25A(g)(4) did not apply because the taxpayer did not claim the credit on his 2011 return. McCarville v. Comr., T.C. Sum. Op No IRS Guidance, So S Corporations Can Still Reimburse Health Insurance Costs of More Than Two Percent Shareholders. In response to an inquiry by a member of the Congress, the IRS stated in an information letter that an S corporation can continue to reimburse a more than 2 percent S corporation shareholder for the cost of health insurance premiums the shareholder incurs where the reimbursement is included in the shareholder s income and deducted under I.R.C. 162(l), assuming all other criteria for eligibility are satisfied. The information letter noted that IRS has not issued additional guidance beyond that specified in Notice , which specified that such reimbursement did not violate Obamacare and would continue to be permissible until IRS said that it wasn t sometime in the future. Thus, taxpayers can continue to rely on Notice , I.R.B. 1. IRS Info. Ltr (Feb. 22, 2016) For ACA Medical Reimbursement Purposes, IRS Confirms that One is Less Than Two. A Congressional Representative wrote a letter to the IRS on a constituent s behalf seeking the IRS position on whether the constituent could continue to reimburse health insurance premiums for his only employee without violating Obamacare and incurring the $100/day penalty of I.R.C. 4980D. The question arose because the IRS, in Notice said that, in general, employer reimbursement of individual health insurance plans violate Obamacare s ban on annual and lifetime limits on benefits because the payment of premiums would be limited. But, Notice also noted that the Obamacare rules exempted a group health plan that has fewer than two participants who are active employees. So, the IRS responded to the inquiry by noting that the constituent s situation was exempt from the penalty. Thus, the employee can obtain health insurance with the employer paying the policy premiums via the reimbursement approach. But, it is still not a good idea for an employer to reimburse one employee s health insurance premiums while covering other employees under a group plan. IRS could construe that situation as involving one plan with the option of providing group premiums and another option of providing coverage for non-group premiums. In that case, the $100/day penalty would apply. IRS Info. Ltr (Feb. 8, 2016) Using IRA Funds To Invest in Personal Business Results in Tax and Penalties. The petitioners, a married couple, bought an unincorporated business using their retirement funds after being advised to do so by an investment broker. They then rolled the retirement funds into IRAs and had the IRAs buy the stock of a C corporation that they formed to acquire the unincorporated business. They then had the transaction involving the acquisition of the unincorporated business structured such that it included a loan from them that they personally guaranteed. The petitioners treated the transfer of funds from their IRAs as tax-free rollovers and did not disclose their personal guarantee. Seven years later, the IRS deemed the distributions to be prohibited transactions and sought a deficiency related to unreported IRA distributions of $431,500 and an additional 10 percent penalty for premature distributions. The Tax Court agreed with the IRS that the petitioners had engaged in a prohibited transaction under I.R.C. 4975(c)(1)(B). The six-year statute of limitations on assessment was triggered because the unreported income exceeded 25 percent of the amount reported on the petitioners 2003 return. Thiessen v. Comr., 146 T.C. No. 7 (2016) Scrap Steel Sales Totaling $317,000 Over 7 Years Not S.E. Taxable. The petitioner incorporated a steel company in 1997, but got into trouble with the IRS over employment taxes and was impacted by the stock market drop in In 2004, a Chapter 7 bankruptcy trustee took over the company to manage its liquidation. As part of winding up the bankruptcy, the trustee abandoned 39

44 a large pile of scrap steel. From 2004 through 2010, the petitioner sold scrap steel up to twice a month to steel wholesalers for a total of just over $317,000. The IRS claimed that the scrap steel sale income was subject to self-employment tax, but the petitioner had reported it as miscellaneous income not subject to self-employment tax. The court first noted that to be s.e. taxable, the income had to derive from a trade or business that the taxpayer conducted, and that trade or business was defined as an activity that the taxpayer engaged in for income or profit with continuity and regularity (citing the Supreme Court s Groetzinger decision of 1987). The court then determined that the s.e. question hinged on whether the petitioner was holding the scrap steel primarily for sale in the ordinary course of a trade or business. On that issue, the court used the multi-factor test utilized in Williford v. Comr., T.C. Memo As for the frequency and regularity of sales, the court determined that this factor was in the petitioner s favor because he sold the scrap steel slowly over time. While the sales were substantial in total, they were sporadic and generated large profits with little effort. Thus, this factor was neutral. Because he held the scrap steel for seven years, the court believed that the petitioner was not holding it for sale in the ordinary course of business. As to whether the petitioner segregated the scrap from business property, the court held the factor was neutral because he had a single pile of scrap. There also were insufficient facts to determine when and why the petitioner acquired the scrap -whether he took possession of it after determining it had value or whether he immediately took possession of it thinking that it might be useful someday. Because the sales took little effort to market the scrap, the factor was neutral, as was the factor involving the time and effort that the petitioner put into researching scrap wholesalers and contacting them to arrange sales. The petitioner also didn t use the sale proceeds to replace his inventory of scrap, which weighed in his favor. Accordingly, the court determined that the petitioner did not hold the scrap primarily for sale to customers in the ordinary course of business because the sales were not part of a trade or business. Ryther v. Comr., T.C. Memo Ag Chemicals Security Credit Only Partially Available. At issue was the availability to the taxpayer of the agricultural chemicals security credit of I.R.C. 45O. That provision says that eligible agricultural businesses can claim a 30 percent credit for qualified chemical security expenditures for the tax year, with certain limitations. Qualified expenditures generally relate to expenses the business incurs to ensure that their ag chemicals will be secure on the premises and that employees are properly trained in using them. However, the expenses must be incurred with respect to any fertilizer commonly used in agricultural operations and any pesticide that is customarily used on crops grown for food, feed or fiber and is a listed pesticide in section 2(u) of the Federal Insecticide, Fungicide and Rodenticide Act (FIFRA). Here, the taxpayer manufactures and distributes various chemicals, and claimed the I.R.C. 45O credit associated with its security expenditures related to the chemicals. The taxpayer manufactured and stored three chemicals for which it claimed the credit against the security expenditures. However, the taxpayer could only provide documentation that one of the chemicals was registered with the EPA as a pesticide as required by the credit statute. Thus, the credit could only be claimed for the security expenditures related to the one chemical. The taxpayer also asserted that its processing centers, storage tanks and transportation units should be viewed as separate facilities for purposes of the per facility limit on the credit. In rejecting the taxpayer s reasoning, the IRS cited Tech. Adv. Memo where the IRS concluded that an eligible facility is one that can locomote itself, and also referenced congressional history which indicated that the Congress was attempting to incentivize on-site security rather than security costs related to transportation units. Thus, only the taxpayer s facilities that were used to process and store qualified chemicals qualified as a facility under I.R.C. 45O. F.A.A F (Nov. 4, 2015) FBAR Fines Don't Count Towards Whistleblower Awards. Under I.R.C. 7623(b)(5)(B), a person can receive an award from the IRS for providing information about a taxpayer that leads to tax, penalties, interest, additions to tax and additional amounts that exceed $2,000,000. In this case, 40

45 the petitioner was participating with the U.S. Department of Justice and the IRS criminal investigation Division in regards to two Swiss bankers. One of the bankers plead guilty and pay a Foreign Bank and Financial Accounts (FBAR) penalty in excess of $2,000,000. The petitioner claimed that he was entitled to a "whistleblower" award. The IRS refused to pay the award on the basis that I.R.C. 7623(b) only requires the IRS to pay an award if the "additional amounts" for purposes of determining whether the $2 million threshold has been satisfied are imposed under the I.R.C. Because FBAR civil penalties are not imposed or collected under the IRC, the court agreed. Instead, FBAR civil penalties are imposed and collected under 31 U.S.C rather than the IRC.Whistleblower W v. Comr., 146 T.C. No. 6 (2016) Lack of Contemporaneous Written Acknowledgement Blows Conservation Easement Deduction. The petitioner attempted to make a charitable contribution of a permanent conservation easement to a qualified charity. The easement was valued at $350,971, but the IRS denied the entire charitable deduction on the basis that the petitioner did not have a contemporaneous written acknowledgment that specified that the petitioner did not receive anything in return for the contribution. The court agreed with the IRS, noting that the deed transferring the easement failed to include any provision stating that it constituted the entire agreement of the parties. Thus, the court said that the IRS couldn't be assured based on a review of the deed that the petitioner did not receive anything in exchange for the donated easement. Thus, the deed transfer did not satisfy the contemporaneous written acknowledgement rules of I.R.C. 170(f)(8)(B)(ii). French v. Comr., T.C. Memo Horse Training Activity Not Engaged in With Profit Intent; Deductions Limited. The petitioner operated a financial consulting and insurance business out of her home. She also conducted a horse training activity. She started training horses in 2005, but was injured in a car accident that year which severely hampered her training activities that year. She had recovered by 2009 and starting riding horses again. She also purchased carriage horses to train and then sell. She was again injured in a car accident in 2010 and bedridden. She spent no time training horses in 2010 and little time in 2011, and sent her horses to a professional trainer. She was able to give some lessons in 2011, but otherwise ceased her training activity and shifted to the creation of a website designed to educate children about animals. She projected that the website would become operational in 2016 and generate at least $100,000 in income for She never kept separate books and records for her horse training activity, simply keeping track of expenses on a notepad. She tried selling or giving away her horses, but couldn't find suitable (to her) transferees. Her barn was damaged by flooding in For 2008 through 2014, the expenses related to the horse training activity exceeded gross receipts each year. For the years in issue, 2010 and 2011, the petitioner netted her six-figure income from financial planning and insurance against the losses from the horse training business. The IRS disallowed the loses on the basis that the horse training activity was not engaged in for profit in accordance with I.R.C. Sec The court agreed. The court did not even need to go through the nine-factor analysis of the I.R.C. Sec. 183 regulations because the petitioner had no evidence that the horse training activity was conducted in a businesslike manner, years of losses, spent little time in the training activity, used the losses to offset income from her other business, and received personal pleasure from the activity. An accuracy-related penalty was imposed. Kaiser v. Comr., T.C. Sum. Op Trust Beneficiaries Liable For Income Tax After Statute of Limitations Expired. The petitioner s father created a revocable trust during his lifetime and named the trust the beneficiary of several of his IRAs. At his death in 2001, $228, was distributed to the trust from the IRAs. Later in 2001, the trust distributed that amount to two children, one of which is the petitioner (what was also the trustee of the trust). The trust filed Form 1041 for 2001 reporting the distributed amount as gross income and also deducting that amount as an income distribution, resulting in no net income. 41

46 The beneficiaries each reported $114,265 on their individual returns for The IRS audited the trust and, in 2004, and the petitioner allowed the IRS to extend the statute of limitations from April 2005 to April of The IRS disallowed the deduction for the distribution of trust income, determining that the trust owed the tax on the distributions instead of the beneficiaries. The trust tax rates were higher than the rates applicable to the beneficiaries. The IRS asserted a deficiency of $80,302 for the trust, and also removed the trust distributions from the gross income of the beneficiaries and issued them refunds based on adjusted 2001 individual returns. The trust made partial payment of the deficiency in early 2005 and later in 2005 the beneficiaries used their refunds to pay the balance of the trust liability. In 2006, the trust filed an amended 2001 return seeking a refund by again claiming a distribution deduction for the trust. The IRS accepted the refund claim in 2008 and refunded the taxes in 2009 that were paid based on the disallowance in In the fall of 2008, the IRS sent deficiency notices to the beneficiaries for 2001 that included the distributed amounts in the beneficiaries gross income. The 2008 assessments came after the expiration of the normal three-year from the date of filing of the return statute of limitations which had expired in 2005, and, as a result, the beneficiaries claimed that the IRS could not adjust their individual returns. However, the IRS claimed that the mitigation provisions of I.R.C allowed the late assessments to bar the beneficiaries from receiving a windfall. The mitigation provisions allow the IRS to correct errors made in a closed tax year by extending the statute of limitations for a year from the date a final determination is made. The mitigation provisions allow the correction of an error in a closed tax year where the same item was erroneously included or excluded from income or where the same item was allowed or disallowed as a deduction. The court agreed with the IRS, noting that all four requirements for mitigation were satisfied a determination had been made in accordance with I.R.C. 1313(a); the determination caused an error (as described in I.R.C. 1312); an adjustment to correct the error is barred by operation of law on the date of the determination; and the determination adopted a position that a party maintained that was inconsistent with the error. Specifically, the court held that mitigation applied because there had been a determination of tax which caused an error. In this case, the court noted that the allowance of the trust s refund claim allowed a deduction to the trust, but the corresponding inclusion of the income of the distribution income was erroneously excluded from the beneficiaries gross income, and the statute of limitations would otherwise prevent the income from being assessed to the beneficiaries. That inconsistency between the allowed trust deduction and the erroneous non-taxation of the beneficiaries triggered the mitigation provision of I.R.C and allowed the late assessment against the beneficiaries. Costello v. Comr., T.C. Memo Brokering Financial Services Is Not Real Estate For Passive Loss Purposes. The petitioner operated a mortgage brokerage, real estate brokerage and tax preparation business. The petitioner had an accounting background and was an IRS enrolled agent. The business incurred rental losses and claimed that the business constituted a real estate trade or business such that the rental losses were not automatically passive and limited in deductibility by the passive loss rules (to the extent of passive income) if the petitioner spent at least 750 hours during the tax year in the business and spent more time working in the business than on non-real estate activities. However, the court determined that the mortgage brokerage activity was not a trade or business as defined by I.R.C. 469(c)(7)(C). In addition, the court noted that during the years in issue, the petitioner was not brokering real estate. The court also determined that the petitioner did not satisfy the 750-hour test without including the time spent brokering mortgages. As such, the petitioner s rental real estate losses were passive and were disallowed. Guarino v. Comr., T.C. Sum. Op

47 119. Auto Dealerships Are Separate Activity From Horse Activity Under Hobby Loss Rules. The petitioner was a third-generation auto dealer with successful dealerships, and his family has been involved in horse-related activities since the 1960s. The petitioner started his own horse activity in For various reasons, the horse activity lost money for the years in issue, but the petitioner argued that the auto dealerships and the horse activity constituted a single activity for purposes of I.R.C. Sec The court held, however, that the activities were separate. Based on the evidence, the court noted that the activities were not conducted in the same locations and there was no relationship between the customers of the horse activity and the customers of the auto dealerships. In addition, there was minimal cross-advertising between the activities and there was no leasing of assets between the two activities. The court also noted that the activities were not similar in nature. On appeal, the Third Circuit affirmed in a short, non-precedential opinion. The court noted that the activities were separate and that the nine-factors contained in the regulations were in the governments favor. Price v. Comr., T.C. Memo , aff d., 117 AFTR 2d (3rd Cir. Mar. 7, 2016) Trust Gets Charitable Deduction for Distribution of IRA To Charity. The decedent established a trust and named the trust the successor beneficiary of an IRA. The trust terms specified that that the IRA was to be distributed to a charity. If the amount distributed to charity was paid out of the trust s gross income, the trust could claim a charitable deduction for the distribution in accordance with I.R.C. 642(c)(1). The IRS noted that while the Uniform Principal and Income Act specifies that a payment from an IRA contained in a trust (or an estate) is allocated 10 percent to income and 90 percent to principal to the extent it represents a minimum required payment from the account and 100 percent to principal to the extent it exceeds the minimum or if there is no current minimum required distribution, the limit is only on the gross income and the trust can claim a deduction for the full amount paid without the deduction being limited to a percentage of income limitation. Priv. Ltr. Rul (Dec. 7, 2015) Income From Gift Cards is Partially Deferrable. Under the general rule, accrual method taxpayers account for income from advance payments from gift card sales in the year they receive the income. However, the IRS issued a Rev. Proc. In 2004 (Rev. Proc ) that allows the portion of the advance payment not recognized for financial accounting purposes in the year of receipt to be deferred until the next year. Treas. Reg allows an additional year of deferral for advance payments for the sale of goods, including the sale of gift cards, if certain conditions are met. That longer period is available if the consumer can redeem the gift cards for goods, even if the gift card may be redeemed for non-integral services. Under this interpretation of the regulation, the retailer will aggregate all gift cards that are outstanding at the end of the tax year in which the cards were sold, and then allocate between the portion that is reasonably expected to be redeemed for merchandise and the portion reasonably expected to be redeemed for nonmerchandise purposes. The portion reasonably expected to constitute sales of merchandise in the future is eligible for the two-year deferral period. The IRS noted that the use of the longer deferral period is accomplished by filing Form 3115, and the taxpayer will recognize the resulting tax benefit entirely in the year of change via an I.R.C. 481 adjustment. Tech. Adv. Memo (Aug. 28, 2015) No Deduction for Job-Related Clothing Expenses. The petitioner, a bartender at a high-end restaurant in New York City, claimed a deduction for the cost of clothing related to his job. The IRS denied the deduction and the Tax Court agreed with the IRS. The court noted that the petitioner s employer did not require him to wear any particular type of clothing and what he 43

48 purchased to wear for his job was adaptable to wearing when he was not at work. Thus, the expenses were non-deductible personal expenses. It was immaterial that the petitioner believed that it was necessary that he wear the clothing at issue in order to look his best at work. Beltifa v. Comr., T.C. Sum. Op Real Estate Sold By REIT Was Not a Prohibited Transaction. A real estate investment trust (REIT), through various subsidiaries, owned and leased residential real estate to third parties. A limited partnership owned most of the stock of the REIT and owned all of the REIT s voting common stock. The limited partnership needed to wind its business down and dissolve. The REIT planned to liquidate by disposing of all of its real property that it owned. The REIT initially acquired the properties with the intent to own them for a long time and to profit from capital appreciation and by renting the properties out. At the time of the proposed sale of the properties, the REIT will have held each of them at least two years. The REIT proposed to use at least one independent third party broker to dispose of the properties. The issue was whether the REIT held the real estate primarily for sale to customers in the ordinary course of business under I.R.C. 1221(a)(1) and, thus, the sale of the property would be a prohibited transaction under I.R.C. 857(b)(6)(B). While the IRS does not ordinarily issue rulings on whether property is held primarily for the purpose of sale to customers in the ordinary course of the taxpayer s trade or business, the IRS determined that the taxpayer had satisfied the unique and compelling test for justifying a ruling. Accordingly, the IRS ruled that the proposed transaction would not constitute a prohibited transaction under I.R.C. 857(b)(6)(B). Priv. Ltr. Rul (Nov. 12, 2015) No Deduction For Unsubstantiated Charitable Deductions. The petitioners, a married couple, claimed itemized deductions of over $51,000 on income of slightly over $50,000. The husband pastored a church and claimed deductions for medical insurance premiums and charitable contributions. The IRS allowed about 20 percent of the claimed charitable deductions but disallowed a medical expense deduction because the substantiated amount did not exceed 7.5 percent of the petitioners AGI. At trial, the IRS conceded a deduction for about 70 percent of the claimed health insurance premiums attributable to the wife s portion of health insurance premiums deducted from compensation. The balance was not deductible due to lack of substantiation. The court upheld the IRS determinations, otherwise. On the claimed charitable deduction, the court noted that the petitioners failed to substantiate their contributions and did not have contemporaneous receipts or bank records. Brown v. Comr., T.C. Memo Refundable State Tax Credits Are Income. The petitioners, a married couple, were New York residents that created a business and elected S corporate status. The corporation was a certified Empire Zone business under the NY Empire Zone Program. For the tax years, the business qualified under the NY EZ Program. The wife owned 100 percent of the business during 2008, and the husband owned 100 percent of the business after that. For 2008, the corporation claimed an Empire Zone Wage Tax Credit of $17,250 and an Empire Zone Investment Tax Credit of $58,827. For 2008, the wife claimed the credits against the couple s NY income tax, and could receive 50 percent of the excess credit as an overpayment of NY income tax which could be refunded. The use of the credits eliminated the petitioners state income tax liability and generated a refund of a NY income tax overpayment of $30,935. The petitioners did not report any of the state refund as taxable on their federal return. The petitioners received credits again in 2010 and 2011 and which generated refunds for those tax years which the petitioners did not report on their federal return for each year. The IRS asserted a deficiency and the court upheld the deficiency on the basis of prior rulings. In one of those earlier cases, the petitioners got a refund of $54,507 in state (NY) income tax in The refund was attributable to refunded state income tax credits which were based on state real property taxes that entities paid in which the petitioners had an ownership interest. The property tax was paid and deducted at the entity level which 44

49 decreased the entity income that ultimately passed through to the taxpayers, resulting in a lower tax liability. The Court, agreeing with the IRS, determined that the petitioners received a tax benefit from the credits and, as such, the credits were income to them. The court cited its prior decision in Maines v. Comr., 144 T.C. No. 8 (2015), which involved similar facts. Elbaz v. Comr., T.C. Memo The citation for this case is Rivera v. Comr., T.C. Memo Advance Payments Count Towards Basis of Partnership Interest. Under I.R.C 752, if a partner s share of partnership liabilities increases or the partner s own liabilities increase by assumption of the partnership liabilities, then the increase is to be treated as a contribution of money by the partner to the partnership. Distributions to a partner can be made without taxable gain to the extent the partner has income tax basis in their interest. Also, basis in the partnership interest allows a partner to deduct their allocable share of losses to the extent of basis, and basis will reduce the amount of gain realized when a partnership interest is sold. Liabilities that increase basis include promissory notes, mortgages and, in general, booked partnership liabilities. Here, a partnership received notice to proceed payments from customers before the partnership began a construction project. The payments were not fully included in income upon receipt because the partnership utilized the percentage of completion method. Thus, the payments were for services to be rendered in the future. The IRS reasoned that the payments counted as a basis-increasing liability (to the extent they had not yet been included in income) under I.R.C. 752 because the partnership would be liable if it didn t perform the work for which it had already been paid. Priv. Ltr. Rul (Nov. 11, 2015) Wrong Entity Claims Expense With Non-Deductible Result. A married couple formed a corporation and a year later the husband formed a second corporation that he solely owned. The second corporation held the name of a hand washing system to be used in the other corporation s food handling process that it was developing via a machine which would use radio frequency identification (RFID) tags. The idea of the system was that an employee could have their hands scanned to verify that the employee had washed their hands as required by food handling rules. However, the second corporation had been dormant for 11 years but the first corporation had hired employees to develop the RFID machine. Ultimately, it was determined that the RFID machine would not be developed and an attempt was made to develop a voice-activated machine. The second corporation hired an employee as a computer technician to develop the hand washing system. The first corporation paid approximately $130,000 per year for two years to the second corporation and deducted the payments as contract payments to develop the voice-activated machine. The IRS denied the deduction on the basis that the first corporation lacked an ownership interest in the second corporation s machine. The court agreed with the IRS, denying the deduction for any payment paid for the hand washing machine. The court noted that the husband failed to present any evidence that he owned the voice-activated hand washing machine and the employee was an employee of the second corporation. Also, the court noted that the first corporation did not receive any benefit from the payment to the second corporation. Key Carpets, Inc. v. Comr., T.C. Memo Federal Court Upholds Colorado Law Subjecting Out-of-State Retailers to Sales and Use Tax Notification and Reporting Requirements Implications For Online Retailers. In 2010, the Colorado legislature enacted Colo. Rev. Stat (3.5)(c)(I) requiring retailers that do not collect Colorado sales taxes (e.g., out-of-state retailers) to send a transactional notice to purchasers informing them that they may be subject to Colorado s use tax. The notice requirement applied to out-of-state retailers having gross sales to CO customers in excess of $100,000 in the prior calendar year. Covered retailers also had to report CO purchase information to the CO Department of Revenue. In addition, purchase summaries had to be provided on an annual basis to CO customers who bought goods from a covered retailer in excess of $500 for the prior calendar year. The plaintiff 45

50 challenged the law on constitutional grounds, claiming that the law contravened the U.S. Supreme Court s decision in Quill Corporation v. North Dakota, 504 U.S. 298 (1992). In that case involving a state s attempt to require a mail order office supply vendor to collect taxes on its sales to residents of the state where the vendor had no physical presence, the Court ruled that the state cannot impose the same tax obligations on out-of-state retailers having no physical presence in the state as they impose on retailers with a physical presence in the state. In this case, the plaintiff claimed that the CO law violated the Commerce Clause by discriminating against and unduly burdening interstate commerce. The trial court agreed and issued a permanent injunction against the law s enforcement. Direct Marketing Association v. Huber, No. 10-cv REB-CBS, 2012 U.S. Dist. LEXIS (D. Colo. Mar. 30, 2012). On appeal, the appellate court determined that could not review the trial court s ruling because the Taxpayer Injunction Act (TIA) divested the trial court of jurisdiction over the plaintiff s claims and because the case involved an attempt to bar CO from exercising sovereign power to collect revenues. The court held that state law provided procedures to challenge use tax notice and reporting requirements that, after administrative remedies were exhausted, the plaintiff could proceed to state court and ultimately to the U.S. Supreme Court. As such, the appellate court remanded the case for dismissal of the Commerce Clause claims and dissolution of the permanent injunction. Direct Marketing Association v. Brohl, et al., 735 F.3d 904 App. (10th Cir. Aug. 2013). The U.S. Supreme Court agreed to hear the case in 2014 (134 S. Ct (U.S. 2014)), and in 2015 the Supreme Court held that federal law (28 U.S.C. 1341) did not bar the lawsuit challenging the enforcement of the law from proceeding. Thus, the Supreme Court reversed the 10 th Circuit s decision and remanded the case. Direct Marketing Association v. Brohl, 135 S. Ct (U.S. 2015). On remand, the Tenth Circuit held that the statute did not violate the dormant Commerce Clause because it did not discriminate against or unduly burden interstate commerce. The court distinguished Quill on the basis that Quill applied only to sales and use tax collection. The court noted that discrimination wasn t present because the statute imposed differential treatment based on whether the retailer collected CO sales and use tax, not on the location of the retailer as in-state or out-of-state. The court also held that the statute did not create any competitive advantage for in-state retailers because CO customers are to pay sales or use tax when they purchase goods. Likewise, there was no undue burden on interstate commerce because it did not require out-of-state retailers to assess, levy or collect tax on behalf of CO. Direct Marketing Association v. Brohl, No , 2016 U.S. App. LEXIS 3037 (10 th Cir. Feb. 22, 2016) IRS Can Sell Farmland of Tax Protestor To Pay Tax Debt. The defendant is a self-employed farmer who hasn t filed a federal tax return or paid federal taxes since at least 1991 on the belief that he has no obligation to pay taxes on his income. The IRS asserted that his tax liability for the tax years was $441,845.75, including penalties and interest through the end of 2015, and sought a judgment for that amount. The IRS also sought a judgment that the defendant s tax liabilities constitute a valid lien on the defendant s property including farmland. that IRS could enforce via foreclosure and sale. The court noted that the defendant did not cooperate with the IRS throughout the audit process. As a result, the IRS estimated his income and expenses based on USDA data for the years at issue. After the audit began, the defendant transferred his personal and real property to various pure trusts. Under the trusts terms, the trusts held title to the property contained in the trusts and the defendant had no right to manage the trust property. The IRS filed liens against the farmland that had been placed in trust. The court determined that the defendant could not object to the IRS estimates of his tax liability because he failed to cooperate with the IRS during the audit process. The court also held that the defendant retained ownership rights to the farmland transferred to the trusts thereby allowing the IRS to seize the farmland and sell it to pay the defendant s tax debt. The court noted that the trusts were simply the defendant s nominee. Indeed, at least with respect to one of the trusts, the defendant was the sole trustee and the sole beneficiary. The defendant retained 46

51 possession and control of the farmland and continued to derive income for the farmland. The court also noted that the defendant s legal counsel had been suspended for six months for making frivolous tax arguments on behalf of himself and clients. United States v. Sanders, No. 11-CV-912-NJR-DGW, 2016 U.S. Dist. LEXIS (S.D. Ill. Feb. 18, 2016) No Iowa Capital Gain Deduction For Sale of Inherited Farmland. In this administrative ruling, the petitioner sold farmland and claimed the capital gain deduction on the Iowa return. The farmland was acquired by the petitioner s parents in 1968 and they farmed it through From 1977 through 1979, the petitioner farmed the land for his parents. From 1980 through 2008, the farmland was farmed by one of petitioner s brothers as a tenant under a lease with the petitioner s parents. The petitioner s father died in 1986 and his mother passed away in The petitioner sold the property later in 2008, triggering a gain to the petitioner of $75, The petitioner claimed the Iowa capital gain deduction for that amount. The Iowa Department of Revenue (IDOR) denied the deduction due to the petitioner s failure to satisfy the 10-year material participation requirement. The petitioner challenged that position on the basis that he had inherited his parents material participation as a lineal descendant. The administrative law judge upheld the IDOR s position. While the petitioner argued that he was attributed his parents material participation under I.R.C. 469(h)(3) (note the IA capital gain deduction rules use the material participation rules of I.R.C. 469) which says material participation is present in a farming activity if paragraph (4) or (5) of I.R.C. 2032A(b) would cause the requirements of I.R.C. 2032A(b)(1)(C)(ii) to be met with respect to real property used in such activity if the taxpayer had died during the tax year. The judge noted that I.R.C. 2032A(b)(4) relates to decedents who are retired or disabled and that I.R.C. 2032A(b)(5) sets forth rules for surviving spouses. Neither of those provisions applied to the petitioner, a lineal descendant. Those provisions also apply to a farming activity, an activity that had ceased in 1980 as far as the parents were concerned. From that time forward, they were engaged in a rental activity. There was no support in the statute for the petitioner s argument that he inherited his parents material participation for purposes of excluding gain on sale on the Iowa return. The judge also noted that the Iowa capital gain deduction provision (Iowa Code 422.7(21)) did not incorporate the active management provision of I.R.C. 2032A(b)(7)(B). Thus, the petitioner could not treat his active management as material participation. In re Weis, No , IA Dept. of Inspection and Appeals (Sept. 4, 2015) No Income From Stock Purchased By IRA. The petitioner sought to buy stock for his IRA, which was not a prohibited transaction. Even though the stock purchase was not a prohibited transaction, the trustee would not complete the transaction. Thus, the petitioner, had the trustee wire the purchase price directly to the corporation with the corporation issuing the stock certificate to the petitioner s IRA for the benefit of the petitioner. The trustee claimed that the stock certificate was received in the following tax year and attempted to mail it on two occasions to the petitioner. The trustee asserted, however, that the petitioner received the stock certificate in the year following the year of the transaction. The trustee issued the petitioner a Form 1099-R for the year of the transaction equal to the purchase price. The petitioner didn t report the income and the IRS asserted a deficiency. However, the court determined that the petitioner did not have income from the transaction because no funds actually passed through his hands. The court noted that an IRA owner can direct how the IRA funds are invested without giving up the tax benefits of the IRA. Here, the court noted, the funds the IRA used to buy the stock went straight to the investment and resulted in the stock shares being issued straight to the IRA. The petitioner had no claim of right to the funds, merely serving as a conduit, and was not in constructive receipt of the funds. McGaugh v. Comr., T.C. Memo Income Triggered from IRA Distribution. The petitioner sought to invest in a company that was developing a liquefied natural gas plant in Colombia. To facilitate the investment, the petitioner 47

52 transferred $125,000 from his IRA (maintained by Edward Jones) to his Edward Jones account that he held jointly with his wife. The petitioner then transferred the funds to his account at a bank. He then loaned the funds to the individual that was soliciting investors for the natural gas plant. The petitioner received a 1099-R for $125,000 indicating that the entire amount was taxable, but reported the amount as a nontaxable rollover into an account that held funds of the investing company. The court disagreed, noting that the petitioner was not merely a conduit for the funds, but had control over them and would have a claim of right to the funds. Vandenbosch v. Comr., T.C. Memo Emotional Distress Damages Taxable. The petitioner was a Postal Service employee and suffered back and neck injuries in an auto accident while on the job. As a result, the petitioner accepted a new position with the Postal Service in which would not have to carry mail, but could work at a desk answering phones and providing window assistance. Thirteen years after the accident, the petitioner was reassigned to again carry mail. However, the petitioner soon again began experiencing pain and her supervisor started retaliating against her when the petitioner requested medical accommodations and generally creating a hostile work environment. The petitioner filed complaints against the Postal Service with the Equal Employment Opportunity Commission (EEOC). The EEOC judge awarded the petitioner $70,000 in damages for emotional distress, and specifically found that the petitioner s damages did not relate to any physical pain that her employer caused. The Postal Service paid the petitioner $70,000 in 2011 which the petitioner did not report, believing the damages to not be includible in income under I.R.C. 104(a)(2). The IRS claimed that the damages were not excludible, and the Tax Court agreed with the IRS. The court noted that the award of damages were emotional distress damages and were not for physical distress or pain attributable to discriminatory actions of the Postal Service. As such, the damage award was for emotional distress attributable to discrimination and were not excluded under I.R.C. 104 in accordance with Treas. Reg (c). Barbato v. Comr., T.C. Memo Donated Coin Collection Required Qualified Appraisal. While cash that is donated to a charity normally need not be accompanied by a qualified appraisal because cash is readily valued property under I.R.C. 170(f)(11)(a)(ii), if the cash is collectible coins and the claimed charitable contribution deduction exceeds the face amount of the coins, an appraisal must be obtained if the contribution exceeds $5,000. In that situation, the exception to the appraisal requirement for cash does not apply. C.C. A (Feb. 5, 2016) Tax Court Case Illustrates Difficulty In Valuing Art For Estate Tax Purposes. The decedent died in mid-2009 during a time of market decline for many art pieces, with the market recovering shortly thereafter. In early 2010, the estate sold a Picasso at auction for almost $13 million, but reported the value for estate tax purposes at $5 million in accordance with an appraisal report that pegged the date-of-death value at that amount. The IRS asserted a $10 value by discounting the selling price to reflect the market conditions as of the date of death. The court agreed with the IRS approach, rejecting the estate s argument that the price received at auction was a fluke. The estate also contained a Motherwell painting that the IRS claimed was worth $1.5 million based on a comparable Motherwell piece that sold in late 2010 for $ million. The court, however, agreed with the estate that the market had rebounded sufficiently by late 2010 such that the sale of that piece at that time did not properly reflect the value of the estate s piece. As such, the court determined the date-of-death value of the Motherwell piece to be $800,000, agreeing with the estate. The estate also contained a Dubuffet piece that the IRS valued higher 48

53 than a comparable Dubuffet that had sold in late 2007 that had sold at $825,000. The court noted that the market had soured after 2007 and, as a result, the estate s use of the Sotheby s appraisal value for the piece of $500,000 was correct. Estate of Newberger, et al. v. Comr., T.C. Memo No Tax-Exempt Status For Farmer s Market. A farmer s market operated a marketplace where farmers and others could sell products directly to the public. The market also set-up special events where local craft vendors could sell goods, do cooking demonstrations and conduct educational programs. Its stated purpose was to strengthen the natural products economy, contribute to healthy lifestyles and support other charities. The IRS denied the market s I.R.C. 501(c)(3) application on the basis that the market provided space at the market for private businesses to sell their products in violation of Treas. Reg (c)(3)-1(d)(1)(ii). Thus, the market was organized for the substantial purpose of providing private benefit to vendors of products at the market which violated its charitable tax status. The IRS determined that the facts involved were basically the same as those mentioned in Rev. Rul Priv. Ltr. Rul (Oct. 7, 2015) IRS Can Foreclose Lien On Couple s Community Property To Pay One Spouse s Tax Debt. A married couple resided in the state of Washington, a community property state, and the husband incurred tax liabilities for unpaid taxes in years Married taxpayers in a community property state who don t file as MFJ must report one-half of the total community income that they earn during the tax year, unless an exception contained in I.R.C. 66 applies. But, the IRS can tax a spouse s entire income if the spouse acted as if they were solely entitled to the income and didn t notify their spouse of the income before filing. In such a situation, innocent spouse relief could apply. In a prior action, the court determined that the IRS had valid tax liens on all of the couple s property and the IRS moved to foreclose it liens on the couple s community property home. However, the wife claimed that the IRS couldn t satisfy her husband s tax debt with her share of the home because state (WA) community debt doctrine didn t apply. But, the court disagreed, noting that all debt acquired during marriage is presumed to be community debt and that the wife had not provide clear evidence to the contrary. The court also rejected the wife s claim that she should have been sent a deficiency notice, finding that was a non-issue because the tax liability was only assessed against her husband. The court also held that the wife was not entitled to innocent spouse relief because her husband did not act as if he were entitled to all of the income or that he failed to notify her of that notion, and because she was aware of his income. United States v. Smith, No. 3:14-cv RJB, 2016 U.S. Dist. LEXIS (W.D. Wash. Feb. 8, 2016) Receipt of Payment to Remain Monogamous Could Constitute Gross Income. The petitioner, 54, was involved in a romantic relationship with a 72-year-old man for just over a year. The couple never married, but the man transferred to the petitioner property worth almost $750,000 which included various items, cash and a Corvette. After almost a year into the relationship, the parties entered into a written agreement that was designed to confirm their commitment and provide her with financial security. The agreement also specified that they shall respect each other and shall continue to spend time with each other and shall refrain from engaging in intimate or other romantic relations with any other individual. Under the agreement, the man was required to pay the petitioner $400,000 at the time of execution. The man made the payment and then the relationship soured and the parties separated. The day after the petitioner moved out of the house they shared, he gave her notice of termination of the agreement. He also determined that she had been unfaithful during the time the agreement was in force. Soon thereafter, he filed suit against the petitioner in state court seeking to have the court nullify the agreement, have his Corvette returned along with a diamond ring and also order the return of cash and other items that he had transferred to the petitioner in 49

54 essence, the property worth almost $750,000. He also claimed that he had been fraudulently induced into the agreement. Also, he filed a Form 1099-Misc with the IRS reporting a transfer to the petitioner of almost $750,000. As a result, the IRS asserted a deficiency and the petitioner filed a Tax Court petition. About two months later, the IRS learned of the state court action and requested copies of depositions, filing and motions related to the Form 1099-Misc. and the fraudulent inducement claim. In the Tax Court action, the petitioner sought a continuance to which the IRS did not object and the Tax Court granted. The state court ruled for the man on his fraudulent inducement claim and ordered the petitioner to pay $400,000 to his estate (he died during the action). The Corvette, ring and cash gifts of approximately $275,000 were held to be gifts that the petitioner could keep. The estate executors then filed an amended Form 1099-Misc that reported $400,000 of income. The petitioner filed a motion in Tax Court seeking summary adjudication claiming that about $375,000 of property transferred to her constituted gifts rather than income, and that the IRS was estopped by the state court opinion from denying that these items were gifts. The Tax Court ruled that IRS was not estopped because it kept informed of the state court action, and it was not bound to the state court action by not opposing the continuance. However, the Tax Court denied the summary adjudication motion, which means that the Tax Court will later decide whether any portion of the nearly $750,000 is gross income to the petitioner. The petitioner will be able to argue that the amounts received were gifts. Blagaich v. Comr., T.C. Memo Rollover Period Waived Due to Emotional Distress. The taxpayer s spouse died owning an IRA that named his estate as the beneficiary. The couple served as trustees of a trust and the taxpayer became the sole trustee and beneficiary when the spouse died and had the authority to distribute the IRA to herself. Within the 60-day rollover period, the taxpayer requested a lump sum distribution from the IRA, and on that same day, the estate received a distribution from the IRA in the same amount. Within the rollover period, the taxpayer deposited the amount in a non-ira account in the name of the decedent s estate that was maintained by a financial institution. Long after the expiration of the 60-day rollover period, the taxpayer put the IRA funds into her own IRA. The taxpayer sought a waiver of the 60-day rollover period and the IRS granted it because even though the IRS treated the taxpayer as having received the proceeds from the trust and not from the decedent, the IRS said the rule doesn t apply where the surviving spouse is the sole trustee of the decedent s trust and has the sole authority and discretion under the trust language to pay the IRA proceeds to herself. Those facts applied in this instance and the relief was granted. Priv. Ltr. Rul (Nov. 9, 2015) Corporate Documents Created Second Class of S Corporation Stock. A corporation amended its articles of incorporation to provide that the corporation could issue stock in various classes. Under the amendment, there were to be no preferences, distinctions or special rights with respect to any particular class of stock. However, the articles of incorporation said that the corporation and its shareholders could enter into a written agreement and specify the manner in which the corporate assets would be distributed in the event of a liquidation, dissolution or winding up of the corporation. The shareholders and the corporation entered into a binding agreement that permitted potentially different rights of the shareholders to proceeds of liquidation. The agreement also stated that the net proceeds on liquidation would be distributed in accordance with a plan is distribution if approved by a certain percentage of corporate shareholders. If no plan was approved, the proceeds would be distributed in a way that could vary by class by the length of a shareholder s employment with the corporation. The corporation then elected S corporate status at a time that the agreement and articles were in effect. The different rights on liquidation created a second class of stock that terminated the S election. However, because the corporation amended the articles to provide for only a single class of stock and remove the differing rights among the shareholders to liquidation proceeds, the IRS granted relief. Priv. Ltr. Rul (Oct. 16, 2015). 50

55 141. Personal and Business Use Asset Is A Single Asset for Exchange Purposes. The taxpayer owned an aircraft that the taxpayer used in his business and also for personal purposes. The taxpayer exchanged the aircraft for a replacement aircraft and sought to defer the gain under I.R.C On the issue of whether the transaction qualified for deferral treatment, the IRS determined that the aircraft was to be considered a single property. The IRS did make mention that addition facts were to be considered, and also noted that the low percentage of business-related flights in the tax year at issue indicated that the aircraft would not qualify for deferral treatment under I.R.C The IRS said that a 50 percent use test was an appropriate measure for determining a property s intended use. C.C.A (Oct. 19, 2015) 142. Taxpayer Not In Real Estate Business With Result That Losses Not Ordinary. The petitioner s business plan was to acquire properties and tear the structures on the properties down and then build single and multi-unit residences for resale or rent the units out. However, from the petitioner bought only one rental property and two other properties on which he tore down the existing structures. On one of the tear down tracts, he constructed a two-condominium building and then sold it. On the other tear down property he incurred developmental costs, borrowing money to do so. However, the petitioner defaulted on the loan and the property was foreclosed on. The petitioner attempted to deduct his loss on the property as a fully deductible ordinary loss from being engaged in the real estate trade or business. The IRS and the court disagreed. The court determined that the intent to develop property is not enough, by itself, to be in the real estate trade or business. The court also held that sales activity, to get ordinary loss treatment, must be frequent and continuous rather than sporadic. Also, the court determined that inadequate properties were involved and that the petitioner s primary source of income was not from real estate activities. In addition, the court noted that the petitioner did not keep good business records. Evans v. Comr., T.C. Memo Failure To Deliver Deed Dooms Charitable Deduction. The petitioner, a partnership, made a charitable contribution of an Open Space and Architectural Façade Conservation Easement to the National Architectural Trust (NAT). The easement protected for perpetuity the façade of a certified historic structure that the petitioner owned. The petitioner claimed a $2.21 million deduction for the contribution, but the IRS denied the deduction and moved for partial summary judgment that the deduction was properly disallowed. The court granted the motion because the deed wasn t recorded in the tax year at issue. While the deed was recorded in the following year, it was only effective in the year recorded under state (NY) law thereby negating the deduction for the year claimed. The petitioner claimed that the easement wasn t created under state law so as not to be subject to the state statute and was merely a common law restrictive covenant, but the court said that the facts showed that the parties clearly intended to create an easement that fit within the parameters of the state statute. The court also rejected the petitioner s argument the recordation was only required to make the easement enforceable against subsequent purchasers. Also, the court held that Treas. Reg A- 13(c)(3)(i) was not satisfied (60-day requirement. Mecox Partners, LP v. United States, No. 11 Civ (ER), 2016 U.S. Dist. LEXIS (S.D. N.Y. Feb. 1, 2016) Self-Rental Rule Applies to S Corporation Lessor - Passive Rents Recharacterized As Non- Passive. The petitioners, a married couple, owned an S corporation that held real estate. They also owned a medical C corporation. The husband worked full-time for the C corporation and materially participated in its business activity. The couple did not, however, materially participate in the S corporation and they were not engaged in a real estate trade or business. For the years at issue, the S corporation leased commercial real estate to the C corporation. The S corporation had rental income of about $50,000 in each of the two years at issue, which the petitioners reported as passive income, not subject to self-employment tax. They also offset the rental income with passive losses from other S flow-through entities they owned as well as losses from other rental properties that they 51

56 owned. While rental income is normally passive regardless of the level of activity by the taxpayer in managing the activity and rental income will offset passive losses generated by other activities, the IRS viewed the rental income as non-passive under Treas. Reg. Sec (f)(6) (the "selfrental" rule) and disallowed passive losses that exceeded adjusted passive income for the years at issue. The petitioners, argued that I.R.C. Sec. 469 did not apply to S corporations and was invalid. The Tax Court disagreed even though I.R.C. Sec. 469, on its face, does not say that it applies to S corporations. The Tax Court held that because it need not identify S corporation due to the S corporation shareholders being the taxpayers to whom I.R.C. Sec. 469 actually applies. In addition, the Tax Court ruled that Treas. Reg (a) validly interpreted "activity" as used in I.R.C. Sec Thus, the rental activity was subject to I.R.C The Tax Court also rejected the petitioners' argument that the self-rental rule didn't apply because the S corporation, as lessor, didn't participate in the C corporation's trade or business. Thus, the Tax Court upheld the IRS determination that the rental income was properly recharacterized as non-passive and couldn't be used to offset passive losses. On appeal, the court affirmed. The court agreed that the statute need not refer to S corporations because S corporations do not pay taxes directly. The court also rejected the petitioners claim that the because the S corporation (as lessor) did not materially participate in the lessee s trade or business the self-rental rule did not apply. The court said there was no basis for reading the regulations in that manner. The S corporation was not the taxpayer for I.R.C. 469 purposes. As a result, the proper focus was on the petitioners. Viewed in that light, the self-rental rule applies and the rental income was non-passive. Williams v. Comr., No , 2016 U.S. App. LEXIS 1756 (5th Cir. Feb. 5, 2016), aff g., T.C. Memo Multi-Million Dollar Deduction Will Be Allowed In Conservation Easement Case. Due to the inability to develop his property because of nesting bald eagles, a wildlife corridor and wetlands on the property, the plaintiff donated a permanent conservation easement on the tract - 82 acres of Florida land. The land was being used as a public park and conservation area, and was preserved as open space. IRS claimed that the easement was worth approximately $7 million and, as a result, the claimed $24 million deduction (pre-easement value of $25.2 million based on highest and best use as residential development, and post-easement value of $1.2 million) resulted in a 40 percent accuracy-related penalty. The IRS based it's before/after valuation on its claim that the tract should be valued in accordance with its present zoning (limited residential development) based on prior zoning problems and likely opposition to a zoning change that would allow a higher-valued use such as multi-family housing. The plaintiff valued the before-easement value of the tract based on the ability to obtain a zoning change that would allow multi-family housing on concentrated parts of the tract which left the environmentally sensitive areas as open space. The Tax Court determined that there was a reasonable possibility that the tract could be rezoned to the higher valued use, but then adjusted the plaintiff's valuation downward to reflect the downturn in the real estate market. The Tax Court determined that the easement had a value of almost $20 million, reflecting the pre-easement value of $21 million and the post-easement value of $1 million (reflecting a reduction in the property's value of slightly over 95 percent). On appeal, the Circuit court affirmed the Tax Court s determination of the tract s highest and best use, but reversed as to the Tax Court s determination of value. The appellate court found that the Tax Court erred by reducing the proposed pre-easement value of the tract from $25.2 million to $21 million to account for a decline in property values in 2006 and departing from comparable sales data as well as relying on evidence outside the record to value the tract. Palmer Ranch Holdings, Ltd. v. Comr., No , 2016 U.S. App. LEXIS 1930 (11th Cir. Feb. 5, 2016), aff g. in part and rev g., in part and remanding T.C. Memo No Deductions for Management Fee Expenses and Losses Subject to Passive Loss Rules. The petitioner and his wife jointly owned a dental practice and got involved in an ESOP, a retirement plan that would be funded by stock in the petitioner s separate corporation. The petitioner paid the 52

57 corporation a management fee to operate the petitioner s dental practice. However, the corporation did not provide any management services and the management fee was decided by the petitioner and was not based on hours or value of services. The IRS disallowed deductions for management fees and the Tax Court agreed, also upholding accuracy-related penalties. Also, the Tax Court determined that the petitioner s claimed losses from the dental practice were subject to the passive loss rules. On appeal, the court affirmed. Elick DDS, Inc. v. Comr., No , 2016 U.S. App. LEXIS 767 (9th Cir. Jan. 15, 2016), aff g., Elick v. Comr., T.C. Memo Another Horse Breeding and Training Activity Not Engaged in With Profit Intent. A married couple operated numerous Steak 'n Shake franchises, but later also began breeding and training Tennessee Walking Horses and formed an S corporation for the horse activity. They owned a farm personally that they rented to the S corporation to conduct the horse activities on. After the husband died in a 2003 house fire, the surviving spouse became President of the corporation that ran the franchises and was very involved in the franchise businesses. They ran up substantial losses from the horse activity from 1994 to 2009, losing money every year except 1997 when they made a profit of $1,500. The only way the horse activity was able to continue was by virtue of about $1.5 million in personal loans from the couple. The IRS examined years that had total losses of about $430,000 which they attempted to deduct. The IRS denied the deductions and the surviving spouse paid the tax and sued for a refund. The court upheld the IRS determination. The court noted that under the multi-factor analysis the taxpayers (and later the widow) didn't substantially alter their methods or adopt new procedures to minimize losses, didn't get the advice of experts and continued to operate the activity while incurring the losses. The court noted that the losses existed long after the expected start-up phase would have expired. Profits were minimal in comparison and the taxpayers had substantial income from the franchises. Also, the court noted that the widow had success in other ventures, those ventures were unrelated to horse activities. The widow moved to amend the judgment to reduce the couple s taxable income by the amount of rental income that they received from the S corporation. The court denied the motion. On appeal, the court affirmed, noting that none of the nine factors of Treas. Reg (b) favored the couple. The court also ruled that the inability to deduct the losses that the S corporation sustained did not alter the fact that an S corporation is a separate entity from its shareholders. Thus, the inability of the couple to deduct the losses from the S corporation s horse activities did not entitle them to exclude the rental income from their personal return. Estate of Stuller v. United States, No , 2016 U.S. App. LEXIS 1233 (7th Cir. Jan. 26, 2016), aff g., 55 F. Supp. 3d 1091 (C.D. Ill. 2014) Taxpayers Not Entitled To Tax Credit for Home Purchase. In 2004, the petitioner bought a house, obtaining a mortgage to finance its purchase. The house was to serve as the petitioner s second home. The petitioner met his future wife in 2005, and she later that year leased an apartment for a one-year term. At the end of the lease, she moved into the petitioner s house and the parties were married one-month later. The couple lived in the house until mid-2007 when they moved to another home that they leased until early They then moved to another leased home and lived there until later in In September of 2008, the couple bought a home. The petitioner used the address of the home purchased in 2004 on his tax returns for and claimed mortgage interest deductions on those returns attributable to that home. The couple received mail and tax documents at the address of the home purchased in The petitioner also claimed a homestead exemption with respect to the home purchased in 2004 for years On their, 2008 return, the couple claimed a first-time homebuyer tax credit (FTHBTC) attributable to the home purchased in The IRS disallowed the credit on the basis that the petitioner owned and used another residence as a principal residence in the three years before the purchase of the home for which the credit was claimed, and imposed an accuracy-related penalty. The petitioner claimed that the 2004 home was not a qualified principal residence because the other homes were his principal residences 53

58 and that he actually intended to rent the 2004 home. The court upheld the IRS determination because the facts favored classification of the 2004 home as the petitioner s principal residence. The court did not uphold the accuracy-related penalty. Blackbourn v. Comr., T.C. Summary Op Ninth Circuit Again Says That Stock Received Upon Demutualization Has No Basis. Following up its late 2015 decision in Dorrance v. United States, No , 2015 U.S. App. LEXIS (9th Cir. Dec. 9, 2015), the U.S. Court of Appeals for the Ninth Circuit has again held that stock received pursuant to an insurance company demutualization does not have any income tax basis in the shareholder s hands. Under the facts of the case, the taxpayers (husband and wife) created an irrevocable trust in 1989 and the trust bought an insurance policy from a mutual life insurance company. The trust paid over $1.7 million in premiums over the next 10 years until the time that the company demutualized. The trust received 40,300 shares and later distributed 5,001 of the shares to the taxpayer in 2004 who sold 4,000 of them in 2005 for $160,000. On the taxpayer s 2005 return, the stock sale was reported with the shares having a zero basis. However, the taxpayer filed an amended return in 2008 for the 2005 tax year claiming an income tax basis in the shares consistent with the U.S. Court of Federal Claims decision in Fisher v. United States, 82 Fed. Cl. 780 (2008), and seeking a refund. The IRS rejected the refund and the taxpayer sued for a refund in federal district court. The district court upheld the IRS position and the appellate court affirmed. The trial court had determined that the open transaction doctrine utilized by the Fisher court did not apply to stock received upon demutualization. Reuben v. United States, No (9th Cir. Jan. 5, 2016) Conservation Easement Deduction Fails Due to Lack of Qualified Appraisal. The taxpayers (who were not represented by legal counsel) were a married couple who lived in a 1898 home in a Chicago north side historic district. In 2007, they donated a façade easement and $10,800 to a qualified charity. The IRS did not challenge the cash donation, but disallowed the deduction associated with the easement that was claimed to be worth $108,000 on the basis that the appraisal was not a qualified appraisal in accordance with I.R.C. Sec. 170(f)(11)(A) and (C) and because the taxpayers had not included an appraisal summary on IRS Form 8283 with their return (which was prepared by a CPA in his mid-80s). The IRS claimed that the easement donation should have been valued at no more than $35,000. The court agreed with the IRS, finding that the failure to include a copy of a qualified appraisal doomed the claimed deduction. The court also upheld the IRS imposition of the 20 percent penalty under I.R.C. Sec. 6662(a) and (b)(1) and, in the alternative, the 40 percent penalty for gross valuation misstatement under I.R.C. Sec. 6662(h) (a strict liability penalty with no reasonable cause exception). Gemperle v. Comr., T.C. Memo Treasury Withdraws Proposed Regulations That Would Have Tweaked Contemporaneous Acknowledgement Rules For Charitable Contributions. Under I.R.C. 170(f)(8), a taxpayer claiming a charitable contribution deduction exceeding $ must substantiate that deduction with a contemporaneous written acknowledge from the donee, showing the amount of the contribution, whether any good and services were received in return for the donation and a description and good faith estimate of any goods and services provided by the donee or that the donee provided only intangible religious benefits. However, I.R.C. 170(f)(8)(D) says that the substantiation rules don t apply if the donee files a return including the contemporaneous written acknowledgement information that the taxpayer was otherwise supposed to report. This provision allows taxpayers to cure their failure to comply with the contemporaneous written acknowledgement requirement by the donee exempt organization filing an amended Form 990. However, without any regulations, the IRS has taken the position that the statutory provision does not apply. Apparently believing that their position was weak and would not be supported judicially, the proposed regulations acknowledge the exception and allow the charitable organization to file a form (yet to be announced) on or before February 28 of the year after the year of the donation 54

59 that shows the name and address of the donee, the donor s name and address, the donor s tax identification number, the amount of cash and a description of any non-cash property donated, whether the donee provided any goods and services for the contribution, and a description and good faith estimate of the value of any goods and services the donee provided or a statement that the goods and services were only intangible religious benefits. The form must be a timely filed form and cannot be filed at the time the taxpayer is under examination, and a copy of the form must be provided to the donor. In early, January of 2016, the IRS withdrew the proposed regulation. The regulation was controversial because done organizations that chose to use the procedure would have been required to obtain (and retain) the Social Security numbers of donors which could have increased the potential for identity theft. REG (Sept. 16, 2015); Prop. Treas. Reg A-13(f)(18)(i-iii); withdrawn January 7, Ag Cooperative Joint Venture Generates DPAD Ruling. An agricultural cooperative provides various products and services to members and markets grain for its members that the members raise. The taxpayer considered combining its grain marketing function with another cooperative. To facilitate the joint marketing function, an LLC taxed as a partnership was proposed to be formed with each cooperative receiving a fixed percentage interest in the LLC. Each cooperative s distributive share of partnership net gain/loss were to be based on the fixed percentage. The taxpayer sought IRS guidance on the various tax aspect of the proposal. The IRS determined that the taxpayer s distributive share of net income/loss from the LLC that was attributable to marketed grain on behalf of members would be patronage-sourced. The IRS also determined that grain payments to members (and participating patrons) would be per-unit retains paid in money (PURPIMs). In addition, the IRS determined that the taxpayer would qualify for an I.R.C. Sec. 199 deduction with respect to grain it purchased from its members and participating patrons, and that the deduction would be computed without regard to any deduction for the grain payments made to members and participating patrons. Priv. Ltr. Rul (Sept. 28, 2015). DEPREICATION-RELATED ISSUES FOR FARM ASSETS A. The following table is reproduced from IRS Publication 225, Farmer s Tax Guide, Chapter 7: 55

60 B. Vineyard assets. 1. The Tax Court determined the proper class life or recovery period for several categories of depreciable vineyard assets [Trentadue v. Comm., 128 TC No. 8, 2007]. a. The court determined that trellising used to support the vines was similar to fencing, was not a permanent land improvement, and accordingly should be categorized in a manner similar to agricultural fencing or other farm machinery and equipment (10-year class life or 7-year recovery period). b. However, a well for irrigation, and a drip irrigation system that was largely buried underground, were categorized as land improvements with a 20-year class life and 15-year recovery period. c. Commentary: The authors criticize this conclusion, for several reasons: 1) The Tax Court held that the trellis of a vineyard is a machine, cost recovery for which is over seven years. The drip irrigation system, however, was found to be a land improvement. The distinction between the two is that the court had no evidence before it that the drip irrigation system was capable of being moved or that the taxpayers had ever moved it, while the taxpayers had stated that they had dismantled a trellis and moved it to a different vineyard. 2) The court missed the point with regard to the drip irrigation system. If the trellis is a machine that was adjusted to train grapevines to produce high-quality grapes, the drip irrigation system would also be such a device, also necessary to produce high-quality grapes. The grapes could not be produced without either the trellis or the drip irrigation. The drip irrigation (together with the trellis) is designed specifically for the vines to deliver water precisely where and when needed. The fact that it is underground is not relevant. 3) Another point missed by the court is that the drip irrigation system would be destroyed if the trellis is moved or dismantled. An asset that so interacts with another asset as to be abandoned has a cost recovery period no longer than the asset with which it is interacting. a) Land grading for the construction of a building is depreciable because the land grading has no value beyond the life of the building (otherwise, land grading being land is not depreciable) [Rev. Rul ]. The ruling has not been cited as support for the position that two distinct assets are necessarily linked due 56

61 to the shorter life of one asset. b) Modern golf course greens are intricately linked to the drainage and irrigation system and thus the land preparation costs associated with the golf course greens are depreciable over 15 years [Rev. Rul ]. 4) Conclusion: Under this theory, the drip irrigation system would be depreciated over the 7-year cost recovery period of the trellis. 57

62 C. Race horses. 1. Previously, the recovery period for a race horse depended on its age when placed in service. a. A race horse two years old or younger at the time placed in service was assigned a sevenyear recovery period [Rev. Proc , asset class ]. b. A race horse more than two years old at the time placed in service is assigned a threeyear recovery period [Sec. 168(e)(3)(A)(i)]. 2. Effective for horses placed in service after 2008 and prior to 2015, all race horses are assigned a three-year recovery period, regardless of age when placed in service [Sec. 168(e)(3)(A)]. D. Buildings and structures. 1. Farm real property appears in at least four classifications: a. Class 00.3 land improvements (cost recovery period = 15 years); b. Class 01.4 single purpose agriculture or horticulture structures (cost recovery period = 10 years); c. Class 01.3 farm buildings (cost recovery period = 20 years); and d. Section 1245 real property with no class life (cost recovery period = 7 years). 2. Commentary: The code generally restricts depreciable real estate to use of the straightline method [Sec. 168(b)(3)]. However, this rule does not apply to property with a recovery period of less than 27.5 years [Sec. 168(e)(2)(B)]. Accordingly, 15 and 20 year depreciable farm real estate may use the 1.5 DB method. 3. Class 00.3 land improvements are items directly added to land, and may be Sec or 1250 property, provided that they are depreciable. a. Examples include sidewalks, roads, canals, waterways, wharves and docks, bridges, fences, landscaping, shrubbery and transmission towers [Rev. Proc ]. b. Earthen improvements are generally not depreciable, although old authorities have allowed depreciation if it can be established that there is physical deterioration over time [IRS Publ. 225, Ch. 7]. If not maintained, the improvement becomes worthless. 1) Earthen dams constructed on a ranch were held to have a useful life due to silting [Ekberg v. U.S., 60-1 USTC 9332, DC-SD, 1959]. 2) Land improvement costs for excavation and dredging are depreciable if the asset is actually exhausting and such exhaustion is susceptible of measurement [Rev. Rul ]. 58

63 3) Expenses for maintaining such improvements should be deductible as repairs. c. Based upon the description, land improvements do not look like buildings. Examples may include: 1) Silage bunkers; 2) Concrete ditches, wasteways and pond outlets; and 3) Irrigation and livestock watering wells. 4. Single purpose ag or horticultural structures are described in Sec. 48(p) (since repealed, but continuing to be a valid definition for this purpose). a. A single purpose ag structure is used for housing, raising and feeding a particular type of livestock and their produce, and the housing of the equipment necessary for such [Sec. 48(p)(2) (repealed)]. Examples include hog houses, poultry barns, livestock sheds, milking parlors and the like. b. A single purpose horticultural structure is a greenhouse specifically designed, constructed and used for the commercial production of plants [Sec. 48(p)(3)(A) (repealed)] and a structure specifically designed, constructed and used for the commercial production of mushrooms [Sec. 48(p)(3)(B) (repealed)]. c. Commentary: Only greenhouses and livestock structures qualify as single purpose ag and horticultural structures. 5. Assets which have the appearance of a building but qualify as Sec assets (and not separately classified as single purpose ag or horticultural structures) are not buildings [Reg (e)(1)(i)]. They are, in essence, items of machinery or equipment which are an integral part of manufacturing [or] production [Sec. 1245(a)(3)(B)(i)]. a. Structures such as storage facilities for potatoes, onions and other cold storage facilities for fruits and vegetables are included in this category. b. Sec. 48(a)(1)(B)(i) (repealed) defined property which qualified for Sec. 38 investment tax credit. The Tax Reform Act of 1986 moved that language into Sec for depreciation recapture purposes. 1) Commentary: Authorities defining property as qualifying for pre-1986 investment tax credit should be valid for determining property described in Sec. 1245(a)(3). c. If used for other purposes after the commodities have been removed, the structures are buildings, rather than Sec real property. 1) If the property is easily adaptable to other uses, it is a building. A building with a kit installed for commodity storage did not qualify for Sec. 38 investment tax credit [Tamura v. U.S., 54 AFTR 2d , CA-9 and Bundy v. U.S., 59 AFTR 2d , DC-NE]. 59

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65 2) However, if the property is of special design and unsuitable for other uses, it is not a building [Palmer Olson v. Comm., TC Memo , 10/22/1970]. 3) Factors which indicate that a structure is closely related to the use of the property it houses include the fact that the structure is specifically designed to provide for the stress and other demands of such property and the fact that the structure could not be economically used for other purposes [PLR ]. 6. Class 01.3 farm buildings are, by elimination, real property items not included in another class. Examples include shops, machine sheds and other general purpose buildings on a farm that are not integral to the manufacturing, production or growing process. 7. Other property (not including a building or its structural components) used as an integral part of manufacturing or production qualifies for Sec. 179 [Sec. 179(d)(1)(B)]. a. By definition, this describes single purpose ag and horticultural structures [Sec. 1245(a)(3)(D)]. b. Land improvements, such as irrigation and livestock watering wells and silage bunkers, may qualify for Sec. 179 if used in the manufacturing, production or growing process [Sec. 1245(a)(3)(B)(i). c. Grain storage in connection with a manufacturing and production activity qualifies for Sec. 179 [by way of Sec. 1245(a)(3)(B)(iii)]. E. 150% declining balance restriction for farming assets. 1. Assets used in a farming business are required to use the 150% declining balance method in place of the 200% declining balance method. Farming business is defined in Sec. 263A(e)(4) [Sec. 168(b)(2)(B)]. a. The business of the taxpayer controls the method available for depreciation, rather than the function of the equipment in the business. Consequently, to determine the available depreciation method, one looks to the taxpayer s business. b. To determine the classification of the asset, which dictates the recovery period, one looks to the asset s use under Rev. Proc A custom harvester is not in a farming business for purposes of determining the depreciation method [TAM ]. The taxpayer does not raise or grow the grain harvested and hauled. The IRS noted that the taxpayer s business is providing a service by cutting and hauling grain. The 200% declining balance method was allowed. 3. Processing activities may cross the boundary from farming to manufacturing. a. Regulations distinguish incidental activities to growing, raising or harvesting of agricultural or horticultural products. For example, a taxpayer in the business of growing fruits and vegetables may harvest, wash, inspect, and package the fruits and vegetables for sale without further processing. This is considered the business 61

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67 of farming [Reg A-4(a)(4)(ii)]. Depreciation is limited to the 150% declining balance method. b. The further processing into another product is not a farming activity. The milling of grain into flour, producing breads and cereals and other similar products is not a farming activity. Likewise, the slaughtering, processing, packaging or canning of products, changing their form, is not a farming activity [Reg A-4(a)(4)(iii), Examples (2) and (3)]. c. If the farming and processing are performed within the same entity, the assets principally used in the farming business are subject to the slower depreciation method, while the processing assets are allowed the faster method. 4. A leasing business is not a farming business, in that no farming activity is being performed by the lessor. Equipment assets may be depreciated by the lessor using the 200% declining balance method. The tenant s use of the property, however, will determine the properties asset class. A building leased to a farm, used in the farming activity by the tenant, is a farm building under Class 01.3 [Rev. Proc ]. F. Correcting accounting methods for fixed assets. 1. Background. a. The acquisition of property consisting of multiple classes of depreciable and nondepreciable assets requires an allocation in proportion to the fair market value of the assets acquired [IRS Pub. 225, Ch. 6]. b. Written allocations provided in purchase documents require the buyer and seller to follow such allocations for tax reporting purposes, absent the showing of duress or fraud [Sec. 1060(a); Comm. v. Danielson, 19 AFTR 2d 1356, CA-3, 05/02/1967]. Most farm purchase documents do not provide an allocation of the purchase price to the various depreciable and nondepreciable components. c. If an asset acquisition represents a business with going concern value, both the buyer and the seller must disclose the purchase price allocation on Form 8954, Asset Acquisition Statement, within their tax returns [Sec. 1060(b); Reg (e)(1)(ii)]. However, the purchase of farm real estate alone does not represent a going concern business; Form 8594 is not required. d. Applying the tax basis from the purchase of an asset to the various depreciable and nondepreciable components establishes an accounting method in terms of the resulting depreciation deductions. A change in basis allocation affecting depreciation deductions is an accounting method change. 2. Effecting an accounting method change. a. An accounting method change may only be made with the consent of the IRS [Sec. 446(e); Reg (e)(2)]. 63

68 b. The accounting method change requires a computation of a Sec. 481(a) adjustment, which represents the cumulative effect of the change as of the first day of the tax year for which the change is to occur. c. Accounting method changes resulting in an increase to income are spread equally over a fouryear period beginning in the year of change. Net negative adjustments are claimed in full in the year of change [Rev. Proc , Sec. 7.03]. d. Accounting method changes are not bound by the statute of limitations [Rev. Proc , Sec. 2.06(1)]. 3. Planning opportunity. a. Some taxpayers may have made aggressive allocations of purchase prices. Unsupported allocations of purchase prices may have been made to depreciable assets such as residual fertilizer value, claiming amortization on excess value attributable to government payments or excess values to depreciable assets such as drainage systems. b. On the other hand, purchases years ago may not have been properly allocated to depreciable assets such as drainage systems. For example, Farm Service Agency (FSA) may have data to provide information on length and size of tile installed on the property under cost sharing programs. c. Automatic changes in accounting method may be utilized to cure problem allocations, under-depreciation and over-depreciation from prior years. The change from impermissible depreciation and amortizable is assigned method change code No. 7 [Rev. Proc , Sec. 6.01]. 1) Taxpayers at risk for errors in depreciation or amortization may strategically choose which year to initiate the change. A high income year may be offset by changes which result in net negative adjustments, fully deducted in the year of change. 2) Taxpayers who claimed excess deductions may benefit from spreading the adjustments over the required four-year period, choosing which year to initiate the change. However, the taxpayer remains at risk for IRS or state agency examination if the government agencies provide notice of examination prior to the filing of Form Farmers and the Sec. 179 Deduction A. Fluctuating Sec. 179 limits. 1. Sec. 179 permits taxpayers to elect to expense the cost of any qualifying property placed in service during the tax year (subject to certain dollar limitations) in lieu of claiming depreciation with respect to that property. a. Sec. 179 property is defined as depreciable tangible personal property acquired for use in a trade or business. b. Which is Sec property (as described in Sec. 1245(a)(3)); and 64

69 c. Which is acquired by purchase for use in the active conduct of a trade or business. 2. Sec. 1245(a)(3) property includes (among others): a. Tangible personal property; b. Other property (not including a building or its structural components) used as integral part of manufacturing or production or which constitutes a facility used in connection with manufacturing or production for the bulk storage of fungible commodities; or c. A single purpose agricultural structure or horticultural structure. 3. Taxpayers making the Sec. 179 expensing deduction must reduce the property s depreciable basis by the amount of the expense deduction and then depreciate any remaining basis. 4. The deduction phases-out on a dollar-for-dollar basis to the extent the taxpayer s eligible purchases exceed $2 million (indexed 2017 amount is $2,030,000). 5. The 2015 PATH Act permanently added the $500,000 and $2 million thresholds. Both are indexed for inflation [2015 PATH Act Sec. 124DivQ]. 6. The Sec. 179 limits apply based on the taxpayer s fiscal year. For example, a taxpayer with an October 31 fiscal year-end applies the indexed Sec. 179 limit applicable to the date at the beginning of the year. Bonus depreciation, however, is based upon the actual placed-in service date. Example 1 Phase-out of $500,000 Sec. 179 annual limit Fair Acre Family Farms, Inc., an S corporation, completed a major addition to its grain bin and drying system in 2017, and also acquired a tractor and combine during It also constructed a swine feeding facility in The sum of these asset additions was $2.2 million. Fair Acre must reduce its $570,000 Sec. 179 limit for 2017 by $170,000, the amount by which its qualifying property acquisitions exceed $2.03 million. Accordingly, Fair Acre may only claim $340,000 of Sec. 179 deductions for 2017 ($510,000 - $170,000). B. Extended election and revocation period for Sec Taxpayers may revoke the Sec. 179 election on an amended tax return. Such revocation, once made, is irrevocable [Sec. 179(c)(2)]. 65

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71 Example 2 Revoking a Sec. 179 deduction on an amended return Joe, a farm proprietor, is a 50% shareholder in an S corporation that conducts a hog breeding activity. The other 50% shareholder is Joe s brother. When Joe receives the Form 1120S Schedule K-1 for 2017, he recognizes that the S corporation has made a Sec. 179 election with respect to $510,000 of farm equipment (Joe is allocated a $255,000 Sec. 179 deduction as a 50% shareholder). However, during 2017, Joe made well and drainage facility improvements of approximately $400,000. Recognizing that these improvements in his proprietorship are 15-year recovery assets, Joe suggests to his brother that the S corporation amend its return to reduce the Sec. 179 election on the farm equipment to $220,000, so that his 50% is no more than $110, IRS regulations allowing late or amended Sec. 179 elections. a. The IRS has issued regulations allowing a late Sec. 179 election to be made on an amended return at any time within the statute of limitations [Reg (c)]. b. The IRS subsequently announced Sec. 179 elections may be made by amended return for any taxable year in which Sec. 179(c)(2) allows a revocation of the Sec. 179 election by the taxpayer [Rev. Proc , Sec.7]. c. The regulations indicate that any amended election must specify the items of Sec. 179 property and the portion of the cost of each item to be taken into account, and must also make other appropriate adjustments to the depreciation computations for the current and any succeeding tax years [Reg (a)]. Example 3 Amended return to elect additional Sec. 179 deduction 67

72 Tom, a farm proprietor, purchased and placed in service one item of Sec. 179 property during 2016, a tractor costing $135,000. On Tom s 2016 tax return, he elected to expense under Sec. 179 only $20,000 of the cost of this asset, as that deduction reduced his joint taxable income to the top of the 15% federal tax bracket. Subsequently, in the course of preparation of Tom s 2018 return it becomes apparent that a Schedule J farm income averaging election would be beneficial, and Tom would be better served if the 2016 base year had lower taxable income. Accordingly, an amended return is prepared for 2016, increasing the Sec. 179 deduction on the tractor by $30,000, to better position the Schedule J income averaging calculation as part of Tom s 2018 tax return. As an added benefit, Tom s SE tax was also reduced for d. Commentary: Following are examples of where an amended Sec. 179 election could be helpful: 1) Any late appearing income, such as a corrected Schedule K-1, that requires an amended return could be offset by an amended Sec. 179 election, assuming the taxpayer did not originally maximize the Sec. 179 limit. 2) If, upon IRS examination, an expenditure originally deducted as a repair is capitalized, the taxpayer has the ability to make a late Sec. 179 election (again assuming that the Sec. 179 maximum amount had not earlier been utilized). 3) As illustrated in the preceding example, an amended Sec. 179 election could be used to better position the base period income for a current Schedule J farm income averaging election. 4) If a taxpayer did not originally properly designate or specify assets that were the subject of a Sec. 179 election, an IRS agent is not able to disallow the election due to lack of disclosure, because the taxpayer has the ability to make a late or corrected election through an amended return. 5) If an asset acquired in recent years was the subject of a Sec. 179 election and is now sold in the current tax year, the Sec. 179 election in that earlier year could be switched to other qualifying assets purchased in this same year, so as to restore basis on the asset that is currently sold. Example 4 Amended return to shift Sec. 179 deduction Tim, an ag producer, purchased and placed in service two items of Sec. 179 property in 2014: a tractor costing $120,000 and a combine costing $230,000. In his 2014 Form 1040, Tim elected to expense the entire $120,000 tractor. In November 2015, Tim decided he no longer needed the tractor and sells that asset for $110,000. Under the regulations, Tim is allowed to file an amended return for 2014, revoking the Sec. 179 election for the tractor, claiming normal depreciation for 2014 on that asset, and making an election under Sec. 179 to claim the $120,000 amount on the combine. The amended return must also include an adjustment to the depreciation previously claimed on the combine [Reg (c)(4), Example 1]. As a result of the amended Sec. 179 election, Tim has eliminated over $100,000 of gain that would have occurred from the sale of the tractor. 68

73 4. Caution: Many states do not follow the expanded federal limitation for state income tax purposes and apply a lower Sec. 179 limitation. C. Limit on Sec. 179 deduction for certain vehicles. 1. Background. a. Any four-wheeled vehicle manufactured for use primarily on roadways and rated at 6,000 pounds unloaded gross vehicle weight or less, or any truck or van with a gross vehicle weight rate of 6,000 pounds or less, is subject to the Sec. 280F annual depreciation limits. b. With the increased Sec. 179 limits, it became possible to entirely deduct the cost of a full size (over 6,000 pound) SUV or pickup truck in the year of acquisition. 2. The 2004 Tax Act limited the ability of a taxpayer to claim a Sec. 179 deduction for certain trucks and SUVs to $25,000 [Sec. 179(b)(6)]. a. The provision applies to SUVs and trucks rated between 6,000 pounds and 14,000 pounds gross vehicle weight. b. While the legislation refers to a sport utility vehicle (SUV), the statutory definition extends to any vehicle primarily designed for use on public roadways which is not subject to the Sec. 280F depreciation limits applicable to vehicles rated at 6,000 pounds or less. 3. The statute excludes three categories of vehicles from the $25,000 limit on the Sec. 179 deduction: a. Any vehicle designed to have a seating capacity of more than nine persons behind the driver s seat (e.g., a hotel shuttle van); b. Any vehicle equipped with a cargo area of at least six feet in interior length which is an open area or is designed for use as an open area but is enclosed by a cap and is not readily accessible directly from the passenger compartment (e.g., a pickup truck); or c. d. Any vehicle which has an integral enclosure, fully enclosing the driver compartment and load carrying device, does not have seating rearward of the driver s seat, and has no body section protruding more than 30 inches ahead of the leading edge of the windshield (e.g., an electrician s van). Commentary: A vehicle that meets one of the three preceding exceptions and has a weight rating exceeding 6,000 pounds remains eligible for the full Sec. 179 deduction. Example 5 SUV subject to $25,000 Sec. 179 limit Ted, a calendar year farm proprietor, acquires and places in service a used SUV (Yukon XL) costing $30,000. This vehicle has a gross vehicle weight rating over 6,000 pounds. Ted may claim a Sec

74 deduction of up to $25,000, and the remaining adjusted basis is eligible for normal depreciation under the general rules. e. Commentary: This Sec. 179 limitation of $25,000 affects larger SUVs and vans over the 6,000 pound definition, but many pickup trucks over 6,000 pounds will continue to have the full Sec. 179 allowance available. Many full-size pickup trucks meet the second exception above, as they have a cargo box area of at least 6 feet in interior length (many are 6½ feet or 8 feet), and this area is not readily accessible directly from the passenger compartment. However, some extended cab pickups have a shorter cargo box area that is under 6 feet in interior length. Those vehicles would be subject to the $25,000 limitation. Example 6 Pickup truck subject to $25,000 Sec. 179 limit Fred, a farmer, is considering the acquisition of a used full-size Ford F-150 pickup truck with a gross vehicle weight rating exceeding 6,000 pounds. Fred is considering two alternatives, both costing about $32,000. One version has four doors and a 5.5 foot pickup box, while another version, also with four doors, has a 6.5 foot pickup box. If Fred acquires the smaller sized pickup box, his first year Sec. 179 deduction would be limited to $25,000, while a version with a larger cargo area of at least 6 feet in interior length will qualify for the full Sec D. Noncorporate-lessor rules. 1. Under the two criteria of the noncorporate lessor rules of Sec. 179(d)(5), property leased to others is not eligible for Sec. 179 unless: a. The term of the lease is less than 50% of the class life of the property; and 70

75 b. During the first 12 months of the lease, the deductions of the lessor with respect to the property (other than taxes, interest and depreciation) exceed 15% of the rental income produced by the property. 1) Commentary: Delaying the rental income payment will not effectively reduce the amount of rent produced by the property. 2. The noncorporate lessor rules present a significant barrier to farm landlords, whether cash rent or crop share, with respect to many real estate improvements. a. While many unrelated party farm leases are short-term in duration (and thus meeting the first test), related party leases that are automatically renewed may present a problem. Courts have typically construed leases between related parties that are annually renewable as leases of a long-term duration [e.g., Thomann v. Comm., TC Memo ]. b. The second test (incurring overhead in the first 12 months of the lease that exceeds 15% of the rental income) is nearly impossible to meet with respect to drainage tile and similar real estate improvements that do not require repairs and maintenance. 1) The 15% test may be met by adjusting the terms of the lease. Example 7 Non-corporate lessor Lou is a farm landlord who recognizes that he needs to replace the irrigation pivot on his land. The terms of the lease had called for rent of $300 per acre with the tenant paying water and power costs of $70 per acre. Lou spends $100,000 to replace the irrigation pivot. His expenses as a landlord (other than interest, taxes and depreciation) do not approach the $45 hurdle he needs to overcome to meet the 15% test. The lease will be for three years. Lou and his tenant modify the rental arrangement so that Lou pays the water and power costs. The rent is adjusted to $370 per acre. Since the water and power cost of $70 per acre is greater than 15% of $370 ($55.50), and the lease is for less than 50% of the 10-year class-life for agricultural equipment [Rev. Proc ], Lou is allowed to claim the Sec. 179 deduction against his rental income. c. If more than one property is subject to a single lease, an allocation of rent and expenses to each property is necessary [dated guidance under Reg (d)(3)]. 3. S Corporations are corporations and therefore not subject to the noncorporate lessor rules. a. In the pre-1990 version of the provision, the noncorporate lessor restrictions referred to the former investment credit definitions. An S corporation was considered to be a person which is not a corporation [Reg (d)(1)(ii)]. b. Subsequent legislation eliminated this treatment of S corporations [PL amending Sec. 179(d)(5)]. 71

76 4. Recognize that equipment items purchased by the landlord and used by the landlord in the leasing business are not subject to the noncorporate lessor rules (e.g., lawnmowers, snowblowers, and similar items acquired by a farm building site owner to maintain the premises that are leased to another party). Only assets actually leased to others are subject to the noncorporate lessor rules. E. Active business taxable income limit. 1. The Sec. 179 deduction cannot exceed aggregate business taxable income [Sec. 179(b)(3)]. a. Aggregate business net income must be derived from businesses actively conducted during the taxable year. This definition includes Sec gains or losses, as well as interest from the working capital of the business [Reg (c)]. b. Active conduct is defined as a facts and circumstances test, to determine if the taxpayer meaningfully participates in the management or operations of the trade or business [Reg (c)(6)(ii)]. c. Wages and salaries received by a taxpayer as an employee are included in the aggregate amount of active business taxable income of the taxpayer. 2. In addition to applying at the individual taxpayer level, this limitation also applies to passthrough entities such as S corporations and partnerships. For the active participation test, the regulations indicate that a partner is considered to actively conduct a business of the partnership if the partner meaningfully participates in the management or operations of the business. A mere passive investor in a business does not actively conduct the business [Reg (c)(6)(ii)]. 3. The limitation for an S corporation is determined by increasing business net income for those deductions claimed for compensation to shareholder-employees [Reg (c)(3)(ii)]. 4. Similarly, the taxable income limitation for partnerships is determined after adding back deductions for guaranteed payments paid to partners [Reg (c)(2)(iv)]. 5. Any Sec. 179 amounts disallowed by reason of the business taxable income limit are allowed as a carryover to the next tax year [Sec. 179(b)(3)(B)]. 72

77 Example 8 Using wage income to support a Sec. 179 deduction Lars is an active farmer who reports as a Schedule F proprietor. A number of years ago, Lars invested in a hog farrowing partnership in which he is a 10% owner. He sells his interest in that partnership and must recognize approximately $150,000 of ordinary income depreciation recapture. Lars would like to run his Schedule F into a loss position to offset some of the depreciation recapture arising from the sale of the partnership interest, and would like to use a Sec. 179 deduction as part of his farm expenses for the current year. However, because Lars does not actively participate in the management of the partnership, that income and gain is not available to support a Sec. 179 deduction, and Lars cannot claim any Sec. 179 expense. Assume, however, that Lars is married, and his spouse, Leah, is employed in a professional position with a $100,000 W-2. The active business taxable income limit for Sec. 179 purposes is applied jointly in the case of a husband and wife who file a joint income tax return [Reg (c)(7)]. Accordingly, if Leah s W-2 is $100,000 and Lars Schedule F has a $40,000 loss before any Sec. 179 deduction, Lars could claim up to $60,000 of Sec. 179 expense under the active business taxable income limit. F. Sec. 179 annual dollar limitation applicable to partnerships. 1. The annual dollar limitation ($510,000 for 2017) applies to partnerships and S corporations as well as to each individual owner [Reg (b)(3)(i)]. 2. Caution: In agricultural operations, it is common for family members to share ownership of equipment. If these co-ownership arrangements rise to the level of a partnership entity, a single Sec. 179 limitation would apply to equipment purchases. Conversely, if the coownership does not represent a partnership, each individual would be entitled to use their respective share of equipment purchases in calculating the Sec. 179 limitation. 3. Commentary: The Form 1065 instructions state that A joint undertaking merely to share expenses is not a partnership. Mere co-ownership of property that is maintained and leased or rented is not a partnership. However, if the co-owners provide services to the tenants, a partnership exists (2016 instructions, page 2). The absence of a formal written partnership agreement is not controlling. Rather, the degree of business activity conducted by the coowners is determinative [Cusik v. Comm., TC Memo ]. G. No Sec. 179 deduction for estates or trusts. 1. An estate or trust may not claim a Sec. 179 deduction [Sec. 179(d)(4)]. 73

78 Example 9 No Sec. 179 deduction for farm estates or trusts Jim, a farm proprietor, dies at age 55. Following his death, his farm proprietorship business is conducted by his estate for a period of 18 months, at which time the farm proprietorship business is distributed to a Marital Trust. During the period that this farm proprietorship is within Jim s estate, as well as during the period when the farming business is conducted by the trust, no Sec. 179 deductions may be claimed. If the farm business remains within the Marital Trust, no Sec. 179 deductions may ever be claimed in connection with this business. In this situation, the trustee should consider whether the farming business should be distributed from the trust to Jim s surviving spouse, so that future Sec. 179 deductions will be permitted. 2. An estate or trust that owns an interest in a partnership or S corporation may not deduct its allocable share of the Sec. 179 expense elected by the partnership or S Corporation [Reg (f)(3)]. This regulation provides that the partnership or S Corporation s basis in the depreciable asset is not reduced by a portion of a Sec. 179 expense that would be allocable to a trust or estate. Rather, the partnership or S Corporation claims depreciation with respect to any depreciable basis allocable to the trust or estate s share of the Sec. 179 expense. a. The authors are unsure as to how this treatment is applied for trust and estate S corporation shareholders, due to the requirement that all items are to be allocated pro rata to all shareholders. b. For a partnership, a special allocation of the Sec. 179 to the non-estate and trust partners, followed by another special allocation of the resulting depreciation expense to the non-estate and trust partners, completes the concept provided by Reg (f)(3). Example 10 Partnership interest held by a trust Senior owned 20% of the family farming business at the time of his death, with his two sons each owning 40%. As a result of Senior s death, his 20% partnership interest passed into a Family Trust, providing income to his surviving spouse. To the extent that a portion of the partnership interest remains within the trust, the partnership may not allocate any Sec. 179 deduction to that 20% partnership interest. A provision may be written into the partnership agreement providing for Sec. 179 deductions to be allocated to non-trust partners, with a commensurate depreciation deduction for the 20% interest held by the Family Trust. That portion of the depreciable basis allocable to the Trust is claimed under normal depreciation rules by the partnership. H. Vineyards eligible for Section The IRS previously ruled that vineyards and other fruit-bearing trees were not Section 179 property [Rev. Rul ]. However, this ruling was issued when the definition of eligible Section 179 property excluded land improvements and also did not refer to Section 1245 status. 2. The current definition of Section 179 property requires that the property is: 74

79 a. Tangible property subject to Section 168 cost recovery; b. Section 1245 property; and c. Acquired by purchase for use in an active trade or business [Sec. 179(d)(1)]. 3. The IRS Chief Counsel has advised that a taxpayer placing a vineyard in service may claim the Section 179 deduction for its costs [CCA ]. a. This ruling determined that a vineyard is other tangible property described in Sec. 1245(a)(3)(B)(i), and accordingly is eligible for the Section 179 deduction. b. The ruling also noted that a vineyard whose costs included labor and other capitalized Sec. 263A planting costs represented property acquired by purchase for Section 179 purposes. The term purchase is defined as any acquisition other than from a related party and other than in a carryover basis transaction or an acquisition from an estate [Sec. 179(d)(2)]. 4. Caution: The inclusion of orchard and vineyards as qualifying for Sec. 179 may cause the taxpayer to exceed the asset acquisition limit, denying Sec. 179 for any assets placed in service during the year. Bonus depreciation is available unless the taxpayer was required to use ADS for depreciation. 5. Commentary: A Chief Counsel Advice is lower level authority than a Revenue Ruling. Rev. Rul has been out of date for over 30 years and, although the CCA states that Rev. Rul no longer applies for purposes of Sec. 179 of the 1986 Code, the IRS has not obsoleted the ruling. In the authors opinion, taxpayers have little risk in following the guidance of the Chief Counsel Advice. 75

80 Sec. 179 Eligibility Checklist With the increased importance of the Sec. 179 deduction (currently $500,000 indexed for inflation), the following Eligibility Checklist can serve as a quick reference. Although the Section 179 deduction is available for qualified real estate, it is unlikely that agricultural property will fit this definition. Of the three categories (qualified leasehold improvement, qualified restaurant property, and qualified retail improvement property), qualified leasehold improvement property may perhaps exist. However, the lease must not be between related parties. Annual Dollar Limit Limit applies separately at the 1065 or 1120S level, as well as at the 1040 level. Caution: If an individual receives Sec. 179 allocations over the annual dollar limit (i.e., from several pass-through partnerships that are not coordinated), the excess allocation is wasted (Rev. Rul. 89-7). However, a later revocation could be made by a pass-through entity to reduce its Sec. 179 amount. A $25,000 limit applies for SUVs with a GVWR (gross vehicle weight rating) over 6,000 lbs. (defined to include a pickup truck with an interior box length of under 6 feet). An amended return election is permitted [Reg (c); Rev. Proc ]. Asset Addition Phase-out Limit Sec. 179 deduction phases out dollar for dollar as eligible asset purchases exceed $2 million (indexed for inflation - $2,030,000 for 2017). Asset additions inside pass-through entities do not count against the asset addition limit of an owner of the entity. Taxable Income Limit Sec. 179 deduction cannot exceed aggregate taxable income derived from active businesses. This limit applies at the entity level (1065 or 1120S) as well as at the 1040 level. Business income includes Sec gains and losses, Sec and 1250 depreciation recapture income, interest income from working capital of a business, wage income, and actively managed rental property [Reg (c)]. Both spouses count as one in a joint 1040 for this test. Business income does not include portfolio income sources, NOLs carried to the year, the 50% SE tax deduction, and a business or rental activity in which the taxpayer does not meaningfully participate in management or operations. Any Sec. 179 deduction limited by business taxable income becomes a carryforward to the next taxable year. Eligible Assets Property subject to Sec depreciation recapture, including single purpose ag structures, orchards, vineyards, assets used in manufacturing or production. Property acquired by purchase (only boot counts if acquired via trade). Asset must be more than 50% used in an active trade or business. 76

81 Ineligible Assets Acquired from a related party (spouse, lineal descendant or ancestor, and a more-than-50% controlled entity). Purchases by an estate or trust, as well as pass-through allocations of a Sec. 179 deduction to an estate or trust [Reg (f)(3)]. Property used in the furnishing of lodging, except for hotel and motel operations. This precludes purchases used in connection with apartment buildings and corporate-provided farm employee lodging [Sec. 179(d)(1); Sec. 50(b)(2)]. Property leased to others under the noncorporate lessor rules, unless: The term of the lease is less than 50% of the class life of the property (generally, 10 years for agriculture equipment), and During the first 12 months of the lease, the deductions to the lessor with respect to the property (other than taxes, interest and depreciation) exceed 15% of the rental income produced by the property. Observation: This second test of incurring expenditures that exceed 15% of the rent in the first 12 months will often disqualify improvements made by landlords. Controlled Group Members Component members of a controlled group are treated as one with respect to the various Sec. 179 limits. The controlled group definition refers to the Sec parent-sub or brother-sister definitions, but applies a "more than 50%" rather than "at least 80%" test. The Sec. 179 deduction may be allocated by election of the members per Reg (b)(7). An S corporation and a related C corporation are members of a controlled group. However, they are not component members of a controlled group per Reg (b)(2)(ii)(C). Thus, an S corporation and a related C corporation may each claim Sec. 179 up to the limit. Examples of Qualifying Farm Assets for Sec. 179 Deduction Water wells (15 yr.) Drainage facilities (15 yr.) Single purpose ag structures and horticultural structures (10 yr.) Vines and orchards (10 yr.) Grain bins (7 yr.) Farm machinery and equipment (7 yr.) Fences ag (7 yr.) Office furniture and fixtures (7 yr.) Computers, calculators and copiers (5 yr.) Dairy or breeding cattle (5 yr.) Trucks and automobiles (5 yr.), but beware of depreciation caps on vehicles under 6,000 lbs. per Sec. 280F Hogs breeding (3 yr.) Tractor units over the road (3 yr.) Milking parlors (10 yr.) Potato, apple, onion, etc. refrigerated storage (7 yr.) Controlled atmosphere storage (7 yr.) 77

82 Farmers and 50% Bonus Depreciation A. Background. 1. Bonus depreciation was retroactively restored for property placed in service through December 31, It was also extended and is scheduled to be phased-out for 2020 [2015 PATH Act Sec. 143DivQ]. 2. Commentary: The 50% bonus depreciation deduction and the increased Sec. 179 deduction amount can both apply for a taxpayer. The 50% bonus depreciation deduction is generally available for the cost of new assets not written off with the increased Sec. 179 deduction. Example 1 Combining Sec. 179 and 50% bonus depreciation deductions Smithco purchases new five-year assets during 2017 costing $650,000. After claiming the maximum Sec. 179 deduction of $500,000, Smithco then claims 50% bonus depreciation of $75,000. The $75,000 of remaining basis is then recovered under the normal rules for depreciating the asset, with another $11,250 allowable in 2017 (5-year, 150%DB, ½ year). Smithco has claimed $586,250 of depreciation ($500,000 + $75,000 + $11,250) in 2017 from its $650,000 of equipment additions. C. Summary of bonus depreciation rules: D. Planning opportunities. Date Acquired & Placed in Service Bonus Depreciation % 1/1/2010 9/8/ % 9/9/ /31/ % 1/1/ /31/ % % % 2020 and thereafter 0 1. General purpose farm buildings, such as machine sheds and shops, are 20-year assets and accordingly qualify for the 50% bonus provision if constructed and placed in service by December 31, They will qualify for 40% in 2018 and 30% in

83 2. In the authors view, a farm residence is also a 20-year asset that qualifies for bonus depreciation. This applies for all entity types. Only a C corporation may provide this type of housing to an owner and qualify. 3. Landlord drainage tile and other land improvements are difficult to qualify for Sec. 179, but the noncorporate lessor rules do not apply for bonus depreciation. 4. If a new asset is acquired by trade, both the boot and any adjusted tax basis of the relinquished asset qualify for the 50% bonus [Reg (k)-1(f)(5)(iii)]. 5. The availability of the 50% depreciation allowance may affect the tax practitioner s decision on which assets should be the subject of the Sec. 179 expensing deduction. a. The taxpayer s total depreciation deduction is enhanced if the Sec. 179 expense allowance is claimed on property not qualifying for bonus depreciation. For example, the Sec. 179 expense allowance should be claimed on used equipment additions that are ineligible for bonus depreciation. b. If a taxpayer can claim greater depreciation deductions than are needed to reach the proper level of taxable income, the taxpayer should claim the 50% bonus and decline some or all of the Sec. 179 deduction. Sec. 179 can be claimed later via an amended election, whereas the 50% bonus depreciation is essentially a use it or lose it arrangement. 6. Depreciation recapture and bonus depreciation upon sale. a. All depreciation expense associated with Section 1245 assets is subject to recapture as ordinary income [Sec. 1245(a)(1)]. b. Bonus depreciation is allowed on certain real property assets, such as machine sheds and shops [Sec. 168(k)(2)(A)(i)(I), Rev. Proc , class 01.3 farm buildings ]. This property is described in Sec in that it is real property that is not Sec property [Sec. 1250(c)]. c. Additional depreciation on Section 1250 property is treated as ordinary income [Sec. 1250(a)(1)(A)]. Additional depreciation is the amount claimed in excess of straight-line [Sec. 1250(b)(1)]. d. Bonus depreciation is not considered a straight-line method [Reg (k)-1(f)(3)]. As a result, bonus depreciation is considered an accelerated deduction, and to the extent it is in excess of straight-line, ordinary income recapture results upon disposition at a gain. e. Commentary: If the building has been held for over 20 years after being placed in service, Sec recapture will be zero, because straight-line depreciation and actual depreciation claimed will be the same amount. Consequently, gain will be subject to the 25% capital gain rate upon disposition up to the amount of total depreciation claimed with the excess gain subject to capital gain rates [1(h)(1)(D) and (E)]. 79

84 7. Recapture of Sec. 179 and bonus depreciation: Conversion to personal use. a. b. c. d. e. If a Section 179 deduction was claimed with respect to business property and that property is no longer predominantly used in business, the benefit of the Section 179 deduction must be recaptured [Sec. 179(d)(10); Reg (f)(2)]. Property is not predominantly in a business use if 50% or more of its use is not business use [Reg (e)(2)]. However, in measuring the recapture income from a conversion to personal or investment use, the taxpayer is allowed to reduce the recapture by the amount of depreciation that would have occurred under Sec. 168 if the Section 179 deduction had not been claimed [Reg (e)(5)]. 50% or 100% bonus depreciation is regular depreciation under Sec Further, the regulations confirm that conversion to personal use after claiming 50% or 100% bonus depreciation does not cause a redetermination or recapture of the bonus amount [Reg (k)-1(f)(6)(iv)]. Commentary: If a taxpayer faces Section 179 recapture because of conversion of an asset from business to personal use, the tax practitioner should examine the eligibility of the asset for 50% or 100% bonus depreciation (i.e., was the asset new and was there no election out of bonus?). Bonus depreciation is regular depreciation that minimizes or possibly eliminates the amount of Section 179 recapture. Example 2 Minimizing Section 179 recapture upon conversion to personal use. John purchased a new tractor in 2011 for $100,000 and claimed a Section 179 deduction to fully expense its cost. In 2015, John retires from farming, but retains the tractor for personal use. Under normal Section 179 recapture rules, John would have been entitled to retain about 4/7ths of the first year depreciation, because under normal depreciation he would have claimed approximately four years of regular depreciation deductions. However, because the tractor was new in 2011, a 100% bonus depreciation year, and because John did not make an election to decline bonus depreciation, he is considered to have fully depreciated the asset under regular depreciation during his period of ownership, and no Section 179 recapture is required. 80

85 8. Availability of bonus for regular tax and AMT. a. In general, bonus depreciation applies for both regular tax and AMT purposes. b. The statute states that qualified property does not include any property subject to the alternative depreciation system (ADS) under Sec. 168(g), other than where the taxpayer has voluntarily elected ADS. This precludes the 50% or 100% deduction for property used predominantly outside the U.S., property used by a tax-exempt entity, and tax-exempt bond financed property. c. Caution: Farmers and other growers who produce plants with a more than two-year preproductive period, such as in the orchard and vineyard industries, are normally subject to Sec. 263A uniform capitalization (UNICAP) rules, unless they elect out of the UNICAP rules. Those who elect out of the UNICAP provisions under Sec. 263A(d)(3) are forced to use ADS. However, this election out of UNICAP is not considered a voluntary election to use ADS; hence, these orchard and vineyard growers are precluded from using bonus depreciation on asset purchases [Rev. Proc , IRB No ]. d. IRS Notice contains a list of plants with a more than two-year preproductive period. 1) Almonds, apples, apricots, avocados, blackberries, blueberries, cherries, chestnuts, coffee beans, currants, dates, figs, grapefruit, grapes, guavas, kiwifruit, kumquats, lemons, limes, macadamia nuts, mangoes, nectarines, olives, oranges, papayas, peaches, pears, pecans, persimmons, pistachio nuts, plums, pomegranates, prunes, raspberries, tangelos, tangerines, tangors, and walnuts. 2) Blackberries, raspberries and papayas have been removed from the list [Notice ]. 9. The bonus depreciation provision electively can be declined by a taxpayer. Election out is made by asset class (in this case, cost recovery period, e.g. for all 3 year assets, for all 5 year assets, etc.) [Sec. 168(k)(2)(D)(iii)]. 10. Commentary: State income tax conformity needs to be considered (i.e., has the applicable state adopted the 50% bonus or expanded Sec. 179 deduction?). GAA Depreciation for Farmers A. Background. 1. A taxpayer may elect to group assets which are subject to Section 168 depreciation into one or more general asset accounts, if the assets have the same: a. Asset class; b. Depreciation method; c. Recovery period/depreciable life; 81

86 d. Depreciation convention (e.g., half year convention); and e. Are placed in service in the same tax year [Sec. 168(i)(4) and Reg (i)-1T]. 2. Caution: Assets subject to the mid-quarter convention may only be grouped with other assets placed in service in the same quarter [Reg T(c)(2)(i)]. 3. For depreciation purposes, each general asset account (GAA) is treated as a single asset. 4. Dispositions. a. A disposition of any asset in a general asset account is treated as having an adjusted basis of zero for purposes of reporting gain or loss. b. All sale proceeds are treated as ordinary income from depreciation recapture until an amount has been recognized which is equal to the original depreciable basis of the particular GAA. Any sale proceeds in excess of the original depreciable basis are reported as Section 1231 capital gains. c. The basis of a disposed asset is not removed from the general asset account (unless a special election is made as discussed below). Rather, any asset that has been disposed of continues to be depreciated within the GAA [Reg (i)-1T(e)(2)]. 5. Commentary: Some state and local jurisdictions require the submission of a copy of the detailed depreciation schedule together with the list of the assets for personal property tax purposes. Electing GAA does not relieve the farmer of the requirement to maintain detailed records. B. Electing GAA depreciation for a self-employed livestock proprietor or partner. 1. Livestock producers who purchase breeding stock can gain advantages of simplified recordkeeping, as well as minimizing self-employment income, by electing GAA depreciation. 82

87 Example 1 Electing GAA depreciation for a hog proprietorship Dave is a hog proprietor who operates a farrow-to-finish hog operation. Each year he purchases about $10,000 of boars and about $40,000 of sows, which he places in his breeding herd as depreciable assets. However, each year some of these sows and boars will typically be culled from his herd and sold for slaughter, due to disease, lack of production, injury, etc. If Dave elects GAA asset depreciation for his current additions, the $10,000 of boars and $40,000 of sows will remain on his proprietorship depreciation schedule, as a single asset, for their entire three-year depreciable life. To the extent that any of the GAA animals are culled and sale proceeds are received, Dave will report these sales proceeds on Form 4797 as ordinary income, with no basis offset. All sales proceeds would be reported as ordinary income until sale proceeds had been received in excess of the original cost amount (sales proceeds would be very unlikely to exceed original cost from culled breeding stock). By retaining the original cost of the breeding boars and sows on his proprietorship depreciation schedule, Dave has assured that the full $50,000 of investment in breeding animals will reduce his selfemployment income. Any proceeds from culled animals, reported in full on Form 4797, incur no selfemployment tax. Accordingly, Dave s self-employment income will be understated by the adjusted basis of culled animals which otherwise would have been moved to the Form 4797, had GAA depreciation not been utilized. Further, Dave has the advantage of simplified tax return calculations when animals are culled each year. 2. Commentary: There are two clear advantages to the use of GAA depreciation for breeding livestock: Simplified recordkeeping; and overstated depreciation deductions on culled animals that reduce self-employment income. The disadvantage is that the timing of reporting gains on early culled animals is accelerated, as the direct basis offset is deferred into future depreciation deductions. 3. Making the election. a. The election must be made on a timely filed (including extensions) income tax return for the year in which the assets to be included in the GAA are placed in service. b. IRS Form 4562, Depreciation and Amortization, contains a notation to indicate adoption of a general asset account election. A box at line 18 may be checked to indicate a GAA election has been made. c. Once made, the election is binding for those assets throughout their depreciable life. [Reg (i)-1T(l)]. C. Qualifying dispositions. 1. Although the GAA election is binding, in the case of a qualifying disposition, a taxpayer removes the asset and its accumulated depreciation from the GAA account and reduces income by the remaining adjusted basis [Reg (i)-1T(e)(3)]. 2. If all of the assets or the last asset in a GAA is disposed of, the taxpayer may treat the GAA as terminated [Reg (i)-1T(e)(3)(ii)]. 83

88 Example 2 Recovering basis on early termination of a GAA Art, who runs a hog farrowing proprietorship, has annually elected GAA depreciation for his sow and boar purchases. During the current year, Art decides to change genetic lines, and sells his current group of sows and boars that have been purchased over the prior several years. Because these sales represent the entire disposition of the assets in the various GAA accounts, Art is entitled to immediately recover the basis from his depreciation schedule when calculating the gain or loss on the disposition of the sows and boars. 3. A qualifying disposition also includes a disposition that does not involve all of the assets, or the last asset, remaining in a general asset account [Reg (i)-1T(e)(3)(iii)(B)]. a. Commentary: The eligibility of a single asset disposition as a qualifying disposition provides the opportunity for the farmer to offset gain with the remaining adjusted tax basis of the asset, if it is favorable to do so. Example 3 Opting out of GAA depreciation for a qualifying disposition 84

89 Opting out of GAA depreciation for a qualifying disposition Al, a dairy proprietor who uses GAA depreciation for his purchased bulls, decides to donate a bull to a charitable organization. Al may either continue to depreciate the bull because it is within a GAA, or he may opt to remove the bull from the account because it meets the definition of a qualifying disposition. As a farm proprietor, Al would likely retain the bull on his farm depreciation schedule and not opt to remove it as a disposition; as a qualifying disposition, the adjusted basis of the bull would be claimed by Al as a charitable contribution, if he was able to itemize. 4. A qualifying disposition also occurs upon a cessation of a business activity, a casualty or theft, a charitable contribution of the asset, a technical termination of a partnership or a nonrecognition transaction such as a Section 1031 exchange or Section 1033 involuntary conversion [Reg (i)-1T(e)(3)]. Termination of the GAA account is mandatory in these cases. 5. This election is accomplished by reporting the gain or loss upon the termination of the GAA within the taxpayer s timely filed return for the year of the disposition [Reg (i)- 1T(e)(3)(i)]. 6. The various nonrecognition transactions do not terminate the GAA election. The transferee is bound by the transferor s election [Reg (i)-1T(e)(3)(iv)]. 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 , 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: 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 85

90 d. The raising, shearing, feeding, caring for, training, and managing of animals. 3. The IRS Instructions for Schedule J, Farm Income Averaging, state that a farming 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 (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 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. a. EFI does not include income, gain or loss from the sale of development rights, grazing rights, or similar rights [Reg (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 (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. 3. 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 commerce. 86

91 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 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 (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. 87

92 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)]. Example 1 b. c. 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 (e)(2)]. 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. 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 (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. 88

93 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 (d)(1)]. 89

94 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 20X3 20X4 $ 20 $ X5 20X6 20X7 $ 20 $ 55 $ _ +22 _ 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 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%. 90

95 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 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. Tax Original Savings Taxable income $ 700K $ 700K $ 700K $ 700K $ 700K Sch. J: 2013 (orig.) 83K 83K 83K (250K) $ 11,500 A $ 783K $ 783K $ 783K $ 450K Rate on added income 35% 35% 39.6% Sch. J: 2014 $ 78K $ 78K $ 78K (235K) $ 7,300 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 $ 700K (300K) $ 400K 35% on 50K $(235) $ 11,500 A $ 9,600 B A $250,000 x 4.6% = $11,500 ($250,000 taken out of 2014 rate of 39.6% to 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). 91

96 92

97 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 Sch. J: per software Taxable income after Sch. J Sch. J to increase earliest base yr. to top of 33% bracket Taxable income after Sch. J $ 315K $ 315K 40K 40K $ 365K $ 365K $ 65K $ 65K $ 380K $ 380K Tax $ 300K $ 566K $ 163K 40K (120K) $ 340K $ 446K $ 155K $ 65K $(195K) $ 365K $ 371K $ 155K 93

98 G. Effect of AMT. 1. Income averaging has no direct impact on the calculation of the Alternative Minimum Tax (AMT) [Reg (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. 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 94

99 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. 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. Case 1 Sch. F/AMTI $ 500,000 Case 2 $ 580,000 Increase $ % $ 80,000 Tentative minimum tax - Regular tax (before ave.) AMT $ 131, ,400) 9,500 $ 154,500 (153,600) $ 900 $ 22,600 28% 31,200 39% $ (8,600) - 11% Regular tax: Sch. J 121, ,600 26, % Total tax $ 131,300 $ 149,500 $ 18, % 95

100 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 (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 (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 subtracted. 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 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 (d)(1)]. I. 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 96

101 out of the ordinary Schedule J computations. J. 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 (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. 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 (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 , 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 97

102 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 self-employment 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. 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 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. 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. e. Maximum bracket taxpayers in 2013, 2014 and 2015 will always benefit from electing farm income averaging on EFI. FINANCIAL DISTRESS-TAX ISSUES The financial situation in the agricultural economy has changed considerably over the few years. For instance, in Kansas, average net farm income in 2015 was the lowest since Crop prices are down and the cost of 1 Net Farm Income by Decile Group. Ibendahl, Gregg. Sep. 14, Kansas State University. [ Accessed on May 31,

103 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. CHAPTER 12 BANKRUPTCY Debt restructuring can be accomplished via the filing of a Chapter 12 bankruptcy petition, a special part of the bankruptcy code applicable for family farmers. Family Farmer To be eligible for Chapter 12 bankruptcy, a debtor must be a family farmer or a family fisherman with regular annual income. 2 A family farmer is defined as an individual or an individual and their spouse who earned more than 50% of their gross income from farming either for the tax year preceding the year of filing or during the second and third tax years preceding the year of filing. 3 This is the farm income test (explained in detail later). A different rule applies to a family fisherman. 4 Additionally, the family farmer s aggregate debts must not exceed $4,153,150 5 (a lower threshold applies for a family fisherman). More than 80% of the debt must be connected with a farming operation that the debtor owns or operates. 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. 6 Farm Income Test As mentioned previously, to be eligible, more than 50% 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 the year of filing. This provision seeks to disqualify tax-shelter and recreational farms from Chapter 12 protection and is applied at the time of bankruptcy filing. Thus, the debtor must be a farmer engaged in farming at the time the petition is filed, and a determination of whether the debtor has the intent to continue farming is made at that time. However, there is no specific requirement in the Bankruptcy Code that the income to fund the Chapter 12 reorganization plan come specifically from farming. The income only needs to be stable and regular. 7 INCOME EXCLUSION OF FORGIVEN DEBT General Rule Except for debt associated with installment land contracts and CCC loans, most farm debt is recourse debt. With recourse debt, the collateral stands as security on a loan. If the collateral is insufficient to pay off the debt, the 2 11 USC 101(19) USC 101(18) USC 101(19)(A) USC 101(18) as adjusted by 11 USC 104. The debt limit is adjusted for inflation at 3-year intervals and was last adjusted on April 1, USC 101(21). 7 In In re Williams, No (1)(12) (Bankr. W.D. Ky. Apr. 22, 2016), the court noted that 11 USC 101(19) requires a debtor to have regular income sufficient 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 did not require the income to be generated from farming activities. So, the debtors did not have to be engaged in farming at the time they filed Chapter 12 and, apparently, they also did not have to intend to return to farming. 99

104 debtor is personally liable on the obligation and the debtor's nonexempt assets are reachable to satisfy any deficiency. 8 When a debtor relinquishes property, the income tax consequences involve a 2-step process. Essentially, the property is sold to the creditor, and the sale proceeds are applied to the debt. There is no gain or loss (and no other income tax consequence) up to the income tax basis on the property. The difference between FMV and the income tax basis is gain or loss. Finally, if the indebtedness exceeds the property's FMV, the debtor remains liable for the difference. Any amount that is forgiven is discharge-of-indebtedness income. Note. Under IRC 108(a)(1)(A)-(C), a debtor is not required to include in gross income any 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 excludes the debt from income, Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), must be completed and filed with the return for the year of discharge. Qualified Farm Indebtedness Qualified farm indebtedness is debt incurred directly in connection with the taxpayer s operation of a farming business. In addition, at least 50% of the taxpayer s aggregate gross receipts for the three tax years immediately preceding the tax year of the discharge must arise from the trade or business of farming. 9 A debtor is not required to include in gross income 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, A person from which the taxpayer acquired the property, or A person who receives a fee with respect to the taxpayer s investment in the property. 10 Under IRC 108(g)(1)(B), a qualified person also includes federal, state, or local governments or their agencies. Observation. Non-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 if the debtor is insolvent or is in bankruptcy. Debtors other than farmers have income from the discharge of indebtedness if they are solvent. 11 The determination of a taxpayer s insolvency is made immediately before the discharge of indebtedness. Insolvency is defined as the excess of liabilities over the FMV of the debtor s assets. 12 Both tangible and intangible assets are included in the calculation. In addition, both recourse and nonrecourse liabilities are included 8 Recourse vs. Nonrecourse Debt. IRS. [ Accessed on May 19, IRC 108(g)(2)(A)-(B). 10 IRC 49(a)(1)(D)(iv). 11 IRS Pub. 225, Farmer s Tax Guide; IRC 108(a)(1). 12 Ibid. 100

105 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. Note. Property exempt from creditors under state law is included in the insolvency calculation. 13 Maximum Amount Discharged. 14 There is a limit on the amount of discharged debt that can be excluded from income under the qualified farm debt 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 reduces the debtor s tax attributes. 15 Unless the taxpayer elects to reduce the basis of depreciable property first, 108(b)(2) sets forth the general order of tax attribute reduction (which occurs after computing tax for the year of discharge 16 ). 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 credits 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 Foreign tax credit carryovers Note. The attributes that can be carried back to tax years before the year of discharge are accounted for in those carryback 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 which they arose. 17 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, minimum tax credit, foreign tax credit carryover, or passive activity loss carryover is reduced by cents for every dollar excluded. 18 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 consequence. Alternatively, if the taxpayer s tax 13 Carlson v. Comm r, 116 TC 87 (Feb. 23, 2001). 14 IRC 108(g)(3)(A)(i-ii). 15 IRC 108(b)(1). 16 IRC 108(b)(4)(A). 17 IRC 108(b). 18 IRC 108(b)(3)(B). 101

106 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. 19 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. 20 Qualified property is defined as any property used or held for use in a trade or business or for the production of income. 21 The basis reduction to the qualified property is applied in the following order. 22 Basis of qualified property that is depreciable property Basis of qualified property that is land used or held for use in the taxpayer s farming business Basis of 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 the basis in the taxpayer s depreciable property, including real property held as inventory. 23 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. 24 The seller also has no immediate adverse tax consequences from the discharge. Instead, the profit ratio that is applied to future installment payments is affected. 25 Deferral of Sales of Livestock Farm Income Deferral Opportunities A. Two statutory deferral privileges exist with respect to the sale of livestock. 1. Sec. 451(e) allows a one-year deferral of the income derived from the sale of excess livestock to the extent the excess sale occurs because of drought, flood, or other weather related conditions. 2. Sec 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. a. Livestock destroyed by disease may be replaced in a tax deferred manner under Sec. 19 Treas. Reg (a)(2). 20 IRC 1017(b)(4)(A). 21 IRC 108(g)(3)(C). 22 Ibid. 23 IRC 108(b)(5)(A) and 1017(b)(3)(E). 24 IRC 108(e)(5)(A). 25 Ltr. Rul (Jun. 30, 1987). 102

107 1033(d), and livestock sold in excess of usual business practices due to drought, flood or other weather-related conditions may similarly be replaced in a rollover manner under Sec. 1033(e). b. If involuntary sales occur because of weather-related conditions or soil or other environmental contamination and it is not feasible to reinvest in livestock, a broader definition of eligible replacement property applies under Sec. 1033(f). B. Deferral of gain on weather-related sales [Sec. 451(e)]. 1. The gain from the sale of livestock sold early due to drought, flood, or other weather-related conditions may be deferred for one year. There are five conditions for eligibility: a. The taxpayer s principal business is farming. b. The taxpayer uses the cash method of accounting. c. Under normal business practices, the sale would not have occurred in the current year except for the drought, flood or other weather conditions. d. The drought, flood, or other condition resulted in the area designated as eligible for assistance by the federal government. e. Only livestock in excess of the number that normally would have been sold under usual business practices is eligible for the deferral. 2. 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. 3. Caution: Reg , which describes details of attaching a statement to the tax return when electing a livestock deferral, states that livestock held for draft, breeding, dairy or sporting purposes are ineligible for this one-year deferral privilege. However, this regulation was adopted in December of 1977, prior to 1988 enactment of legislation that expanded the one-year deferral privilege to include draft, dairy, breeding or sporting animals. Also, the regulation is incorrect in its reference to drought conditions as the cause for eligible deferrals, because the statute was amended in 1997 to extend this deferral privilege to floods and other weather-related conditions. 4. Commentary: Animals held for productive/depreciable use may also be eligible for Section 1033 involuntary conversion treatment. In that case, due to the rollover of the gain into the replacement animals, the gain is effectively deferred over a greater period of time through lower depreciation deductions on the replacement animals see C. below for a discussion of this privilege. 5. Calculation of deferred gain. a. Example 1 103

108 The gain to be postp oned 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 practice in the absence of the weather condition. One-year deferral of excess livestock sales Mitch is a dairy farmer who sells most of his raised heifers. Over the prior three years, he has sold the following number of head: Year Head 20X X X6 21 Total 76 Average 25 In 20X7, due to a severe drought, Mitch was forced to sell 45 raised heifers due to the lack of availability of feed. Mitch sold all of the animals at $1,500 per head. Accordingly, Mitch sold 20 more animals than his previous three-year average. The gain eligible for deferral under Sec. 451(e) is $30,000 (20 excess head x $1,500 per head). b. Commentary: While the preceding example determines the usual number of sales under normal business practice by calculating the prior three year average, the regulation itself is less specific. Reg (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." Many tax practitioners use the prior three year average, because the regulation does request the taxpayer to disclose the number of animals sold in each of the three preceding years. However, if the prior three years' sales activity is not representative of normal business practice, appropriate adjustment should occur. c. Successive elections. 1) According to Reg (f), if the taxpayer makes an election to defer livestock sales for successive years, 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 104

109 practice for the later year, earlier years for which a deferral election was made shall not be considered. 2) Commentary: If a taxpayer defers excess livestock sales from 20X1 to 20X2 under a Section 451(e) election, those deferred sales are not again taken into account in 20X2 to determine if excess head were sold for purposes of an election in the second year. Rather, the animals sold early in 20X1 (and deferred for tax reporting to 20X2) remain for head count purposes in 20X1. This increases the base year head count for the look-back from 20X2 and makes a successive deferral election more difficult. 6. The statement of election to postpone the gain for one year must include the taxpayer s name and address and the following information: a. A statement that the election is made under Sec. 451(e). b. 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. c. A statement explaining the relationship of the area of drought or other condition to the early sale or exchange of the livestock. d. The number of animals sold in each of the three preceding years. e. 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. f. The total number of animals sold and the number sold because of drought and other conditions during the year. g. A computation of the income to be postponed for each class of livestock. 7. Principal business of farming requirement. a. Farming is defined by reference to Sec. 6420(c)(3), and includes the raising or harvesting of any agricultural or horticultural commodity, including the raising, shearing, feeding, caring for, and training, and management of livestock, bees, poultry, and fur-bearing animals and wildlife by an owner, tenant, or farm operator. b. The IRS has ruled favorably that an employee who also maintained a cattle ranching business was in the principal business of farming [PLR ]. 8. Federally designated assistance area. a. The livestock need not be raised within the actual area of drought or other weatherrelated condition, and the sale does not need to occur within the designated area. 105

110 b. 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 within the area [Reg (c); IRS Notice 89-55]. c. The disaster area designation can be made by the President, the Department of Agriculture or any of its agencies, or by other federal departments or agencies [IRS Publ. 225]. 9. Election deadline. A taxpayer who sells livestock early on account of weather-related conditions that are given federal disaster status may make the one-year deferral election at any time within the four years following the close of the first tax year in which any gain is recognized [Sec. 451(e)(3)]. C. Involuntary conversion of livestock (Sec. 1033). 1. Sec allows gains that are realized from involuntary conversions (the destruction, theft, seizure or condemnation of property) to be deferred under election, assuming the taxpayer has properly complied with the election requirements and has timely purchased qualified replacement property. 2. Replacement period. a. In general, the purchase of replacement property under Section 1033 involuntary conversion rules must occur within two years after the close of the first year in which any gain is realized [Sec. 1033(a)(2)(B)]. 1) This provision applies to gains on livestock sold on account of disease. 2) The replacement period is three years for condemnation of real estate used in a business or held for investment [Sec. 1033(g)(4)]. b. The applicable replacement period for draft, breeding or dairy livestock sold early on account of drought, flood or other weather-related conditions is four years after the close of the first taxable year in which any part of the gain on conversion is realized [Sec. 1033(e)(2)]. 3. The election. 1) The taxpayer must establish that the sale would not have occurred but for the drought, flood or weather-related conditions that resulted in the area being designated as eligible for federal assistance. 2) The IRS is given authority on a regional basis to extend the replacement period if the weather-related conditions which resulted in the application of this provision continue for more than three years [Sec. 1033(e)(2)(B)]. a. The election to defer gain under the involuntary conversion rules can be made at any time within the normal statute of limitations for the period in which the gain was recognized, assuming it is before the expiration of the period within which the converted property must be replaced [Reg (a)-2(c)(2); CCA ]. 106

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112 b. If the election is filed to defer gain and eligible replacement property is not acquired within the four-year replacement period, an amended return for the year in which the gain was originally realized must be filed to report the gain. 4. Livestock destroyed by disease. a. If livestock are destroyed, sold or exchanged because of disease, the transaction qualifies for Section 1033 involuntary conversion treatment [Sec. 1033(d)]. b. Livestock that are sold or exchanged because they have been exposed to disease, and would not otherwise be sold at that time, are considered eligible [Reg (d)-1(a)]. c. The disease need not be of epidemic proportions [Rev. Rul ]. However, the sale of a herd of beef cattle that developed the dwarf gene did not qualify because dwarfism in beef cattle is not a disease [Rev. Rul ]. d. The election statement and tax return disclosure requirements for replacement of diseased livestock are the same as any involuntary conversion, except the taxpayer must include a recital of the evidence that livestock were destroyed or sold because of disease [Reg (d)-1(b)]. e. Commentary: This diseased livestock rollover privilege applies to inventory or resale animals, in addition to breeding or productive animals. The following weatherrelated rollover privilege only applies to productive livestock. 5. Livestock sold due to drought or weather-related conditions [Sec. 1033(e)]. a. The sale of livestock (other than poultry) held by a taxpayer for draft, dairy or breeding purposes in excess of the number that would have been sold under the taxpayer s usual business practice is treated as an involuntary conversion if the early sale occurred solely on account of drought, flood or a weather-related condition that resulted in the area being designated as eligible for federal assistance. b. While a sale or exchange of the livestock must be solely on account of the drought or weather conditions that affected the water, grazing or other needs of the livestock, it is not necessary that the livestock were held in a drought or flood area, or that the actual sale occurred in a drought or flood area [Reg (e)-1(b)]. c. 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 [Reg (e)-1(c)]. 108

113 Example 2 Section 1033 conversion of livestock Hans is a dairy farmer who normally culls and sells 30 dairy cows annually. Because drought conditions severely limited the hay and alfalfa supply in the area, Hans sells 55 dairy cows this year, and also sells an extra 20 raised heifers (inventory animals raised for resale) that would have been sold in the next year. Hans may make a Section 1033 involuntary conversion election for the 25 dairy cows, deferring the gain against the basis of the first 25 dairy or breeding cows purchased within the next four years. The extra 20 resale animals sold are not eligible for involuntary conversion treatment because they were not held for draft, dairy or breeding purposes. d. Commentary: In the preceding example, the early sale of the 20 heifers would be eligible for the one-year income deferral of Sec. 451(e); see B., preceding, for a discussion of these rules. The early sale of the 25 extra dairy cows in the preceding example also would be eligible for the Section 451 one-year income deferral, but this is generally less advantageous when Section 1033 rollover treatment is available. By electing Section 1033 rollover treatment, the gain from the animals sold early results in a basis reduction of the replacement livestock. Accordingly, the deferred gain is effectively recognized by means of reduced depreciation over the subsequent five-year period. e. Practice Pointer: In some limited cases, a taxpayer with raised breeding or dairy animals where the sale can be reported at the 0% or 15% capital gain rates may prefer to recognize this gain, especially where the depreciation on the replacement animals will flow to a Form 1040 where higher rate income tax and potentially SE tax will be reduced by these depreciation deductions. This might particularly be the case where replacement animals qualify for the Section 179 deduction. f. The tax return in which any gain is first realized and deferred under Sec should include: 1) Evidence of the drought, flood or weather-related condition that caused the early sale; 2) Computation of the gain realized; 3) Number and kind of livestock sold; and 4) Number of each kind of livestock that would have been sold under normal business practice [Reg (e)-1(e)]. g. The tax return for the year in which the livestock are replaced should include: 1) Date of purchase of replacement stock; 2) Cost of the replacement livestock; and 3) The number and kind of replacement livestock. 109

114 h. In general, in a Section 1033 rollover, the replacement property must be similar or related in service or use. 1) Historically, the regulations have required the replacement livestock to be functionally the same as the involuntarily converted livestock (i.e., held for the same useful purpose as the old). Thus, dairy cows should be replaced by dairy cows [Reg (e)-1(d)]. But breeding cattle may replace buffalo of the same sex [PLR ]. 2) However, as a result of 2004 legislation that was enacted retroactively to apply to sales of livestock that occurred in returns with a due date after 2002, a taxpayer is allowed to replace involuntarily converted livestock sold early due to drought, flood, or other weather-related conditions with other farm property (other than real property), if it is not feasible for the taxpayer to reinvest the proceeds in similar or related use livestock. 3) Commentary: As a result of this provision, a taxpayer who is forced to sell cattle early because of drought in a federally designated disaster area, and who is unable to reinvest the proceeds in replacement livestock due to extended drought, could satisfy the Section 1033 replacement rule by reinvesting in farm equipment or other tangible personal property for farming use. i. If, because of soil or other environmental contamination, it is not feasible to reinvest the proceeds from involuntarily converted livestock into other livestock of a like-kind, a taxpayer may invest the proceeds into other tangible or real property used for farming purposes [Sec. 1033(f)]. 1) The Committee Report accompanying enactment of this provision indicates that it was intended to assist, among others, farmers who lost their herds due to contamination from polybrominated biphenyl (PBB) [Sen. Comm. Rpt., P.L ]. 2) A communicable bacterial disease that made cattle unsuitable for breeding, known as brucellosis or Bang s disease was held not to be an environmental contaminate that allowed the liberal Section 1033(f) reinvestment privilege [PLR ; N.W. Miller, Jr., 615 F Supp. 160, 1985]. 110

115 Installment Sale of Inventory by Cash Method Farmers. 1. The statute allows farmers to use the installment method of reporting when disposing of property used or produced in the business of farming [Sec. 453(l)(2)(A)]. a. In the Committee Report supporting this legislation, Congress stated that Gain from the sale of property which is not required to be inventoried by a farmer under his method of accounting will be eligible for installment method reporting as a gain from a casual sale of personal property even though such property is held for sale by the farmer. b. Any threat of alternative minimum tax (AMT) on deferred payment farm commodity sales was eliminated when the 1997 Taxpayer Relief Act retroactively repealed Sec. 56(a)(6) for dispositions in tax years beginning after Formerly, this provision imposed AMT on inventory reported under an installment method. c. Commentary: Cash method farmers have the unique opportunity of using the installment method with respect to raised inventory items. Other taxpayers are not permitted to use an installment method with respect to resale or inventory property. d. This farm property exception was interpreted in a case involving a farm equipment dealer selling irrigation systems. The dealer had used installment reporting on those sales where payment was received after year-end, asserting that the statutory language of property used in farming applied to the sale of irrigation systems to farmers. The court, however, noted that the statute should be read in the past tense, and therefore only applied to property that was actually used in the trade or business of farming by farmers. The equipment dealer was denied use of the farm installment sale privilege [James L. Thom, 134 F Supp. 2d, 1093, USTC 50,345, DC, Ne.; aff d USTC 50,293, CA-8]. 2. Election out of installment treatment on specific grain contracts. a. Sec. 453(d)(1) allows a taxpayer to elect out of installment treatment on any disposition of property. b. The election to not use the installment method is made by reporting the entire gain from the sale of the property in the year of the sale. The election out of installment treatment must be made by the due date, including extensions, for filing the tax return for the year in which the sale takes place [IRS Publ. 537]. c. Commentary: Many cash method farmers and ranchers will have multiple deferred sale commodity contracts that effectively utilize the Section 453 installment sale method to defer payment to the subsequent tax year. If, during the course of tax return preparation, such a producer s taxable income is too low, the taxpayer may elect out of the installment sale method for one or more deferred commodity sale contracts, and electively tax that sale in the year of disposition rather than the year of collection of the proceeds. d. Practice Pointer: Tax practitioners should carefully document deferred grain sales that are accelerated and assure that those same sales are not taxed again in the subsequent year. 111

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117 Example 5 Electing to currently tax a deferred grain sale Bert is a cash method grain farmer who has a regular knack for providing incomplete data to his tax advisor at the time of December year-end tax planning. In February or March at tax preparation time, Bert often has extra items of income or expense that he overlooked at the time of his tax planning projection, requiring his tax advisor to look for post year-end strategies to adjust Bert s income. This year is no exception, as Bert informs his tax advisor that he made a recordkeeping error in posting his transactions that were used for the year-end projection, and his actual income is $80,000 lower than anticipated. Bert s tax planning projection included a Section 179 deduction of approximately $100,000, and simply electing not to claim this first year depreciation deduction would solve the problem and bring Bert s tax return results in line with the year-end tax planning projection. However, this action effectively defers the deduction over the next seven years. As an alternative, Bert s tax advisor learns that Bert has deferred a number of grain sales that were made shortly after harvest, with the payments on these various deferred contracts made at varying times during January of the current year. The tax advisor examines these various contracts, and reports about $80,000 of specific deferred contracts as taxable within the year of sale, rather than the year of payment. This election to decline the installment method on those deferred payment sales is accomplished simply by reporting the selected contracts in Bert s Schedule F for the year of sale. The effect of this decision is to move income from the current year to the prior tax year, which is a superior decision to the more traditional approach of declining to claim the Section 179 deduction. 3. Commentary: The election out of the installment method can be a valuable tool in the preparation of income tax returns when Congress is slow to enact extenders such as the enhanced Section 179 deduction and 50% bonus depreciation. When those deductions are renewed, additional income can be brought back into the current year by electing out of deferred grain sale contracts. 4. Escrows, letters of credit, and other installment sale issues. a. In some cases, particularly with respect to livestock sales, the selling farmer and the buying entity may attempt to use an escrow, letter of credit, or some other third party debt in order to create installment treatment to the selling farmer, rather than simply utilize the note of the entity purchasing the commodity. b. Debt of the purchaser. One of the conditions of installment treatment is that the debt obligation must be that of the purchaser. If the seller accepts a third party note, the seller is considered to have constructive receipt equal to the fair market value of that third party debt [Temp. Reg. 15A.453-1(b)(3)]. c. Escrow accounts. If an installment obligation is secured by cash or a cash equivalent, the funds are treated as a payment on the obligation [Temp. Reg. 15A.453-1(b)(3)(i)]. However, an escrow account will not produce constructive receipt to the seller if the account imposes a substantial restriction on the seller s right to receive the deposited funds. This restriction must serve a bona fide purpose of the buyer. An escrow arrangement that only restricts the seller s right to receive the funds based on the passage of time is not considered to produce a substantial restriction, and will represent a payment on the installment note (Rev. Rul ; Rev. Rul ; Rev. Rul ; PLR ). 113

118 1) The doctrines of constructive receipt, economic benefit and agency require recognition of income. 2) Self-created escrows will not defer recognition of income, in that the seller is in constructive receipt of the income immediately prior to the formation of the escrow. 3) The escrow arrangement must be an agreement to which both the buyer and the seller are parties. The seller s right to demand payment of the escrowed proceeds needs to be restricted by a binding agreement with the purchaser [Reed v. Comm., 53 AFTR 2d , CA-1, 12/05/1983]. a) The arrangement must be part of a bona fide arm s-length agreement made before the closing between the purchaser and seller. b) The seller must receive no present beneficial interest or incidental benefits from the purchase funds while the funds are in escrow, such as the payment of interest or use of the funds for a letter of credit. c) The escrowee must not be acting under the exclusive authority of the seller [Busby v. U.S., 50 AFTR 2d , CA-5, 1982]. d) Letters of credit. A third-party guarantee, such as a standby letter of credit, is not regarded as a payment on an installment debt, and does not produce taxable constructive receipt. The regulations specifically protect an installment seller from accelerated taxation on a standby letter of credit if it is issued by a bank or other financial institution, is nonnegotiable, and serves as a guarantee of the installment note [Temp. Reg. 15A.453-1(b)(3)(iii)]. 5. Interest on farm commodity installment sales. a. In general, interest is required on installment sale obligations [Sec. 1274]. Accordingly, farm commodity installment sales that include interest payments by the purchaser are acceptable. b. However, many farm commodity installment sales represent a deferred contract with a single subsequent payment that occurs without stated interest. 1) The provision does not apply to any payment which is received within six months of the date of sale [Sec. 483(c)(1)]. 2) Longer term scheduled payments without interest should be acceptable using the former deferred payment contract body of law developed by pre-1980 rulings and cases and existing Reg regarding constructive receipt. c. Deferred payment contracts avoid constructive receipt by using a binding written contract executed before the taxpayer had the right to the proceeds from the sale of the commodity. The contract should not be used as collateral for any loan, and the selling farmer s right to the money should be evidenced by a contract rather than a note. These deferred payment agreements do not provide interest (Rev. Rul ; Rev. Rul ; H.C. Crimmins, D. N.D., 1980, aff d. CA-8, 1981, 81-1 USTC 9576; C.B. Schniers, 69 TC 511, 1977). 114

119 6. Caution: C corporations that are exposed to the AMT (generally those with $5 million or more in gross receipts) may still have exposure on the question of whether a deferred payment commodity sale does or does not include interest income to the corporation. These corporations are exposed to the Adjusted Current Earnings (ACE) rules of AMT, and ACE income is to be computed without regard to any use of the installment method per Sec. 56(g)(4)(D)(iv). Here, the technical distinction between selling cash method raised commodities on an installment sale versus a deferred payment contract may be important. For those corporations, in order to avoid AMT, the sale should be without interest under the authority of the old deferred payment contracts. With interest income included, the IRS might assert that the commodity sale occurred under Sec. 453 as an installment sale, and accordingly was immediately taxable for AMT/ACE purposes. G. Deferred payment sales by crop share landlords. 1. The IRS has ruled that a cash method crop share landlord was taxable on the sale of grain at the time of entering into a price later contract with a grain elevator, rather than at a later point when the grain was priced and the landlord received the cash (TAM ). 2. The IRS took this position, despite acknowledging the existence of regulations that allow a crop share landlord to not include crops in rental income until the year they are reduced to money or the equivalent of money [Reg (a)]. 3. In subsequent litigation, the Tax Court and the Seventh Circuit determined that a landlord farmer was entitled to report the sale of grain from crop share rentals sold to an elevator under a price later contract using the installment method. The court concluded that the contract was not payable on demand, called for a determinable price for the grain one year later, and accordingly qualified for Section 453 installment sale treatment. Under the terms of the contract, the elevator became obligated to pay a determinable price for the grain one year after the contract date, with a right by the farmer to obtain payment at an earlier date (Applegate vs. Comm., 92-2 USTC 50,623, CA-7, 12/7/92, aff g. 94 TC No. 42). Crop Insurance and the Deferral Election A. Background. 1. A cash method farmer may elect to postpone reporting insurance proceeds on damaged crops from the year of damage to the following year via an election [Sec. 451(d); Reg ]. a. The taxpayer must report on the cash method of accounting. b. The taxpayer must establish that under normal business practice the income from the damaged crop would have been reported in a year following the year of damage or destruction [Rev. Rul ]. 115

120 1) If crop insurance is received for two or more crops, the taxpayer must determine that under normal business practices the income from the damaged crops would have been reported in a year following the year of damage or destruction. 2) If a taxpayer receives insurance proceeds from damage to two or more specific crops, and if both crops are eligible, the election to defer is deemed to cover all proceeds attributable to the crops representing a single business. Example 1 Insurance proceeds received for two crops Tom is a cash method grain farmer maintaining a single set of books for his operation. Tom s corn and soybean crops were damaged by a severe hailstorm, and Tom received insurance proceeds for both crops. Tom cannot elect to defer the corn insurance proceeds and report the soybean proceeds as income, or vice versa. If Tom makes an election to defer the crop insurance proceeds, the election applies to all proceeds because he operates a single farming business. 3) A taxpayer operating two separate farms and maintaining separate books and records for each business may make a separate election for each business [Reg (a)(2); IRS Publ. 225]. c. The farmer must customarily defer more than 50% of the income from the damaged crop. [Nelson v. Comm. (2009, CA8) 103 AFTR 2d ]. However, there is no guidance to determine how this test is computed, whether it is based upon a majority of years met, how many years to include, based upon production sold in quantity or dollars, etc. 2. Crop insurance is not income from an installment sale, which requires a disposition of property [Sec. 453(b)(1)]. The planning opportunity of electing out of the installment method is not available to accelerate crop insurance income. B. Procedural requirements. 1. A statement of election to postpone the income must be attached to the Form 1040 in the year the damage occurred. 2. The election statement to accomplish the crop insurance deferral must contain the following: a. A statement that the election is made under Sec. 451(d) and Reg b. Identification of the specific crop or crops destroyed or damaged. c. A statement that under normal business practice the farmer would have included income from the damaged crop in a year following the destruction or damage. d. Identification of the cause of destruction or damage and the dates it occurred. 116

121 e. The amount of payments received and the date each payment was received for each crop. f. The name of the insurance carrier or payor from whom the amounts were received [Reg (b)(1)]. 3. An election to defer insurance proceeds may be made in either an original return or an amended return. a. Commentary: The ability to defer crop insurance through an amended return election can be important when a farmer has an unusually low income year. The tax practitioner should review the preceding year's income, to determine if any crop insurance or government disaster program payments were received and reported in the prior year without a deferral election. An amended return could be prepared to electively defer that prior year income to the current low income tax return. b. A copy of a sample election to defer insurance proceeds is reproduced at the end of this topic. 4. An election made for a particular tax year is binding, unless the District Director consents to a change requested in writing by the taxpayer. The decision to defer crop insurance proceeds can be made independently for each year insurance is received [Reg (b)(2)]. 5. Insurance proceeds for purposes of this election include payments from private carriers as well as USDA agricultural disaster payments. If a deferral election is made, all current year eligible receipts, whether from private crop insurance or USDA disaster programs, must be deferred [IRS Notice 89-55]. 6. In the case of insurance carriers that allow deferral of the premium payment by a farmer until harvest, the insurance proceeds issued to the taxpayer often are reduced by the unpaid premium. However, in making the Section 451 deferral election, the gross proceeds must be deferred, while the premium expense is allowed as a current deduction. Practitioners need to be sure to match the amount on the Form 1099 received from the insurance carrier with the proceeds reported by the taxpayer to properly handle this situation. Example 2 Insurance proceeds netted against unpaid premium Tom, the taxpayer in Example 1, suffers hail damage to his crops. The insurance company determines that Tom is entitled to $68,000 of crop insurance proceeds, but only issues a check for $51,000 after reduction for the unpaid insurance premium. Tom should deduct the $17,000 amount as an expense in the current year. If Tom elects to defer the crop insurance proceeds, the gross amount of $68,000 will be reported in the following tax year. 117

122 Commentary: Practitioners need to be alert for this situation at the time of year-end planning. Farmers often report the cash amount received (net of the unpaid premium), resulting in additional expenses available for current deduction that have not been considered in the year-end tax plan. 7. Late government disaster payments. a. USDA agricultural disaster payments are eligible for the election under Sec. 451(d) to include the proceeds in income in the year following the taxable year of destruction or damage [Rev. Rul ]. b. In some years, farmers have received government disaster payments in years subsequent to the year of damage or destruction of the crops. However, these late government disaster payments are not deferrable. 1) Sec. 451(d) states that the deferral election allows a taxpayer to defer proceeds to the "year following the taxable year of the destruction or damage." 2) The regulations at (a)(1) state the following: "However, if a taxpayer receives the insurance proceeds in the taxable year following the taxable year of the destruction or damage, the taxpayer shall include the proceeds in gross income for the taxable year of receipt." Example 3 Late receipt of government disaster payments High Acre Farms, Inc. received $200,000 of government disaster payments in 20X7, attributable to drought and crop destruction occurring in 20X5 and 20X6. Because the disaster proceeds were received in a year following the year of damage or destruction of the crop, no deferral election under Sec. 451(d) is available. 118

123 8. Strategies. a. Because the election to defer is binding if made, but the election may be made on an amended return, a taxpayer may choose to file the tax return without the election to defer crop insurance to await further developments. If tax rates increase, or the taxpayer has greater income in the following year, deferral may not be the best option. b. The taxpayer may choose to extend the tax return to have as much time as possible to weigh the benefit of the election. Of course, a payment may need to be made with the extension form. c. The taxpayer might not qualify for deferring crop insurance due to the taxpayer s customary business practice of collecting more than 50% of the crop proceeds in the year of harvest. In this situation, the farmer might consider delaying the filing of the insurance claim, so that the proceeds won t be collected until the following year. d. Farm income averaging should be considered. If the farmer has low base year income, forgoing the election to defer may provide an opportunity to utilize the lower brackets of the previous three years. e. Claiming the income in the current year may create a doubling-up of crop income. However, the diversified farmer might defer crop income from other crops to offset the additional income received from the crop insurance. In addition, the farmer may have the opportunity to accelerate expenses into the current year or elect Sec. 179 on qualifying assets placed in service during the year. f. The farmer may want the income in the year of harvest, but the crop insurance receipt is delayed. As noted above, the election out under the installment method is not available to accelerate recognition. The farmer may consider selling all or part of the crop insurance claim to a related or unrelated party. 1) A cash sale ensures the acceleration into the current year. 2) Selling the rights to the claim for a note should also accelerate income. Gross income includes the receipt in the form of cash, property and services, taxable income the year actually or constructively received [Sec. 446]. A farmer s gross income includes cash and the value of merchandise or other property received [Reg (a)]. The amount realized from the sale or other disposition of property is the sum of any money received and the fair market value of property other than money [Sec. 1001(b)]. 3) Reconciliation of Form 1099 reporting may be necessary. 119

124 Example 4 Sale of rights to crop insurance proceeds Monte suffered a crop disaster in 20X7, for which he has filed a crop insurance claim. The claim has been accepted but won t be received by Monte until 20X8. Monte typically receives income from the sale of crops in the year of harvest. Without the insurance proceeds, he will have a large loss. Monte enters into a contract with his neighbor, Todd, that calls for Todd to purchase 100% of the insurance claim from Monte for $2 million to be paid by March 1, 20X8. Because this is not a sale qualifying for the installment method, Monte is required to include the entire sale in his 20X7 return, reporting it on Schedule F. The crop insurance proceeds collected in 20X8 will be nontaxable to Monte, as these proceeds belong to Todd. However, it will need to be reported on Schedule F. C. Eligibility of Revenue Protection insurance for deferral election. 1. Revenue Protection represents a privately developed insurance policy that includes government reinsurance. a. Revenue Protection may be viewed as an alternative to multi-peril insurance, but it is broader in scope, as it covers any revenue losses to the farmer, whether caused by low price, low yield or a casualty event. b. Essentially, a farmer sets the contract to guarantee a certain level of revenue, and shortfalls are covered regardless of the event which caused the below par revenue. c. The farm s actual production history is utilized to set current coverage, with the policy allowing coverage levels from 50% to 85%. A minimum guarantee is set by a commodity base price, but there is a second price test at harvest, which can produce a greater guaranteed return. 2. Per Sec. 451(d), the election of a cash method farmer to defer crop insurance applies where insurance proceeds are received as a result of destruction or damage to crops or are received as a result of the inability to plant crops because of such a natural disaster. 3. The IRS has previously ruled that crop insurance programs that provide payments without regard to actual losses fall outside of the statutory definition of destruction or damage to crops. Accordingly, the IRS has concluded that payments under these contracts do not qualify for the deferral election [IRS Notice 89-55]. 4. Conclusions. a. If a cash method farmer receives Revenue Protection proceeds as a result of a total inability to plant a crop due to flooding, or because of hail or other destruction or damage to standing crop, the Section 451(d) election for insurance deferral should be available. 120

125 b. Other Revenue Protection payments, arising from low yields or low price, would not meet the statutory definition of representing income arising from crop damage or destruction, and would not be eligible for deferral. c. Where Revenue Protection payments are received partially as a result of nonqualifying events (e.g., low prices or low yields) and partially because of qualifying events (e.g., hail or flooding damage to crops), the tax practitioner should attempt to identify the portion of the Revenue Protection proceeds attributable to crop destruction or damage, and use only that portion of the proceeds in any Section 451(d) deferral election. 121

126 Sample Election to Defer Reporting of Crop Insurance and Disaster Proceeds I.D. No. Statement RE: Deferral of Crop Insurance Attachment to Schedule F, Line 8 I. The taxpayer elects to defer reporting of crop insurance and disaster proceeds under Section 451(d) of the Internal Revenue Code of 1986 and Section of the Regulations. II. III. The crop destroyed was Under normal business practice, income from the destroyed and damaged crops would have been included in gross income in a later tax year. IV. The cause of the damage was Date of damage V. The total amount of payment received VI. Name of insurance carrier IRS To Continue Attacking Cash Method For Farmers Via the Farming Syndicate Rule Overview IRS has a long history of challenging taxpayers that it believes are distorting income reporting by use of the cash method of accounting. As examples of the continued IRS attack on farmers using the cash method of accounting, in 2016, the IRS tried to deny a farmer s surviving spouse a deduction for the cost of inputs she used to plant the crop that he had purchased before death, but died before he could use them to plant the spring crop. Estate of Backemeyer v Comr., 147 T.C. No. 17 (2016). While the farmer had deducted the costs of the inputs as pre-paid expenses in the year before he died, the IRS claimed she couldn t deduct the same amount the following year on her return even though the value of 122

127 the inputs were included in his estate under I.R.C The IRS position revealed a complete misunderstanding of associated tax rules and the Tax Court let the IRS know it in ruling for the estate. In 2015, the IRS tried to deny a deduction for a California farming corporation that deducted the cost of fieldpacking materials until the year the materials were actually consumed. The IRS lost the case based on its own regulation. Agro-Jal Farming Enterprises, Inc., et al. v. Comr., 145 T.C. 145 (2015). A year earlier, a federal appeals court, in a case involving a Texas cattle and horse breeding limited partnership sternly disagreed with the IRS attack on that operation s use of cash accounting via the farming syndicate rule. Burnett Ranches, Limited v. United States, 753 F.3d 143 (5th Cir. 2014). Despite the rebuke, the IRS has now issue a non-acquiescence to the court s decision, signaling that their attack on the cash method will continue. AOD ; IRB 868. In both the 2014 Texas case and the 2015 California case, the IRS trotted-out the farming syndicate rule in an attempt to bar the deductions. Because the IRS has now issued a non-acquiescence to the 2014 Fifth Circuit decision which signals its intent to continue examining the issue outside the Fifth Circuit, practitioners should be reminded of what the IRS is looking for and why the Courts have rejected their theories. The Farming Syndicate Rule In the farm and ranch sector, that alleged distortion often arises in the context of pre-payment for inputs such as fertilizer, seed, feed or chemicals. Various tests and rules have been adopted over the years to deal with material distortions of income when pre-purchases are involved. See, e.g., Rev. Rul , C.B One of those rules, which is designed to place a limitation on deductions for farming operations, was developed in the 1970s and is known as the Farming Syndicate Rule. I.R.C. 461(j). The Congress enacted the rule in 1976, and it eliminates farming syndicates from taking deductions for feed, seed, fertilizer and other farm supplies before the year in which the supplies are actually used or consumed. The rule establishes two tests for determining whether a farming syndicate is present. A farming syndicate is (1) a partnership or other enterprise (except a regularly taxed corporation) engaged in farming if the ownership interests in the firm have been offered for sale in any offering required to be registered with any federal or state securities agency (I.R.C. 461(j)(1)(A)) or (2) a partnership or other enterprise (other than a C corporation) engaged in farming if more than 35 percent of the losses during any period are allocable to limited partners or limited entrepreneurs. I.R.C. 461(j)(1)(B). IRS Position. The farming syndicate rule does not impact many farming and/or ranching operations, but it does catch some of the extremely large operations and a few individuals who are inactive investors in farming operations. That s because there is an exception to the rule for holdings attributable to active management. If an individual has actively participated (for a period of not less than 5 years) in the management of the farming activity, any interest in a partnership or other enterprise that is attributable to that active participation is deemed to not be held by a limited partner or a limited entrepreneur. I.R.C. 461(j)(2)(A). That means that the interest doesn t count toward the 35 percent test. But, IRS has taken a strict interpretation of the statute. In the IRS view, the exception for active management only applies to an individual. Indeed, the statute does state, in the case of any individual [emphasis added] who has actively participated. I.R.C. 461(j)(2)(A). Thus, in C.C.A (Jun. 16, 2008), the Chief Counsel s office determined that a partnership interest held by an S corporation with only one shareholder was to be treated as held by a limited partner for purposes of the farming syndicate rule. The partnership raised and bred livestock, and its members were two trusts along with the S corporation. The S corporation was owned by a trustee who was also a beneficiary of 123

128 the trusts. One of the trusts was the general partnership of the partnership. The partnership reported income on the cash method, but IRS took the position that the partnership interest that the S corporation held had to be treated as a limited partner interest because it wasn t held by an individual. This was the result, according to the IRS, even though the S corporation s sole shareholder was an individual. Thus, for purposes of the farming syndicate rule, the interest held by the S corporation was treated as an interest that was held by a limited partner. Texas Case. Burnett Ranches involved a Texas cattle and horse breeding limited partnership that was 85 percent owned by an S corporation as a limited partner. As such, the limited partnership met the definition of a farming syndicate. However, the court held that the ranch qualified for the active participation exception to the farming syndicate rule even though the majority owner actively participated in managing the cattle operation through the owner s wholly-owned S corporation. The court noted that the west Texas operation had been family-run for many generations dating back into the 1800s, with the current majority owner family member simply owning her interest via an S corporation. There was no question that that majority owner managed the operation and would satisfy the active management test in her own right. The IRS acknowledged as much. But, IRS said the farming syndicate rule was triggered and cash accounting was not available because the ownership interest was held in an S corporation rather than directly by the majority shareholder as an individual. Consequently, IRS said that the partnership could not use cash accounting for the years in issue The limited partnership paid the alleged deficiencies (which amounted to several million dollars) and sued for a refund in federal district court. The sole basis for the IRS denial of the cash method under the farming syndicate rule and the required switch to the accrual method was the fact that the S corporation owned the partnership interest, even though it was an S corporation that was 100 percent owned by the person that performed the entire management function of the business. The district court ruled for the limited partnership. The IRS appealed, continuing to maintain that the majority owner s interest in the limited partnership via her S corporation barred the active management exception from applying. The court disagreed, largely on policy grounds. The court noted that the Congressional intent behind the active management exception of I.R.C. 464(c)(2)(A) was to target high-income, non-farm investors, not the type of taxpayer that the majority owner represented. The court stated, Ms. Marion s business and ownership history with these ranches and their operations is the very antithesis of the farming syndicate tax shelters that 464 was enacted to thwart.. Indeed, the owner of the S corporation was the current descendant in a long line of descendants of the founder of the ranching operation dating to the mid-1800s. The court went on to state, [We] doubt that our interpretation of 464 will stymie the I.R.S., an agency tasked with uncovering abusive tax-avoidance schemes of myriad forms, not just those in the nature of a farming syndicate. We deem it beyond peradventure that her limited partnership interest in Burnett Ranches is excepted from 464 s primary thrust of requiring farming syndicates to employ the accrual basis of accounting. The court also noted that the statutory term interest was not synonymous with legal title or direct ownership, but rather was tied to involvement with or participation in the underlying business. Thus, the court determined that there was no basis for distinguishing between the partnership interest of a rancher who has structured his business as a sole proprietorship and a rancher who has structured his business as [a subchapter S] corporation. The term individual was used in the statute to refer to the provision of active management rather than in reference to having an interest in the activity at issue. Conclusion 124

129 The court s opinion provides needed guidance on the narrow interpretation of the farming syndicate rule by the IRS. The opinion is binding authority inside the Fifth Circuit - Louisiana, Mississippi and Texas. But, with AOD ; IRB 868, the IRS has signaled that it will pick more battles on the same issue elsewhere. That seems a bit ridiculous on this issue. The IRS is spending its budget to pursue collection of tax dollars based upon its technical reading of required active participation, ignoring the 85 percent effective ownership of the person who, as was stipulated, actively participated. It is no wonder that Congress has reduced the IRS budget over the years trying to send the message to the IRS to go after the real abuses, and don t bother taxpayers that are trying to comply with the tax laws. This family involved in Burnett Ranches actively managed the ranches for over 150 years, long before the income tax was a problem (and in fact, before the area became part of the United States!). The IRS should leave honest taxpayers alone, and go after syndicates that are truly abusive. IRS Continues (Unsuccessfully) Attack on Cash Accounting By Farmers Part II Overview However, Itfor business and tax purposes, farmers often find it advantageous to prepay and deduct the cost of supplies. If structured properly, prepayment provides deductions in the year of the payment, favorable prices may be received, and planting and harvesting may be more efficient due to having adequate input supplies on hand. But, certain rules must be followed and the IRS can challenge transactions that aren t within the guidelines. In recent years, the IRS has indicated its opposition to the cash method of accounting for farmers. Up until the Tax Court decision in 2015, litigation involving a California farming operation using the cash method and prepaid expenses had been ongoing for several years. Another Tax Court case, decided yesterday, involved an IRS attempt to deny a deduction for prepaid expenses under the tax benefit rule. The IRS lost both cases. Basic Rules on Pre-Paying and Deducting Input Costs In accordance with Rev. Rul , CB 210, to properly structure prepayments, the expenditure must be an actual payment rather than simply a deposit, and the prepurchased materials or supplies must be used within the next year to avoid a conflict with the IRS about whether the expense needs to be capitalized. Zaninovich v. Comm r, 616 F.2d 429 (9th Cir. 1980), rev g, 69 TC 605 (1978). In addition, farmers may not deduct prepaid farm supplies in excess of 50% of the otherwise deductible farming expenses (the 50% rule ). IRC 464(f). However, a farm syndicate is not allowed to deduct supplies until actually used or consumed. IRC 461(h)(2)(A)(iii). That point was at issue in the 2015 Tax Court case Tax Court Opinion In Agro-Jal Farming Enterprises, Inc., et al. v. Comm r, 145 T.C. No. 5 (2015), the plaintiff raised strawberries and vegetables. It used field-packing materials such as plastic clamshell containers and cardboard trays and cartons in its in-field packing process. It purchased these materials in bulk, in advance of the harvest. The supplies not used by yearend were reflected as expenses in its accrual basis 125

130 financial statements in the year consumed, rather than when paid. The plaintiff reported its income for tax purposes on the cash basis, but prepared GAAP financial statements for financing purposes. The plaintiff also kept detailed records of the field packaging materials on hand at the end of the year, which it capitalized on its yearend financial statements. The Tax Court was faced with the issue of whether the plaintiff could deduct the packaging materials in the year the materials were paid for or whether they could only deduct the amounts as the materials were used The IRS conceded that cash method farmers may deduct farm supplies immediately upon purchase but argued that the farming syndicate rules limited an immediate deduction for expenses attributable to feed, seed, fertilizer or other similar farm supplies. It asserted that the plaintiff s field packing materials were not other similar farm supplies for this purpose. The IRS cited the 50% rule of IRC 464(f) for the definition. However, if the field packing materials were farm supplies under this provision, the 50% limit would not be exceeded, and their cost would be fully deductible. In essence, the IRS argued that only feed, seed, fertilizer, or other similar farm supplies may be deducted immediately upon purchase but that all other supplies could only be deducted as consumed. The plaintiff presented two counter-arguments. The first was that the field packing materials constituted other similar farm supplies. The second argument, based upon the farm syndicate rules, was that only those farmers who were within the definition of a farming syndicate were barred from using cash accounting. Because Agro-Jal did not fall under that definition, the plaintiff argued they could utilize the cash method for all farm supplies that were consumed within a year. The Tax Court agreed with the plaintiff and held that the plaintiff s expenses for field packing materials were fully deductible in the year of purchase. The court noted that the farm syndicate rules were aimed at abusive taxpayers (i.e., farming syndicates as that term is defined) and to certain especially abused expenses (i.e., feed, seed, fertilizer, or other similar farm supplies). Those situations were not present under the facts of the case. The Tax Court also viewed feed, seed, and fertilizer as evoking a class of expenses associated with the growing of crops or the raising of livestock. The field packing materials were neither, the court reasoned, which would appear to place them outside the reach of the 50% test and the farm syndicate rule. Thus, the court agreed with the IRS on this point: because the named items in the statutory list (feed, seed, and fertilizer) are used directly in production activities, the field packaging materials were not similar to those items and were, therefore, outside the scope of IRC 464. The court then proceeded to analyze the issue under the general rules for supplies (i.e., those supplies that are not farm supplies ) contained in Treas. Reg That regulation was amended by TD 9636 (the tangible property regulations) effective for tax years beginning after However, under the version in effect for the tax years at issue, the court held that the supplies were not limited to deductibility in the year consumed because the taxpayer deducted them when paid. According to the court, Treas. Reg merely prevents a double deduction, once in the year paid and once in the year consumed, when it states: provided that the costs of such materials and supplies have not been deducted for any previous year. Thus, the plaintiff was allowed to deduct the supplies when purchased, even though it accounted for the supplies not consumed by deferring the expense on its financial statements. 126

131 By determining the amount to report as a deferred expense on the balance sheet, the plaintiff had determined a physical inventory, meaning that the supplies were nonincidental. That is a distinction made by the tangible property regulations for tax years beginning after However, because the years at issue predated the effective date of the revisions made by the tangible property regulations, the Tax Court did not address the distinction between incidental and nonincidental materials and supplies. A different and more specific regulation, Treas. Reg (a), applies to agriculture. This regulation provides that, A farmer who operates a farm for profit is entitled to deduct from gross income as necessary expenses all amounts actually expended in the carrying on of the business of farming. The court did not address Treas. Reg (a) or mention it because it was not necessary. Because the IRS based its arguments solely on Treas. Reg , the court kept its focus there. The court determined that Treas. Reg did not require capitalization because the amounts for the field packing materials were properly claimed in an earlier year Tax Court Opinion In Estate of Backemeyer v. Comr., 147 T.C. No. 17 (2016), the husband was a sole proprietor farmer who purchased crop inputs (herbicides, seeds, fertilizer and lime, fuel, etc.) worth over $200,000 in the fall of 2010 that he planned to use in connection with planting the spring 2011 crops. However, the husband died on March 13, 2011, before using any of the inputs. The inputs were listed in his estate s inventory with their value pegged to their purchase price. Shortly before he died, he sold his 2010 crop in January of 2011 and that income was reported on line 3b of his 2011 Schedule F. His estate did not include any interest in any stored grain. The farm inputs passed to a family trust that named his surviving wife as the trustee. The wife ran the farming operation after her husband s death and took an in-kind distribution of the farm inputs from the trust which she used to grow corn and soybeans in She sold a portion of the crops grown in 2011 later that fall and reported those sale proceeds ($301,000) on line 3b of her 2011 Schedule F. She sold the balance of the 2011 crops in 2012, a year that she filed as a single taxpayer. The couple filed a joint return for 2010 on which they claimed over $230,000 as pre-paid expenses. On the joint 2011 return, which included two Schedule Fs, the wife s Schedule F claimed as expenses the exact same amount that had been claimed as pre-paid expenses on the husband s 2010 Schedule F. The IRS rejected the deduction on the wife s 2011 Schedule F, thereby increasing taxable income by $235,693 and resulting in a tax deficiency of $78,387. The IRS explained its reason for denying the deduction was because the petitioners use the cash method for [their] farming activity, prepaid expenses that were paid in 2010 are deductible in 2010, and are not added to basis. According to the IRS, the taxpayers were getting a double deduction which they were not entitled to, and if the court were to allow the deduction on the wife s 2011 Schedule F, then that same amount should be included in the husband s 2011 Schedule F. If that didn t happen, the IRS claimed, a material distortion of income would result. The IRS also claimed that the surviving wife was not entitled to a step-up in basis under I.R.C in the inherited farm inputs. The IRS also tacked on an accuracy-related penalty under I.R.C. 6662(a) of $15,864. In its reply brief, the IRS jettisoned all of those arguments and claimed that the tax benefit rule controlled the outcome of the case. Thus, the surviving spouse properly deducted the inputs on her 2011 return because she had received the inputs with a stepped-up basis and proceeded to use them in her farming business. But, IRS claimed, the tax benefit rule required the inclusion in the husband s 2011 return of the amount of the prepaid input expense that had previously been deducted in The IRS claimed that Bliss Dairy, Inc. v. Comr., 460 U.S. 370 (1983) required that outcome. In that 127

132 case, a cash method corporate dairy deducted the purchase cost of cattle feed. Early in the next year, the corporation liquidated while there was a significant amount of feed remaining on hand. The corporation distributed its assets to its shareholders in a nontaxable transaction. The shareholders continued to operate the dairy and deducted their basis in the feed as an expense of doing business. The U.S. Supreme Court said that the tax benefit rule applied because the liquidation of the corporation changed the cattle feed to being used in a non-business use which was now inconsistent with the earlier deduction. The IRS said the facts of the current case were the same and should produce the same result. The IRS claimed that because the husband died before using the inputs in his farming business, the inputs were converted to a non-business use at the time they were transferred to the trust. Then, upon distribution to the wife for use in her farming business, the inputs were converted back to business use which entitled her to deduct their cost, but also required the husband s return to recognize income because he converted the inputs from one use to another by dying unexpectedly at the wrong time. The Tax Court didn t buy the IRS argument. In Frederick v. Comr., 101 T.C. 35 (1993), the Tax Court laid out a four-factor test for application of the tax benefit rule: (1) a deduction was taken in the prior year; (2) the deduction resulted in a tax benefit; (3) an event occurred in the current year that is inconsistent with the premises on which the deduction was originally based; and (4) a nonrecognition provision of the Code does not prevent inclusion in gross income. While the first two factors were satisfied, the Tax Court determined that factors (3) and (4) were not. As to factor (3), the court noted that neither the husband s death nor the distribution of the inputs to his wife for use in her farming business were inconsistent with the deduction on his 2010 return. The Tax Court noted that had the wife inherited the inputs in 2010 and used them in 2010, the initial deduction would not have been recaptured for income tax purposes because of the estate tax. They were subject to the estate tax on their purchase price, which was the same basis for the income tax deduction. Thus, application of the tax benefit rule would result in double taxation of the value of the inputs. Factor (4) had also not been satisfied. Upon the husband s death, the basis step-up rule applied. Also, the gross income of the recipient of an asset does not include the value of the inherited assets. Upon disposition by the heir, the heir has taxable gain only to the extent the proceeds exceed the stepped-up basis. Also, upon death, depreciation recapture is not triggered under either I.R.C or I.R.C Those rules are a partial codification of the tax benefit rule and don t apply at death. Thus, the tax benefit rule did not apply and require the inclusion in the husband s 2011 Schedule F of the amount that had been deducted for the pre-paid inputs that were claimed on the 2010 Schedule F. In addition, the court also removed the accuracy-related penalty. Conclusion Farmers are specifically allowed to deduct amounts actually expended that are attributable to items used in conducting their farming business. This general principle is only limited if other specific Code provisions provide otherwise (e.g., IRC 263A for the uniform capitalization rules, IRC 464 for the 50% rule, IRC 175 for soil and water conservation expenditures, etc.). In addition, Treas. Reg (a) was not impacted in any manner by the tangible property regulations, and it remains the authority for farmers to deduct all amounts actually expended in carrying on the business of farming. In addition, the tax benefit rule is inapplicable where crop inputs are deducted in an earlier year and then again in a later year by a surviving spouse who inherits the inputs as the result of a spouse s unexpected death and uses them in the surviving spouse s farming business. 128

133 NEW CAPITALIZATION AND REPAIR REGULATIONS UPDATE AND REVIEW A. Background 1. 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 The new regulations are generally effective for taxable years beginning on or after January 1, However, taxpayers did have the option to early adopt the regulations for taxable years beginning on or after January 1, b. Also issued on September 13, 2013 were proposed regulations [REG ] providing guidance on the application of general asset account and disposition rules under Sec Final regulations on dispositions were issued in August of 2014 [T.D. 9689]. 2. 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. 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 (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. 129

134 168(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 (a)-3(e)(5)(i)]. b. For buildings, each building and its structural components is a single unit of property [Reg (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 (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. 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 (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 130

135 materials and supplies [Reg (c)(1)]. 131

136 3. Commentary: The 12 month rule in the second and third definitions of a material and supply item coincides with existing regulations holding that a taxpayer is not required to capitalize any intangible right or benefit that does not extend beyond 12 months [Reg (a)-4(f)(1)]. Example 1 Materials and supplies: Farm fuel FACTS: Alex Farms purchases $50,000 of diesel fuel and gasoline for use in its farming operations during the 2015 crop season. Alex Farms expects to consume this gasoline and diesel fuel within the next 12 months. RESULT: Alex Farms may deduct the $50,000 fuel expenditure under Reg (c)(1)(ii). D. De minimis safe harbor election. 1. Amounts paid to acquire or produce tangible property, not exceeding a certain dollar threshold, may be deducted under the de minimis safe harbor. a. To be eligible, however, a taxpayer must: 1) Have an applicable financial statement ( AFS ); 2) Have at the beginning of the taxable year written accounting procedures treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount, or amounts paid for property with an economic useful life of 12 months or less; 3) Treat the amounts paid during the taxable year as an expense on its AFS in accordance with its written accounting procedures; and 4) Treat the amounts that do not exceed $5,000 per invoice or per item as not capitalized [Reg (a)-1(f)(1)(i)]. The additional costs associated with the property (delivery fees, installation services, etc.) must be included in the per item cost if included on the same invoice [Reg (a)-1(f)(3)(i)]. b. AFS is defined as: 1) A financial statement filed with the Securities and Exchange Commission (the 10-K or the Annual Statement to Shareholders); 2) A certified audited financial statement by an independent CPA that is used for credit purposes, reporting to equity holders, or any other substantial non-tax purpose; or 3) A financial statement required to be provided to the federal or a state government or any federal or state agencies [Reg (a)-1(f)(4)]. 132

137

138 2. Most farm businesses will not have an AFS. However, taxpayers without an AFS can also utilize the de minimis safe harbor by satisfying the same requirements except that the maximum amount paid for the property is reduced to $500 per invoice or item instead of $5,000 [Reg (a)-1(f)(1)(ii)]. a. For taxpayers without an AFS and using the $500 limit, the accounting policy to expense need not be in writing. b. A taxpayer with both an AFS and a non-qualifying financial statement must meet the requirements of the AFS in order to utilize the safe harbor. 3. De minimis expensing policy exceeding $500. a. The de minimis safe harbor is not intended to prevent a taxpayer from reaching an agreement with its IRS examining agents that, as an administrative matter, based on risk analysis or materiality, the IRS examining agents will not review certain items [Preamble to TD 9636, IV.B]. 1) The safe harbor is not intended to be a threshold of materiality. 2) The taxpayer has the burden of showing that deducting amounts in excess of the threshold does not distort income. b. Commentary: In IRS website guidance published in March of 2015 (Tangible Property Regulations Frequently Asked Questions), the IRS clarified that a business may have a policy for books and records of deducting amounts more than $500 and properly deduct those amounts for federal tax purposes, providing that the taxpayer can show that the policy clearly reflects income. This IRS guidance also suggested that the taxpayer should still elect the de minimis safe harbor for items costing $500 or less to assure that the deduction of the items costing $500 or less will not be questioned by the IRS. 4. Election statement. a. A taxpayer makes the de minimis safe harbor election annually by attaching a statement to its timely filed federal tax return. 1) A taxpayer making the election must apply the election to all amounts paid during the year for property meeting the requirements discussed above [Reg (a)- 1(f)(5)]. 2) An exception is provided for certain rotable, temporary or standby emergency spare parts [Reg (d)]. b. The de minimis safe harbor is elected by attaching a statement titled Section 1.263(a)-1(f) de minimis safe harbor election to the timely filed original federal tax return, including extensions, for the taxable year in which the de minimis amounts are paid. The statement should include the taxpayer s name, address, and taxpayer identification number, as well as a statement that the taxpayer is making the de minimis safe harbor election. 134

139 135

140 c. The de minimis safe harbor is an annual election, not a change in method of accounting. No Form 3115 is required to elect the de minimis safe harbor, nor is a Form 3115 required to stop applying the de minimis safe harbor for a subsequent year [IRS FAQs]. d. The election is generally available for amounts paid in taxable years beginning on or after January 1, e. In the case of a consolidated group filing a consolidated income tax return, the election is made for each member of the consolidated group by the common parent [Reg (a)-1(f)(5)]. 6. IRS increases the de minimis amount for non-afs taxpayers. a. Believing that an increase in the de minimis safe harbor limit for non-afs taxpayers furthered the goal of the tangible property regulations to reduce administrative burden, the IRS increased the limit from $500 to $2,500 for costs incurred during tax years beginning after The IRS will not raise the issue on examination for pre-2016 tax years if the taxpayer satisfies the other de minimis safe harbor requirements [IRS Notice ]. b. Commentary: The increase of the de minimis safe harbor offers small taxpayers flexibility and allows them to fully expense many asset purchases without utilizing any of their Sec. 179 limits both the annual $510,000 (2017 indexed amount) expense limit and the asset addition phase-out thresholds. This can free-up the Sec. 179 deduction for larger dollar items. c. Caution: Taxpayers need to be mindful of the de minimis rule characterizing all income from the sale of expensed items as ordinary income. The regulations hold that property to which a taxpayer applies the de minimis safe harbor is not treated as a capital asset under Sec nor as property used in a trade or business under 1231 [Reg (a)- 1(f)(3)(iii). This rule could increase the tax upon the sale of items that appreciate in value (e.g. breeding and dairy animals). If those items were depreciated and/or expensed using Sec. 179, only Sec. 179 and depreciation is recaptured as ordinary income. There is an informal IRS letter indicating that these sales should be reported on Form d. The regulations specifically prohibit the use of the de minimis safe harbor election for property that is held as inventory for resale [Reg (a)-1(f)(2)(i)]. e. Commentary: There is no authority for selecting a different de minimis safe harbor amount for different classes or categories of assets within the same tax year. Accordingly, taxpayers who purchase breeding stock with a per-unit cost less than their de minimis safe harbor election will face ordinary income upon disposition of those animals. 136

141 Example 2 Deducting breeding stock under the de minimis election FACTS: Hawkeye Hogs occasionally purchases gilts as replacement breeding stock for its hog producing operation. During the current year, Hawkeye purchases 300 gilts at $250 each, for a total expenditure of $75,000. RESULT: If Hawkeye makes a de minimis safe harbor election for the current year, it may expense the $75,000 expenditure, as each item is under the $2,500 threshold. By using the de minimis election, Hawkeye does not consume any of its Section 179 limit for the current year for the purchase of these breeding animals. The sale of cull sows will result in ordinary income reporting. The income is not subject to SE tax. 7. Consequences of de minimis safe harbor election. E. Repairs. a. The de minimis safe harbor is an administrative convenience that allows a taxpayer to deduct small dollar expenditures for the acquisition or production of property that otherwise must be capitalized under general rules [IRS FAQs]. b. Amounts deducted under this de minimis rule are not capitalized nor are they treated as a material or supply [Reg (a)-1(f)(1)]. c. All tangible property is eligible for the de minimis rule except land and property that is or is intended to be included in inventory [Reg (a)-1(f)(2)]. d. Also, a taxpayer may be required to capitalize small expenditures under Sec. 263A, such as the requirement to capitalize all direct and allocable indirect costs of constructing a new building. e. Commentary: The IRS FAQs clarify that a taxpayer making the safe harbor de minimis election is not required to capitalize all amounts in excess of the $500/$2,500 limitation. For example, incidental material and supply costs exceeding the $500/$2,500 amount are currently deductible, and the expenditure may also be deductible under the general improvement versus repair definitions. The de minimis safe harbor election simply eliminates the burden of determining whether every small dollar expenditure must be properly deducted or capitalized. 1. The general rule is that a taxpayer may deduct amounts paid for repairs and maintenance to tangible property as long as the amounts paid are not otherwise required to be capitalized [Reg (a)]. Consequently, an examination of what needs to be capitalized as an amount paid to improve tangible property, discussed below, is necessary in order to determine what can be deducted as a repair. 2. Routine maintenance safe harbor. The capitalization regulations provide a safe harbor for 137

142 routine maintenance on tangible property that is deemed not to improve the unit of property. a. Routine maintenance is the recurring activities that a taxpayer expects to perform to keep a unit of property in its ordinary efficient operating condition. Routine maintenance activities include the inspection, cleaning, testing, and replacing of parts (with comparable replacement parts) of a unit of property. 1) For property other than buildings, activities are routine only if the taxpayer reasonably expects at the time it places the property in service to perform the activities more than once during the class life of the unit of property [Reg (a)-3(i)(1)(ii)]. The class life is typically longer than the recovery period; see Rev. Proc ) For farm machinery and equipment, grain bins and other assets used in ag production, the class life for 7 year recovery property is 10 years [Class 01.1, Rev. Proc ]. 3) For buildings, the taxpayer must reasonably expect at the time it places the building in service to perform the activities more than once during a 10-year period beginning when the building is placed in service by the taxpayer [Reg (a)-3(i)(1)(i)]. b. Commentary: The 2011 regulations removed buildings from the routine maintenance safe harbor. Although a concession was made by the IRS to again include buildings in the safe harbor, its application will be significantly limited by the new 10- year period (rather than the 40-year class life, or 25-year class life for farm buildings or 15-year class life for single purpose agricultural or horticultural structures). c. Unlike the other safe harbors established by the regulations, the routine maintenance safe harbor is an accounting method and not an optional annual election. Therefore, the safe harbor is adopted by filing an accounting method change and not an annual statement. See the discussion of Rev. Proc below. F. Acquisitions and improvements. 1. The capitalization regulations state that no deduction is allowed for: a. Any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or real estate; or b. Any amount paid restoring property or making good the exhaustion thereof for which an allowance is or has been made [Reg (a)-1(a)]. 2. Acquisitions. Taxpayers must capitalize amounts paid to acquire or produce a unit of real or personal property. Such amounts include the invoice price, transaction costs and work performed prior to the date that the unit of property is placed in service. Taxpayers must also capitalize amounts paid to acquire real or personal property for resale [Reg (a)- 2(d)]. a. The only exceptions to capitalization are amounts paid to acquire or produce tangible property which are materials and supplies [Reg ] or for property falling 138

143 within the de minimis safe harbor [Reg (a)-1(f)]. b. Commentary: Therefore, a taxpayer must always capitalize amounts paid to acquire or produce tangible property unless the property qualifies as materials and supplies or qualifies under the de minimis safe harbor and the taxpayer makes the safe harbor election. 3. Improvements. Generally, a taxpayer must capitalize amounts paid to improve a unit of property owned by the taxpayer [Reg (a)-3(d)]. A unit of property is improved if the amounts paid for activities after the property is placed in service: are for a betterment to the unit of property; restore the unit of property; or adapt the unit of property to a new or different use. See the Worksheet following this Topic. 4. Betterment. An amount is paid for a betterment to the unit of property only if the expenditure: a. Corrects a material condition or defect that either existed prior to the taxpayer s acquisition of the property or arose during the production of the property, regardless of whether the taxpayer was aware of the condition or defect at the time of acquisition or production; b. Is for a material addition to the property (physical enlargement, expansion, or extension) or a material increase in the property s capacity; or c. Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property [Reg (a)-3(j)(1)]. 5. Determining whether an expenditure is for the betterment of the unit of property is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately prior to the circumstances necessitating the expenditure [Reg (a)-3(j)(2)(iv)]. a. Not a material increase in efficiency Example 3 139

144 FACTS: Rachel owns a hog farrowing complex with 10 venting and climate control units. After many years of use, the building begins to experience climate control problems. Rachel engages a contractor who recommends replacement of 2 of the units. The 2 new units are expected to eliminate the climate control problems and to be 10% more energy efficient. RESULT: The replacement of two units is not a material addition or increase to the venting and climate control system. The 10% efficiency increase is not expected to materially increase the productivity, efficiency, strength, quality, or output of the system. Rachel is not required to capitalize the amounts paid for the new units as a betterment. SOURCE: Reg (a)-3(j)(3), Example (20). 6. Restoration. An amount is paid to restore a unit of property only if the expenditure: a. Is for the replacement of a component of a unit of property and the taxpayer has recognized gain or loss on the sale or exchange of the component, or has deducted a loss for the component (such as in a partial disposition); b. Is for the repair of damage to a unit of property for which the taxpayer has taken a casualty loss under Sec. 165; c. Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use; d. Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or e. Replaces a part or a combination of parts that comprise a major component or substantial structural part of the unit of property [Reg (a)-3(k)(1)]. 1) The determination of whether the replacement of parts comprises a major component or substantial structural part of the unit of property is made on a facts and circumstances basis. 2) Relevant factors include the quantitative or qualitative significance of the part or combination of parts in relation to the unit of property. 3) A major component is a part or combination of parts that performs a discrete and critical function in the operation of the unit of property. 4) A substantial structural part is a part of combination of parts that comprises a large portion of the physical structure of the unit of property [Reg (a)-3(k)(6)]. 140

145 Example 4 Not a replacement of major component or substantial structural part FACTS: Ralph owns a building that he uses in his livestock breeding operation. He pays an amount to replace 30% of the wiring throughout the building with new wiring. RESULT: 30% of the wiring is not a significant portion of the wiring major component and does not comprise a substantial structural part of the electrical system. Ralph is not required to treat the amounts paid for the replacement as a restoration. SOURCE: Reg (a)-3(k)(7), Example (21). f. Commentary: The regulations include 31 examples illustrating what is and is not a restoration. There are no bright line tests; the definitions are to be applied based on the facts and circumstances. Although Example 4 above might suggest that 30% of a major component is not significant, other examples in the restoration regulations reach opposite conclusions (windows representing 30% of the surface area of a building are a substantial part in regulation Example 27, while 40% of the sinks are not a significant portion of a major component in Example 23). 141

146 7. Adaptation. An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer s ordinary use of the unit of property at the time the property was originally placed in service by the taxpayer [Reg (a)-3(l)(1)]. Example 5 Not a new or different use FACTS: Jenn owns a hog feeding facility originally built with pens holding approximately 25 hogs. She reconfigures the structure into two spaces each holding 200 hogs. RESULT: The amount paid to reconfigure the pens does not adapt Jenn s structure to a new or different use SOURCE: Based upon Reg (a)-3(l)(3), Example (2). Example 6 New or different use FACTS: Aaron owns a cattle feeding facility with floor slats designed for cattle. He reconfigures the facility into a hog raising structure, requiring a replacement of the floor slats to accommodate the smaller feet of hogs. RESULT: The amount paid to convert the cattle structure into a structure for raising hogs adapts the structure to a new or different use. The conversion is not consistent with Aaron s use of the structure at the time it was placed in service. SOURCE: Based upon Reg (a)-3(l)(3), Example (1). 8. See the following Worksheet, designed for use as a quick reference tool in reviewing the betterment, restoration and adaptation definitions that require capitalization. 142

147 Worksheet: Tests for Improvements Requiring Capitalization Tests for Betterments [Reg (a)-3(j)(1)] An amount is paid for a betterment to a unit of property (UOP) only if it: 1. Corrects a material condition or defect that either existed prior to the taxpayer s acquisition of the UOP or arose during the production of the UOP; 2. Is for a material addition to the UOP (physical enlargement, expansion, extension, or addition of a major component) or a material increase in the capacity 1 of the UOP; or 3. Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the UOP. Tests for Restorations [Reg (a)-3(k)(1)] An amount paid restores a UOP only if it: 1. Is for the replacement of a component of a UOP and the taxpayer has deducted a loss for the component (i.e., claimed a partial disposition for the component); 2. Is for the replacement of a component of a UOP and the taxpayer has recognized gain or loss on the sale or exchange of the component; 3. Is for the repair of damage to a UOP for which the taxpayer has taken a casualty loss under Sec. 165; 4. Returns the UOP to its ordinary efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use; 5. Results in rebuilding a UOP to a like-new condition after the end of its class life; or 6. Replaces a part or a combination of parts that comprise a major component 2 or substantial structural part 3 of the UOP. Test for Adaptations [Reg (a)-3(l)(1)] 1. An amount is paid to adapt a UOP to a new or different use if the adaptation is not consistent with the taxpayer s ordinary use of the UOP at the time the property was originally placed in service by the taxpayer. Notes: 1 Although the Preamble states that no quantitative bright lines were established, one example in the regulations concludes that a 25% increase in capacity is material. 2 A major component is defined as a part or combination of parts that performs a discrete and critical function in the operation of the UOP. For buildings, a part or combination of parts that comprise a significant portion of a major component is treated as a major component. In the regulations, one example concludes that 40% of sinks do not comprise a significant portion of a major component of a plumbing system (Ex. 23) and another example concludes that 40% of the flooring is a significant portion of a major component of a building structure (Ex. 29). 3 A substantial structural part is defined as a part or combination of parts that comprises a large portion of the physical structure of the UOP. In the regulations, one example concludes that 30% of rooftop HVAC units is not a substantial structural part of an HVAC system (Ex. 18); however, another example concludes that windows representing 30% of the surface area of a building are a substantial 143

148 structural part of the building structure (Ex. 27). 144

149 G. Dispositions. 1. Generally, a taxpayer must recognize gain or loss on the disposition of an asset under normal tax rules. A disposition occurs when ownership of an asset is transferred or when the taxpayer permanently withdraws the asset from use [Reg (i)-8(b)(2), TD 9689, 8/18/2014]. a. The final regulations allow a taxpayer to elect to apply the disposition rule when a taxpayer disposes of a portion of an asset (i.e., something less than the entire asset) [Reg (i)-8(d)(2)(i)]. b. However, the disposition rule always applies to the disposal of a portion of an asset as a result of a casualty event under Sec. 165, a non-recognition transfer (e.g., a Section 1031 exchange), or a sale [Reg (i)-8(d)(1)]. c. If the disposal of a portion of an asset is treated as a disposition (either because the taxpayer elects or under the mandatory rule), the taxpayer may use any reasonable method to determine the basis of the disposed portion as long as it is consistently applied to that asset [Reg (i)-8(f)(3)]. H. Election to capitalize repair and maintenance costs. 1. There are circumstances in which taxpayers would rather capitalize repairs for tax purposes. The regulations permit an election to capitalize repairs and maintenance items as improvements, if these costs are treated as capital expenditures for financial accounting purposes by the taxpayer (or as the regulations state on its books and records regularly used in computing income ) [Reg (a)-3(n)]. 2. The election is made by attaching a statement to the timely filed original tax return stating that the taxpayer is electing to capitalize repair and maintenance costs that have also been capitalized on its books and records. 3. This is an annual election; it is not an accounting method and does not need to be applied consistently. 4. The statement to make this election must be titled Section 1.263(a)-3(n) Election and must include the taxpayer s name, address, taxpayer identification number, and a statement that the taxpayer is making the election to capitalize repair and maintenance costs under Reg (a)-3(n). 5. Commentary: This election adds another tool for tax preparers to apply during the tax return preparation process if a cash method farmer s income is lower than desired. However, the tax practitioner should advise the taxpayer of the need to conform the capitalization treatment in the taxpayer s books and records or other financial accounting statements. 145

150 Meals and Lodging Furnished to Employees for Convenience of Employer Overview Meals and lodging furnished in-kind to an employee (including the employee s spouse and children) for the convenience of the employer on the employer s business premises are excluded from the employee s gross income 35 and are deductible by the employer (as a non-cash fringe benefit) if they are provided inkind. 36 From the employer s perspective, meals and lodging provided to employees are not considered to be compensation. They are deductible as an ordinary and necessary business expense. 37 With respect to employer-provided lodging, the employee must accept the lodging as a condition of employment. 38 In addition to being excluded from income, the value of meals and lodging furnished for the employer s convenience is not wages for FICA and FUTA purposes. 39 Exclusion of Employer-Provided Meals On the business premises. To be excluded from an employee s income, the meals must be furnished on the employer s business premises. 40 The business premises is the employee s place of employment 41 where the employee performs a significant portion of his duties 42 or the employer conducts a significant portion of its business. Thus, the meals cannot be furnished at someplace that is merely near the place of employment or where significant duties are performed, but is a convenient place to provide the meals. 43 For the convenience of the employer. The meals must also be provided for the convenience of the employer. If they are not, the value of the meals is subject to FICA and FUTA taxes. 44 The key is that the meals (or lodging) must not be intended as compensation. On this point, an employment contract that fixes the terms of employment isn t controlling, by itself. 45 The same is true for a state statute. 46 In essence, why an employer provides meals and lodging to employees is based on objective facts and not on stated intentions. There must be some reasonable connection between providing employees with meals and lodging and the business interests of the employer. 35 I.R.C The value of meals and lodging is includible in an employee s income if the employee can choose to receive additional compensation instead of receiving the meals or lodging in-kind. 36 I.R.C Id. The exclusion of the value of meals and lodging from an employee s income has no bearing on the employer s deduction. See, e.g., Harrison v. Comr., T.C. Memo I.R.C. 119(a)(2). Treas. Reg (b)(3). 39 Rowan Companies, Inc. v. United States, 452 U.S. 247 (1981) (offshore oil rigs) (a)(1). 41 Treas. Reg (c)(1). 42 Rev. Rul , CB 103 (even though meals were not served at the place of employment, they were served where a major part of the employer s business was conducted). 43 Id. 44 Rev. Rul , C.B See PLR (value of meals included in employees income; not reasonable to believe wages excludible). 45 I.R.C. 119(b)(1)(employment contract or state statute not determinative of whether meals (or lodging) are intended as compensation). 46 Id. 146

151 Example: FarmCo operates on property that it leases from its shareholders/officers. Farmco requires the corporate officers to be on the farm premises at all times to monitor activities and deal with issues as they come up. Farmco reimburses the shareholders grocery expenses. In addition, the shareholders residence was on the farm and the groceries were cooked in the shareholders home. Result: In Dobbe v. Comr., 47 the Tax Court held that such an arrangement was for the shareholders own convenience and not for the convenience of the employer. While the shareholders were engaged in day-to-day farm operations, and may have eaten some meals while dealing with farm issues, the court held that they did so for their own convenience. In addition, the court pointed out that other employees weren t treated similarly and the corporation failed to establish that the reimbursement was necessary to make sure that qualified employees would be available to address corporate unexpected issues of the farm corporation. Also, it was not proved that the lease covered the residence on the property. Note: For leased residences, it is advisable to have a written lease detailing the amount of rent the corporation is to pay and detailing the corporation s access right to the residence. Cash meal allowances or reimbursements are includible in gross income to the extent the allowance constitutes compensation. 48 Likewise, meal allowances provided on a routine basis for overtime work are not occasional meal money for purposes of the de minimis rules, 49 and are treated as wages for FICA, and withholding purposes (and presumably for FUTA as well). 50 Note: As to what can count as meals, the U.S. Court of Appeals for the Third Circuit, in a case involving employer-provided housing that met the test for excludability (discussed later), held that the cost of groceries (including such things as napkins, toilet tissue and soap) were excludible from the employees income. 51 The court reached this conclusion because the employee was required to live on the business premises as a condition of employment. 52 Treatment of meals as a fringe benefit. If more than one-half of the employees to whom meals are provided on an employer s premises are provided for the convenience of the employer, then all of the meals are treated as furnished for the employer s convenience. 53 If that test is met, the value of all meals is excludible from the employee s income and is deductible by the employer. 47 T.C. Memo See, e.g., Priv. Ltr. Rul (Sept. 30, 1997). See also Koven v. Comr., T.C. Memo Temp. Regs T(d)(2). 50 Priv. Ltr. Rul (Feb. 15, 1991) 51 Jacob v. United States, 493 F.2d 1294 (3d Cir. 1974). 52 The IRS does not agree with court s conclusion. See Priv. Ltr. Rul (Apr. 23, 1991). The U.S. Tax Court has reached a different conclusion. See Tougher v. Comr., 51 T.C. 737 (1969). As a result, the IRS does not follow the Third Circuit s opinion outside of the Third Circuit, and takes the position in those jurisdictions that the value of such items is wages for FICA purposes (b)(4). 147

152 Employee option. If employees have the option of not purchasing meals provided by the employer at a cost, the IRS has taken the position that the excess of fair market value over the price of the meals is taxable income to the employees. 54 Employer-Provided Lodging In general. For the value of lodging to be excluded, the employer must furnish the lodging to the employee and the employee must be required to accept the lodging on the premises as a condition of employment and for the convenience of the employer. 55 The term lodging includes such items as heat, electricity, gas, water and sewer service unless the employee contracts for the utilities directly from the supplier. 56 The term also includes household furnishings 57 and telephone services. 58 Note: If the employee is required to pay for the utilities without reimbursement from the employer, the utilities are not furnished by the employer and are not excludible from income. 59 The lodging must be provided in-kind. 60 Cash allowances for lodging (and meals) are includible in gross income to the extent the allowance constitutes compensation. 61 As a condition of employment. The employee must accept the employer-provided lodging as a condition of employment. That can only occur if the employee s acceptance of the lodging is necessary for the employee to property perform their job duties. Thus, it makes no difference if the employee is required to accept the employer-provided lodging. The key is whether the employer provided lodging is necessary for the performance of the employee s duties. Thus, the standard is an objective one and it is immaterial, for example, that corporate documents (such as a board resolution) require the employee to live in corporate-provided lodging. 62 Convenience of the employer. With respect to employer-provided lodging, the convenience of the employer test is basically the same as the requirement that the lodging be provided as a condition of 54 Priv. Ltr. Rul (no date given) (a)(2). 56 Rev. Rul , C.B. 61; Harrison v. Comr., T.C. Memo (amounts for gas and electricity paid by corporation in grain and dairy operation were necessary for residences to be habitable and so excludible from income of employees); Vanicek v. Comr., 85 T.C. 731 (1985), acq., C.B. 1 (portion of cost of utilities for residence provided by employer not deductible because of lack of evidence showing how utility cost could be apportioned between business and personal use). See also Inman v. Comr., T.C. Memo ; McDowell v. Comr., T.C. Memo (propane, gas, telephone and utilities excludible in addition to food and depreciation; taxpayers lived on ranch eight months out of year with closest town 80 miles away). 57 Turner v. Comr., 68 T.C. 48 (1977). 58 Hatt v. Comr., T.C. Memo Turner v. Comr., 68 T.C. 48 (1977) (costs of utilities and furnishings purchased by welder for house in which welder required by employer to reside not deductible because utilities and furnishings not provided by employer). 60 See Priv. Ltr. Rul (Sept. 30, 1997)(cash housing allowance provided to employee was not excludible from income; lodging not also on business premises); PLR (Feb. 11, 1998)(same). 61 Regs (e). 62 See, e.g., Peterson v. Comr., T.C. Memo ; Winchell v. United States, 564 F. Supp. 131 (D. Neb. 1983). 148

153 employment. 63 Thus, if the lodging meets the test as being provided as a condition of employment it will also be deemed to be provided for the convenience of the employer. 64 On the business premises. To be excluded from income, meals must be furnished on the business premises of the employer. 65 For lodging, the employees must be required to accept the lodging on the business premises of his employer. 66 Thus, both meals and lodging must be provided on the business premises. Note: The regulations specify that business premises of the employer generally means the place of employment of the employee. 67 In addition, it is immaterial whether the meals and lodging are provided on premises that the corporation leases rather than owns. On this point, the regulations state, For example, meals and lodging furnished in the employer s home to a domestic servant would constitute meals and lodging furnished on the business premises of the employer. Similarly, meals furnished to cowhands while herding their employer s cattle on leased land would be regarded as furnished on the business premises of the employer. 68 Caselaw on the business premises issue. The courts have dealt with the business premises issue in numerous cases. The following is a summary of some of the more relevant decisions: In Dole v. Comr., 69 the court held that on the business premises, for purposes of the lodging exclusion, meant living quarters constituting an integral part of business property or premises on which the employer carries on some of its business activities. The court disallowed the exclusion, however, because the lodging in question was located approximately a mile from mills where the taxpayers were employed it was not located on the business premises. In addition, the employees were not required to accept the lodging as a condition of their employment. In Comr. v. Anderson, 70 the employer owned a motel and built a house within two blocks of the motel for the motel manager and his family to live in. The employer paid for the home, utilities, laundry, cleaning expenses, milk and groceries. The Tax Court held that the value of the meals and lodging were excludible from the employee s income because they were provided on the employer s business premises. However, the appellate court reversed, pointing out that, to be excluded, meals or lodging must be provided either at the place where an employee performs a 63 See, e.g., Vanicek v. Comr., 85 T.C. 731 (1985). 64 Rev. Rul , C.B. 60. In the Rev. Rul., IRS said that Treas. Reg (a)(3)(i) which governs the convenience of the employer test as to meals also applies to lodging. Thus, even if there is a compensatory reason for providing the lodging, the lodging will be deemed to have been provided for the employer s convenience if there is a substantial non-compensatory business reason for providing it (a)(1) (a)(2). 67 Regs (c). It doesn t necessarily matter if the lodging is not physically contiguous to the actual business premises if the employee conducts significant business activities in the residence. See, e.g., Faneuil v. United States, 585 F.2d 1060 (Fed. Cl. 1978). 68 Regs (c)(1) T.C. 697 (1965), aff d., 351 F.2d 308 (1st Cir. 1965) F.2d 59 (6th Cir. 1966), rev g 42 T.C. 410 (1964). 149

154 significant portion of his duties or on premises where the employer conducts a significant portion of the business. 71 In McDonald v. Comr., 72 the taxpayers, a married couple, moved to Japan and the husband s employer reimbursed their cost of lodging in Japan. The court held that the value of the employer-provided lodging was includible in the employee s gross income to the extent it exceeded the amount of rent that the taxpayers paid. The court held that the lodging was not furnished for the employer s convenience, were not on the business premises and was not provided as a condition of employment. As noted above, whether the employer actually owns the property where the lodging (and meals) is provided is irrelevant. 73 The key is that the lodging (and meals) is provided on the business premises, and ownership has no bearing on that fact. In Benninghoff v. Comr., 74 government ownership of a home was not sufficient to prove the home was on the business premises. Instead, the court ruled that there must be a direct, substantial relationship between the lodging and the interests of the employer. Under the facts of the case, that relationship was not present. Thus, the value of the lodging was not excludible. Other cases also bear this point out: In Boykin v. Comr., 75 the rental value of quarters provided on the grounds of a Veteran s Administration Hospital was excludible from the taxpayer-physician s gross income. 76 In Lindeman v. Comr., 77 the taxpayer was the general manager of a hotel that was located on property that the taxpayer s employer leased. While the IRS denied the exclusion of value of the employer provided lodging, the court held that it was immaterial that the hotel was on leased property and that the key was that the employee performed a significant portion of his duties in the residential quarters on the employer s premises. 78 In most of the farm and ranch cases decided to date, whether the meals and lodging were provided on the business premises has not been an issue, but there are a few cases where it has been an issue. The following cases illustrate the application in farm/ranch settings: In Peterson v. Comr., 79 the value of a home provided to the president of a poultry breeding corporation adjacent to the corporation s poultry farm was not excluded from income. The court acknowledged that the facility in question was on the business premises of the employer, but the court held that the taxpayer was not required to live on the premises as a condition of 71 Id T.C. 223 (1976). 73 See Bornstein v. Comr., T.C. Memo (apartment occupied by taxpayer and supplied by employer was not located at employer s place of business, therefore, its value was not excludible from the employee s income) F.2d 398 (5th Cir. 1980), aff g, 71 T.C. 216 (1978) F.2d 249 (8th Cir. 1958). 76 Id T.C. 609 (1973). 78 Id. 79 T.C. Memo

155 employment 80 and the taxpayer failed to show that the housing was furnished for the convenience of the employer. 81 In Wilhelm v. United States, 82 the value of food and lodging provided by a ranching corporation was not taxed to the shareholder-employees. Under the facts of the case, the ranch was located in a remote location several miles from the nearest town. The court noted that the ranch was a grass ranch that put up very little hay and required constant attention by persons experienced in grass ranch requirements to keep cattle alive. The court also noted that during snowstorms the cattle needed to be fed daily, needed to be moved, waterholes had to be kept open, and the cattle had to be protected against the hazards of being trapped or falling into ravines. The court felt that the employees had no choice but to accept the facilities furnished by the corporate employer, and that the food and lodging were furnished to the employees not only for the convenience of the employer, but that they were indispensable in order to have the employees on the job at all times. The same court went further in In Caratan v. Comr., 83 each shareholder-employee of a closely-held farm corporation lived in a corporation-owned house on the business premises. The taxpayers met the burden of proving that the lodging furnished to them was indispensable to the proper discharge of their employment. This was the case even though the corporation was located within a ten minute drive from a residential area of a nearby town. The court reasoned that the issue was not the remoteness of the corporation, but whether there was a good business reason to require the employees to reside on the premises. In J. Grant Farms, Inc. v. Comr., 84 the value of lodging and cost of utilities of a farm managersole shareholder and family was held to be excludible from the manager s income because the manager s residence on the farm was necessary and a condition of employment in the swineraising and grain drying operation. Likewise, in Johnson v. Comr., 85 a married couple, as the sole shareholders of a corporation, were allowed an exclusion from income of the fair rental value of the corporate-owned residence located on the premises where the husband was the manager of the corporation s grain drying and storing operation. In Waterfall Farms, Inc. v. Comr., 86 a corporate farming operation rented the residence where the taxpayer (who was a corporate shareholder, office and the sole corporate employee) lived. The shareholder/employee was provided food and lodging, but the court held that the amounts weren t excludible because the corporation couldn t prove that substantial business activity occurred at the residence. That was the key reason that the court determined that the food and lodging were not provided on the corporation s business premises. The fact that the corporation rented the residence was not material as to the business premises issue (a)(2) (a) F. Supp. 16 (D. Wyo. 1966). 83 Dilts v. United States, 845 F. Supp (D. Wyo. 1994) (employee-shareholders of S corporation denied exclusion for both meals and lodging including groceries and utilities). 84 T.C. Memo T.C. Memo T.C. Memo

156 Summary Employer-provided meals and lodging is an important fringe benefit that corporations can provide for their employees. But, it is important to properly structure such arrangements within the confines of the guidelines set forth by the IRS and the courts. Sample Corporate Resolution (Grain Farming) [with permission from the Iowa Bar Tax Manual] Whereas, the corporation s employees are required to perform duties which include extended working hours during the crop production cycle, and the duties include a requirement to reside on the corporate farm premises to supervise and secure grain inventory and machinery/equipment of the corporation; and Whereas, in consideration for those extended hours and on-site duties, the corporation has provided onpremises meals and lodging as a condition of employment within the definitions of I.R.C. 119; Now, therefore, it is resolved that effective immediately that the corporation shall make its on-premises eating facility available to all of its employees, to allow those employees to attend to their extended duties and on-site supervision requirements. Charitable Gifts of Raised Commodities A. Background. Gifts of Raised Commodities 5. Cash method farm proprietors have a unique opportunity to make "pre-agi" charitable contributions of commodity inventory, which is readily marketable by the charitable recipient. 6. Cash method farm proprietors potentially achieve a number of advantages with the contribution of farm commodities to a charitable organization. a. Income tax savings result for standard deduction filers. 1) The standard deduction has eliminated the tax advantage of charitable contributions for many farmers ($12,700 for joint filers for 2017). 2) A charitable contribution of unsold inventory removes the income before recognition, and avoids the need to claim a charitable contribution as an itemized deduction. b. Self-employment (SE) tax decreases if unsold inventory is donated. 152

157 D. Inventory vs. crop share rents. 1. A charitable contribution of unsold raised commodities is only effective if it constitutes inventory of an active farm proprietor or partner. 2. A contribution of unsold crop-share rents by a farm landlord triggers taxation to the donor, as the assignment of income principle applies [Rev. Rul ; Cullison, 71-1 USTC 9136, E.D. Ark. 1970; Parmer, 468 F2d 705, CA-10, 1972]. E. Mechanical requirements for a charitable contribution of raised commodities. 1. The charitable donation of unsold raised commodities is best utilized by a cash method farmer. All of the costs incurred to raise the crop have been deducted as operating expenses. a. A farmer required to use the accrual method must capitalize all inventory costs and the costs of any other property [Sec. 263A(a)(1)(B)]. A charitable donation applies the inventory basis to a charitable deduction. b. An accrual basis farmer donating crops in which all of the costs were incurred in the year of harvest receives the same benefit as the cash method farmer. Unless the farmer is required to use the accrual method, costs or raising crops are deductible. 1) Unsold crop on hand at the end of the year is recognized as income at fair market value. 2) Gross income of an accrual method farmer includes the inventory value of products on hand and not sold at the end of the year [Reg (b)(2)]. Until the end of the year, the crop has a zero tax basis, and all costs are treated as operating expenses. Therefore, since the crop has been donated, it is not on hand at year-end and the crop expenses are allowed in full. 2. The transaction must be segregated into two steps: a. Gift of the commodity to the charity, with evidence that title to the commodity was transferred to the charity; and b. Sale of the commodity by the charity. 3. Commentary: It is not necessary to contribute crop raised in a prior year. Reg A-1(c)(4) allows a farmer to currently deduct costs of producing inventory as business expenses, even if the inventory is contributed to charity (this is contrary to the rule for noncharitable family gifts). 153

158 F. Charitable contribution deduction. 1. When inventory is transferred to a charity, the donor's charitable deduction is the smaller of the property's fair market value or the adjusted tax basis of the property [Reg A-4(b)(1)]. Accordingly, for raised inventory of a cash method farmer (including an accrual basis farmer not required to be on the accrual method), no charitable contribution deduction is allowable because of the zero tax basis of the property. 2. If raised breeding livestock that qualifies for Section 1231 capital gain treatment is given to charity, a charitable deduction at fair market value applies, if the property is given to a charity for a use related to its exempt purpose or function (e.g., to a university agricultural school for breeding use at an experiment or training site). On the other hand, if the Section 1231 raised breeding animals are donated to a charity for a subsequent sale by the charity, the deduction is limited to the adjusted tax basis of the property (i.e., zero for raised livestock) [Sec. 170(e)(1)(B); Reg A-4(b)(2)(ii)]. 3. The written acknowledgment rules of Sec. 170(f)(8) and the requirement to use Form 8283 should not apply to most charitable contributions of commodities because no charitable contribution deduction is taken by the taxpayer. a. Sec. 170(f)(8) states "No deduction shall be allowed... for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgment...". b. The Form 8283 instructions indicate "You must file Form 8283 if the amount of your deduction for all noncash gifts is more than $

159 Example 1 Illustration of charitable grain tax savings Don Jeere, a cash method farmer, normally reports Schedule F income of about $50,000 on his joint return. Sue, his spouse, has W-2 income of about $50,000. Don and Sue contribute about $5,000 annually to their church, but have not itemized deductions in many years because their only other significant Schedule A deduction is state income tax paid (and the Jeeres live in a state with a small 2.5% flat income tax rate). Accordingly, Don and Sue contribute $5,000 of raised unsold grain to the church, as opposed to selling the grain and contributing cash. As a consequence of not selling $5,000 of grain to fund their church contribution, Don and Sue reduce their federal income tax by $1,250 (25% federal income tax rate x $5,000), their state income tax by $125 (2.5% state income tax rate x $5,000), and their self-employment tax by $706 (15.3% x $5,000 x 92.35%), for a total tax savings of $2,081. G. Corporate gifts of raised inventory. 1. A cash method farming entity that has zero basis raised inventory is in a similar position to make contributions of unsold inventory to a charity in a tax-efficient manner. a. A partnership or S corporation would normally pass through any charitable deduction to its owners, but a contribution of zero basis inventory results in no deduction because of the zero basis. Effectively, there is no pass-through reporting to the owner. b. Similarly, a C corporation contributing zero basis cash method farm inventories would claim no deduction. This avoids any issue with the 10%-of-taxable-income charitable limitation that otherwise faces a C corporation. 2. Issue of possible personal benefit to a controlling C corporation shareholder. a. A closely-held corporation arguably could lose the right to charitable treatment if the transfer is considered to have personal benefit to a controlling shareholder and is recharacterized as a constructive dividend to the shareholder. However, this issue was generally resolved in a 1979 Revenue Ruling, in which the IRS determined that a charitable contribution by a closely-held corporation is treated as a constructive dividend only if property or economic benefit is received by the shareholders or their families as a result of the contribution (Rev. Rul. 79-9). b. This ruling was based on a full Tax Court opinion that reached the same conclusion [Knott v. Comm., 67 TC 681, 1977]. 155

160 c. In a Private Letter Ruling, the IRS opined that a corporate contribution that satisfies a charitable pledge by a shareholder, or any member of the shareholder s family, is considered a direct economic benefit and would produce a constructive dividend [PLR ]. 3. A 2006 Tax Court case imposed constructive dividend treatment on charitable contributions made by a closely-held corporation, with no reference in the court opinion to Rev. Rul or the Knott case. However, in the facts of this case, the closely-held corporation had claimed the charitable contributions as business expenses under various misleading categories, and it was only upon IRS examination that these charitable contributions became apparent [H.J. Builders, Inc. v. Comm., TC Memo , 12/28/2006). H. Summary re: charitable commodity gifts. 1. The most crucial step to be followed is the transfer of the unsold commodity to the charity rather than conveying the proceeds after the sale. a. For public storage. 1) The commodity should be delivered to the elevator, with a storage receipt made out to the charity. 2) The receipt should be delivered to the charity with a letter from the donor indicating the commodity belongs to the charity and the charity may sell the commodity as it sees fit. 3) The buyer/grain elevator should refrain from issuing a check to the charity without specific instruction by the charity to sell the commodity. b. For home storage. 1) The commodity needs to be segregated and identified as belonging to the charity (e.g., create a bill of sale to transfer title to the charity). 2) The charity needs to arrange for the sale of the commodity, together with incurring carrying costs, including insurance and disposal costs. 3) Realistically, the charity will desire an immediate sale. The best market may be back to the farmer, who may be utilizing the commodity as livestock feed or for other purposes on the farm. If this is the case, the taxpayer should be advised of the inherent risks of IRS rejection of the charitable gift. 2. If the mechanical steps are not closely followed, the IRS will treat the transfer as if the grain was sold by the farmer, followed by a cash contribution to the charity. 156

161 3. Caution: Many grain producers annually certify or document their bushels of production to the Farm Service Agency, for purposes of enrolling that grain production in various ag subsidy programs. Farm producers who intend to make a charitable contribution of unsold raised commodities should be sure to accomplish their FSA certification prior to any donation of those commodities to charity. 157

162 Gifts of Commodities and Kiddie Tax Rules I. Background. 1. Cash method farm proprietors have had several situations where gifts of farm commodities to family members are advantageous: a. Moving income to minor children to take advantage of their lower tax rates; b. Assisting with college costs for children of the taxpayer; and c. Supporting parents of the taxpayer. 2. The expansion of the Kiddie Tax through age 23 limits the ability to shift unearned income in the form of gifts and subsequent sales of commodities to children of farm proprietors. J. Tax consequences of commodity gifts to the farmer as donor. 1. There is no income recognition by a donor upon a gift of unsold inventory [Rev. Rul ; Rev. Rul ]. 2. The "assignment of income" doctrine prevents a transfer of accrued income or other accrued earnings from one taxpayer to another. However, the courts, and subsequently the IRS, have held that a gift of unsold raised farm commodities represents a transfer of an asset (i.e., inventory) rather than an assignment of income [Estate of Farrier, 15 TC 277, 1950; SoRelle, 22 TC 459, 1954; Romine, 25 TC 859, 1956]. 3. The farmer/donor sidesteps the income tax on commodities that are transferred by gift to another taxpayer. Further, the self-employment tax is also eliminated on the commodities, as excludable gross income is not considered in determining self-employment income [Reg (a)-2(a)]. 4. Commodities that are the subject of a gift should have been raised or produced in a prior tax year, to avoid any expense adjustments for the donor. a. If current year crop is given, current year costs applicable to the commodity are not deductible by the donor [Rev. Ruls and ]. b. However, costs deducted on prior returns will apparently not be disturbed by the IRS. Thus, a farmer reporting on a calendar year basis under the cash method is allowed full deductibility of expenses if a gift of raised commodity is not made until 158

163 the tax year after harvest (i.e., the grain which is the subject of the gift was raised in a year prior to the gift, and all associated expenses would have been deducted in the prior year). c. IRS Publ. 225 concurs with this position, holding that costs that apply to gifts of agricultural products may not be deducted as a farm business expense in the year of the gift or any later year (but by implication, costs deducted in a year prior to the gift will remain allowable) (IRS Publ. 225, Ch. 5). 5. Form 709, U.S. Gift Tax Return, is required if the value of the gift exceeds the $14,000 annual exclusion per donee. a. Gifts in excess of the annual gift tax exclusion require Form 709. Gift-splitting is available for married donors. b. The gift of community property is deemed to be a gift of one-half from each spouse. If the gift does not exceed the combined annual gift tax exclusion for the year, Form 709 is not required (see instructions to Form 709 for treatment of gifts of community property). K. Tax consequences of commodity gifts to donee. 1. The donor's tax basis in the commodity carries over to the donee [Sec. 1015(a)]. a. In the case of raised commodities given in the year after harvest by a cash method or voluntary accrual method producer, the donee receives the zero basis of the donor. b. Conversely, a farmer required to use the accrual method will have tax basis in raised commodities; if this tax basis approaches the market value of the commodity, there will be little income shifting accomplished from a gift. 2. Assuming that the donee has not materially participated in the production of the commodity, the income from the sale of the commodity is classified as unearned income, and thus not subject to self-employment tax. a. Even though the raised farm commodity was inventory in the hands of the farmerdonor, the asset will typically not have inventory status in the hands of the donee, and thus represents a capital asset reportable on Schedule D at sale. b. Sec defines a capital asset as all property other than items such as inventory and items held for resale, and Section 1231 productive assets used in a trade or business. 159

164 c. Prior case law has established that an asset may be inventory in the hands of one taxpayer, but change its character in the hands of a second taxpayer, even if that taxpayer is related to the original holder of the inventory [Greenspon, 229 F2d 947, CA-8, 1956; Estate of Ferber, 22 TC 261, 1954]. 3. The holding period of an asset in the hands of a donee refers back to the holding period of the donor [Sec. 1223(2)]. a. Commentary: If the donee holds the commodity for more than a year after the harvest date, the donee has long-term capital gain or loss. L. Use of proceeds by the donee. 1. If the proceeds from the sale of the commodity by the donee revert back to the donor, even by loan, the IRS will assert that the donor has retained control over the funds and tax the commodity sale to the donor. 2. In an early case, the Tax Court held that income was taxable to the parent, despite a purported transfer of farm property to children. The funds were not segregated in the hands of the children, but rather were retained by the parent [D. J. Fry, 4 TC 1045, 1945]. 3. A parent was taxed on sales from a citrus grove owned by his four children, because the sales proceeds of the fruit were often retained by the parent and not reported by the children within their tax returns [Lawhon, 499 F2d 352, CA-5, 1974]. 4. A farmer was found to be taxable on crops that were given to his children, where the sale proceeds from the crops were immediately loaned from the children to the parents [G. J. Parkhill, 385 F Supp. 204, DC Tex., 1974]. 5. A farm proprietor who made a gift of unsold soybeans to his wife was held to be taxable on the income for self-employment tax purposes. The proceeds from this "gift" were deposited in a joint account where the husband maintained control over the funds [TAM ]. 6. In a second private ruling regarding the validity of grain gifts from a self-employed farmer to his spouse, the IRS National Office similarly ruled that the gift lacked economic substance. The IRS held that the gift was a tax avoidance transaction, with no evidence that the donee/spouse had actual title to and control of the grain. Again, under the taxpayers' facts, the proceeds from the commodity sale were deposited into a joint account [TAM ]. 160

165 M. Other issues regarding gifts of commodities. 1. Commodity gifts of raised livestock. a. A donee who receives raised animals and takes responsibility for the care and feeding of these animals after the date of gift may face the risk of materially participating in the raising of the animals, and thus be subject to the self-employed social security tax. b. Several cases have allowed children to report the gain from the sale of cattle received as a gift, assuming the children evidenced a reasonable degree of control over the cattle and their sales proceeds. Physical segregation of the cattle at the time of gift is helpful, and any post-gift maintenance expenses for the animals should be paid by the donees [Harold Smith, TC Memo ; Harley Alexander, 194 F2d 921, CA-5, 1952; Jones Livestock, TC Memo ; Adolf J. Urbanovsky, TC Memo ]. 2. Crop share landlords. a. A crop share landlord receives commodities as the equivalent of rental income; the commodities do not have an inventory-asset status in the hands of the landlord. b. A gift or transfer by a landlord of a commodity received in a share rental arrangement is treated as an "assignment of income" disposition, causing full taxation to the donor/landlord at disposition [Rev. Rul ; Tatem, 400 F2d 242, CA-5, 1968; Rev. Rul ]. 3. A gift of zero basis culled dairy or breeding stock, as a capital asset, avoiding the requirement of reducing current year costs of raising immature livestock. N. Summary: Commodity gifts to family members. 1. Cash-method farm proprietors who intend to make a gift of raised commodities to another individual should recognize that the transaction must be accomplished in two distinct steps. a. The donor makes a gift of unsold inventory, using prior year crop or commodity, and documents the transfer of the title/ownership in the commodity as transferred to the donee. b. The donee independently and at a later date accomplishes a sale of the commodity, recognizing income because of the zero basis in the commodity. The income is reported typically as a short-term capital gain (but see above regarding holding period). 161

166 2. The donee, as the owner of the sold commodity, must retain full ownership and control of the sale proceeds from the commodity. Loans and other circular arrangements that move the funds, or their economic benefit, back to the donor will be collapsed by the IRS and courts. O. Unearned income status of commodity gifts and the Kiddie Tax. 1. Unearned income of a dependent child includes items such as interest, dividends and rents, as well as income recognized from the sale of raised grain received as a gift. This assumes that the commodities were transferred as a gift and not as compensation for services. 2. Commentary: The Kiddie Tax has a small inflation-indexed exemption [Sec. 1(g)]. For children who sell commodities received as a gift and are subject to the Kiddie Tax: a. A dependent child is allowed a standard deduction that offsets the first $1,050 of unearned income (2017 amount). b. The next $1,050 of unearned income is subject to tax at the child s single tax rate of 10%. c. The child s unearned income in excess of $2,100 is taxed at the parents top tax rate. P. Kiddie Tax Details. 1. The Kiddie Tax reaches two groups who have attained age 18 (the Age Test) and whose earned income does not exceed half of their support (the Support Test) [Sec. 1(g)(2)(A)]. 2. Age Test. The expanded Kiddie Tax applies to a child who has attained age 18 before the close of the year and: a. Has not attained the age of 19 as of the close of the year (i.e., the child attained his or her 18 th birthday during the year); or b. Is a full-time student at an educational organization during at least five months of the year who has not attained age 24 (i.e., a child who is a student who attained his or her 19 th to 23 rd birthday during the year). 3. Support Test. In addition, a child age years old must have earned income that does not exceed one-half of the amount of the individual s support for the 162

167 year. In measuring support, amounts received as a scholarship by a student are not taken into account. 4. Definition of support: a. Support includes food, shelter, clothing, medical care, education and the like. Generally, the amount of support will be the amount of expense incurred in furnishing the item of support. If the item of support is in the form of property or lodging, the item is measured in terms of its fair market value [Reg (a)(2)(i)]. b. Support includes items such as a wedding for a child [Rev. Rul ] and the cost of education [Reg (a)(2)(i)]. Student loan proceeds used to pay for education count as support from the child if the child is the obligor [McCauley v. Comm., 56 TC 48, 1971]. c. Capital items provided to a child may represent support. An automobile purchased by the parent and owned by the parent but used by the child is not an item of support, other than out-of-pocket costs associated with the auto provided by the parent. However, an auto purchased and titled in the name of the child is an item of support of that child in an amount equal to its cost, whether provided by the parent or by the child [Rev. Rul ]. d. Only amounts actually expended during the year are considered in testing support [Rev. Rul ]. Example 1 Child attains age 18 during the year During the year, Sue attained her 18 th birthday. Whether or not Sue meets the definition of a student during the year, she will be subject to the Kiddie Tax if her earned income is less than or equal to 50% of the cost of her support. Assuming that Sue s food, housing, transportation, and any educational costs are $16,000, Sue is subject to the Kiddie Tax if her earned income (W-2 or self-employment income) is $8,000 or less. Example 2 Kiddie Tax applicable to college student age 20 Sam is a college student, age 20, with several scholarships. During the year, items expended for Sam s support include room, board, tuition and other miscellaneous items that total $26,000. However, Sam has received several scholarships in the total amount of $6,000 that reduce the outlay for Sam s tuition. Accordingly, Sam s total support is $20,000. Sam s W-2 income from employment at his university is $5,000. Accordingly, Sam is subject to the Kiddie Tax, even though attaining age 20 this year. 163

168 Example 3 Increasing compensation to avoid the Kiddie Tax Assume the same facts as Example 2, except that Sam s parents determine that Sam is exposed to the Kiddie Tax. Prior to year-end, Sam s parents, who operate a farm proprietorship, issue a wage payment to Sam in the amount of $6,000, which is a reasonable wage payment for the services that Sam rendered to the farming operation during his full-time employment on the farm during his college summer vacation. As a result, Sam s total earned income is $11,000 ($5,000 Form W-2 from employment at his university and $6,000 Form W-2 from his parents for summer farm work). This total earned income of $11,000 is more than half of Sam s $20,000 of support, after ignoring support provided by his scholarships. Accordingly, Sam is not subject to the Kiddie Tax, and any unearned income will not be exposed to the parents higher tax rates. Observation: In the preceding example, an opportunity would arise to make gifts of unsold grain or other raised commodities to Sam, for sale within the same year. Sam could recognize the unearned income from the sale of his commodities without imposition of the Kiddie Tax. These amounts would then be held, and disbursed by Sam for items of support in the subsequent year. Note that the application of the Kiddie Tax to those age 18 through 23 compares the child s earned income to that individual s items of support for the year, and ignores the amount of unearned income. It may be possible to recognize significant amounts of unearned income from commodity sales and yet have the child exempt from the Kiddie Tax due to earned income that exceeds half of those support expenditures for the year. Q. Long-term capital gain opportunity. 1. When a gift of commodities occurs, the holding period of the asset in the hands of the donee refers back to the holding period of the donor [Sec. 1223(2)]. 2. Accordingly, a donee who exceeds the 12-month holding period requirement on the sale of commodities is entitled to the preferential long-term capital gain rates. 3. Commentary: Even though the long-term capital gain rate of parents making a gift of commodities is often at the 15% (maybe 20%) rate and the Kiddie Tax applies, a significant tax advantage still exists. Not only are the ordinary tax rates of the parent avoided on the sale of the commodity, but the self-employment tax is also avoided (this assumes the child did not participate actively in raising the grain). 164

169 Example 4 Using capital gain rates on a commodity gift Phil, a farm proprietor, has a daughter who will need significant funds for higher education. Based on advice from his tax advisor and anticipating this need at least a year in advance, Phil and his spouse make a gift of approximately $20,000 of unsold commodities to his daughter. The daughter holds the commodity in storage, titled in her name, and after a 12-month holding period, the commodity is sold and reported as a long-term capital gain on her tax return. Assuming that the Kiddie Tax applies, most of the capital gain (other than the exempt Kiddie Tax amount) is taxed at Phil s capital gain rate of 15%, rather than the daughter s capital gain rate of 0%. However, without this planning, the grain would have been taxable at an ordinary federal income tax rate of 25% in Phil s 1040, and would have incurred additional self-employment tax as well. R. Other observations and strategies. 1. The application of the Kiddie Tax to college students makes Section 529 plans an attractive strategy for accumulating investments for higher education costs. Earnings and gains from Section 529 plans are not taxable, and funds can be withdrawn tax-free if expended for higher education costs. 2. The Kiddie Tax does not apply to the Net Investment Income Tax. Taxable income diverted to the children through commodity gifts reduce the parent s modified AGI. The resulting unearned income of the child is not combined with the parent s AGI or with the parent s net investment income. 3. If Kiddie Tax applies, the client should not prepare the child s return. It must be coordinated with the parent return, and should be prepared by the parents tax preparer. 4. In general, Kiddie Tax results in disclosure of parent taxable income in the child s return (i.e., line 6 of Form 8615 discloses parent s taxable income). As an alternative, Form 8814 can be used to report the child s interest, dividends and capital gain distributions in the parent s return. But this approach is not permitted if the child has wage income or other unearned income such as grain income from gifts. As a result, parent income will generally be reported within the child s return if Kiddie Tax applies. Many parents will have concern about this disclosure. 165

170 SELF EMPLOYMENT TAX ON FARM RENTAL INCOME A. Background Rental income from farm leases (whether cash rents or crop-shares) generally does not create selfemployment income. However, if enough participation is generated by the landlord, then this rental income may become subject to SE tax. B. The Mizell Case 1. The taxpayer, Lee Mizell, was a 25% partner in an active farming partnership with his three sons. He also was a lessor, leasing about 730 acres of Arkansas farmland to the farm partnership. Mizell had been a farm proprietor; in 1986, the farm partnership was formed with his three sons, with each partner holding a 25% ownership interest. The separate leasing of land to the partnership began in 1988, when Mizell leased the 730 acres to the partnership. The lease called for Mizell to receive a one-quarter share of the crop; the partnership was responsible for all expenses. Mizell reported his 25% share of partnership income as self-employment earnings. However, the crop share rent on the land lease was treated as rental income that was exempt from self-employment tax. a. Upon examination, the IRS assessed self-employment tax on the crop share lease income for the years 1988, 1989 and Both the IRS and the taxpayer 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 the aggregate in measuring self-employed earned income. Mizell, on the other hand, 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. C. Analysis of statute and Mizell opinion. Generally, rentals from real estate, whether cash rent or crop share, are excluded from the definition of self-employment income. 87 There is an exception, however, if three criteria are met: 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 87 I.R.C. 1402(a)(1). 166

171 There is actual material participation by the owner Tax Court opinion in Mizell v. Comr.. 89 The Tax Court 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 landlord and tenant. By measuring material participation with consideration to both the crop share lease and Mizell's obligations as a partner in the partnership, the court found that the rental income must be included in Mizell's net earnings for self-employment purposes. 2. The IRS National Office in 1996 privately ruled that a husband and wife in Wyoming who leased land to their agricultural corporation were subject to SE tax on the cash rental income, because both the husband and wife were employees of the corporation. 90 The IRS based its ruling on the Mizell opinion, continuing to argue that the use of the word arrangement in the first two criteria is intended to convey a broad interpretation, such that other roles of the landlord (for instance, as an employee or as a participating partner) must be considered. a. Note. The IRS viewpoint is that the landlord role may not be separated from the employee or partner role, and thus the employee or partner-level participation by the landowner triggers SE tax on the rental income. D. Conclusions based on Mizell. The Mizell case represented a clear threat to the common pattern under which an individual leases farmland to an operating entity in which the individual is also a material participant. This case was the first reported decision to address the question of the real estate exemption from self-employment income for a landlord leasing to his own active farming entity, even though the statute was enacted in the mid s. Further, the fact that the income in this case involved a crop share lease, as opposed to a cash rent arrangement, was apparently not a significant factor. E. Note. The wording of Treas. Reg (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. F. U.S. Tax Court Cases 88 Treas. Reg (a)-4(b)(1). 89 T.C. Memo (1995). 90 T.A.M (May 6, 1996). 167

172 1. In November of 1998, three cases were tried in U.S. Tax Court, before Judge John Pajak (presiding in St. Paul, MN). These cases resulted in Tax Court Memorandum opinions issued in late 1999: In Bot v. Comr., 91 the Tax Court concluded that rental income (at the rate of $90 per acre) received by Judy Bot for 240 acres of land, paid to her by Vincent Bot s farm proprietorship, was subject to SE tax. The court construed the salary of Judy Bot from Vincent s farm proprietorship, averaging about $15,000 per year, to be part of a single arrangement that included the lease. In fact, the court noted that Mrs. Bot had performed farming services, averaging about 1,900 hours per year, for 38 years of farming history. The court noted that Mrs. Bot s employment agreement and salary only began in In Hennen v. Comr., 92 the judge similarly held that SE tax must be imposed on rental income received by Teresa Hennen on 200 acres of land leased to her husband s farm proprietorship. Mrs. Hennen worked about 1,000 hours per year in the farming operation, and received a salary of about $3,500 per year. McNamara v. Comr., 93 involved a husband and wife who owned 460 acres that they leased to their farming C corporation under a cash rent written lease, with payments averaging about $50,000 per year. Michael McNamara was employed full time by the corporation, and Nancy McNamara was employed doing part-time bookkeeping and farm errand duties (annual compensation to her was approximately $2,500 per year). Again, the judge held that the rental arrangement and the employment roles mustbe treated as one, and imposed self-employment tax on the rental income. G. Taxpayer Victory: The Eighth Circuit McNamara Decision. 1. In December of 2000, the Eighth Circuit released its opinion in the consolidated McNamara, Bot, and Hennen cases on the topic of whether farmland rentals are subject to SE tax where the landlord also participates as an employee of the tenant/farm operator. The Eighth Circuit reversed all three Tax Court opinions, and remanded the cases back to the Tax Court for possible further consideration The opinion and approach of the Eighth Circuit represent a strong victory for farm taxpayers on the issue. The court focused on the argument of the taxpayers that the lessor/lessee relationship should stand on its own, apart from the employer-employee relationships. The Eighth Circuit interpreted I.R.C. 1402(a)(1) as requiring material participation by the landlord in the rental arrangement itself in order to subject the arrangement to SE tax. The court stated that The mere existence of an arrangement requiring and resulting in material participation in agricultural production does not 91 T.C. Memo T.C. Memo T.C. Memo McNamara v. Comr.., 263 F.3d 410 (8th Cir. 2000), rev g., T.C. Memo

173 automatically transform rents received by the landowner into self-employment 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. 3. The remand of the Eighth Circuit back to the Tax Court was only for the purpose of giving the IRS an opportunity to illustrate that there was a connection between the rental amount and the labor arrangement. In these three cases, there was no existence of such a connection, as all of the rents were cash rents, and the cash rents, as noted by the court, were at or slightly below fair market value. a. On July 10, 2002, Judge John J. Pajak of the U.S. Tax Court issued an Order and Decision in the Hennen, Bot and McNamara cases acknowledging the reversal of his earlier opinions by the Eighth Circuit, concurring that the rents in question were at or below fair market value, and ordering that no tax deficiencies applied. 4. Note. The IRS has issued an Action on Decision, recommending non-acquiescence to the McNamara case in jurisdictions outside of the Eighth Circuit. 95 However, within the Eighth Circuit, the IRS indicated that it will follow the McNamara decision and not attempt to assert a connection between a labor agreement and a land lease, assuming the facts indicate conformity to fair rental value under the lease and reasonable wages. H. Subsequent Tax Court Opinions. 1. In Johnson v. Comr., 96 the taxpayers farmed in southern Minnesota and leased 617 acres of land to their farm corporation. Their lease with the corporation was verbal, as was their employment agreement with the corporation. For the three years at issue ( ), the salary paid by the corporation was nominal. Mr. Johnson received $1,000 of compensation in one year, and nothing in the other two years. The rental payments were $66,715 in 1993, $60,000 in 1994, and $104,878 in There was no additional land under lease in a. The IRS position acknowledged the Eighth Circuit McNamara opinion, noting that rents are not subject to self-employment tax "when the landlord has two independent arrangements with the lessee for rent and wages and there is no nexus between the two arrangements." However, the IRS asserted that the withdrawal by the Johnsons of virtually all funds from the 96 T.C. Memo a. 95 A.O.D (Oct. 22, 2003), I.R.B. No The IRS reiterated its opposition to McNamara in a letter dated to Sen. Mark Kirk of Illinois, stating that it intends to continue to litigate the issue in cases outside the Eighth Circuit. IRS Info (Jun. 29, 2012). 169

174 corporation as rent indicated that there were not two separate arrangements. b. Immediately prior to the trial, the taxpayers conceded that $44,878 of the 1995 rent of $104,878 should be reclassified as services and subjected to self-employment tax, thus reducing the 1995 rent to a fair market value amount consistent with the preceding years of $60,000. c. The Tax Court concluded that the rental arrangement, as adjusted for 1995, represented fair market value amounts for all three years, and that the rental payments were independent of any service requirements by the individuals. In the court's view, the rental payments stood on their own, as the individual taxpayers "were not obligated or compelled to perform petitioner's farm-related activities in the production of (the corporation's) agricultural commodities as a condition to the company's being obligated to pay rent to petitioner pursuant to the overall rental agreement." d. Observation. The outcome in the Johnson case illustrates the importance of maintaining rental payments at market value amounts. Paying excessive rents, while also understating compensation, gives the IRS the ability to argue that the rents represent disguised compensation. 2. In Solvie v. Comr., 97 the taxpayers leased real estate to their controlled corporation and also received compensation as employees of the corporation. The compensation paid to the husband and wife together was $31,600 in 1993, $22,000 in 1994, and $20,800 in The rent paid by the corporation to the individuals was straightforward for two of three years and did not involve a proposed IRS adjustment. For the first two years, the individuals received land and building rents from their corporation of $50,400 per year. In 1995, in addition to the base rent of $50,400, additional rent was paid to the individuals for a newly constructed hog barn, with the rent paid at the rate of $21 per head for each hog rotated through the building. This increased the rent paid in 1995 by $44,500. a. The IRS imposed self-employment tax for 1995 only, asserting that the new hog barn rent represented self-employment income to the individuals. The IRS argued that the McNamara standard was not applicable because the taxpayers had not established a fair rental value for the new hog barn nor had they established that a separate employment agreement existed for 97 T.C. Memo

175 their additional labor in this facility. The IRS view was that the classification of all funds paid by the corporation for the new hog barn in 1995 as rent, rather than as wages, demonstrated that there were not independent arrangements with respect to the real estate rental and compensation for services in this hog barn. b. The Tax Court concluded that the 1995 rent paid for the new hog barn of $44,500 represented self-employment income to the Solvies. There were three factors that led the court to this conclusion: The rent the Solvies collected for the new hog barn was more than double the rent they had collected from the corporation on their other buildings, and those buildings had a slightly greater hog production capacity than the new building. The 1995 wages paid by the corporation to the Solvies did not increase, despite the extra hog production. The new hog barn rent was calculated on a per head basis, meaning that the Solvies would not have received any rent for the facility if the corporation was not processing hogs through that barn. A volume-based payment implies that the lease is more than just consideration for the use of property, and includes some consideration for services. c. Observation. If the Solvies had structured the $44,500 of rent that they drew from the corporation in connection with the new barn as partially a fixed rental payment and partially as increased salary, they likely would have prevailed in this case. However, receiving the rent as a per-head amount and taking no extra compensation for their increased labor caused the IRS to pursue the issue through litigation. I. Strategies in Response to Cases 1. Practitioners should review client leases and consider the need for language within the lease that clarifies that the landlord is not providing any services or participation as part of the rental arrangement. a. Clarifying language might read as follows: Lessor shall have no responsibility or personal participation, as landlord, in the raising or production of commodities under this lease. The lessee shall have all responsibility, management and control of commodity production and of use and control of the real estate during the term of this lease, without the consultation or participation of the lessor. 171

176 b. Self-rental leases should not exceed the market value for comparable land. Excessive rents will give the IRS the opportunity to argue that the rental contract was part of an arrangement involving the landlord s services. 2. Assuming that the lessor is also providing services, there should be a separate written employment agreement that defines duties, and establishes reasonable compensation for those services. C Corporation Penalty Taxes Overview C corporations were all the rage in agriculture in the 1960s and 1970s. Many farming operations were structured that way in those decades and farmland was placed inside them. However, with the advent of limited liability companies in the late 1970s in Wyoming and Colorado (and, later, all states) and other unique entity forms, and a change in the tax law in 1986, they became less popular. 2017, however, could be the start of renewed interest in the C corporate form. A primary driver of what might cause some to reconsider the use of the C corporation is that President-elect Trump campaigned in part on reducing the corporate tax rate. Similarly, in the summer of 2016, the U.S. House Ways and Means Committee released a proposed blueprint for tax reform that also contained a lower corporate tax rate. If that happens, the use of C corporations may be back in vogue to a greater extent than presently. If C corporations do gain in popularity, there are a couple of C corporate penalty taxes that practitioners need to remember are lurking in the background. In addition, a recent IRS Chief Counsel Advice (C.C.A (Sept. 8, 2016)) illustrates that the IRS hasn t forgotten that these penalty taxes exist. Accumulated Earnings Tax The accumulated earnings (AE) tax is in addition to a corporation's regular income tax. I.R.C The AE tax is designed to prevent a corporation from being used to shield its shareholders from the individual income tax through accumulation of earnings and profits, and applies to accumulated taxable income of the corporation (taxable income, with certain adjustments. I.R.C. 535). There is substantial motivation, even in farm and ranch corporations, not to declare dividends because of their unfavorable tax treatment. Dividends are taxed twice, once when they are earned by the corporation and again when corporate earnings are distributed as dividends to the shareholders. This provides a disincentive for agricultural corporations (and other corporations) to make dividend distributions. Consequently, this leads to a build-up of earnings and profits within the corporation. The AE tax (at a rate of 20 percent) applies only to amounts unreasonably accumulated during the taxable year. Indeed, the computation of accumulated taxable income is a function of the reasonable needs of the business. So, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax. To that end, 172

177 the statute provides for an AE credit which specifies that all corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax. I.R.C. 535(c)(2)(A). However, the credit operates to ensure that service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) only have $150,000 leeway. I.R.C. 535(c)(2)(B). But, remember, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax. That s because the tax applies only if a particular corporation has accumulated more than $250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable needs of the business. Reasonable business needs. For agricultural corporations, it is important that legitimate business reasons for accumulating earnings and profits in excess of $250,000 be sufficiently documented in annual meeting minutes and other corporate documentation. IRS regulations concede that some accumulations may be proper, and agricultural corporations should try to base their need for accumulating earnings and profits on the IRS guidelines. Treas. Reg (b). For instance, an acceptable reason for accumulation is to expand the business through the purchase of land, the building of a confinement unit or the acquisition of additional machinery or equipment. Similarly, earnings and profits may be accumulated to retire debt, hire additional people, provide necessary working capital, or to provide for investments or loans to suppliers or customers in order to keep their business. Conversely, the IRS specifically targets some accumulations as being improper. Treas. Reg (c). These include loans to shareholders or expenditures of funds for the benefit of shareholders, loans with no reasonable relationship to the business, loans to controlled corporations carrying on a different business, investments unrelated to the business and accumulations for unrealistic hazards. Thus, while there are many legitimate business reasons for accumulating excess earnings and profits, there are certain illegitimate reasons for excess accumulations which will trigger application of the accumulated earnings tax. This all means that it is very important that the corporation's annual meeting minutes document a plan for utilization of accumulated earnings and profits. For example, in Gustafson's Dairy, Inc. v. Comm'r, T.C. Memo , the AE tax was found not applicable to a fourth-generation dairy operation with one of the largest herds in United States at one location. The corporation had accumulations of $4.6 million for herd expansion, $1.6 million for pollution control, $8.2 million to purchase equipment and vehicles, $2 million to buy land, $3.3 million to retire a debenture, and $1.1 million to self-insure against loss of herd. The court found those accumulations to be reasonable particularly because the dairy had specific, definite or feasible plans to use the accumulations, which were documented in corporate records. Those corporate records (minutes) also showed how the corporation computed its working capital needs. The key point is that the corporation had a specific plan for the use of corporate earnings and profits, knew its working capital needs, and wasn t simply trying to avoid tax. Personal Holding Company (PHC) Tax The other penalty tax applicable to C corporations is the PHC tax. I.R.C This tax is imposed when the corporation is used as a personal investor. The PHC tax of 20 percent for tax years after 2012 is levied on undistributed PHC income (taxable income less dividends actually paid, federal taxes paid, excess charitable contributions, and net capital gains). 173

178 To be a PHC, two tests must be met. The first test is an ownership test, and is satisfied if five or fewer people own more than 50 percent of the corporate stock during the last half of the taxable year. Most farming and ranching operations automatically meet this test. The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted ordinary gross income (reduced by production costs) comes from passive investment sources. See, e.g., Tech. Adv. Memo (Nov. 2, 1991). The potential problem of rental income. Rental income is included in adjusted ordinary gross income unless adjusted rental income is at least 50 percent of adjusted ordinary gross income, and dividends for the taxable year equal or exceed the amount (if any) by which the corporation's nonrent personal holding company income for that year exceeds 10 percent of its ordinary gross income. In other words, if the mixture of rental income and other passive income sources exceed 10 percent and the rental income exceeds 50 percent, the PHC tax could be triggered. Thus, farming and ranching corporations engaged predominantly in rental activity may escape application of the PHC tax. But if the corporation's non-rent personal holding company income (dividends, interests, royalties and annuities) is substantial, the corporation must make taxable dividend distributions to avoid imposition of the PHC tax. Thus, for corporations owning agricultural land that is cash rented out and the corporation's only passive income source is cash rent, there is no PHC tax problem. For many farm and ranch corporations, the problem of being a PHC is serious. A common scenario is for a farmer or rancher to retire with a tenant or child continuing to farm or ranch the land and pay rent. If the operation has been incorporated, the receipt of rents could cause the corporation to be a PHC. In this situation, it is critical to have the proper type of lease to avoid imposition of the PHC tax. For example, in Webster Corporation v. Comr., 25 T.C.55 (1955), the IRS argued that a farm corporation had become a personal holding company. The IRS lost, but only because the lease was a material participation crop share lease and substantial services were being provided by a farm manager. The farm manager's activities were imputed to the corporation as land owner. The court held that income under such a lease was business income and not rental income. However, if the lease is not a material participation share lease, then the landlord receives rent. Certainly, fixed cash rents will be treated as rent. If the corporation receives only rental income, the rents are not PHC income. But if the corporation also receives other forms of investment income, the rents can be converted into personal holding company income. In the typical farm or ranch corporation setting, there is usually a mixture of rental income and other passive income sources. Over time, the corporation typically builds up a balance in the corporate treasury from the rental income and then invests that money which produces income from other passive sources. As a result, there is, at some point in time, a mixture of rental income and other passive income sources that will eventually trigger application of the personal holding company tax. For farming and ranching operations structured as multiple entities, this is one of the major reasons why the landholding entity should not be a C corporation. The only income that a landholding C corporation entity will have initially is rental income. However, the tendency to invest the buildup of rental income over time will most likely trigger application of the personal holding company tax down the road. 174

179 Taxable income Finally, a limiting factor in both of these taxes is taxable income. If the corporation doesn t have taxable income, it isn t accumulating earnings and is not subject to the AE tax. Also, corporations without taxable income are usually not subject to the PHC tax. Use Form 1120, Schedule PH, as a guide. Conclusion A more favorable tax climate for C corporations could spawn renewed interest in their formation and usage. But, remember the penalty taxes that can apply. The IRS hasn t forgotten them, as illustrated by that recent Chief Counsel Advice. That Chief Counsel Advice referenced earlier also points out that that the AE tax can apply even though the corporation is illiquid. It doesn t depend on the amount of cash available for distribution. It s based on accumulated taxable income and is not based on the corporation s liquid assets. In addition, IRS noted, I.R.C. 565 contains consent dividend procedures that a corporation can use to allow the payment of a deemed dividend when a corporation is illiquid. In any event, both the AE tax and the PHC tax are penalty taxes that will be strictly construed. There is no wiggle-room. So, remember the possible penalty taxes and plan accordingly when utilizing a C corporation. POTPOURRI SESSION THE INTEREST-CHARGED DOMESTIC INTERNATIONAL SALES CORPORATION S. Background. 1. Since 1971, the Federal government has provided tax benefits to U.S. corporations involved in exporting through enactment of legislation recognizing Domestic International Sales Corporations or DISC. In 1984, the provisions were modified to provide the tax incentives through the Interest-Charge DISC. 2. The IC-DISC is not subject to income tax. 3. Actual and deemed dividends from the IC-DISC are qualified dividends taxed at the Sec. 1(h) rate (i.e., long-term capital gain). 4. Tax benefits are also provided through deferral mechanisms. 175

180 5. Tax benefits may be received regardless of the form of farming operation (proprietorship, partnership, S or C corporation). 6. Caution: The following discussion includes only the basic concepts of the IC-DISC structure. There are substantial restrictions and limitations beyond those discussed below. The information presented herein is for the purpose of introducing the concept and availability of the opportunity. A DISC should only be formed with the assistance of experienced tax and legal advisors, and should be preceded by an analysis of the risks and rewards of the strategy. T. Basic requirements. 1. The property sold must be manufactured, produced, grown or extracted in the U.S. 2. The property must be held for sale, lease, or rental in the ordinary course of a trade or business for direct use, consumption, or disposition outside the U.S. (the destination test ). The test is generally considered satisfied if the taxpayer establishes one of the following: a. The IC-DISC delivers property to a carrier or freight forwarder for delivery outside the U.S. The issues of timing of the passage of title, the status of the purchaser as domestic or foreign, and whether the goods will be used or resold are not relevant. b. The sale is to an unrelated person for delivery in the U.S. and after the sale by the IC-DISC, there is no further sale, use, assembly or other processing within the U.S. The property must be delivered outside the U.S. within one year after the sale by the IC-DISC. c. The sale is to an unrelated IC-DISC, for the same purpose of direct use, consumption or disposition outside the U.S. 3. The fair market value of the property being exported can t be attributable to articles which had earlier been imported into the U.S. 4. Commentary: With modern food tracing requirements, fruit and vegetable growers are able to trace products to grocery stores and other ultimate destinations outside of the U.S., providing evidence of compliance with the destination test. In addition, grain growers delivering to export elevators may be able to obtain documentation of export. 176

181 5. The DISC structure is statutory; see Sections U. Computation of tax benefit opportunity. 1. Although there are other ways for the IC-DISC to earn income, the most direct and common is for the IC-DISC to receive a commission for having participated in the export transaction. The commission safe harbor is the greater of: a. Four percent of the qualified export receipts on reselling the property; or b. Fifty percent of the combined taxable income from export sales. Example 1 4% commission Helen raises wheat as a sole proprietor. She sells her wheat throughout the year to the River Elevator, accumulating $1 million of crop revenue. From information provided by the elevator, she is able to document that all of her wheat is exported from the U.S. Based upon her commission agreement with her IC-DISC, she pays $40,000 (4% of $1 million) to the IC-DISC, claiming a deduction against her Schedule F income. The IC-DISC income is $40,000, less expenses incurred by the IC-DISC. If Helen distributes the net income, she will receive a qualified dividend, subject to tax at the long-term capital gain rates. Helen has reduced her self-employment taxable income, as well as ordinary income, replacing that income with qualified dividend income. 2. As an alternative (or in combination), the IC-DISC may be used as a deferral mechanism, rather than paying tax currently as a qualified dividend. a. Each shareholder of the IC-DISC pays interest in an amount equal to the deferred tax liability associated with the DISC multiplied by the base period T-bill rate. b. The computation is made by each shareholder. The liability will vary depending upon the shareholder s marginal tax rate. 3. The IC-DISC may be used as a method of reducing C corporation taxable income. a. The shareholders of the IC-DISC need not be the same as the owners of the related supplier (i.e., the producing farm entity). b. Where the related supplier is a C corporation, the commission paid to the DISC reduces C corporation taxable income. If the shareholders of the IC-DISC are individuals, the income is subject to one layer of taxation. 177

182 c. The income is also converted to be taxed at the qualified dividend tax rate. 4. Estate tax planning opportunities are also available. a. The shareholders of the IC-DISC may be younger members of the farmer s family, thereby transferring value to the younger generation without estate or gift tax. b. The shareholders of the IC-DISC are not required to be involved in the manufacturing, production or growing process. V. Summary. 1. The IC-DISC, properly utilized for qualifying farmers, may substantially reduce the tax liability. The benefits depend upon the current entity structure, conversion of income from ordinary to qualified dividend, and estate tax sensitivity of the farmer. 2. The tax benefits need to be quantified to determine if the benefits provided overcome the cost of forming, operating and administering the IC-DISC. 3. Planners should note that the IC-DISC benefits are based upon strictly following the requirements of the export incentive. The above is intended to provide notice as to the opportunity, and does not contain all that is needed to implement an IC-DISC strategy. DOMESTIC PRODUCTION ACTIVITIES DEDUCTION - AGRICULTURE* Roger A. McEowen** * Originally prepared for the ISBA 77 th Annual Bloethe Tax School, Des Moines, Iowa, December 7-9, ** The author wishes to acknowledge the input of Chris Hesse, Principal with CliftonLarsonAllen, LLP, in the preparation of these materials. Domestic Production Activities Deduction (enacted as part of the American Jobs Creation Act of 2004, H.R. 4520, enacted October 22, 2004, and effective Jan. 1, 2005) Historical Background 1. Formerly tax law rewarded U.S.-based companies that exported goods overseas. Generally the U.S. business had to have a foreign presence to qualify for the tax treatment. But with passage of the Extraterritorial Income Exclusion Act of 2000, effective January 1, 2000, Congress extended favorable tax treatment to small businesses that exported but did not have a foreign sales presence or activities outside the United States. 178

183 2. The Jobs Bill repealed the extraterritorial income (ETI) exclusion and replaced it with the current domestic production activities deduction, subject to the following transitional rules: a. For transactions in 2004, taxpayers retained 100% of their ETI benefits; b. For transactions in 2005, taxpayers retain 80% of their ETI benefits; c. For transactions in 2006, taxpayers retain 60% of their ETI benefits. d. The exclusion was fully repealed beginning in Binding Contracts: The 2004 Jobs Bill authorized 100% deductibility for binding contracts with an unrelated party as defined in IRC 943(b)(3) that were in effect as of September 17, 2003 and at all times thereafter. A binding contract included a purchase option, renewal option, or replacement option included in the contract which was enforceable against the seller or lessor. H.R. 4287, The Tax Increase Prevention and Reconciliation Act of 2005, Pub. L , repealed the binding contract-relief effective for tax years beginning after May 17, Terminology. IRC 199 contains many terms which may be unfamiliar to tax preparers. The following acronyms are used throughout this chapter. 1. QPAI = Qualified production activities income 2. DPGR = Domestic production gross receipts 3. CGS = Cost of goods sold 4. QPP = Qualified production property 5. MPGE = Manufactured, produced, grown, or extracted 6. DPAD = Domestic Production Activities Deduction 179

184 Calculating and Claiming the DPAD Except for domestic oil-related production activities, 98 for tax years beginning after 2009, the DPAD is equal to the lesser of: 9% of the taxpayer s QPAI for the year 9% of the taxable income of the taxpayer (for an individual, this limitation is applied to AGI) 50% of the Form W-2 (FICA) wages of the taxpayer for the taxable year. 99 Note. The taxable income limitation excludes taxpayers with current year NOLs or with NOL carryovers that eliminate current year taxable income from taking the DPAD. 100 The deduction percentage (the applicable percentage) transitioned over several years as follows: For tax years beginning in 2005 and 2006, the deduction rate was 3%. For tax years beginning in 2007, 2008 and 2009, the deduction rate was 6%. For tax years beginning after 2009, the deduction rate is 9%. Note. The deduction is from taxable income, and is subject to an overall limit of 50% of current year Form W-2 wages that were associated with qualifying activity employment. The W-2 wage limitation is discussed later. AMT Effect. The DPAD is allowed for both regular tax and alternative minimum tax (AMT) purposes (including adjusted current earnings). However, the DPAD is not allowed in computing SE income. 101 Pass-Through Entities. The DPAD is available to pass-through entities such as S corporations, partnerships, and estates or trusts, but the deduction is applied at the shareholder, partner, or beneficiary level. 102 Note. Thus, for S corporations and partnerships, the basis of the shareholder or partner is not reduced on account of the DPAD. S corporations and partnerships with qualified activities are required to separately pass through the share of QPAI to each owner, the corresponding Form W-2 wage amount, and any additional detail that is needed to allow computation of the overall deduction at the Form 1040 level. The DPAD for pass-through entities 98 For domestic oil-related production activities, IRC 199(d)(9) limits the deduction to 6%. For purposes of this provision, the term oil related production activities income is the qualified production activities income of the taxpayer that is attributable to the production, refining, processing, transportation, or distribution of oil, gas, or any of their primary products. Oil means oil recovered from both conventional and nonconventional recovery methods (including crude, shale and oil recovered from tar and oil sands). Oil-related QPAI equals the excess of DPGR from the production, refining or processing of oil, gas or any primary product thereof ( oil-related DPGR) over the sum of the cost of goods sold and other expenses, losses or deductions that are properly allocated to such receipts. But, oil-related DPGR does not include gross receipts derived from the transportation or distribution of oil, gas or any primary product thereof. Prop. Treas. Reg (f)(1)(i). 99 IRC 199(a)(1) and (b)(1). 100 See IRC 63 and IRC 199(d)(6). 102 IRC 199(d)(1)(A). 180

185 is discussed in more detail later in this chapter. Estates and trusts are eligible for the DPAD if the income is not passed through to the beneficiaries. Note. Most service activities do not qualify for the deduction. 103 Agricultural Cooperatives. Agricultural cooperatives may also claim the DPAD. However, the amount of any patronage dividend or per-unit retain allocations to a member of the cooperative that are allocable to qualified production activities are deductible from the gross income of the member. Further discussion is provided later in this section. Members of agricultural cooperatives include the DPAD for their distributions from the cooperative. The rules for cooperatives provided in 199(d)(3) and Treas. Reg apply to any portion of the DPAD that is not passed through to the cooperative s patrons. In addition, a cooperative s QPAI is computed without taking into account any deduction allowable under IRC 1382(b) or (c) relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions. Reporting. Form 8903, Domestic Production Activities Deduction, is used to calculate the DPAD. Individuals claim the amount calculated on Form 8903 as an adjustment to income on line 35 of Form 1040, which includes their share of the DPAD from pass-through entities. C corporations claim the amount calculated on Form 8903 on line 25 of Form 1120, U.S. Corporation Income Tax Return. Eligibility-Farm Landlords. Whether a farm landlord is eligible depends on whether the rents are from real property (in which event they are not taken into account for purposes of the DPAD) or from the conduct of a trade or business. As a practical matter, however, few farm landlords can claim the deduction due to the W-2 wage limitation. Note. It is the MPGE of tangible personal property that gives rise to the deduction, not real property. For example, in CCA , the IRS stated that mobile billboards constitute tangible personal property that qualify for the deduction, but traditional and modern billboards are real property (an inherently permanent structure) that is not qualified for the deduction. Qualified Production Activities Income (QPAI) QPAI equals the taxpayer s DPGR reduced by the sum of: CGS (cost of goods sold) allocable to DPGR; Other deductions, expenses or losses directly allocable to DPGR, and A ratable portion of other deductions and expenses not directly allocable to DPGR or another class of income. 105 When gross receipts and expenses are recognized in different taxable years, taxpayers must take receipts and expenses into account for purposes of the DPAD in the tax year the items are recognized under the 103 See, e.g., CCM F (Jul. 16, 2013) (Pharmacy that processed photos at retail stores could claim DPAD for photo processing services because photos are created from raw materials. However, affixing resulting processed photo and/or movie files onto photo CDs and movie DVDs is not a qualified service activity because the files are intangible products and the CDs or DVDs were not changed in form). 104 Nov. 28, IRC 199(c)(1). 181

186 taxpayer s method of accounting for federal income tax purposes. 106 However, if the taxpayer is engaged exclusively in the production of qualified property in the United States and has no other sources of income, QPAI is likely to equal overall taxable income (AGI for individuals). Domestic Production Gross Receipts (DPGR) QPAI is derived from DPGR, which includes gross receipts resulting from the following. 107 Any lease, rental, license, sale, exchange or other disposition of qualifying production property (QPP) that was manufactured, produced, grown, or extracted by the taxpayer in whole or significant part within the United States; Any qualified film produced by the taxpayer; 108 Electricity, natural gas, or potable water produced by the taxpayer in the United States; Construction performed in the United States; 109 Engineering or architectural services performed in the United States (for construction projects in the United States); Note. The regulations specifically state that farmers and ranchers that grow and produce tangible personal property such as grain and livestock, qualify for the DPAD. Qualifying activities include cultivating soil, raising livestock, fishing and mining minerals. Treas Reg (e)(1). Agricultural growing activities extend to the packaging of the commodity by the farmer (e.g., the baling of hay). However, the packaging by a nonfarmer (washing, sorting, grading and boxing of fruit) might not rise to the level of a MPGE activity. Activities that constitute packaging, repackaging, labeling and minor assembly are generally not qualifying activities. Treas. Reg (e)(2). The statute states that this section shall be applied by only taking into account items which are attributable to the actual conduct of a trade or business. 110 Unfortunately, the final regulations provide no clarification as to what level of activity constitutes a trade or business. This is a major issue for taxpayers who are not materially participating landlords. However, the Tax Court has noted that a factor in determining the 106 Treas. Reg (e). 107 IRC 199(c)(4)(A). 108 Subscription packages sold by multi-channel video programmer distributor did not qualify for the DPAD because they didn t qualify as property under I.R.C. 168(f)(3) or Treas. Reg (k)(1), but a portion of the taxpayer s gross receipts from the subscription packages could qualify as DPGR under I.R.C. 199(c)(4)(A)(i)(III) and Treas. Reg (k) to the extent the receipts were derived from individual film included in packages that was qualified film, and were each film that the taxpayer produced is considered to be an item under Treas. Reg (d)(1)(ii) (d)(1)(ii). Tech. Adv. Memo (Aug. 5, 2016). 109 Simply approving or authorizing payments does not constitute being engaged in construction in accordance with Treas. Reg (m)(2). The taxpayer must actually be engaged in construction activities that involve the erection or substantial renovation of real property as that phrase is defined in Treas. Reg (a)-3. Thus, a substantial renovation or real property is a renovation requiring the costs to be capitalized as an improvement under Treas. Reg (a)-3, but does not include costs for the replacement of certain components of a unit of property. In essence, the repair regulations are tied to the DPAD. If the renovation is an improvement, the taxpayer will be considered to have been involved in a construction activity for DPAD purposes. 110 IRC 199(d)(5). 182

187 availability of the DPAD in a contractual situation is whether the taxpayer actively and extensively participated in the management and operations of the activity. 111 In addition, there must be gross receipts or QPAI from the activity in order for the taxpayer to claim the DPAD. 112 A taxpayer s method for determining DPGR and non-dpgr must be a reasonable method that accurately identifies the gross receipts derived from activities described in IRC 199(c)(4) based on all of the information available to the taxpayer to substantiate the deduction. Note. As discussed above, for purposes of complying with the MPGE requirement, packaging, repackaging, labeling, or minor assembly activities alone 113 (i.e., with no other MPGE activities performed on the item) do not qualify as MPGE activities within the meaning of Treas. Reg (a)(1). However, when additional qualifying MPGE activities occur with respect to the same qualified property, the exception does not apply and the DPAD is available. 114 Qualifying Production Property. (QPP) QPP includes the following types of property. 115 Tangible personal property Any computer software Sounds recording as defined in IRC 168(f)(4) QPP must be manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States. 116 One of two tests must be satisfied for a determination of whether QPP meets this requirement. 1. Under the substantial-in-nature test, if the MPGE activity performed by the taxpayer is substantial in nature based on all the taxpayer s facts and circumstances, the test is satisfied Under the cost safe harbor test, the test is satisfied if the conversion costs (direct labor and factory burden) incurred by the taxpayer in the United States for the MPGE of the QPP are at least 20% of the taxpayer s total cost for the property. 118 When multiple corporations are involved in developing and commercializing a product, this collaboration may constitute a partnership based on the facts of the situation. If the result is the production of a product produced in significant part in the United States, the DPAD is allowable and is allocated to the partners Advo, Inc. & Subsidiaries v. Comm r, 141 TC No. 9 (2013). 112 Longino v. Comm r., TC Memo (Mar. 18, 2013) (No DPAD available for grading or surveying expenses on property claimed to be held for timber harvesting because no timber harvested; hence, property did not generate any gross receipts or QPAI). 113 Treas. Reg (e)(2). 114 CCA (Aug. 9, 2012). 115 IRC 199(c)(5). 116 IRC 199(c)(4)(A)(i)(I). 117 Treas. Reg (g)(2). 118 Treas. Reg (g)(3). 119 CCA (Feb. 21, 2013). 183

188 DPGR for Agricultural Operations. DPGR includes the gross receipts from growing and producing tangible property such as grain and livestock. Other activities in the agricultural context include the following. Support/Service Activities. Gross receipts from seed and/or chemical sale endeavors do not qualify as DPGR because these activities do not involve manufacturing or growing. Similarly, gross receipts from services provided to other producers (e.g., trucking, combining, spraying, plowing, custom machine work, etc.) also do not qualify. Crop Insurance/FSA Subsidies. The proceeds from business interruption insurance, governmental subsidies, and governmental payments not to produce are treated as gross receipts that qualify for the DPAD. Accordingly, crop insurance and FSA subsidies qualify as production receipts. 120 Sales of Productive Livestock. The sale of raised livestock, as well as purchased livestock held for resale, qualifies for the DPAD based on the growing category of DPGR. Raised Livestock. The regulations are silent about whether raised livestock that is placed into a breeding herd, and subsequently culled in later years after productive use as a breeding or dairy animal, qualifies as DPGR. However, because the definition of DPGR includes the sale of personal property that the taxpayer grows and because there is no distinction in the DPGR rules requiring that the asset be held as inventory rather than held for productive use, proceeds from raised breeding and dairy stock should qualify as DPGR. 121 Purchased Breeding and Dairy Livestock. Purchased breeding and dairy stock that has been acquired as a mature animal and is held by the taxpayer for productive use, depreciated, and subsequently sold may not meet the manufactured, produced, grown, or extracted (MPGE) requirement. Further, it is clear that only one taxpayer can claim the DPAD for an item of tangible property. 122 Based on these facts, it would appear that purchased mature breeding and dairy animals that are subsequently sold do not count as qualifying DPGR. Custom Feeding. Custom feeders are farmers as defined by I.R.C. 464(e) and Treas. Reg A-4(a)(4). In contract situations such as this, the regulations provide guidance on which party is entitled to the DPAD. Under prior regulations, the taxpayer had to bear the benefits and burdens of ownership and be the exclusive owner of the underlying property such that the taxpayer is the only one who could claim the DPAD. 123 Several factors were important in making this determination, including whether legal title had passed, how the parties treated the transaction, whether rights of possession were vested in the buyer, which party controlled the production process, and whether the taxpayer actively and extensively participated in the management and operations of the activity. 124 Under new temporary regulations effective Aug. 27, 2015, the benefits and burden test is eliminated and replaced with a requirement that the taxpayer actually perform the qualifying activity under the contract. In other words, the DPAD is tied to the taxpayer that actually produces the property Treas. Reg (i)(1)(iii). 121 Treas. Reg (f)(1) 122 Id. 123 Id. 124 See, e.g., Advo, Inc. & Subsidiaries v. Comm r, 141 TC No. 9 (2013). 125 REG (Aug. 26, 2015). 184

189 Hedging Transactions. Gains or losses from hedges qualify as DPGR if the hedge involves the purchase of supplies used in the taxpayer s business, the sales of stock in the trade of the taxpayer or other property of a kind that would be included in inventory if it is on hand at the close of the taxable year, or property held for sale to customers in the ordinary course of the trade or business. If the hedge involves the purchase of stock in trade, inventory property, or property held for sale, gains and losses are taken into account in determining the CGS. 126 Note. Proposed regulations effective August 27, 2015, define a hedging transaction to include transactions in which the risk being hedged relates to stock in trade and inventory that is held for sale that gives rise to DPGR (rather than limiting hedging to QPP giving rise to DPGR), or are supplies of a type regularly used or consumed by the taxpayer in the ordinary course of the taxpayer s trade or business. 127 Storage. Storage, handling, or other processing activities (other than transportation activities) within the United States related to the sale, exchange, or other disposition of agricultural products qualify as DPGR, provided the products are consumed in connection with, or incorporated into, the MPGE of QPP, regardless of whether this is done by the taxpayer. EXAMPLE 1. Abe, Bob, Chuck, and Don are unrelated. Abe owns grain storage bins in Kansas. Abe stores Bob s wheat in the bins and charges a storage fee. Bob grew his wheat in Kansas. Bob sells his wheat to Chuck, a processor of wheat who processes Bob s wheat into flour in Kansas. Chuck stores flour in Don s warehouse until it is sold to a local bakery. The gross receipts from Abe s storage activity, Bob s wheat farming activity, and Chuck s processing activity are DPGR. Don s income from the flour s storage in his warehouse is not DPGR. Don s activity does not involve the rental of a grain production facility. EXAMPLE 2. Tex places his hogs in the Swine Place feedlot. The fees Swine Place collects on Tex s pigs were, under prior regulations, previously determined not to be DPGR. Under prior regulations, only income attributable to pigs owned by Swine Place generated DPGR. To constitute DPGR, the taxpayer had to bear the benefits and burdens of ownership of the QPP during the period of the MPGE activity in order for the applicable gross receipts to qualify as DPGR. However, under regulations issued on August 26, 2016, the fees that Swine Place collects would appear to qualify as DPGR because Swine Place performed the qualifying activity under the contract with Tex. A taxpayer that purchases ag commodities on its own account, stores, packs, sorts, etc. and then sells the packed product, could be engaged in MPGE with respect to the product, if the product later becomes an ingredient in a later stage MPGE activity. However, if the taxpayer purchases the commodity, stores it, sorts and packs, and re-sells the product for market sale, the taxpayer is not engaged in MPGE because the product is not further processed. Note. The United States Court of Appeals for the Eighth Circuit has held that cold storage is a manufacturing activity under the pre-1986 version of the investment tax credit. 128 The court determined that the refrigeration process constituted a process similar to canning or sterilizing. The court also cited other cases holding that freezing or chilling of food 126 Treas. Reg (i)(3). 127 Prop. Treas. Reg (i). 128 L&B Corporation v. Com r., 862 F.2d 667 (8th Cir. 1988). 185

190 products to prevent spoilage is a manufacturing or processing activity. The court refuted the argument that the taxpayer had to perform other manufacturing or processing activities in order for it to be a processor itself. Mineral Interests. Gross receipts from operating mineral interests count as DPGR. However, gross receipts from mineral royalties and net profits interests (other than those derived from operating mineral interests) are treated as returns on passive interests in mineral properties. Because the owner makes no expenditure for operation or development, royalties and net profits interests are not treated as DPGR. 129 De Minimis Rule. A safe harbor or de minimis rule is provided that allows the taxpayer with less than 5% of total gross receipts from non-dpgr items to treat all gross receipts as DPGR. 130 However, if the amount of the taxpayer s gross receipts that do not qualify as DPGR equals or exceeds 5% of the total gross receipts, the taxpayer must allocate all gross receipts between DPGR and non-dpgr. In the case of a pass-through entity, the determination of whether the 5% test is satisfied is made at the entity level. 131 For owners of pass-through entities, the determination of whether less than 5% of the owner s total gross receipts are non-dpgr is made at the owner level, taking into account all of the owner s gross receipts from all trade or business activities. 132 EXAMPLE 3. John is a sole proprietor farmer who paid $20,000 in W-2 wages in He reports the following income and expense on his 2016 Schedule F and Form Schedule F Form 4797 ( 1231 Machinery Sale) Total Gross receipts $500,000 $20,000 $520,000 Expenses/basis (440,000) (10,000) (450,000) Net 60,000 10,000 70,000 John qualifies under the 5% de minimis test. His non-dpgr from dispositions of equipment is $20,000, which is less than 5% of his total business gross receipts (5% $520,000 = $26,000). Accordingly, John is entitled to claim the entire business net income of $70,000 as QPAI and claim a DPAD of $6,300 (9% $70,000). Gross receipts for purposes of calculating the DPGR are not reduced by CGS, including the cost of depreciable property held for productive use. 133 Thus, gross receipts from the sale of equipment, vehicles, 129 Treas. Reg (h)(9). 130 Treas. Reg (d)(3)(i). 131 Treas. Reg (d)(3). 132 Ibid. 133 Treas. Reg (c). 186

191 livestock, and other 1231 productive property are not reduced by the adjusted basis of the property, for purposes of determining whether the taxpayer meets the 5% de minimis test. Note. If the gross amount of Form 4797 sales that are not QPAI (e.g., machinery sales) exceeds 5% of total gross receipts, the taxpayer must segregate those gross receipts in calculating QPAI. Allocating Deductions Between DPGR and Non-DPGR. If a taxpayer does not qualify under the 5% de minimis test because they have over 5% of gross receipts from non-qualifying activities, it is necessary to allocate deductions to arrive at QPAI attributable to DPGR. The regulations provide three methods for allocating deductions apportioned to DPGR Section 861 method. This is the general method available to all taxpayers. Business deductions are allocated and apportioned to DPGR on a line-by-line basis by applying the cost allocation and apportionment rules of the regulations under IRC Simplified deduction method. Any taxpayer with average annual gross receipts of $100 million or less or total assets at the end of the year of $10 million or less may use the simplified deduction method. Under this method, a taxpayer s deductions are generally apportioned ratably between DPGR and non-dpgr based on relative gross receipts. However, cost of goods sold must track specifically to DPGR or non-dpgr. Note. Average annual gross receipts is based on the three taxable years preceding the current taxable year Small business simplified overall method. A qualifying small taxpayer with average annual gross receipts of $5 million or less or a taxpayer with under $10 million of gross receipts who is eligible to use the cash method under Rev. Proc may use DPGR and non-dpgr to apportion all deductions including CGS based on relative gross receipts. Eligible taxpayers include those engaged in farming who are not required to use the accrual method of accounting. Note. For tax years beginning on or after June 1, 2006, the final regulations require that only gross receipts attributable to a business (excluding wages) may be considered for simplified allocation purposes. 136 EXAMPLE 4. Assume the same facts as Example 3, except that John reports higher farm equipment sales on Form Schedule F Form 4797 ( 1231 Machinery Sale) Total 134 Treas. Reg (d), (e) and (f). 135 Treas. Reg (g). 136 Treas. Reg (c)(2). 187

192 Gross receipts $500,000 $50,000 $550,000 Expenses/basis (440,000) (10,000) (450,000) Net 60,000 40, ,000 John fails the 5% de minimis test because his nonqualifying receipts ($50,000 of equipment sales) exceed $27,500 (5% $550,000 total business gross receipts). Thus, John s equipment sales are non-dpgr, and he must allocate expenses to his $500,000 of qualifying DPGR. As a cash method farmer, John is entitled to use the small business simplified overall method to allocate expenses based on his ratio of DPGR ($500,000) to total gross receipts ($550,000), which is 90.9%. John uses the amounts in the following table to complete Form Line 1: DPGR $500,000 Line 4: Expenses ($450, %) (409,050) Line 6: Net qualifying production income 90,950 Line 13: ($90,950 9%) 8,186 John benefited from using the small business simplified overall method in determining expenses attributable to DPGR, because some of his farm expenses were effectively allocated to non-dpgr (machinery sale receipts). If John had used the 861 method, he would have reported the $60,000 Schedule F net income as his net QPAI and could only claim a DPAD of $5,400 (9% $60,000). Tax Planning/Observation (Equipment Sales). In general, taxpayers who dispose of machinery, equipment or other business 1231 property reported on Form 4797 may find it possible to use those non-qualifying receipts in the 199 computation. Those business gross receipts may be under 5% and qualify for inclusion under the de minimis test (as illustrated in above) or the taxpayer may benefit under one of the simplified allocation methods (as illustrated in above). The simplified allocation methods generally should be beneficial with respect to equipment sales because businesses tend to dispose of fully depreciated items with little or no basis. Accordingly, when a simplified allocation method is used, business expenses that otherwise apply to DPGR are effectively shifted to the non- DPGR equipment sales. John s Form 8903 follows. 188

193 189

194 TAX PLANNING AG MANUFACTURER - COST OF GOODS SOLD (COGS): Taxpayers may find it beneficial to compare QPAI results for the simplified deduction method and the small business simplified overall method if several DPGR and non-dpgr lines of business with COGS are involved. The simplified deduction method may result in a higher QPAI computation. This result would occur due to required direct allocation of COGS against qualifying income (DPGR) and prorata allocation of all other expenses based on the proportion of qualifying income (DPGR) to nonqualifying income (non-dpgr). EXAMPLE 5. Bill s single-member LLC manufactures fertilizer products and also provides consulting services regarding best farming practices. In 2016, the LLC reported the following income and cost of goods sold. Manufacturing Consulting Total Gross receipts $160,000 $40,000 $200,000 CGS (60,000) (20,000) (80,000) Gross profit 100,000 20, ,000 Other expenses for the business totaled $50,000. Thus, 2016 net income for the business was $70,000 ($120,000 $50,000). Bill s net QPAI is calculated as follows, using both the simplified deduction method and the small business simplified overall method. Simplified Deduction Method Mfg Consulting Total Gross profit $100,000 $20,000 $120,000 Other expenses (40,000) a (10,000) b (50,000) Net income 60,000 10,000 70,000 DPAD rate 9% Tentative DPAD $5,400 a ($160,000 manufacturing gross $200,000 total gross) $50,000 other expenses = $40,000 b ($40,000 consulting gross $200,000 total gross) $50,000 other expenses = $10,000 Small Business Simplified Overall Method Mfg Consulting Total Gross receipts $160,000 $40,000 $200,000 CGS and other expenses (104,000) a (26,000) b (30,000) Net income 56,000 14,000 70,000 DPAD rate 9% 190

195 Tentative DPAD $5,040 a ($160,000 manufacturing gross $200,000 total gross) $130,000 total expenses = $104,000 b ($ 40,000 consulting gross $200,000 total gross) $130,000 total expenses = $ 26,000 As shown in the preceding calculation, Bill s tentative DPAD is higher using the simplified deduction method. If the amount calculated is less than half of the W-2 wages for the business, he can claim a DPAD of $5,400. Tax Planning/Observation. The simplified deduction method computation in the preceding example resulted in a higher QPAI because CGS was a significant factor in both the DPGR and non-dpgr lines of business. If the consulting business had no CGS allocation or a relatively small CGS, the small business simplified overall method would produce a higher QPAI result. EXAMPLE 6. Tom s single-member LLC manufactures fertilizer products and also provides consulting services regarding best farming practices. In 2016, the LLC reported the following income and cost of goods sold. Manufacturing Consulting Total Gross receipts $160,000 $40,000 $200,000 CGS (80,000) 0 (80,000) Gross profit $80,000 $40,000 $120,000 Other expenses for the business totaled $50,000. Thus, net income for the business for 2016 was $70,000 ($120,000 $50,000). Tom s net QPAI is calculated as follows, using both the simplified deduction method and the small business simplified overall method.. Simplified Deduction Method Mfg Consulting Total Gross profit $80,000 $40,000 $120,000 Other expenses (40,000) a (10,000) b (50,000) Net income 40,000 30,000 70,000 DPAD rate 9% Tentative DPAD $3,600 a ($160,000 manufacturing gross $200,000 total gross) $50,000 other expenses = $40,000 b ($40,000 consulting gross $200,000 total gross) $50,000 other expenses = $10,

196 Small Business Simplified Overall Method Mfg Consulting Total Gross profit $160,000 $40,000 $200,000 CGS and other expense (104,000) a (26,000) b (130,000) Net income 56,000 14,000 70,000 DPAD rate 9% Tentative DPAD $5,040 a ($160,000 manufacturing gross $200,000 total gross) $130,000 total expenses = $104,000 b ($ 40,000 consulting gross $200,000 total gross) $130,000 total expenses = $ 26,000 As shown in the preceding calculation, Tom s tentative DPAD is higher using the small business simplified overall method. If the amount calculated is less than half of the W-2 wages for the business, he can claim a DPAD of $5,040. W-2 Wage Limitation The DPAD cannot exceed 50% of the Form W-2 FICA wages paid by the employer for the taxable year. 137 Thus, farm businesses that issue no Forms W-2 cannot claim the DPAD unless they receive DPAD as a pass-through from a cooperative. EXAMPLE 7. Mitch, a sole proprietor grain farmer, reports $70,000 of net income on his 2016 Schedule F. All of Mitch s Schedule F net income is attributable to qualifying production and growing activities. Thus, his DPAD could be $6,300 (9% $70,000). However, Mitch must have paid at least $12,600 in qualifying Form W-2 wages to claim the full $6,300 deduction ($12,600 50% = $6,300). Form W-2 wages are the aggregate amount required to be included on Forms W-2, including all remuneration paid in any medium other than cash. 138 Noncash remuneration is excluded from wages if it is paid for agricultural labor unless the noncash remuneration is wages as defined in IRC 3121(a). Under 3121(a), wages means all remuneration for employment, including the cash value of all remuneration paid in any medium other than cash except for in-kind wages paid for agricultural labor. 139 Any services performed by a child under the age of 18 in the employ of their father or mother are also excluded from wages IRC 199(b). For detailed guidance on the definition of eligible wages, see Rev. Proc , I.R.B IRC 3401(a). 139 IRC 3121(a)(8)(A). 140 IRC 3121(b)(3)(A). 192

197 Note. Form W-2 wages for purposes of the DPAD does not include any amount that is not properly included in a return filed with the Social Security Administration (SSA) on or before the 60th day after the due date (including extensions) for the return. 141 Additionally, wages paid to an employee for domestic services performed in the taxpayer s private home are not included in the taxpayer s W-2 wages. Thus, only wages that are subject to federal income tax withholding that are reported on Form W-2 count as qualified wages for the purposes of the 50 percent test. Payments to independent contractors do not count as wages nor do guaranteed payments to partners. Also, the same wages cannot be claimed by more than one taxpayer when computing the DPAD. For ag producers that cannot claim a full DPAD because of a lack of W-2 wages, there might be a benefit by paying wages to family members that are presently providing uncompensated labor to the farming operation. In determining whether it might be beneficial from a tax standpoint to compensate family members for their labor, the additional FICA that will be incurred will need to be balanced against the tax savings from the DPAD. EXAMPLE 8. Butch, a sole proprietor farmer, has $60,000 of Schedule F net income. He would be eligible for a DPAD up to $5,400 ($60,000 9%) if he had adequate wage payments from his farming operation. Monica, his wife, assisted significantly with farm planting and harvesting; thus, she could be paid a reasonable wage for her labor. Butch wants to know if paying wages to Monica of $10,800 is worthwhile in order to obtain a DPAD. The social security and Medicare taxes paid on Monica s wage would offset the SE tax on Butch s Schedule F net income. The $10,800 wage reduces Butch s Schedule F net income to $49,200 ($60,000 $10,800). The DPAD on the net income is $4,428 ($49,200 9%), which is lower than half the amount of wages paid to Monica. The tax savings from the DPAD using a 15% tax rate is $664; at a 25% tax rate, the savings is $1,107. Additionally, state tax savings may also apply. Using this strategy, Butch has lower social security earnings and Monica has higher social security earnings. This may or may not be a desired result. Tax Planning/Observation. For taxpayers with lower QPAI who are in lower marginal tax brackets, the process of preparing Forms W-2, W-3, and 943 (or Form 941) may not be worth the nominal savings. If net SE earnings exceed the maximum social security base amount ($118,500 for and $127,200 for 2017), incurring extra labor costs to qualify for the DPAD is generally not worth it. W-2 wages are calculated based on the calendar year, with fiscal-year taxpayers using the calendar year that ends during their fiscal year. If a fiscal-year taxpayer has a short year that doesn t include a calendar year-end, the wages paid by the taxpayer during the short year are treated as DPAD wages for the short tax year. Methods for Calculating W-2 Wages. Taxpayers must make some adjustments in order to determine wages for purposes of 199. There is no single box on Form W-2 or W-3 that includes all of the items 141 Treas. Reg (a)(3). 193

198 of information to compute the wage limitation. As a result, the IRS, in Rev. Proc , provides three alternative methods for making the required calculations. 1. Under the Unmodified Box Method, the taxpayer can treat wages as the lesser of the aggregate amount reported as wages, tips and other compensation (Box 1) or Medicare wages and tips (Box 5) on all Forms W-2 filed with the SSA for all employees during the year. 2. Under the Modified Box 1 Method, the taxpayer can calculate wages by subtracting amounts that are not wages for withholding purposes and amounts that are merely treated as wages for withholding purposes from the totals reported in Box 1. The result is then increased by employee salary reduction contributions to 401(k) arrangements and similar plans (reported in Box 12 of Form W-2). 3. Under the Tracking Wages Method, the taxpayer can track the actual amount of wages subject to federal income tax withholding, subtract supplemental unemployment compensation benefits that were included in that amount, and then add employee salary reduction contributions to 401(k) arrangements and similar plans (reported in Box 12 of Form W-2). This method must be used if a short tax year is involved. Note. The unmodified box method provides the simplest calculation. The modified box 1 and tracking wages method provide greater accuracy. Pass-Through Entities The DPAD is available to trusts, estates, S corporations, partnerships, and other pass-through entities. 142 Trusts and Estates For grantor trusts, a person is treated as owning all or part of the trust and reports QPAI as if the income had been generated by activities performed directly by the owner. 143 For a non-grantor trust or estate, all income and expense items must be allocated to the beneficiaries based on the proportion of distributable net income deemed to be issued to that beneficiary for the taxable year. 144 Thus, a trust or estate may claim the DPAD to the extent that QPAI is allocated to the trust or estate, but the deduction applies at the beneficiary level. Partnerships and S Corporations In applying the deduction to pass-through entities, each owner is allowed to compute the deduction by taking into account their distributive or proportionate share of DPGR and allocable expenses. Partnerships are required to compute the partner s deduction separately, aggregating the partner s pro-rata share of the items allocated to the partnership s QPAI, including any QPAI expenses incurred by the partner directly, with items that are from sources other than the partnership IRC 199(d)(1), (2). 143 Treas. Reg (d). 144 Ibid. 145 Treas. Reg (b). 194

199 For S corporations, the deduction is determined at the shareholder level. Each shareholder separately computes the DPAD by aggregating their pro-rata share of items allocated to the S corporation s qualified production activities with those items of the shareholder from sources other than the S corporation. 146 Treatment of expenses. Each partner or shareholder must take into account their distributive share of expenses allocated to the qualified production activities of the partnership or S corporation, regardless of whether the partnership or S corporation otherwise has taxable income. If there are disallowed losses or deductions because of a lack of basis, the at-risk rules, or the passive activity rules, a proportionate share of the losses or deductions that reflect expenses allocated to qualified production activities are suspended as well. Subsequently, when those losses or deductions are released, the partner or shareholder takes into account (in the year they are released) their proportionate share of production activity losses or deductions previously suspended. Special allocations. A partnership may specially allocate items of income, gain, loss, or deduction allocated or attributable to the partnership s qualified production activities, subject to the normal IRC 704(b) rules, including the rules for determining substantial economic effect. Gain or loss from disposition of interests. QPAI generally does not include gain or loss recognized on the sale, exchange, or other disposition of an interest in the pass-through entity. Nevertheless, some sales or exchanges of a partnership interest (or distributions treated as a sale or exchange) under IRC 751 might give rise to an item of QPAI being taken into account for the deduction. When 751 applies, it is not clear how to determine when items of QPAI are generated. Note. Because the DPAD is applied at the partner or shareholder level, partner or shareholder basis is not reduced as a result of the 199 deduction. Pass-Through Entities and Qualifying Wages For pass-through entities, the wage limitation is applied by allocating to the individual (such as a partner) their share of W-2 wages or a portion of the QPAI allocated to the individual for the taxable year. 147 Partnership and S corporation wages pass through to the Form 1040 for DPAD purposes. 148 Thus, an individual who has a sole proprietorship qualifying farm activity that has no wage expense but who also owns an interest in a partnership or S corporation that expends wages in a qualifying production activity can use the pass-through wages from the partnership or S corporation activity to support a DPAD in connection with the farm proprietorship. EXAMPLE 9. Doug is a single farmer with a grain farming operation for which he reports $50,000 of net Schedule F income. He pays no wages for this business. Doug is also a partner in a cattle feeding operation that allocates to Doug $40,000 in total yearly wages and a small net income of $10,000 annually. The partnership separately allocates all wages attributable to production activity 146 Treas. Reg (c). 147 IRC 199(d)(1)(B). 148 IRC 199(d)(1)(A)(iii). 195

200 to Doug. Doug s eligible production income is $60,000 ($50,000 from Schedule F + $10,000 for the partnership). Doug s 2016 DPAD is $5,400 ($60,000 9%) because this is less than half of the W-2 wages allocated to him ($40,000 50% = $20,000). A partnership or S corporation that is eligible to use multiple allocation methods (e.g., the simplified deduction method or the small business simplified overall method) to determine QPAI may use either method. Also, taxpayers can change their allocation method from one year to the next, or make changes in allocating QPAI to owners versus allocating detailed DPGR and attributable expenses. 149 Cooperatives A patron of and agricultural or horticultural cooperative can be allocated a share of the cooperative s patronage dividends. 150 Numerous IRS private letter rulings exist specifying the classification of payments a cooperative makes for commodities and holding that the payments to patrons are per unit retain allocations paid in money in accordance with IRC 1382(b)(3). Thus, the amounts are patronage dividends for DPAD purposes. Any person who receives a qualified payment from a specified agricultural or horticultural cooperative is eligible for a DPAD if the cooperative passes a portion of the DPAD to its patrons. 151 A specified cooperative is a cooperative to which part I of subchapter T of the Code applies and the cooperative has MPGE in whole or significant part within the United States from any agricultural or horticultural product or has marketed agricultural or horticultural products. Many nonexempt agricultural cooperatives retain the DPAD for use against their own taxable income. However, many pooling cooperatives (those that operate with marketing agreements requiring members to deliver commodities to the coop) elect to pass through the DPAD to their patron-members. In order for a patron to qualify for the deduction, the cooperative must designate the patron s portion of the DPAD in a written notice mailed by the cooperative to its patrons not later than the 15th day of the ninth 149 Rev. Proc , IRB I.R.C. 199(d)(3). 151 Treas. Reg (a). 196

201 month following the close of the cooperative s taxable year. 152 The amount of the patron s DPAD is reported to the patron in Box 6 of Form 1099-PATR, Taxable Distributions Received From Cooperatives. 153 A cooperative patron of a federated cooperative may pass the deduction to its member patrons. 154 Reporting by Cooperative The DPAD passed through on Form 1099-PATR is reported on line 23 of the patron s Form 8903 without regard to the taxable income limitation. 155 The deduction is allowed even if the patron s return does not report net farm income or have wage payments. 156 A DPAD reported on Form 1099-PATR to a passthrough entity is, in turn, passed on to partners/shareholders as a separate Schedule K-1 item, even if the pass-through entity has a loss or basis limitation. Several recent IRS private letter rulings have clarified that cooperatives (including grain cooperatives) can elect to treat all commodity payments to members as per-unit retain allocations reflecting not only the apportionment of profit, but the entire amount paid for the purchase of commodities from the agricultural producer. The effect is to allow those cooperatives to calculate QPAI without any cost of sales, so that the cooperative s DPAD can be very large. Note. A cooperative s DPAD is a deduction only against patronage-sourced income and cannot be computed by aggregating patronage and nonpatronage-sourced income. 157 To avoid duplication of benefits, the patronage dividends and per-unit allocations received by a patron from a cooperative that are taken into account as part of the cooperative s QPAI may not be taken into account in computing the patron s QPAI from its own activities. This is true regardless of whether the cooperative keeps or passes through the DPAD. 158 Thus, if most of a patron s production is sold to a cooperative, the QPAI computation at the cooperative level virtually eliminates all QPAI at the Form 1040 level. Observation. If the cooperative passes through the DPAD to the patron, the result may be a much larger deduction than would be possible from a Schedule F net income computation alone. 152 IRC 199(d)(3)(A)(ii). 153 Treas. Reg (g). 154 Treas. Reg (h). 155 Treas. Reg (h). 156 Treas. Reg (a) & (b). 157 FSA F (Feb. 27, 2013). See also CCM F (May 16, 2013). 158 Treas. Reg (l). 197

202 Cooperatives can elect to pass none, part, or all of their DPAD through to members based on their patronage. 159 The W-2 wage limitation is applied only at the cooperative level regardless of whether the cooperative chooses to pass through some or all of the deduction. Any amount passed through by the cooperative to its patrons is not subject to the W-2 limitation a second time at the patron level. 160 If an audit determines (or an amended return reports) that the amount of the DPAD passed through to the patrons exceeded the amount allowable, recapture occurs at the cooperative level. 161 Reporting by Producer Method 1 (Schedule F, Lines 3a/3b) IRS Preferred Method. The IRS has been issuing matching letters related to per-unit retain amounts and is taking the position that per-unit retain allocations should be reported by the producer on Schedule F, lines 3a/3b, as a cooperative distribution. The amount reported should be subtracted from the producer s gross sales computation. 159 IRC 199(d)(3). 160 Treas. Reg (i). 161 Treas. Reg (j). 198